Posts Tagged ‘collateral’
Monday, November 8th, 2010
Late last month, the 9th Circuit Bankrpuptcy Appellate Panel clarified earlier precedent and held that adequate protection determinations are entirely within a bankruptcy court’s discretion – and not, as suggested by a number of recent decisions, subject to a “bright line” test of the time when adequate protection was requested.
The facts in People’s Cpaital and Leasing Corp. v. Big3D, Inc (In re Big3D) weren’t in dispute: Big3D, which operated a commercial printing business and leased specialized equipment from People’s Capital (PCLC), encountered difficulties in making its equipment lease payments to PCLC. A series of lease amendments failed to rectify Big3D’s ongoing missed payments. PCLC sued Big3D for breach of contract in Fresno and obtained a prejudgment writ of possession regarding its equipment. Two days later, Big3D was in Chapter 11 protection in California’s Eastern District. Big3D’s bankruptcy schedules assigned PCLC’s equipment a value of $400,000 – about $50,000 more than the amount of Big3D’s debt to PCLC – and acknowledged that PCLC held a secured claim for this amount.
About 6 months passed. Then, in March 2009, PCLC sought relief from the automatic stay – or, alternatively, adequate protection – in Big3D’s bankruptcy case. PCLC claimed the value of its equipment had remained constant at $380,000 from the time of its lawsuit through the date of Big3D’s Chapter 11 case, and thereafter had declined $45,000 in the first 6 months of Big3D’s case “because of adverse economic conditions” – but as of the time of PCLC’s request, was depreciating at an estimated rate of approximately $3,350 monthly.
Though the facts weren’t in dispute, PCLC’s entitlement to adequate protection was. Big3D and PCLC agreed that, moving forward, PCLC should receive adequate protection payments of $3,500 monthly. But the parties were at odds over PCLC’s entitlement to adequate protection for the first 6 months of Big3D’s case, in which PCLC sat by and did nothing to protect its rights.
PCLC cited Paccom Leasing Corp. v. Deico Elect’s., Inc. (In re Deico Elect’s., Inc.), 139 B.R. 945 (9th Cir. BAP 1992), for the proposition that adequate protection should be provided to a creditor as of the time from which the creditor could have obtained its state court remedies if bankruptcy had not intervened. According to PCLC, this was immediately prior to Big3D’s case, since PCLC had already been awarded a writ of possession and was about to foreclose. Therefore, PCLC argued, its $3,500 month was perhaps a good start, but not enough – it should also receive adequate protection payments for the entire first 6 months of Big3D’s case.
The Bankruptcy Court for the Eastern District of California disagreed, instead reading Deico as granting it “discretion to fix any initial lump sum [of adequate protection], the amount payable periodically, the frequency of payments, and the beginning date [of adequate protection], all as dictated by the circumstances of the case and the sound exercise of that discretion.” The Bankruptcy Court focused on PCLC’s acknowledgment that depreciation of its equipment was related to economic conditions – and not to Big3D’s continued use during its Chapter 11 case. It also expressed concern over PCLC’s apparent delay in getting around to seeking adequate protection. In the end, the Bankruptcy Court declined to award PCLC any adequate protection for the first 6 months of Big3D’s case. PCLC appealed, claiming the Bankruptcy Court had abused its discretion.
An en banc Appellate Panel first determined that the Bankruptcy Court had not, in fact, abused its discretion. Specifically, the Panel reckoned that to exercise its remedies, PCLC would have had to take possession of the equipment and sell it for cash. It took issue with PCLC’s claim that a mere writ of possession was sufficient to entitle it to adequate protection all the way through Big3D’s case: “To be entitled to adequate protection, Deico requires that [the creditor] establish both a temporal point at which it would have ‘exercised’ its state law remedies outside of bankruptcy, and the amount the equipment declined in value after that time.” It also accorded weight to the Bankruptcy Court’s observation that PCLC hadn’t been prompt in seeking relief – but had waited for 6 months before seeking adequate protection.
The Panel further determined that, despite a gradual shift in the case law from an early focus on the petition date to a more recent emphasis on the date of the adequate protection request as the time from which adequate protection payments should apply, Deico provides bankruptcy courts with needed flexibility in determining adequate protection for specific creditors in specific cases:
“When a creditor can or could exercise its statutory or contractual remedies to realize upon collateral is an inherently factual determination, but the fact that such a determination can be complicated does not make it unworkable. The discretionary standard adopted by Deico gives bankrupcy courts the needed flexibility to make appropriate adequate protection determinations as provided for in the Bankruptcy Code, based upon the evidence presented by the parties.”
As a result, Deico remains good law in the 9th Circuit. Courts continue to have wide discretion to fashion adequate protection remedies according to the particulars of the case before them. Debtors are without a “bright line” from which to gauge the need to come up with adequate protection payments. And creditors are on notice: It is critical that any request for adequate protection be (i) supported by a thorough brief explaining when – but for the intervention of bankruptcy – state law remedies could have been exercised; (ii) backed by solid evidence detailing the loss of value in the creditor’s collateral; and (iii) on time.
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. 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.
Monday, September 28th, 2009
The bankruptcy blogosphere is replete with commentary on Chrysler LLC’s sale, through Section 363 of the Bankruptcy Code, to a newly-formed entity. The sale, of substantially all of Chrysler’s assets for $2 billion, gave secured creditors an estimated $0.29 on the dollar. Other, unsecured creditors received more. Though challenged, the sale ultimately received the 2d Circuit’s approval in a decision issued August 5.
Was the Chrysler sale proper? Or did it constitute an inappropriate “end run” around the reorganization provisions that ordinarily apply in a confirmed Chapter 11 plan?
Harvard Law’s Mark Roe and Penn Law’s David Skeel tackle this question in a paper released earlier this month entitled “Assessing the Chrysler Bankruptcy.” Roe and Skeel argue, in essence, that there was no way to tell whether or not the sale was proper because the sale lacked valuation, an arm’s length settlement, or a genuine market test (i.e., an auction) – all traditional measures of whether or not secured creditors received appropriate value for their collateral. They then suggest that the Chrysler transaction may portend a return of sorts to the equitable receiverships used to reorganize the nation’s railroads at the end of the ninenteenth century.
Roe and Skeel follow two fundamental strands of thought.
First, they review the basic facts of the Chrysler sale against the context of other so-called “363 sales” and ask where Chrysler fits within this context.
Their answer is that it really doesn’t fit.
Most complex bankruptcy sales (i.e., sales that effectively determine priorities and terms that the Code is structured to determine under Section 1129) are insulated from running afoul of the Code’s reorganization provisions through judicial innovations such as expert valuations or priority determinations, creditor consents, or competitive auctions. According to Roe and Skeel, the Chrysler sale had none of these. Instead,
“[Chrysler's] sale determined the core of the reorganization, but without adequately valuing the firm via [Section] 1129(b), without adequately structuring a . . . bargain [with creditors or classes of creditors], and without adequately market testing the sale itself. Although the bankruptcy court emphasized an emergency quality to the need to act quickly . . . there was no immediate emergency. Chrysler’s business posture in early June did not give the court an unlimited amount of time to reorganize, but it gave the court weeks to sort out priorities, even if in a makeshift way.”
How was the Chrysler sale deficient in these respects?
Though it involved a valuation presented by Chrysler, “the court did not give the objecting creditors time to present an alternative valuation from their experts . . . . Here, the judge saw evidence from only one side’s experts.”
For those who may protest that the Chrysler sale did, indeed, enjoy the consent of Chrysler’s secured lenders, Roe and Skeel argue that the largest of these lenders were beholden to the U.S. Treasury and to the Federal Reserve – not only as regulators, but as key patrons via the federal government’s rescue program. They were, therefore, willing to “go along with the program” – and the Bankruptcy Court was inclined to use their consent to overrule other objections from lenders not so well situtated. On this basis, Roe and Skeel contend that the secured lenders’ “consent” – such as it may have been – wasn’t independent “consent” at all.
Roe and Skeel also point out that the “market test” proposed as a means of validating the sale was, in fact, not a test of Chrysler’s assets, but of the proposed sale: “There was a market test of the Chrysler [sale], but unfortunately, it was a test that no one could believe adequately revealed Chrysler’s underlying value, as what was put to market was the . . . [sale] itself.”
The authors then go on to argue that the sale was mere pretense – and that, in fact, “there was no real sale [of Chrysler], . . . at its core Chrysler was a reorganization”:
“Consider a spectrum. At one end, the old firm is sold for cash through a straight-forward, arms-length sale to an unaffiliated buyer. It’s a prime candidate to be a legitimate [Section] 363 sale. At the other end, the firm is transferred to insider creditors who obtain control; no substantial third-party comes in; and the new owners are drawn from the old creditors. That’s not a [Section] 363 sale; it’s a reorganization that needs to comply with [Section] 1129.
. . . .
[To determine where a proposed sale falls along this spectrum,] [a] rough rule of thumb for the court to start with is this stark, two-prong test: If the post-transaction capital structure contains a majority of creditors and owners who had constituted more than half of the old company’s balance sheet, while the transfer leaves significant creditor layers behind, and if a majority of the equity in the purportedly acquiring firm was in the old capital structure, then the transaction must be presumed to be a reorganization, not a bona fide sale. In Chrysler, nearly 80% of the creditors in the new capital structure were from the old one and more than half of the new equity was not held by an arms-length purchaser, but by the old creditors. Chrysler was reorganized, not sold.”
Was the Chrysler transaction – however it may be called – simply a necessary expedient, borne of the unique economic circumtsances and policy concerns confronting the federal government during the summer of 2009?
Roe and Skeel argue that, in fact, the government could have acted differently: It could have picked up some of Chrysler’s unsecured obligations (i.e., its retiree obligations) separately. It could have offered the significant subsidies contemplated by the deal to qualified bidders rather than to Chrysler. It could even have paid off all of Chrysler’s creditors in full. But it did none of this.
Second, Roe and Skeel consider that “[t]he deal structure Chrysler used does not need the government’s involvement or a national industry in economic crisis.” Indeed, it has already been offered as precedent for proposed sales in the Delphi and Phoenix Coyotes NHL team bankruptcies – and, of course, in the subsequent GM case.
One very recent case in which South Bay Law Firm represented a significant trade creditor involved a similar acquisition structure, with an insider- and management-affiliated acquirer purchasing secured debt at a significant discount, advancing modest cash through a DIP facility to a struggling retailer, and proposing to transition significant trade debt to the purchasing entity as partial consideration for the purchase.
The deal got done.
What’s to become of this new acquisition dynamic? Employing a uniquely historical perspective, Roe and Skeel travel back in time to observe:
“The Chrysler deal was structured as a pseudo sale, mostly to insiders . . . in a way eerily resembling the ugliest equity receiverships at the end of the 19th century. The 19th century receivership process was a creature of necessity, and it facilitated reorganization of the nation’s railroads and other large corporations at a time when the nation lacked a statutory framework to do so. But early equity receiverships created opportunities for abuse. In the receiverships of the late 19th and early 20th century, insiders would set up a dummy corporation to buy the failed company’s assets. Some old creditors – the insiders – would come over to the new entity. Other, outsider creditors would be left behind, to claim against something less valuable, often an empty shell. Often those frozen-out creditors were the company’s trade creditors.”
They trace the treatment of equity receiverships, noting their curtailment in the US Supreme Court’s Boyd decision, the legislative reforms embodied in the Chandler Act of 1938, and the 1939 Case v. Los Angeles Lumber Products decision which articulated the subsequently-enacted “absolute priority rule” (but preserved the “new value exception”). Against this historical background, “Chrysler, in effect, overturned Boyd.”
But with a twist.
“One feature of Chrysler that differed from Boyd may portend future problems. Major creditors in Chrysler were were not pure financiers, but were deeply involved in the automaker’s production.” In cases where the value of the assets is enhanced by the continued involvement of key non-financial creditors, “players with similar [legal] priorities will not . . . be treated similarly.”
Translation: When non-financial creditors are driving enterprise value, a Chrysler-style sale suggests that some will make out, and some creditors – even, on occasion, some secured lenders – will get the shaft.
If accurate, Roe’s and Skeel’s Chrysler analysis raises some significant considerations about access to and pricing of business credit. It raises new concerns for trade creditors. It likewise presents the possibility that the Chapter 11 process – which has, in recent years, tilted heavily in favor of secured lenders – may not be quite as predictable or uniformly favorable as in the past.
Meanwhile . . . it’s back to the future.