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.