When a portfolio company underperforms, a sponsor may consider various options to address the perceived performance issues, including changes to a portfolio company’s management team, cost structure, capital structure or other parameters, depending on the nature of the issue(s) at hand. When changes in capital structure may be desirable, often in the context of excessive debt and related liquidity issues, a sponsor’s choices may include a consensual workout outside of bankruptcy, or a court-supervised restructuring under Chapter 11 of the U.S. Bankruptcy Code that can restructure and discharge debt over the objections of certain dissenting creditors. The range of options available to a sponsor in such situations has potentially been narrowed by a recent court decision.
Newfound Negotiating Leverage of Minority Bondholders
In Marblegate Asset Management, LLC v. Education Management Corporation,1 the Federal District Court for the Southern District of New York held that the U.S. Trust Indenture Act2 (TIA) protects minority bondholders by invalidating provisions in a bond indenture that would have the practical effect of eliminating a bondholder’s right to receive payment on its bonds without its consent.
In Marblegate, Education Management Corporation (EDMC), an operator of for-profit colleges, had sought to restructure debt issued under an indenture by one of its subsidiaries by forcing the bondholders to choose, pursuant to an exchange offer, between either (i) a partial recovery for all bondholders through receipt of an equity interest in the issuer’s parent that had guaranteed the bonds, if all bondholders would consent to the proposed exchange, or (ii) no recovery for non-consenting bondholders and a partial recovery for consenting bondholders, if one or more bondholders failed to consent to the proposed exchange. The no-recovery outcome for non-consenting bondholders would be achieved by eliminating the parent’s guaranty of the bonds and leaving them with a claim only against a shell entity without assets.
The court analyzed Section 316(b) of the TIA, which states that a bondholder’s right to receive principal and interest payments under an indenture or to institute suit for the enforcement of any such payment shall not be “impaired or affected” without the bondholder’s consent.
The court summed up the situation concisely: “In effect, Marblegate bought a US$14 million bond that the majority now attempts to turn into US$5 million of stock, with consent procured only by threat of total deprivation, without resort to the reorganization machinery provided by law.” The “reorganization machinery” of a federal a bankruptcy case was not a feasible option for EDMC, because much of its funding came from federal grants which would no longer be available after a bankruptcy filing.
The court considered the legislative history of the relevant TIA provisions and took an expansive approach as to the rights they guaranteed to bondholders, finding that Congress intended that a bondholder must have not only the right to sue on its bonds but also the separate right to receive payment, unless such bondholder otherwise consents.
The court held that, despite the terms of the indenture, which as a technical matter permitted each of the various actions taken pursuant to the exchange offer, the exchange offer as structured violated the TIA because it effectively would leave non-consenting bondholders with no ability to receive payment on their bonds, and therefore the related indenture provisions were invalid.
The decision is currently under appeal to the U.S. Court of Appeals for the Second Circuit.
What a Sponsor Can Do
If upheld on appeal, the Marblegate decision could restrict a sponsor’s ability to achieve an out-of-court restructuring with a portfolio company’s bondholders under an indenture subject to the TIA, absent unanimous bondholder consent. This could entice minority bondholders to become “holdouts” in an effort to either disproportionately influence the outcome of a negotiation or demand to be bought out at a premium to market. (A sponsor could still, as an alternative, condition an exchange offer on its being accepted by a designated super-majority of bondholders, such that any remaining de minimis hold-out class would be stripped of covenants but not of economic rights. However, this in turn may incentivize bondholders to try to become part of the small hold-out class whose payment rights would not be affected and, in addition, still may prevent a sponsor from exploiting existing flexibility under an indenture, as inMarblegate.) There are, however, options a sponsor could consider going forward in order to mitigate the potential effects of such an outcome in an out-of-court restructuring.
Some bond indentures, such as those issued in private placements for resale only to qualified institutional buyers under Rule 144A3 and without registration rights, are not subject to and do not provide bondholders with the protections afforded by the TIA, and thus the TIA issues on which the Marblegatecourt based its decision would not be relevant, assuming the relevant indenture did not contain similar language tracking the TIA provisions at issue. Thus, if a sponsor were planning (market conditions permitting) to finance or refinance via the capital markets its portfolio company’s acquisition or other debt, it could consider doing so via such a Rule 144A offering. As noted, the sponsor would also need to ensure that the indenture in question would not track the particular language at issue from the TIA, which under current market practice is carried over in many Rule 144A indentures.
Sponsors could take care to negotiate the relevant indenture language in such a case so as to avoid inclusion of the provisions that were pivotal in the Marblegate decision. While there would be no guarantee that the bond market would embrace such an approach, it would appear to be in the best interests of many bondholders as well, particularly those who invest for the longer term and who may from time to time find themselves hampered in their efforts in a workout to reach an acceptable consensual resolution, by virtue of smaller holdout positions. It would also benefit distressed buyers seeking to facilitate such a transaction.
We expect to see developments in this area if the Marblegate decision is upheld on appeal.
Bankruptcy Court Signals that Agreements Among Lenders Will be Enforced
In our last newsletter, we discussed the implications of the increased use of unitranche facilities to finance leveraged acquisitions, as alternative financiers (with whom the unitranche structure originated) have assumed a more prominent role as arrangers and underwriters of such financings. Unitranche facilities effectively combine a first-lien loan and second-lien loan into a single facility with a single set of operating covenants for the target business and a single set of closing conditions. We had noted the advisability of sponsors continuing the trend of insisting to see the agreement among lenders, both as it is being negotiated and as it is finalized, although the borrower is neither a party to the agreement nor bound by it. It is advisable due to the potential strategic significance to the portfolio company and its sponsor of many of the provisions commonly included within agreements among lenders, particularly with respect to amendments, waivers, covenant resets, default remedies and the like. The allocation of rights under an agreement among lenders becomes increasingly pivotal upon a deterioration in the performance of the portfolio company or other looming workout or restructuring scenario with respect to its outstanding indebtedness.
Recent proceedings in the RadioShack bankruptcy case in Delaware4 have been the first significant indication that a bankruptcy court will recognize and enforce the terms of agreements among lenders, thus reinforcing the importance to sponsors of knowing the terms contained in such agreements
A question long surrounding the agreement among lenders has been whether, given that the borrower is not a party to it and not bound by it, it should be recognized and given effect by bankruptcy courts. On the one hand, creditors have resort to state courts to enforce rights under agreements that are strictly between them, and perhaps should not have standing in a federal bankruptcy court to assert rights arising from agreements that do not involve the bankrupt borrower as a party. On the other hand, the agreement among lenders will often address many matters of seeming direct relevance to a bankruptcy case, such as who has the right to offer DIP financing and on what terms, and thus, although the bankrupt borrower is not a party, perhaps the bankruptcy court should indeed recognize and enforce it.
The agreement among lenders at issue in the relevant RadioShack proceedings prohibited the “last-out” lenders from receiving any recovery until the “first-out” lenders were paid in full. Claims had been made in the case by the unsecured creditors committee under various theories of liability against both the first-out and last-out lenders, in respect of which contractual indemnification from the debtor was available in favor of the respective lenders to the extent of any liability. The court was conducting a hearing on a proposal made by the last-out lenders to acquire certain RadioShack assets pursuant to a sale under Section 363(b) of the Bankruptcy Code, via a credit bid of their debt and a cash payment to the first-out lenders in an amount equal to all principal and interest owed to them, in a transaction that would release the last-out lenders (but not the first-out lenders) from the claims of the unsecured creditors committee and would not set aside any reserve for potential liability of the debtor to the first-out lenders pursuant to the contractual indemnity in their favor in respect of such unreleased claims. The first-out lenders objected to the proposed sale on the ground (among others) that it would violate the provision in the agreement among lenders prohibiting the last-out lenders from receiving any recovery until the first-out lenders were completely paid off (and which specifically included a reference to amounts due under indemnities), since the first-out lenders would be subject to additional exposure on such account under the transaction as proposed.
The parties wound up resolving their dispute consensually (by agreeing to set aside a limited reserve for the benefit of the first-out lenders for their potential exposure) and the court therefore did not need to issue a formal ruling on the issue. The bankruptcy judge stated orally at the hearing, however, when referencing the rights of the first-out lenders and the provision in the agreement among lenders noted above, that if the dispute were not resolved consensually, “[The first-out lenders have] rights that must be respected under the documents and rights that must be respected under the [Bankruptcy] Code…. At a minimum, I would regard the indemnification rights as part of the collateral package and part of the rights that the first out lenders have and that I am obliged to treat and respect them . . . .”5
What a Sponsor Should Do
The RadioShack judge’s signal that the terms of the agreement among lenders would have been recognized and enforced by the bankruptcy court underscores the importance to a sponsor of being kept informed of the terms of the agreement among lenders under a portfolio company’s unitranche facility. Sponsors now should have additional negotiating leverage to see and review the agreement among lenders as it is being negotiated in the course of a unitranche financing transaction. Sponsors should seek acceptable assurances from its unitranche lenders that the agreement among lenders documentation provided to the sponsor is accurate and complete, not subject to undisclosed side letters, and not subject to future amendment without notice to the sponsor or, in respect of certain key terms, sponsor consent. In that way a sponsor can remain alert to important terms that could impact future events at its portfolio company, particularly in case of its underperformance.