During this most recent bankruptcy cycle there have been a series of rulings impacting secured creditors in general, and in particular secured creditors seeking to gain control of a debtor through credit bidding. Whether creditors in cases such as Philadelphia Newspapers, Scotia Pacific and DBSD intended to loan-to-own from the outset, or opted to control to take control mid-process in order to maximize recoveries, the rulings that impacted them will shape both the court’s and creditors’ actions in the cycle to come. While the Chrysler case received much broader media attention, its implications are more limited given the unique constituencies and circumstances. That said, distressed investors in secured debt should consider carefully the risks when deploying capital in sectors with significant union concentration where the federal and state governments are going to bring significant influence to bear given the effects a bankruptcy has on working class voters and their communities.
This article is the first in a series of articles examining key legal decisions during last bankruptcy cycle. The purpose is to synthesize the voluminous array of legal analysis and opinions on these rulings and develop essential take aways for distressed investors. While distressed investors rely heavily on the advice and counsel of their FAs and attorneys, in the final analysis the PM must execute his strategy and be accountable for the results. Therefore, it is important to survey the legal landscape and be aware of some of the pitfalls distressed investors face. Particularly for funds that focus on control investments, or who have holdings concentrated in an industry that may result in them being deemed a “strategic investor”. Given the enormous growth in the leveraged loan market, particularly the 2nd lien loan market, many of the rulings in the last bankruptcy cycle were related to secured creditors. The focus of this article is on decisions impacting control distressed investments more commonly referred to as loan-to-own.
In late 2008 and early 2009 as the markets began a precipitous decline, credit, including traditional third party DIP financing from commercial banks, dried up. Many distressed investors were unable to deploy funds to capitalize on the markets’ dislocation. They were getting margin calls on the total return swaps, redemptions from investors and suffering significant mark-to-market losses.
For those players with sufficient dry powder and locked up capital, being the DIP provider gave them the most strategic position in the capital structure, and very often the DIP was the fulcrum security. DIP loans with stringent covenants and milestones calling for a POR or sale within 120 days, enabled the DIP lender’s to gain control of the company.
With traditional DIP lenders on the sidelines, first lien lenders seized the opportunity to roll-up their pre-petition debt into post-petition debt. Such actions are generally frowned upon by the courts because pre-petition debt effectively becomes cross-collateralized with post-petition assets. Moreover, some members of the first lien facility such as CLO’s or long only asset managers are precluded by their charters from originating or participating in DIP loans.
Those creditors who were left behind by the roll-up DIP objected to these loans on the basis that the rules and procedures of bankruptcy did not allow for members of the same class to leap frog them and obtain better recoveries and terms. Nevertheless, with no viable alternative the courts approved many of these loans, although frequently they amended some of the more egregious terms after some trial-and-error. Roll-up DIPs effectively became de facto bridge loans to a credit bid. In situations where the first lien lenders were not the DIP lender, the scenarios were far different and led to some interesting conflicts between debtors and secured creditors, particularly related to secured creditors’ right to credit bid their claims.
Philadelphia Newspapers
In 2006, Philadelphia Newspapers, LLC (debtor), acquired the Philadelphia Inquirer, Philadelphia Daily News, and philly.com for $515 million with a $295 million loan secured by a first priority lien on substantially all of the debtors’ assets. In February 2009, the debtors filed for Chapter 11 after defaulting on their loan agreements. The debtors’ proposed plan called for a sale of substantially all the debtors’ assets in an auction as well as a transfer of their Philadelphia headquarters to the secured lenders. The bid procedures required cash funding and specifically precluded the lenders from credit bidding. (1)
The Stalking Horse bidder in this case was an entity controlled by the local Carpenters Union pension fund and Bruce Toll, a personal friend of the debtor’s CEO. Additionally, until the day before the asset purchase agreement was signed, the Stalking Horse held 50% of the ownership interests in the parent of the debtor corporation. (2) Since the Newspaper properties represent iconic brands in Philadelphia, the debtor also engaged in a public relations campaign branding itself as David “local newspaper” vs. Goliath “Wall Street hedge funds”. This was ironic given that the CEO had mismanaged the leveraged buyout of the company, filed it for bankruptcy and instituted significant head count reductions effecting middle class working people while he earned an $800K annual salary. Nevertheless, the debtor successfully painted the banks as the villain.
The debtor’s POR included a 363 sale at public auction of substantially all the debtor’s assets free and clear of all liens. The sale would not include the debtor’s headquarters which would be transferred to the secured lenders in full satisfaction of their claim. Under the Plan, the purchase would generate approximately $37 million in cash for the Lenders. Additionally, the Philadelphia headquarters which was valued at $29.5 million and would be subject to a two-year rent free lease for the new owners (representing a recovery of about 20%). The Lenders would receive any cash generated by a higher bid at the auction. The plan also established a $750,000 to $1.2 million liquidating trust fund in favor of general unsecured trade creditors and provided for a distribution of 3% ownership to the GUCs if the senior lenders agreed to waive their deficiency claims. (3) Secured lenders objected to the plan because it required all bids on the sale to be in cash, thus if the secured lenders wanted to bid on the assets they would have to pay in cash only to receive the cash back under the plan. Although secured creditors would essentially be paying themselves with a cash bid, the group held firm to the principle of a secured creditors’ right to credit bid.
In October 2009, the bankruptcy court issued an order refusing to bar the lenders from credit bidding. The bankruptcy court reasoned that Section 1129(b)(2)(A) of the Bankruptcy Code (known as the cramdown provision), when read in conjunction with Sections 363(k) and 1111(b), required that a secured lender be able to credit bid in any sale of the debtors’ assets. This provision states that a plan is “fair and equitable” and thus confirmable over the objections of a secured class, provided that the secured class is given the “indubitable equivalent” of its secured interest. Moreover, before a court may “cram down” a plan over the objection of a dissenting creditor class, both the absolute priority rule and the fair and equitable standard must be satisfied. However, the debtor appealed and the district court reversed the bankruptcy court’s decision. The 3rd US Circuit Court of Appeals affirmed the district court’s ruling and addressed the issue of whether secured creditors have a statutory right to credit bid their claims in a 363 sale done in the context of a plan of reorganization. (4)
The 3rd Circuit upheld the POR relying on what is characterized as the “plain meaning” of the Bankruptcy Code Section 1129 (b)(2)(A). The court held the plan could be confirmed as it met the “fair and equitable” requirement of Section 1129 (b)(1) arguing that secured creditors received the “indubitable equivalent” of their claims under the plan. Section 1129(b)(2)(A) lists three alternative paths by which a plan may be “fair and equitable” to secured lenders:
- the secured lenders retain their liens to the extent of the allowed claims and receive deferred cash payments equal to the allowed amount of their claim;
- the property is sold free and clear of liens and the secured lenders attach their liens to the proceeds of a Section 363(k) sale (which specifically incorporates credit bidding);
- OR the secured lenders realize the Indubitable Equivalent of their claims (does not mention credit bidding)(5)
The court reasoned that according to the plain meaning of the statute, the use of the word “or” between the three subsections is a disjunctive clause which allows the debtor to choose one of the three alternatives when selling its assets free and clear of liens. Therefore, if the debtor offers the indubitable equivalent under subsection (iii), the secured lender’s right to credit bid is precluded. The court applied reasoning used by the 5th Circuit In Re Pacific Lumber Co. In the PALCO case the court terminated the debtor’s exclusivity after 1 year and confirmed a plan put forth by a joint bid by a secured creditor and competitor. Additionally, the plan paid the noteholders full cash value of their claims while precluding them from credit bidding on the assets.
The court rejected the secured creditors’ claim that they had the right to credit bid and commented that the credit bid was unnecessary given that noteholders were receiving the full cash value of their claim. The court in Philadelphia Newspapers cited the approach the 5th Circuit took in the PALCO case as one concerned with “fairness to creditors” rather than the mecanics of a cramdown. Moreover, the court emphasized that lenders retained the right to object to the plan at confirmation on the grounds that “the absence of a credit bid did not provide it with the ‘indubitable equivalent’ of its collateral.” (6)
Judge Thomas Ambro of the 3rd Circuit wrote a strong dissenting opinion based on the principle of statutory construction; that specific principles prevail over general ones. (7) The legal reasoning employed in the dissent is beyond the scope of this article, however it provides some great insight and is worth reading.
The PALCO and Philadelphia Newspapers rulings have established that in the context of a plan of reorganization credit bidding is not a right (at least in the 3rd and 5th Circuits). This is significant in that the 3rd Circuit governs Delaware where many large corporate bankruptcies are overseen. However, the issue of the right to credit bid in a 363 sale outside of a plan was not addressed. The court remanded back to the bankruptcy court the issue of whether secured creditors were receiving the Indubitable Equivalent and that the plan met the Fair and Equitable test. That issue was never decided as creditors took matters into their own hands and won the auction with a cash bid of $138.9mm.
What these rulings demonstrate is that secured creditors have lost some strategic ground in being able exercise influence and take possession of the collateral through the right to credit bid. Funds employing a loan-to-own strategy should weigh carefully how these decisions may impact the timing and manner of deployment of capital in a distressed investment. Had the secured creditors been the DIP lenders in these situations, they would have been able to exert far more influence in determining the outcome. It is likely that during the next cycle banks will again be reeling from mark-to-market losses in their trading and CMBS books and will again not be able to deploy DIP capital as was the case in the 2008-2009 cycle. The early part of the cycle will be ripe with opportunities for those funds with dry powder to effectuate control through a third party or roll-up DIP loan.
DBSD
DBSD, a subsidiary of ICO Global, is a satellite communications company focused on S-Band spectrum that received authorization from the FCC to integrate an ancillary terrestrial component (ATC) into its MSS (Mobile Satellite Service) system allowing them to provide integrated mobile satellite and terrestrial communications services. While the spectrum has enormous value, the large capital expenditures required to launch satellites and fund the cash burn until they are operational, has forced two major players DBSD and Terrestar, majority-owned by Harbinger Management, to seek bankruptcy protection.
The strategic value of these assets has brought into conflict hedge funds such as Harbinger a major player in the space through its company LightSquared, and DISH Network, controlled by satellite mogul Charlie Ergen, who also owns Echo Star Communications. Mr. Ergen has tried to gain control of both DBSD and Terrestar through a loan-own-strategy by investing in the debt of these two companies. The prospect of a strategic buyer using a loan-own-strategy has generated a lot of controversy. In the case of DBSD, it led to a rare decision by Judge Robert E. Gerber of the United States Bankruptcy Court for the Southern District of New York to “designate” or disallow the vote of DISH, a ruling the Second Circuit Court of Appeals upheld.
The facts in the DBSD case are unique in that a strategic buyer (rival corporation) had purchased all of the debtors’ $40mm first-lien secured debt at par in addition to $111mm of $650mm 2nd lien debt not subject to a PSA (Plan Support Agreement). The purchases were made after the debtors had filed an amended plan of reorganization that would have satisfied the first lien debt in full with a new secured PIK note and modified liens.
The creditor’s admitted purpose in buying the debt was to vote against the plan and take control of the debtor. The court found that: “When an entity becomes a creditor late in the game paying 100 cents on the dollar, as here, the inference is compelling that it has done so not to maximize the return on its claim, acquired only a few weeks earlier, but to advance an ‘ulterior motive’ condemned in the case law.” (8)
Under section 1126(e) of the Bankruptcy Code, a court may, on request of a party in interest, “designate” (disqualify) the votes of an entity whose acceptance or rejection of a plan of reorganization is not in good faith. (9) The Bankruptcy Code does not define good faith, thus courts have developed a basis for determining actions that demonstrate a “badge of bad faith”. Such actions include, among other things, attempting to assume control of the debtor, to put the debtor out of business or otherwise gain a competitive advantage, or to destroy the debtor out of pure malice (10)
The court found that “DISH’s acquisition of First Lien Debt was not a purchase to make a profit or increase recoveries under a reorganization plan. Instead DISH made its investment in DBSD as a strategic investor looking ‘to establish control over this strategic asset.’ The Court cited evidence that DISH purchased the debt at par after an amended plan had been filed; and that internal DISH documents and sworn testimony revealed plans to use the purchase of debt to “control the bankruptcy process” and “acquire control” of the debtor, a “potentially strategic asset.” Therefore, Judge Gerber concluded that “DISH’s conduct is indistinguishable in any legally cognizable respect from the conduct that resulted in designation in Allegheny, and DISH’s vote must be designated for the same reasons.” (11)
Under the proposed plan, the first lien debt was to be restructured under an amended facility that extended the maturity of the Senior Debt from one year to four years, provided payment in kind (“PIK”) interest at 12.5 percent, with no cash payments until final maturity. In addition, the first lien creditors would receive liens on all of reorganized DBSD’s operating assets, but not on the securities, which were to be used to secure a working capital line and fund continuing operations. In determining whether the plan should be confirmed, the court analyzed whether the creditor was provided the indubitable equivalent of its claim. The court examined the issue of whether the secured creditors' claim would have the same level of protection as it did prior to confirmation, in other words, did the new note have sufficient collateral cushion. The court ruled that given the assets securing the debt had an enterprise value six times the amount of debt due at maturity, their level of protection was equal. (12)
DISH appealed Judge Gerber’s ruling and upon appeal, the United States District Court for the Southern District of New York affirmed his decision. The District Court held that the Bankruptcy Court’s finding that DISH had acted as a strategic investor seeking control over the debtor was not clearly in error, and rejected the argument by DISH that there was insufficient evidence to establish that they had displayed a lack of good to satisfy section 1126(e) of the Bankruptcy Code. (13) DISH appealed to the 2nd US Circuit Court the designation of its vote and in addition argued that they cannot be forced to accept a reduced collateral package that strips them of their lien on the securities with no substitution. (14) The Second Circuit upheld the District court’s ruling. However, it appears that Mr. Ergen is not going away quietly. It was announced recently that DISH struck a deal with DBSD’s management that would keep all of the debt unimpaired and allow DISH to acquire a controlling interest in the debtor.
While this ruling had unique circumstances given that the creditor was a strategic buyer who purchased its claim at par after a plan had been disclosed, it may provide ammunition to junior creditors seeking to assert leverage in a case where a control distressed hedge fund or private equity fund is seeking to obtain control through the debt. Would the decision be applicable if all the facts were the same except that the creditor in question was a large distressed fund?
At the very least distressed investors looking to acquire controlling interests need to be aware of the risks of being deemed a “strategic investor” It is likely that aggressive junior creditors seeking to avoid a cramdown will now cite this case as a basis for leaving senior creditors unimpaired or unable to vote. Moreover, Philly News and PALCO have left open the question of credit bidding outside of a plan. While not all distressed investors seek control when investing, very often it becomes the only effective means for exercising remedies and maximizing recoveries. In light of these rulings, control distressed investors should be prepared to face some challenges on several fronts in the next cycle. Praemonitus Praemunitus. (Forewarned is Forearmed)
Endnotes:
(1) In re Philadelphia Newspapers: Potential Ramifications for Secured Lenders in Debt Restructurings. McDermott Publications: 12.2.2009
(2) Ibid.
(3) Recent Decisions May Stop Secured Creditors from Credit Bidding. Elena González. http://www.abanet.org/litigation/committees/bankruptcy/articles/071310-gonzalez-credit-bidding-secured-creditors.html
(4) Ibid.
(5) Ibid.
(6) Ibid.
(7) Right To Credit Bid Denied In Philadelphia Newspapers, Dow Jones Daily Bankruptcy Review | 10. Wednesday, March 31, 2010. Marshall S. Huebner and Kevin J. Coco.
(8) Disenfranchising Strategic Investors in Chapter 11: “Loan to own” Acquisition Strategy May Result in Vote Designation Jones Day, Recent Developments in Bankruptcy and Restructuring.
(9) SDNY Bankruptcy Court Thwarts Takeover by Claims Purchaser. Cadwalder Restructuring Review April 2010. By Peter Friedman, Leslie W. Chervokas and Samuel S. Cavior.
(10) Ibid.
(11) Ibid.
(12) Ingredients for a Successful Cram Up Reorganization. New York Law Journal, March 1, 2010. Jeffrey Levitan.
(13) Ibid
(13) Ibid
