It is perhaps stating the obvious that Chapter 11 of the US Bankruptcy Code offers a well-known and very flexible means of extracting the most value from distressed assets.  But in these economic times, it is worth remembering that Chapter 11 is by no means the only avenue for addressing insolvency – nor is it always the best . . . or most appropriate.

Bankruptcy (or “Section 363”) sales have been a time-honored and tested means of moving distressed assets quickly and cost-efficiently from buyer to seller.  But the lack of credit necessary to fund the transition period required for such sales during the recent downturn, combined with a handful of recent appellate decisions which cast doubt on the validity of contested sales, serve as reminders that other transactional structures sometimes work just as well – or even better.

The folks at Turnaround Management Association (TMA) released a spate of articles last week which illustrate the point: Two of TMA’s pieces (one on ABC’s and Receiverships and one on alternative sale structures for distressed acquisitions) compare and contrast federal bankruptcy proceedings with other means of optimizing the transfer of distressed assets. A third focuses on “strict foreclosures” (or “Article 9 sales”).

All three are well worth a read.

The esoteric world of credit default swaps and other derivative securities often appears far removed from the everyday practice of Chapter 11.  But the impact of this little-known (and often less-understood) corner of the securities market upon the bankruptcy world has recently garnered considerable academic interest – and is now attracting some legislators’ attention as well.

Several posts on this blog (beginning here) have summarized the intersection between credit default swaps and bankruptcy.  Some academics have explored the potential indirect effect of these securities upon out-of-court netogiations – focusing primariliy on the potential problems of “holdout” creditors and the ”empty creditor hypothesis.”  Others (here and here) have offered their preliminary thoughts on the continued usefulness of the Bankruptcy Code’s “securities safe harbors,” originally included to shield financial markets from the effects of large bankruptcy filings – but now perceived as distorting creditor priorities and possibly exacerbating the financial risk created by such events.

Some portions of this debate (such as the true impact of CDS’s on corporate insolvency) continue to play out in the realities of Chapter 11 economics.  Other portions (such as the continued viability of the Bankruptcy Code’s “safe harbor” rules) are beginning to work themselves – albeit slowly – into legislative proposals.

Within the last 30 days, Florida’s Sen. Bill Nelson has offered a brief, 2-page amendment to the proposed financial reform legislation now working its way through the US Senate.  In essence, the amendment would strip the “safe harbors” out of the Bankruptcy Code, ostensibly “leveling the playing field” for all creditors.

For its simplicity, the amendment – which has no co-sponsors – has provoked still further discussion amongst academics.  Seton Hall’s Steve Lubben commends it as a good “first step” toward amending the Bankruptcy Code, but believes further compromise is necessary (his proposed compromises are outlined here).  Harvard’s Mark Roe says, in an updated research paper, that the amendment deserves “central consideration” in connection with financial reform legislation.

In light of the tumultuous economic events of 2008 and 2009, a number of proposals for significant bankruptcy reform have surfaced – many of which have been summarized on this blog.

One of last year’s posts focused on the ongoing debate over the impact of credit derivatives on failing companies, and on the continued usefulness of Bankruptcy Code provisions designed to insulate the financial markets from the bankruptcy process.

Last week, Harvard’s Mark Roe added to that discussion with a paper entitled “Bankruptcy’s Financial Crisis Accelerator: The Derivatives Players’ Priorities in Chapter 11”

The essence of Professor Roe’s proposal is set forth at p. 3:

Although several of [the Bankruptcy Code’s safe-harbor super-priorities for derivatives and repurchase agreements] are functional and ought to be kept, the full range is far too broad. Most are more likely to destabilize financial markets than to stabilize them and most need to be repealed.

Professor Roe’s thoughtful analysis is a worthwhile read.

With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.

Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.  His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.

As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.  Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”

In particular, Ray covers the “pros and cons” of this approach.

The floor is yours, Ray.

Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

The 363 Sale Process

A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

Advantages for the Stalking Horse Bidder

Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

“First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

Disadvantages to the Stalking Horse Bidder

Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

Questions?

Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

Meanwhile, happy hunting.

A significant amount of ink has been spilled in recent months over the state of the financial derivatives markets and their role in 2008’s financial melt-down.

Some of that ink has spilled into the area of corporate insolvency - and in particular, into an examination of whether or not credit default swaps (CDSs) - a type of derivative instrument designed to let a creditor hedge its risk with a debtor – have any impact on the dynamics of work-out negotiations when the debtor experiences difficulty repaying the debt.

This blog has devoted two prior posts (here and here) to the role of CDSs and bankruptcy.  One of the troubling issues raised by researchers (and noted here) in connection with the distressed debt market has been whether or not high-risk investors (i.e., speculators) might be incentivized to buy CDSs on distressed debt, banking on the debtor’s default (akin to “naked short selling” of a company’s stock) on the anticipation that the debtor would fail – thereby triggering a payout on the CDS.  This issue is known more popularly as the “empty creditor problem” – so-called because speculators holding the CDSs issued with respct to a distressed company are not legitimate creditors, but merely risk-takers maneuvering to profit from (and thereby attempting to engineer) corporate failure.

As 2009 draws to a close, the International Swaps and Derivatives Association (ISDA) has stepped into the debate with a recently published research paper on the matter.  Entitled “The Empty Creditor Hypothesis,” the ISDA’s research paper argues – convincingly – that this sort of speculation is far less a problem than some have suggested.  This is so primarily because the pricing on CDSs begins to rise dramatically as the CDS-backed debtor begins to falter.  Therefore, the profits to be made from purchasing such CDSs are, effectively, non-existent – and there is little reason to speculate in them.

The ISDA’s point is that there simply isn’t enough of a profit to be made in purchasing CDSs typically issued on distressed firms – and therefore, insufficient potential payoff to attract the sort of “empty creditors” that have concerned distressed debt researchers.  As a result, the “empty creditor problem” really isn’t a “problem.”

But speculation isn’t the only point of impact that CDSs may have on a distressed debtor’s efforts to negotiate with creditors.  Where the holder of a CDS is also the original lender or the holder of CDS-backed debt, the existence of such derivative securities – which effectively “back-stop” the underlying debt similar to the way in which a fire insurance policy “back-stops” the risk of loss on a building – may incentivize the company’s creditors to be far less flexibile in their discussions with the debtor.

The ISDA attempts to address this potential effect by pointing to a small sample of data available for the research paper, which suggests that during the period that CDS hedging has been available, workouts (i.e., restructuring events) have grown as a percentage of the number of defaults recorded during the same period.  Therefore, “the . . . statistics presented . . . would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”  However, the ISDA admits that

“[a] full analysis of the relationship between [the] likelihood of restructuring and availability of hedging with credit default swaps would require extensive data collection, . . . and is beyond the scope of this note.”

The ISDA’s research paper has received attention – and succinct summaries – from the New York Times, London’s Financial Times, and Reuters.

The ISDA’s suggestion that CDSs have essentially no impact on corporate restructuring smacks of whistling by the graveyard: In fact, the impact of CDSs has been noted, at least anecdotally, in several large corporate bankruptcy filings during 2008 and 2009.  Nevertheless, the precise nature and extent of the “CDS effect” remains to be seen – and is likely fodder for another research paper . . . or five.

Several posts this year – the most recent one here – have noted the general buyers’ market prevalent for strategic buyers shopping for distressed M&A.

A recent CFO.com article drives home the same point, but with more specificity . . . and an important caveat.  Kate O’Sullivan’s piece entitled “Strategic Buyers Still in the Catbird Seat” observes that though overall M&A activity has been off by as much as 1/3 from 2008 levels, strategic buyers closed 94% of this year’s deals.  Strategic buyers appear to have a continued advantage heading into 2010, and – as was the case this year – distressed assets are expected to comprise a significant portion of next year’s deal activity.

However, the current buyers’ market is not necessarily a bargain-hunters’ bonanza.  Though a recent survey by the Association for Corporate Growth (ACG) and Thomson Reuters (summary available here, with statistical summary here) suggests a modest pick-up in transactional volume for 2010, O’Sullivan (citing the ACG data) notes continued constraints on credit and – perhaps more importantly – a fundamental disconnect over valuations buyers and sellers are willing to accept.

Either or both factors may hamper any significant increase in deal volume over 2009, but the ACG survey suggests that pricing multiples may be the sticking point for many deals.  “[M]ultiples for middle-market transactions in general have fallen markedly, from a high of 10.1 times EBITDA (earnings before interest, taxes, depreciation, and amortization) in 2007 to 8.4 times EBITDA today, according to survey respondents. They may go still lower: 80% of respondents say they expect to pay no more than 5 times EBITDA for targets in the next six months.”

Not surprisingly, most sellers will be reluctant to sell at prices reflecting just half the multiple they could have obtained only 36 months ago: “37% of survey respondents cite valuation problems as the biggest hurdle for deals right now.  ‘Sellers try to argue that you shouldn’t look at the current environment when valuing their company, that it’s just a bump in the road.  But buyers are reluctant to buy that argument,’ says [ACG Chairman Den] White.”

What buyers will buy remains to be seen.  Stay tuned for a fascinating 2010.

Prior to the economic downturn – when sales were rising and debt was cheap – many businesses found it convenient to spur further growth by taking on “second-tier” secured financing, or engaging in aggressive leveraged buy-outs (LBO’s).  With the recession and resulting steep drop-off in firm revenues worldwide, many of the same businesses (and LBO targets) found themselves over-leveraged and struggling to service their debt.  First priority lenders have responded to this distress by negotiating exclusively with their debtors for pre-arranged “restructuring” plans that, in effect, provide for the transfer of assets and repayment of the first-priority debt – but provide little, if anything, to “second-tier” lenders and other creditors.

A recent piece from Reuters discusses what junior creditors are doing about it.

As illustrated in recent Chapter 11 cases such as Six Flags Inc., Pliant Corp., and Trump Entertainment Resorts, Inc., junior creditors are attempting to fight back with competing restructuring plans of their own – proposed plans that provide them with better returns, or with a meaningful equity stake in the reorganized debtor. 

A review of the dockets in each of those cases indicates that these efforts have met with varying degrees of success.  The Reuters piece suggests three variables that can impact the success of this strategy:

- Valuation.   Arguably the most critical factor in supporting a plan that competes with one pre-negotiated with the first-priority creditors is evidence demonstrating that the debtor is, in fact, worth more than the first-priority creditors claim.  That demonstration can be challenging, particularly in light of today’s uncertain economy and pricier debt.  Even so, junior creditors are likely to argue credibly that a company whose revenues were historically strong should not be under-valued purely on the basis of weaker performance in a generally weaker economy.  Still other junior creditors seeking to preserve their original position may be willing to advance additional funds, thereby opening up a possible source of financing otherwise unavailable to the debtor.

- The Court.  Concerns such as docket management and the court’s philosophical disposition to maximize enterprise value or protect the position of junior creditors – or not – are factors that have real effect on the success of junior creditors’ bid to present a competing plan.

- Cost-Benefit.  Finally, the presence – or absence – of effective negotiation between the parties can impact the perceived benefit of a competing plan.  When everyone is talking and a plan can be effectively built, a successful outcome is more likely than a full-blown “plan fight” which weighs down the estate with administrative expense and can, if sufficiently large, even jeopardize the debtor’s successful post-confirmation operations.

The purchase of debt on the cheap and subsequent use of activist litigation to seize control of a troubled company, or obtain other economic concessions from the debtor, is a common tactic in Chapter 11 practice.  But it is not without risk – especially when the purchased debt comes with possible strings attached.

From New York’s Southern District last week, a cautionary tale of what can happen when an agressive distressed debt investor presses its luck despite ambiguous lending documents:

ION Media Networks’ Pre-Petition Credit Arrangements and Pre-Arranged Chapter 11.

ION Media Networks Ltd. and its affiliates (“ION”) entered into a series of security agreements with its first- and second-priority lenders during the “go-go” days of 2005.  The documents included an intercreditor agreement setting forth the respective parties’ rights to ION’s assets.

By early 2009, ION was involved in restructuring discussions with the first-priority lien holders.  Those discussions resulted in a Restructuring Support Agreement (“RSA”) by which ION conveyed 100% of ION’s reorganized stock to the first-priority lien holders upon confirmation of a Chapter 11 plan.  In furtherance of the RSA, the ION companies filed jointly administered Chapter 11 cases in May 2009.

Enter Stage Right: Cyrus.

In the meantime, Cyrus Select Opportunities Master Fund Ltd. (“Cyrus”) purchased some of ION’s second-lien debt for pennies on the dollar.  Using its newly acquired stake, Cyrus systematically attempted to interpose itself into ION’s pre-arranged reorganzation:  It objected to DIP financing proposed by the first-priority lien holders, requested reconsideration of the DIP financing order so it could offer alternative financing on better terms, objected to ION’s disclosure statement, commenced its own adversary proceeding for a declaratory judgment, prosecuted a motion to withdraw the reference with respect to two adversary proceedings concerning ION’s FCC broadcast licenses, objected to confirmation, proposed amendments to the Plan to enable it more effectively to appeal adverse rulings of the Bankruptcy Court, and even filed supplemental papers in opposition to confirmation on the morning of the confirmation hearing.

Cyrus’ basic objective in this campaign was quite straightforward.  It sought to challenge the rights of ION’s first lien holders (and DIP lenders) to recover any of the enterprise value attributable to ION’s FCC broadcast licenses.  Its ultimate objective was to leverage itself into economic concessions from ION and the first lien holders - and a hefty profit on its debt acquisition.

Cyrus picked its fight (i) while its position was “out of the money”; and (ii) in the face of an Intercreditor Agreement prohibiting Cyrus from “tak[ing] any action or vot[ing] [on a Chapter 11 plan] in any way . . . so as to contest (1) the validity or enforcement of any of the [first lien holders'] Security Documents … (2) the validity, priority, or enforceability of the [first lien holders'] Liens, mortgages, assignments, and security interests granted pursuant to the Security Documents … or (3) the relative rights and duties of the holders of the [first lien holders'] Secured Obligations . . .”).

Cyrus apparently decided to go forward because, in its view, ION’s valuable FCC broadcast licenses were not encumbered by the first-priority liens that were the subject of the Intercreditor Agreement.  As a result, Cyrus claimed a right to pro rata distribution, along with the first-priority lien holders (who were themselves undersecured), in the proceeds of the purportedly unencumbered FCC licenses.  Therefore, its objections, based on Cyrus’ position as an unsecured creditor, were appropriate.  By the time the cases moved to confirmation, the ION debtors had commenced their own adversary proceeding to determine whether or not Cyrus’ objections were so justified.

Second-Guessing Cyrus’ Strategy.

Cyrus’ game of legal “chicken” was, in the words of New York Bankruptcy Judge James Peck, a “high risk strategy” designed to “gain negotiating leverage or obtain judicial rulings that will enable it to earn outsize returns on its bargain basement debt purchases at the expense of the [first lien holders].”

Unfortunately for Cyrus, its “high risk strategy” was not a winning one.

In a 30-page decision overruling Cyrus’ objections to ION’s Chapter 11 plan, Judge Peck appeared to have little quarrel with Cyrus’ economic objectives or with its activitst approach.  But he was sharply critical of Cyrus’ apparent willingness to jump into the ION case without first obtaining a determination of its rights (or lack thereof) under the Intercreditor Agreement:

Cyrus has chosen . . . to object to confirmation and thereby assume the consequence of being found liable for a breach of the Intercreditor Agreement.  Cyrus’ reasoning is based on the asserted correctness of its own legal position regarding the definition of collateral and the proper interpretation of the Intercreditor Agreement.  To avoid potential liability for breach of the agreement, Cyrus must prevail in showing that objections to confirmation are not prohibited because those objections are grounded in the proposition that the FCC Licenses are not collateral and so are not covered by the agreement.  But that argument is hopelessly circular. Cyrus is free to object only if it can convince this Court or an appellate court that it has correctly analyzed a disputed legal issue. It is objecting as if it has the right to do so without regard to the incremental administrative expenses that are being incurred in the process.

In contrast to Cyrus’ reading of the Intercreditor Agreement, Judge Peck read it to “expressly prohibit[] Cyrus from arguing that the FCC Licenses are unencumbered and that the [first lien holders'] claims . . . are therefore unsecured . . . .  At bottom, the language of the Intercreditor Agreement demonstrates that [Cyrus' predecessors] agreed to be ’silent’ as to any dispute regarding the validity of liens granted by the Debtors in favor of the [first lien holders] and conclusively accepted their relative priorities regardless of whether a lien ever was properly granted in the FCC Licenses.”

Judge Peck further found that because Cyrus’ second-priority predecessor had agreed to an indisputable first-priority interest in favor of the first lien holders regarding any “Collateral,” this agreement also included any purported “Collateral” – and, therefore, prohibited Cyrus’ dispute of liens in the FCC broadcast licenses . . . even if such licenses couldn’t be directly encumbered:

The objective was to prevent or render moot the very sort of technical argument that is being made here by Cyrus regarding the validity of liens on the FCC [l]icenses. By virtue of the Intercreditor Agreement, the parties have allocated among themselves the economic value of the FCC [l]icenses as “Collateral” (regardless of the actual validity of liens in these licenses).  The claims of the First Lien Lenders are, therefore, entitled to higher priority . . . .  Affirming the legal efficacy of unambiguous intercreditor agreements leads to more predictable and efficient commercial outcomes and minimizes the potential for wasteful and vexatious litigation . . . .  Moreover, plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled.

Judge Peck acknowledged case law from outside New York’s Southern District that disfavors pre-petition intercreditor agreements which prohibit junior creditor voting on a Chapter 11 plan or a junior creditor’s appearance in the case as an unsecured creditor.  But these features were not the ones at issue here: Cyrus was permitted to vote, and it could (presumably) make a general appearance as an unsecured creditor.  However, it could not, in this capacity, object to the ION Chapter 11 plan.

Finally, Judge Peck noted that his own prior DIP Order acknowledged the first lien holders’ senior liens on “substantially all the [ION] Debtors’ assets.”  As a result, Cyrus was independently prohibited from re-litigating this issue before him – and couldn’t have done so in any event because it had no standing to raise a proper objection.

Food for Thought.

The ION decision raises a number of questions – about the activist litigation tactics often used to extract the perceived value inherent in distressed debt acquisitions, and about the debt itself.

Was Cyrus overly aggressive in enforcing its purchased position?  Judge Peck suggests, in a footnote, that Cyrus would have been free to raise objections to a settlement between the ION debtors and unsecured creditors by which the unsecured creditors were provided consideration sufficient to meet the “best interests of creditors” test required for confirmation.  But wouldn’t any objection ultimately have raised the same issues as those put forward by Cyrus independently – i.e., the claimed lack of any direct encumbrance on ION’s FCC licenses, and the extra value available to unsecured creditors?

Or perhaps Cyrus wasn’t agressive enough?  For all the paper it filed in the ION cases, shouldn’t Cyrus have concurrently given appropriate notice under its second-priority debt Indenture and commenced an adversary proceeding to determine its rights under the Intercreditor Agreement?

Finally, what of Cyrus’ purchased position?  Was the Intercreditor Agreement truly “unambiguous” regarding Cyrus’ rights?  Didn’t the “Collateral” described and the difficulty of directly encumbering FCC licenses create sufficient ambiguity to trigger an objection of the sort Cyrus offered?  Are “purported liens” the same as “purported collateral“?  And is a distinction between the two merely “technical”?

For distressed debt investors (and for lenders negotiating pre-petition intercreditor agreements), ION Media offers provoking food for thought.

But while you’re thinking . . . be sure to check your loan documents.

The fiduciary duty of directors and officers to the shareholders of their corporation is a fundamental axiom of corporate law.  Almost as familiar is the notion that when a corporation enters the “zone of insolvency”, those fiduciary duties expand to include creditors as well.

What may be far less familiar is determining precisely when the corporation has entered the zone of insolvency – and what to do when it does. 

Where is the “zone of insolvency”?

It has been said that the zone of insolvency is a bit like obscenity:  It’s practically impossible to define . . . but you sure know it when you see it.  It may not be as well known that many businesses transit the zone of insolvency with surprising frequency at various points during their corporate lifecycles.

A recent law review article notes that “between 2000 and 2004, approximately 4% of 6,178 large publicly held companies engaged in merger and acquisition activity that placed over 75% of their assets at risk. Likewise, approximately 467 smaller businesses risked half their assets, and at least 603 smaller businesses risked one-fifth of their assets. Thus directors’ and officers’ fiduciary duties may oscillate between shareholders and creditors numerous times per year depending on the risk-taking strategies in which they engage.”  Jonathan T. Edwards and Andrew D. Appleby, The Twilight Zone of Insolvency: New Developments in Fiduciary Duty Jurisprudence That May Affect Directors and Officers While in the Zone of Insolvency, 18 J. Bankr. L. & Prac. 3 Art. 2 (2009) (citing Anna M. Dionne, Living on the Edge: Fiduciary Duties, Business Judgment, and Expensive Uncertainty in the Zone of Insolvency, 13 Stan. J.L. Bus. & Fin. 188, 191 (2007)).

Add to this the changing nature of financial investments in many companies (which now feature “hybrid” instruments with both equity and debt characteristics) and the dramatic adjustment of multiples and valuations that have occured in the capital markets over the last 12 months, and it is easy to see that the “zone of insolvency” is hardly a bright line.  Instead, it is more akin to a solar flare – it can depend as much upon the corporation’s financial structure and upon market conditions as upon the decisions made by the corporation’s officers and directors.

What to do once you’re there?

When a financially at-risk corporation faces either operational or balance sheet insolvency, its directors and officers may face a variety of unique pressures and challenges.  Among them:

- Time pressure: A corporation with little or no operating liquidity is like a swimmer deprived of oxygen – precious little time remains before everything goes completely black.

- Credit constraint:  The corporation may face an uphill battle for additional, needed credit. Frequently, the only readily available source of cash are parties with close ties to the corporation – i.e., insiders.  And such parties are apt to require advantageous terms in exchange for their incremental risk.

- Anxious stakeholders:  Creditors and shareholders anxious to protect their respective stakes in the corporation are likely to increase their scrutiny of every new transaction, and to “second-guess” anything that might further jeopardize their positions.

Top management’s response to these pressures is well-summarized by the adage that “process rules.”  Because each corporation’s situation calls for a unique set of decisions, and because corporate officers and directors have general duties of care and loyalty to the corporation (and to creditors when the corporation is operating in the “zone of insolvency”), they best protect themselves who ensure that any decision:

- Is advised by (but not delegated to) outside advisors.
- Involves directors who are independent and disinterested.
- Considers shareolders and creditors.
- Documents full, open, neutral and reasonable exploration of available options.

Two very recent articles offer similar advice and summarize some practical tips on insulating directors and officers – or on identifying behavior that may fall short of the fiduciary duties expected of such individuals when a corporation faces troubled times or elevated risk.

Gerard S. Catalanello and Jeffrey R. Manning offer their insights in a recent Turnaround Management Journal piece entitled “A Fresh Look into the Zone of Insolvency,” while Frank Aquila and Peter Naismith provide similar guidance in ”Directing Within the ‘Zone’,” available in Banking Director magazine’s 4th Quarter’s issue.  Each is worth perusal.

When do “zone of insolvency” considerations kick in?  And how frequent are such concerns likely to be in this market?  Catalanello and Manning put it this way:

[G]iven the realities of today’s economy and the capital markets, a company that has debt maturing in the next 18 months is likely to be at least approaching the zone [of insolvency].  If its corporate debt is trading at a material discount (i.e., more than 20 percent discount to par), a company probably is well over that stark demarcation.

Officers, directors . . . and creditors – take note.

A recent study conducted by risk management solutions provider PayNet, Inc. highlights an interesting trend amongst small businesses: Of 750 small business bankruptcy filers owing an aggrate of $58 million, 50 percent were current with one or more of their lenders when they filed.

The study, released at last week’s Equipment Leasing and Finance Association meeting in Southern California and summarized in a recent Bloomberg piece, indicates that borrowers are refusing to telegraph their distress before they throw in the towel. According to PayNet President Bill Phelan, such borrowers “pay and pay and pay, . . . and then they file for bankruptcy.”

The article highlights the increased risk this type of borrower behavior creates for lenders who typically monitor their borrowers’ accounts for any sign of delinquency.  According to Bloomberg, the PayNet study also indicates that most borrowers who sought bankruptcy protection had at least one account in delinquency.  The upshot, according to Phelan (as quoted in Bloomberg), is that lenders who can see how borrowers are performing on obligations other than their own enjoy a better chance of identifying at-risk borrowers:

“Just because you’re getting paid doesn’t mean everything’s OK . . . . It’s not the full picture.”

The loans analyzed by PayNet are typical of those held by very small businesses – the study is based on an an average loan size of just over $77,000.  Taken at face value, Bloomberg’s assessment of the PayNet study suggests many small business owners have grown far more savvy about “strategic defaults.”

As noted, lenders should beware.  And so should vendors and equipment lessors.

Creditors and equipment lessors should pay close attention to trends in accounts payable aging, the recordation of a UCC-1 (if applicable), the presence (or availability) of personal guaranties from principals or other third parties, and the “mix” of goods and services provided (an analysis which may impact the priority of a claim in the debtor’s bankruptcy) . . . among other things.

The small loans addressed by PayNet are indication of a larger trend: PayNet reports that an estimated 100,000 small businesses have sought bankruptcy protection in the last year alone.  This data corresponds with earlier predictions about the anticipated “ripple effect” of larger Chapter 11 filings, reported here.

Amidst the “green shoots” of a claimed economic recovery, “swift and silent” small business Chapter 11’s are something to think about.