The law surrounding distressed acquisitions has been evolving rapidly for the past decade. The loan-to-own strategy, in which a would-be buyer purchases existing debt at a discount as a tool to achieve ownership of the target company, has been one of the favored strategies of value investors. During the same period, it has been the subject of significant scrutiny.
In the past several years, a number of issues regarding loan-to-own strategies have been resolved by the courts, and new decisions provide fresh guidance for distressed buyers.1 Accordingly, the time for an update is at hand, and this article uses the recent developments to define some best practices for loan-to-own purchasers.
First, a word on the loan-to-own strategy is in order. There are always four ways to buy a company—(1) a stock purchase, (2) a merger, (3) an asset purchase, and (4) a debt purchase (i.e., the loan-to-own play). The debt purchase, unlike the other methods, does not result in immediate ownership. Instead, the debt owner transposes the debt into ownership through one of the first three strategies.
In a typical scenario, the loan-to-own purchaser credit bids the secured debt at a distress sale to become the owner of the assets (an asset purchase), and the loan purchaser may need to use its vote to block a reorganization to force the sale. In another strategy, the loan purchaser uses its vote to control a reorganization to swap its debt into equity through a Chapter 11 plan (essentially a stock purchase), becoming the owner of the reorganized company.
If these are the typical strategies, then the most important protections for a loan-to-own buyer are its ability to credit bid and its ability to vote on the plan. Stripped of either of these, the would-be buyer faces the potential of being “crammed down” in a bankruptcy—stuck holding the debt for the long term against a company that successfully reduces the principal amount and the interest rate in bankruptcy and then pays the lower amount over many years.
So, what is the current status of attacks on the loan-to-own strategy, and what does it teach about best practices?
One of the major strategies to circumvent credit bidding over the past decade has been for the debtor to build the bankruptcy sale into a Chapter 11 plan and then try to prohibit the secured creditor from bidding by substituting a different, valuable right in the place of its credit bid. The substitution method is known as giving the creditor the “indubitable equivalent” of its claim; the problem is that it’s often not entirely equivalent, and the creditor would much rather have the right to credit bid.
By 2010, courts of appeal around the country were divided over whether this strategy to avoid credit bidding was permissible, and the issue had to be firmly put to bed by the U.S. Supreme Court in 2012. In Radlax Gateway Hotel et al v. Amalgamated Bank,2 the Supreme Court found that a secured creditor cannot be given the “indubitable equivalent” of its claim in a bankruptcy sale plan as a substitute for having the right to credit bid at the bankruptcy sale. So, Radlax was a victory for loan-to-own buyers, protecting their right to credit bid even when the sale is part of a Chapter 11 plan. The indubitable equivalent attack on credit bidding in the sale context is now dead.
Bankruptcy sales are often referred to as “363” sales, based on the section of the U.S. Bankruptcy Code that addresses them. Section 363 provides secured lenders with the right to credit bid at sales “unless the court orders otherwise for cause.” The million dollar question, then, is what constitutes “cause?” Radlax decided that the “indubitable equivalent” attack is a non-starter, but where other “cause” exists, Radlax is not the end of the story.
On January 17, 2014, the Bankruptcy Court for the District of Delaware issued a memorandum opinion in In re Fisker Automotive Holdings, Inc.,3 limiting the right of Fisker’s senior lender to credit bid “for cause.” The opinion was a serious blow to the right of lenders to credit bid at 363 sales. While the Bankruptcy Code has long permitted courts to limit a lender’s right to credit bid for cause,4 Fisker may represent a shift in what constitutes “cause.”
The loan-to-own buyer in Fisker purchased the $168.5 million senior secured claim at a discount for $25 million from the original lender. The buyer then negotiated a deal to buy all of the assets of Fisker in a 363 sale for $75 million as part of a credit bid. The unsecured creditors’ committee objected and complained that the buyer’s ability to credit bid its entire $168.5 million would not just chill bidding, but would result in no other bids, even though a second cash buyer had expressed interest. The committee also argued that the extent of the senior secured lien was in dispute and uncertain, and that the lender was rushing the sale process.
After concluding that “cause” is not limited to inequitable conduct, the court capped the buyer’s credit bid at $25 million, the amount it paid for its claim. The result was that to bid higher than $25 million, the loan-to-own buyer would be forced to put up cash (and hope that it would receive most of the cash back in later distributions in the bankruptcy).5
So far, Fisker has not resulted in an avalanche of cases limiting creditors’ rights to credit bid. Only one court has relied on Fisker to limit a lender’s right to credit bid in any material way.6 In In re The Free Lance-Star Publishing Co. of Fredericksburg, VA7 the court expressed concern that credit bidding can be abused in loan-to-own situations, especially when the secured creditor is driving the process.
Specifically, the Free Lance-Star court was concerned about loan-to-own creditors using the credit bid process to depress value. The court found evidence that the creditor in Free Lance-Star (1) improperly recorded UCC financing statements against assets on which it did not have liens, (2) was overzealous in its participation in preparing marketing materials for the debtor’s assets (including insisting on the amount of its credit bid being displayed in bold type on the front page), and (3) was attempting to credit bid against assets on which it may not have had liens. As a result, the court limited the lender’s credit bid rights to approximately 10 percent of its total claim.
Neither Fisker nor Free Lance-Star has yet led to a proliferation of credit bid caps. However, both suggest a new willingness by courts to limit credit bidding in certain loan-to-own scenarios.8 While the line is not yet clear (and the mere chilling of other bids should not be enough to block a credit bid), loan-to-own buyers are well-advised to tread lightly with accelerated timelines, marketing input, control, and conduct that can be characterized as overreaching. Would-be buyers also should be very careful in their due diligence prior to purchasing loans to identify potential issues that could lead to disputes regarding the amount or validity of their liens.
The second right that is sacrosanct to loan purchasers is the ability to vote on Chapter 11 plans. Often, a lender with a large claim can effectively control the voting on the plan, and a would-be purchaser may use its claim as a way to block a successful reorganization to force a sale or propose an alternate plan.
In general, lenders are entitled to vote on Chapter 11 plans, but there is an exception—a party can have its vote “designated” (i.e., disqualified) if a court finds that the vote was not in good faith, was not solicited or procured in good faith, or is not consistent with the Bankruptcy Code.9 While it can be a nebulous standard, in practice courts have typically allowed lenders to vote except in the case of highly inequitable conduct. If the lender’s vote is disqualified, the lender loses its voice in the vote tally and can end up being forced to live for years with a Chapter 11 plan that it severely dislikes.
The seminal case now is one that was decided in 2011. In In re DBSD North America, Inc.,10 the 2nd U.S. Circuit Court of Appeals, whose jurisdiction includes the influential Southern District of New York, designated the vote of a would-be buyer carrying out a loan-to-own strategy, finding voting disqualification appropriate when a party acts in bad faith and with ulterior motives. The court found that designation “was intended to apply to those who were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled.”11 Therefore, a Bankruptcy Court may designate a vote of an entity that votes with an “ulterior motive,” that is, an entity with “an interest other than an interest as a creditor” that “voted with such an impermissible motive.”12
In DBSD, the 2nd Circuit addressed the situation where an indirect competitor of the debtor who was also a part-owner of a direct competitor bought a blocking position in a class of claims (actually, all of the claims) after a plan had been proposed with the intention not to maximize its return on the debt, but to enter into a strategic transaction with the debtor. The would-be buyer was attempting to use its creditor status as an advantage compared to simply proposing a separate plan or making a traditional bid for the company. “In effect, [the buyer] purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring [the debtor’s economic] rights, not toward protecting its claim.”13
The court noted significant evidence of “ulterior motive,” including the creditor’s admissions in court regarding its position as a competitor of the debtor, its willingness to overpay for the claims it bought, its attempt to propose its own plan (including filing the alternate plan during the exclusivity period), and its internal communications, which showed a desire “to obtain a blocking position” and “control the bankruptcy process.”14 As a result, the court disqualified the creditor’s vote. In doing so, however, the court emphasized that its opinion imposed no categorical prohibition on purchasing claims with acquisitive or other strategic intentions. The court also noted that whether a vote should be designated is a fact-intensive question.
Fortunately for distressed debt buyers implementing loan-to-own strategies, DBSD has not resulted in widespread vote designations by other courts. Only a few cases have relied on DBSD in concluding that a creditor’s vote was cast in bad faith, justifying designation, and those decisions have not involved loan-to-own situations.
In In re RLD, Inc.,15 for example, a California Bankruptcy Court found that a secured creditor, by casting a vote to fix its own mistake, had an ulterior motive permitting disqualification. The issue involved two debtors in separate bankruptcies who were co-obligors on a note and who filed Chapter 11 plans that were each contingent on approval of the other’s plan. The lender had misunderstood the interest rate it was being paid in the first case. Recognizing its mistake too late to take action in the first case, the lender objected to the plan in the second case in an attempt to fix the error. The court concluded that the lender had an ulterior motive because “by objecting to and voting against the [second] plan, the effect the [lender] seeks to achieve is to render the [first] plan meaningless and thereby undo its mistake.”
In addition, a Connecticut Bankruptcy Court disregarded a creditor’s vote in In re Derby Dev. Corp.16 because the creditor was not acting for its own interest as a creditor, but rather to advance the debtor’s interest (notably, the opposite of most loan-to-own strategies). The creditor agreed to purchase a mechanic’s lien from an insider and vote in favor of the debtor’s plan, free from the insider status, and thereby supply a non-insider vote by an impaired class of creditors. In effect, the creditor’s vote was disqualified because the creditor was attempting to circumvent the protections of the Bankruptcy Code against insider voting.
In contrast, other courts following DBSD’s logic have found situations in which votes should be permitted, and these cases provide examples of appropriate motives in voting on a plan. In In re Charles Street African Methodist Episcopal Church,17 a Massachusetts Bankruptcy Court found that a creditor’s desire, resulting from its own liquidity problems, to be paid immediately on loans that have matured was not a “bad faith” basis for voting to reject the debtor’s proposed Chapter 11 plan and was not an ulterior motive. A New York Bankruptcy Court in In re LightSquared Inc.18 declined to extend DBSD’s holding to cover votes cast with respect to claims that were acquired before a plan had been proposed and where there were valid, economically self-interested reasons for the voting parties to reject the plan.
The case of In re GSC, Inc.19 involved allegations that a creditor voted against a plan to pursue a sale transaction that would have given it more than its appropriate share of the debtors’ assets. The court noted that even if there was evidence to this effect, the objectors needed to establish the creditor’s intent to pursue this alternative purpose at the time of voting and that, even if the objectors could have succeeded in making such a showing, the objectors would “have had to further prove that [the creditor’s] sole or primary goal in rejecting the [p]lan was to benefit at the expense of other creditors.”
Finally, in In re Lichtin/Wade, LLC20 an entity purchased secured debt and proposed its own plan. The debtor moved to designate all votes cast by the creditor against the debtor’s plan because the creditor was not acting as a creditor but as a strategic party “for its own ulterior motive of obtaining control of the [d]ebtor’s business operations.” The court refused to designate the creditor’s votes because the creditor acted to maximize its investment and advance its own economic interest rather than “advancing a strategic competitive interest against the [d]ebtor.”
The court heavily relied on testimony that if the creditor’s goal had been to own the debtor’s real property, it would have been easier and less costly for the creditor to file a motion to lift the stay and seek foreclosure. The court also found that the debtor and creditor were not competitors, there was evidence that the creditor saw an opportunity for a good investment, and the creditor underwent an extensive underwriting process prior to purchasing the debt to determine that the purchase would be economically beneficial. The court concluded that the creditor’s actions were motivated “primarily [by its desire] to improve its plan treatment rather than to take complete control of the [d]ebtor’s business.”21
The takeaway from DBSD and its progeny is that designation of votes is an extreme remedy, and it continues to be used sparingly. Loan-to-own buyers can likely avoid vote designation as long as their actions after buying the debt are consistent with maximizing recovery on the debt and are not unreasonably aggressive.
Following Fisker and DBSD, the focus of most recent attacks on credit bidding and plan voting has shifted to “cause” and “good faith.” However, there remain a few cases that predate them that continue to influence the process and should be considered by loan-to-own purchasers.
Equitable Subordination. Equitable subordination is a common attack on the claim of secured creditors in hopes that the creditor’s claims will be de-prioritized and paid only after the claims of other creditors. The standard is generally very difficult for the attacking party to satisfy. In the 2006 case of In re Radnor Holdings, Corp.,22 the court found that a creditor’s loan-to-own motive was not sufficient cause for equitable subordination and that the creditor should be allowed to credit bid. The secured creditor was not an insider; did not exercise “day-to-day control” over the debtor’s business affairs or direct the debtor’s business; did not engage in misconduct; did not seek to benefit itself at the expense of others; did not seek to mislead trade creditors, public noteholders, or other stakeholders; and at all times acts in good faith. Although subordination can be a weapon used to attack secured lenders, Radnor makes it clear that such conduct must be egregious for a court to apply the equitable remedy.
In contrast is In re Yellowstone Mountain Club, LLC,23 where extreme circumstances led to an extreme result. There, the Bankruptcy Court equitably subordinated a $232 million secured claim of the original lender (not a claim purchaser) on grounds of egregious conduct. At the height of the Great Recession, the court was offended by the lender’s lack of due diligence, negligent lending practices, significant overleverage, imposition of hefty fees for the loan, and the lender’s knowledge that the loan proceeds were not being used for the business but instead were being distributed to equity.
The lender’s actions in making the loan “were so far overreaching and self-serving that they shocked the conscience of the Court.” Yellowstone remains an outlier, because few situations have facts so overwhelming. For loan-to-own buyers, Yellowstone is simply a reminder that a lender’s extreme behavior (its own or its predecessors’) can put its bankruptcy claims at risk and that diligence in loan-to-own claim purchases is critical.
The ‘Not So Free, Not So Clear’ Attack. It’s a fitting end to any article on distressed acquisitions to mention the 9th Circuit Bankruptcy Appellate Panel’s 2008 decision in Clear Channel,24 which at the time of its issuance struck fear into the hearts of credit bidders—indeed, those of all buyers of assets out of bankruptcy. The Clear Channel ruling called into question the ability of a credit bidding senior lender—and maybe even a bankruptcy 363 sale itself—to wipe out junior liens unless the junior lienholders were either paid or consented to the sale. The court in Clear Channel also allowed a junior creditor to continue asserting its challenge to the sale after the sale had closed and at a time when the Bankruptcy Court’s sale order was not subject to a stay.
While the ruling in Clear Channel has been heavily criticized by commentators and rejected in many courts, Clear Channel continues to be a question mark on 363 sales in at least some jurisdictions. Fortunately for distress buyers, the majority of courts reject Clear Channel.25 The result is that loan-to-own buyers seeking to use credit bid rights to buy assets free and clear of junior liens should be mindful of the particular court in which the bankruptcy is pending.
Potential bankrupt sellers usually have similar concerns about jurisdiction, as Clear Channel may negatively affect the value of their assets in a bankruptcy sale and the amount of time that it takes to close the sale. Therefore, would-be buyers who are early enough to the fray should make a point of helping their seller pick the best jurisdictions in which to file (or at least, the jurisdictions to avoid) to help prevent any uncertainties associated with Clear Channel from infecting the sale.