Monday, May 16th, 2011
When a retailerÂ becomes insolvent, suppliers or vendors who have recently provided goods on credit typicallyÂ have the ability toÂ assert “reclamation” rights for the return of those goods.Â Retailers may respond to theseÂ rights by seeking the protection the federal bankruptcy laws – and, in particular, the automatic stay.
When a retailer files for bankruptcy while holding goods which are subject to creditors’ “reclamation” rights, what should “reclamation” creditors do?
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The Bankruptcy Code itself provides some protection for “reclamation” creditors by providing such creditors additional time in which to assert their claims, and by affording administrative priority for a certain portionÂ for such claims even when they are not formally asserted.
But is merely asserting a reclamation claim under the Bankruptcy Code sufficient to protect a supplier once a retailer is in bankruptcy?Â A recent appellate decision from Virginia’s Eastern District serves as a reminder that merely speaking up about a reclamation claim isn’t enough.
When Circuit City sought bankruptcy protection in 2009, Paramount Home Entertainment was stuck with the tab for more than $11 million in goods.Â Though it didn’t object to blanket liens on Circuit City’s merchandise which came with the retailer’s debtor-in-possession financing, and stood by quietly while Circuit City laterÂ liquidated its merchandise througÂ a going-out-of-business sale, Paramount did file a timely reclamation demand as required by the Bankruptcy Code.Â It also complied with what it understood to be the Bankruptcy Court’s orders regarding administrative procedures for processing its reclamation claims in Circuit City’s case.Â It was therefore unpleasantly surprised when Circuit City objected to Paramount’s reclamation claim – and when the Bankruptcy Court sustained that objection – on the grounds that Paramount hadn’t done enough to establish or preserve its reclamation rights.
Paramount appealed the Bankruptcy Court’s ruling, claiming that it complied with what it understood to have been the Bankruptcy Court’s administrative procedures for processing reclamation claims.Â Â Paramount argued that to have done more (i.e., to have sought relief from the automatic stay to take back its goods or commenced litigation to preserve its rights to the proceeds of such goods) would have disrupted Circuit City’s bankruptcy case.
In affirming the Bankruptcy Court, US District Judge James Spencer held that the Bankruptcy Code, while protecting a creditor’s reclamation rights, doesn’t impose them on the debtor.Â Instead, a reclaiming creditor must take further steps consistent with the Bankruptcy Code and state law to preserve the remedies which reclamation claims afford.Â Merely asserting a reclamation claim under the Bankruptcy Code – or under a Bankruptcy Court’s administrative procedure – isn’t enough:
“Filing a demand, but then doing little else in the end likely creates more litigation and pressure on the Bankruptcy Court than seeking relief from the automatic stay. . . or seeking a [temporary restraining order] or initiating an adversary proceeding.Â In this case, Paramount filed its reclamation demand, but then failed to seek court intervention to perfect that right.Â As the Bankruptcy Court held, the Bankruptcy Code is not self-executing.Â Although [the Bankruptcy Code] does not explicitly state that a reclaiming seller must seek judicial intervention, that statute does not exist in a vacuum.Â The mandatory stay as well as the other sections of the Bankruptcy Code that protect and enforce the hierarchy of creditors create a statutory scheme that cannot be overlooked.Â Once Paramount learned that Circuit City planned to use the goods in connection with the post-petition [debtor-in-possession financing], it should have objected.Â It didn’t.Â To make matters worse, Paramount then failed to object to Circuit City’s liquidation of its entire inventory as part of the closing [going-out-of-business] [s]ales.”
Let the seller beware.
Tuesday, April 19th, 2011
Title II of the Dodd-Frank Act provides â€śthe necessary authority to liquidate failing financial companies that pose a systemic risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.â€ť
Under this authority, the government would have had the requisite authority to structure a resolution of Lehman Brothers Holdings Inc. – which, as readers are aware, was one of the marquis bankruptcy filings of the 2008 – 2009 financial crisis.
Readers are also aware that Dodd-Frank is an significant piece of legislation, designed to implement extensive reforms to the banking industry.Â But would it have done any better job of resolving Lehman’s difficulties than did Lehman’s Chapter 11?
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Predictably, the FDIC is convinced that a government rescue would have beenÂ more beneficialÂ – and in “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” (forthcoming in Vol. 5 of the FDIC Quarterly), FDIC staff explain why this is so.
The 19-page paper boils down to the following comparison between Chapter 11 and a hypothetical resolution under Dodd-Frank:
[U]nsecured creditors of LBHI are projected to incur substantial losses. Immediately prior to its bankruptcy filing, LBHI reported equity of approximately $20 billion; short-term and long-term indebtedness of approximately $100 billion, of which approximately $15 billion represented junior and subordinated indebtedness; and other liabilities in the amount of approximately $90 billion, of which approximately $88 billion were amounts due to affiliates. The modified Chapter 11 plan of reorganization filed by the debtors on January 25, 2011, estimates a 21.4 percent recovery for senior unsecured creditors. Subordinated debt holders and shareholders will receive nothing under the plan of reorganization, and other unsecured creditors will recover between 11.2 percent and 16.6 percent, depending on their status.
By contrast, under Dodd-Frank:
As mentioned earlier, by September of 2008, LBHIâ€™s book equity was down to $20 billion and it had $15 billion of subordinated debt, $85 billion in other outstanding short- and long-term debt, and $90 billion of other liabilities, most of which represented intracompany funding. The equity and subordinated debt represented a buffer of $35 billion to absorb losses before other creditors took losses. Of the $210 billion in assets, potential acquirers had identified $50 to $70 billion as impaired or of questionable value. If losses on those assets had been $40 billion (which would represent a loss rate in the range of 60 to 80 percent), then the entire $35 billion buffer of equity and subordinated debt would have been eliminated and losses of $5 billion would have remained. The distribution of these losses would depend on the extent of collateralization and other features of the debt instruments.
If losses had been distributed equally among all of Lehmanâ€™s remaining general unsecured creditors, the $5 billion in losses would have resulted in a recovery rate of approximately $0.97 for every claim of $1.00, assuming that no affiliate guarantee claims would be triggered. This is significantly more than what these creditors are expected to receive under the Lehman bankruptcy. This benefit to creditors derives primarily from the ability to plan, arrange due diligence, and conduct a well structured competitive bidding process.
Convinced?Â You decide.
Sunday, July 18th, 2010
A recent post over the July 4 holiday weekend offered a “30,000 foot view” of the 2008 world-wide financial meltdown and offered some broad observations about its causes – and remaining challenges to recovery.
From the Federal Bank of New York last week comes yet another broad overview – this one of the “shadow banking” system that has come to comprise a significant portion of the US’s (and the world’s) financial infrastructure – particularly that of the world financial markets.
In Shadow Banking, researchers Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky describe the financial components of thisÂ ad hocÂ banking system, its role in recent asset bubbles, its brittleness under stress, and the role of the Federal Reserve and other federal agencies in relieving that stress.
As described in the abstract:
The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, â€śshadow banksâ€ť are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.
This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.
We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserveâ€™s discount window, or public sources of insurance, such as federal deposit insurance.Â The liquidity facilities of the Federal Reserve and other government agenciesâ€™ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks.Â Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.
Monday, July 5th, 2010
Last weekendâ€™s July 4 holiday afforded members of the US business and restructuring community an opportunity for reflection on recent economic history.Â Those who took the opportunity to do so would have benefitted from â€śThe Great Recession of 2008-2009: Causes, Consequences and Policy Responses,â€ť a recent discussion paper authored by Sher Verick and Iyanatul Islam and prepared under the auspices of the Institute for the Study of Labor (an independent think-tank associated with the University of Bonn, Germany).
According to the authorsâ€™ abstract:
“Starting in mid-2007, the global financial crisis quickly metamorphosed from the bursting of the housing bubble in the US to the worst recession the world has witnessed for over six decades.
Through an in-depth review of the crisis in terms of the causes, consequences and policy responses, [the] paper identifies four key messages. Firstly, contrary to widely-held perceptions during the boom years before the crisis, the paper underscores that the global economy was by no means as stable as suggested, while at the same time the majority of the worldâ€™s poor had benefited insufficiently from stronger economic growth.
Secondly, there were complex and interlinked factors behind the emergence of the crisis in 2007, namely loose monetary policy, global imbalances, misperception of risk and lax financial regulation.
Thirdly, beyond the aggregate picture of economic collapse and rising unemployment, this paper stresses that the impact of the crisis is rather diverse, reflecting differences in initial conditions, transmission channels and vulnerabilities of economies, along with the role of government policy in mitigating the downturn.
Fourthly, while the recovery phase has commenced, a number of risks remain that could derail improvements in economies and hinder efforts to ensure that the recovery is accompanied by job creation. These risks pertain in particular to the challenges of dealing with public debt and continuing global imbalances.”
Verick and Islamâ€™s work offers an excellent overview for anyone seeking to view economic events of the last two years through a â€świde-angleâ€ť lens.
Monday, May 3rd, 2010
A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11’s.Â Â Perhaps more accurately, the post focuses on Chapter 11’s that could be – but aren’t – formally designated as “Small Business” Chapter 11’s.
Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.Â Anecdotally, Prof. Lawless refers to one of the cases he surveyed:Â a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.
So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?
The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:
– Congress’ 2005 amendments impose additional filing requirements.Â Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.Â One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.
– The “small business” deadlines are too compressed.Â For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.Â This period can, of course,Â be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”Â But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.
– The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.
– Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.
– The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, butÂ which were neverÂ reallyÂ aÂ good idea from a practical perspective.
With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11’s.
But are they always?
It may be that â€śsmall businessâ€ť cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.Â For example:
– Additional filing requirements.Â There may be circumstances where the clientâ€™s non-compliance with income tax filing requirements preclude any â€śsmall businessâ€ť self-designation.Â But most businesses â€“ even troubled ones â€“ can generate a very rudimentary set of financial statements.Â Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.Â It’s worth noting that in Californiaâ€™s Central District, the additional â€śup-frontâ€ť filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trusteeâ€™s Office.Â In one â€śsmall businessâ€ť Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one â€“ though certainly not the only â€“ reason a â€śsmall businessâ€ť filing was recommended for the client.
– Compressed deadlines.Â Part of South Bay Law Firm’s pre-petition planning involves a review of the clientâ€™s â€śexit strategy.â€ťÂ The fundamental question is: What is the clientâ€™s perceived business objective for the contemplated Chapter 11?Â If there isnâ€™t one,Â the client has more fundamental issues to consider â€“ and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.Â If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy”Â are typically reduced to an informal â€śPlan Term Sheetâ€ť which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.Â At South Bay Law Firm, ourÂ experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.Â And with the â€śend gameâ€ť relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.Â ThisÂ is a factor critical to the speed that is so important to an economically successful Chapter 11.
– More reasons for dismissal.Â It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.Â But more often, the real challenge isnâ€™t Section 1112 â€“ or the US Trusteeâ€™s Office.Â Instead, itâ€™s helping the â€śsmall businessâ€ť Chapter 11 debtor focus on the administrative requirements of a Chapter 11 â€“ and in Californiaâ€™s Central District, there are many.Â To that end, the extra discipline required up-front for a â€śsmall businessâ€ť Chapter 11 is, in fact, an important test of the debtorâ€™s ability and willingness to get through the process with success.Â If the debtor canâ€™t even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.
– Itâ€™s all an impractical (though perhaps well-intended) judicial idea.Â For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, btÂ very practical â€“ at least in the larger scope of Chapter 11 economics.Â But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner),Â their result –Â docket efficiency and speed of administration â€“ are both great sources of judicial pleasure.Â The judicial clerkship experience resident at South Bay Law Firm attests that there really is noÂ better way to make friends with everyone behind the bench than making their job easier â€“ even if the job is just a tad bit harder on counsel’s end.Â We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a â€śjump ballâ€ť in front of the person wearing the black robe.
All of this may be very interesting, but how does it implicate the law firm business model?
Only this way: In an industry predominated by an â€śhourly feeâ€ť pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and â€śweeds outâ€ť many candidates unsuitable for Chapter 11 â€“ â€śsmall businessâ€ť or otherwise.Â This, in turn, has the effect of making â€śsmall businessâ€ť Chapter 11â€™s generally quicker and cheaper â€“ and therefore potentially less profitable, at least from an â€śhourly feesâ€ť point of view.Â It also tends, at least initially,Â to restrict or limit overall client “volume.”
However, it also has the effect of creating a relatively well-defined â€śproductâ€ť which is potentially salable to a larger segment of troubled small businesses.Â And a larger overall market segment means a larger absolute number of â€śsmall businessâ€ť debtors who are possessed of the discipline and determination to reorganize their businesses successfully.
Sunday, December 20th, 2009
Several posts this year – theÂ 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.Â 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.Â 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.Â Though a recent survey by the Association for Corporate Growth (ACG) and Thomson Reuters (summary available here, with statistical summaryÂ 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.Â “[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.Â ‘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.Â But buyers are reluctant to buy that argument,’ says [ACG Chairman Den] White.”
What buyers will buy remains to be seen.Â Stay tuned for a fascinating 2010.
Monday, November 30th, 2009
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.Â 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 luckÂ 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 lendersÂ during the “go-go” days of 2005.Â 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.Â 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.Â 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.Â Using its newly acquired stake, Cyrus systematically attempted to interpose itself into ION’s pre-arranged reorganzation:Â 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.Â It sought toÂ 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.Â Its ultimate objective was to leverage itself into economic concessions from ION and the first lien holdersÂ – and a hefty profit on its debt acquisition.
Cyrus picked its fight (i) while its positionÂ 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.Â Â 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.Â Therefore, its objections, based on Cyrus’ position as an unsecured creditor, were appropriate.Â By the time the cases moved to confirmation, the ION debtors had commenced their own adversary proceeding to determine whether or not Cyrus’ objections wereÂ 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.Â Â 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.Â 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.Â 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.Â 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,Â 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 . . . .Â At bottom, the language of the Intercreditor Agreement demonstrates that [Cyrus’ predecessors]Â 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).Â The claims of the First Lien Lenders are, therefore, entitled to higher priority . . . .Â 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 . . . .Â 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.Â But these features were not the ones at issue here: Cyrus was permitted to vote, and it could (presumably) make a generalÂ appearance as an unsecured creditor.Â 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.”Â 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?Â 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.Â 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?Â 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?Â Was the Intercreditor Agreement truly “unambiguous” regarding Cyrus’ rights?Â 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?Â Are “purported liens” the same as “purported collateral“?Â 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 . . .Â be sure to check your loan documents.
Monday, November 9th, 2009
The fiduciary duty of directors and officers to the shareholders of their corporation is a fundamental axiom of corporate law.Â 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 doÂ when it does.Â
Where is the “zone of insolvency”?
It has been said that the zone of insolvency is a bit like obscenity:Â Â It’s practically impossible to define . . .Â but you sure know it when you see it.Â 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.”Â 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 bothÂ 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.Â Instead,Â 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 financiallyÂ at-risk corporation faces either operational or balance sheet insolvency, its directors and officers may face a variety of unique pressures and challenges.Â 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:Â 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.Â Â And such parties are apt to require advantageous terms in exchange for their incremental risk.
– Anxious stakeholders:Â 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.”Â 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 inÂ “Directing Within the ‘Zone’,” available in Banking Director magazine’s 4th Quarter’s issue.Â Each is worth perusal.
When do “zone of insolvency” considerations kick in?Â And how frequent are such concerns likely to be in this market?Â 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].Â 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.