An emerging strategy many hedge and private equity funds (each a "Fund," and collectively the "Funds") are pursuing is known as the "loan to own" investment. In this type of investment, a Fund's investors acquire debt, and sometimes certain amounts of equity or management control, such as voting power or board seats, from a lender of a distressed company
The Fund often buys the debt at a deep discount, then nudges the Company toward a bankruptcy filing where the Fund can take advantage of the economic leverage associated with the face amount of the debt it acquired to turn the debt into an equity ownership of the Company in the chapter 11 process.
The bankruptcy tool that is typically used to move from the prepetition discounted debt and equity acquisition to the post-petition complete and clean ownership by the Fund is the right to credit bid at a public auction sale of a Company under Section 363(k) of the Bankruptcy Code (the "Code"), pursuant to which Funds set the bidding threshold at the face amount of the debt, rather than at the discounted value paid.
The theory being, if the fair market value of the Company is closer to the value paid by the Fund prepetition, the creation of the competitive bidding threshold at the artificially high face amount will reduce the likelihood of competitive bids, which is the Funds' desired strategic outcome. Without competitive bidding there is no chance of any increase in the cash resources of the Company that would typically fund distributions to creditors.
Thus, in many cases the unsecured creditors are left with little or no recoveries on their claims. The classic loan to own scenario, resulting in a rapid section 363 sale to the prepetition Fund, is nothing more than a liquidation with a predetermined result, benefiting only the top ranks of the creditor food chain.
The question is, what recourse is there for creditors?
Challenging Credit Bids
A. Equitable Subordination
Under section 510(c) of the Code, to the extent the Funds and/or Companies may have engaged in inequitable conduct which has injured other creditors, the claims of the investors could be equitably subordinated to the injured creditors' claims. The requisite "inequitable conduct" could include: (i) fraud, illegality and breach of fiduciary duties, including improper dealings with an "insider," (ii) undercapitalization, and (iii) use of the Company as a mere instrumentality or alter ego.
Although an equitable subordination claim is typically leveled against an "insider,", non-insider claims may also be subject to equitable subordination. Moreover, equitable subordination may be granted even without creditor misconduct if necessary to prevent injustice and insure fairness for creditors.
B. Good Faith
Showing a breach of fiduciary duties by directors or officers could involve proving, among others, inadequate consideration of options and lack of good faith. Under Section 1129(a)(3) of the Code, a "court shall confirm a plan only if . . . [t]he plan has been proposed in good faith and not by means forbidden by law." The standard for meeting such good faith requirement, as stated by the court in In re Johns-Manville Corp., requires a showing that "the plan was proposed with honesty and good intentions and with a basis for expecting that a reorganization can be effected."
In other words, a court may determine good faith is lacking where a Fund has proposed a plan under the pretext of financially resuscitating a Company but with the true motive of converting its debt position into a controlling equity position.
C. Recharacterization
Creditors can assert that debt owed to the Funds should be treated as equity, thus preventing the Funds from including such debt in a credit bid, an effect similar to equitable subordination. Recharacterization is appropriate where the facts show that a debt transaction was actually an equity infusion.
Courts often examine the following factors to determine whether to recharacterize debt: (i) the names given to the debt instruments, (ii) the presence of a fixed maturity date, interest rate and payment schedule, (iii) the repayment source, and (iv) the adequacy of capitalization.
Although a highly fact-specific argument, no single fact is decisive, however, such factors distill to one essential concept: the more a debt transaction reflects the characteristics and intent of an arm's length debt deal, the more likely it is that it will be treated as a debt, rather than equity, transaction.
D. Preferable Alternatives / Valuation
Creditors can also make a process-based argument against a restructuring plan by pointing out the procedural shortcomings of a Company's management in selecting a Fund's plan. Such shortcomings could include the Company's failure to pursue alternative transactions and/or proposals, and restrictions limiting the scope of the search for transactions.
Valuation arguments are also inherently fact-specific and, ultimately, unlikely to succeed: courts prefer a market approach to valuation, and a Fund's valuation may be the most accurate indicator of fair market value of a Company.
Courts' Treatment of Arguments Opposing Loan to Own
A. In re SubMicron
In Cohen v. KB Mezzanine Fund II LP,1 the Fund ("KB") held secured debt of the debtor, SubMicron Systems Corp. ("SubMicron") that was subordinated to a first lien lender. During the period leading up to SubMicron's bankruptcy, KB made additional subordinated loans to SubMicron.
In approving the § 363 sale to KB, the court rejected the creditors committee's argument for recharacterization, noting that the parties called the transfers at issue "debt", the transfers had a fixed maturity date and interest rate and the obligations were recorded as secured debt on SubMicron's 10-Q SEC filing and UCC-1 financing statements. The court also rejected the equitable subordination argument, finding that KB's transfers did not injure creditors, because without the loans, SubMicron would have had to liquidate without the possibility of a sale to an alternate purchaser. The court also held that KB was entitled to bid the face amount of its claims, and were not limited to bid the value of the secured collateral. Thus, loan to own lenders may bid the full amount of their claim, even if it is greater than the value of the assets, and thereby usurp the debtor's going concern value.
B. In re Radnor Holdings
In The Official Committee of Unsecured Creditors of Radnor Holdings v. Tennenbaunz Capital Partners LLC et al.,2 the Fund (collectively, "TCP") loaned the Radnor Holdings Corp. and its affiliates ("Radnor"), $95 million and purchased $25 million of Radnor's preferred stock. The committee brought a variety of claims against TCP, including recharacterization, equitable subordination and breach of fiduciary duty.
The bankruptcy court rejected the creditors committee's challenges. Focusing on the parties' intent under the SubMicron decision, the court ruled that the transfers were not equity because: (i) the parties treated the advances as debt; (ii) it was appropriate for a lender to extend additional credit to a distressed borrower to protect its existing loans; (iii) despite the fact that Radnor missed its 2005 EBITDA target, there was no evidence that TCP "knew" Radnor could not meet its 2006 EBITDA target; and (iv) TCP did not have control over Radnor's day-to-day operations so as to compel recharacterization. The court found that TCP acted in good faith with a view to maximize the debtors' value, and thus equitable subordination was not appropriate. Finally, the court rejected the committee's claims regarding breach of fiduciary duty, finding that the TCP loans actually increased Radnor's solvency, and Radnor's directors were entitled to attempt to continue to operate using loans to turn the company around.
C. In re Granite
In re Granite Broadcasting Corp., et al.,3 involved competing plans of restructuring for Granite Broadcasting Corporation and five of its wholly-owned subsidiaries ("Granite") submitted by Silver Point Capital Finance LLC ("Silver Point"), holder of approximately 80% of Granite's 9.75% senior secured notes, on the one hand, and by parties (the "Preferred Holders") holding over 50% of Granite's 12.75% cumulative exchangeable preferred stock, on the other hand. The court had to determine whether Silver Point's plan was proposed in good faith and whether such plan undervalued Granite.
In reaching the Conclusion that Granite acted in good faith and no damages resulted from certain Silver Point's debt financing, the court pointed to the lack of a clear and feasible plan from the Preferred Holders that could have been effectuated given the time constraints, the Preferred Holders' deliberate decision not to compete with Silver Point in submitting a plan that included an long term recapitalization, and the Preferred Holders' demand of immediate control of the Board. The court also summarily rejected a valuation challenge by the Preferred Holders, stating that the valuations posited by the Preferred Holders' experts were based on projections of Granite's future performance, and other assumptions for which there was no support.
Conclusion
Knowing that creditors will make the arguments discussed above in challenging Funds, there are procedures that Funds and Companies that prefer the Funds' plans to those of other creditors employ to insure the success a loan to own investment. To the extent the facts of a loan to own case support a Fund's opponents, a lack of concrete damages resulting from the Fund's inequitable conduct may have the effect of making such conduct moot.
The decision in the Granite case is indicative of the high burden creditors face in succeeding on a claim for breach of fiduciary duties and/or lack of good faith. Certainly, in the wake of Granite, any Company that prefers the plan of a Fund now knows to appoint a committee comprised of independent members of its board of directors to evaluate such plan and any alternatives. Taking steps to insure the decision-making process is free from defects will provide a Company's board of directors the leniency afforded to corporate actions viewed under the business judgment rule. Likewise, Funds can nip arguments for equitable subordination in the bud in the same manner as with good faith arguments, i.e., avoiding inequitable conduct. As to the common argument of recharacterization, the lesson here seems to be "leave no smoking gun."
Although the loan to own cases discussed above constitute wins for Funds, the results of any challenge to limit credit bids of such Funds will depend on the facts of each case. So far, there have been very few reported challenges. In particular, the good faith of the lenders (including the degree to which they may have directed further advances to set up their credit bid) and the "arms-length" nature of the loan transaction as a true debt deal will be tested in connection with potential attacks on credit bids on recharacterization and equitable subordination grounds. Considering these matters will almost always be hotly contested, it is only a matter of time until a loan to own case with different facts is determined against the Fund.
Footnotes
1. 432 F.3d 448 (3d Cir. 2006).
2. 353 B.R. 820 (Bankr. Del. 2006).
3. 369 B.R. 120 (Bankr. S.D.N.Y. 2007).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.