When Easy Money Disappears: How Junior Creditors Can Protect Themselves in the Next Downturn
Beginning in 2008, we experienced a worldwide financial crisis that was more severe than any economic downturn since the Great Depression. While financial markets in the United States began recovering in early 2009, economic growth and employment activity have remained anemic. The Federal Reserve’s quantitative easing has provided enormous liquidity which has boosted asset prices, lowered bond yields and made financing available for all but the smallest or most hopeless companies. Deals are getting done at higher and higher EBITDA multiples. Public companies seem to be using easy money to fund stock buybacks and M&A activity rather than reinvesting in their underlying businesses, thereby possibly undermining future growth opportunities. The high yield market is booming amid amazingly low yields and narrow spreads over investment-grade bonds. Yet, default rates continue to remain at or near historic lows. As a result, most companies in financial distress have been able to refinance their way out of trouble. Easy money means that there is a paucity of business bankruptcy filings despite ample evidence of excessive leverage.
Easy money has unleashed a flood of covenant lite debt, leveraged buyouts, dividend recaps, leveraged CLOs and other forms of excess that preceded the 2008 financial crisis. There has also been a proliferation of second lien debt, usually accompanied by inter-creditor or subordination agreements under which the second lien lenders waive many rights, including the ability to oppose actions the first lien lenders may take after default.
Easy Money Cannot Last Forever
Yet, while not predicting an imminent end to current conditions, it is logical to assume that the days of easy money cannot go on forever. At some point, interest rates will rise back to historical norms, whether due to continued tapering by the Federal Reserve of its quantitative easing, a natural reversion to the mean, inflation fears or other causes. Today’s ample liquidity will become less plentiful at some point, if not dry up. When that happens, the excesses engendered by easy money will likely be exposed to cruel market forces. For instance, companies that piled on too much debt during the good times will no longer be able to refinance their way out of trouble and will face default. Easy money may also be permitting companies to put off addressing non-financial issues such as operational and management problems.
Problems Likely to be Encountered in the Next Downturn
As a result of these liquidity-induced excesses, when the next downturn occurs the companies most likely to experience financial distress will probably exhibit some or all of the following characteristics: complex capital structures, excessive leverage, covenant lite debt, fully-encumbered assets with at least two layers of secured debt, inter-creditor disputes, insufficient financing, deteriorating values and operational problems that were not addressed while money was easy. Moreover, holders of covenant lite debt may not be able to declare a default until the issuer fails to make a payment. During the intervening months, the issuer’s finances and operations may continue to deteriorate. Newer capital providers such as CLOs and business development companies probably do not have the infrastructure to address defaults and restructurings. The recent trend toward shorter stays in Chapter 11 may save costs, but allows far less time to fix operational problems.
Companies facing these issues are more likely to end up being liquidated or being forced to engage in a quick sale to preserve what little going concern value remains. Thus, creditor recoveries are likely to suffer in the next downturn. For many over-leveraged companies, the fulcrum security – the level in the capital structure that is partially in and partially out of the money – may be the senior debt, and so even second lien lenders may fail to obtain any recovery from their borrower’s business assets. In fact, it is not uncommon to see a company in financial distress do a deal with its senior lenders that leaves little or no value for junior classes. These deals are often memorialized in a prepackaged bankruptcy filing (“prepack”) or a restructuring support agreement, so that the parties can move more quickly to consummate their preferred transaction and leave less time for junior creditors to organize and oppose the deal.
Possible Strategies for the Next Downturn
However, junior creditors are not without remedies. This article will discuss possible strategies to be employed in the next downturn when junior creditors of over-leveraged companies are faced with restrictions in inter-creditor agreements, covenant lite debt, a quick Section 363 sale, a prepack and other issues that may inhibit recoveries.
Restrictions in inter-creditor agreements are not always as binding as creditors are led to believe. While most courts will uphold most restrictions in inter-creditor or subordination agreements, their restrictions are usually construed narrowly. Thus, most courts focus on the precise language of the restrictions in question and if the agreements are not tightly drafted, their prohibitions may not be enforceable. Moreover, courts will generally not infer that specific conduct is prohibited just because similar conduct is prohibited. In addition, some courts will strike down some restrictions as unenforceable waivers of rights granted under the Bankruptcy Code or as against public policy. For example, some courts have found that the waiver of a creditor’s right to vote on a plan is unenforceable. Careful analysis of relevant documentation may yield loopholes that provide negotiating leverage for creditors who are supposedly out of the money. Junior lienholders may also be able to circumvent waivers or restrictions in an inter-creditor agreement by proposing their own plan of reorganization.
Even holders of covenant lite debt do not have to remain idle while the issuer deteriorates. While they may not be able to exercise remedies under their loan documents, even creditors holding unmatured claims have standing to sue (1) to avoid as fraudulent transfers, or enjoin the payment of, dividends or redemption of stock if the borrower is insolvent, or would be rendered insolvent, and (2) to recover damages from directors or control persons for breach of fiduciary duty if the borrower is insolvent or in the zone of insolvency. While directors do not owe a duty directly to creditors, creditors still have standing to bring derivative actions for breach of fiduciary duty. Short of litigation, creditors can provide written notice to the board and owners that the borrower appears to be in the zone of insolvency and creditors will seek appropriate court relief to rectify or enjoin borrower misconduct. The threat of litigation from well-organized creditors may dissuade self-dealing and other egregious behavior. Moreover, if the borrower also issued more traditional debt instruments (containing the usual covenants, events of default and remedies), which are in default or likely to soon be in default, creditors may wish to consider purchasing such traditional instruments. Creditors can then use a default under the traditional instrument to negotiate appropriate protections that hopefully avoid further losses on the covenant lite debt.
Senior lenders often try to force a quick sale to stanch losses. This may make perfect sense for the company and the senior lender, but may have adverse consequences for junior creditors if the company’s assets are sold at a low point in the industry cycle or when market conditions deter prospective buyers and/or inhibit deal financing. While creditors should not obstruct a sale that is in the best interests of the debtor’s estate, steps should be taken to ensure that value is maximized. Creditors should assess the debtor’s pre-petition marketing effort to ascertain whether it was sufficiently robust and make sure that the proposed bid procedures do not tilt the playing field too heavily in favor of the stalking horse bidder. The claims and liens of the senior lender should be analyzed to determine their validity, perfection and enforceability, as well as whether the liens cover all of the assets that are being sold. Senior lenders will generally have the right to credit bid at a bankruptcy sale, which will likely chill the bidding. However, the right of the senior lender to credit bid may be curtailed if the liens do not extend to all of the assets being sold or if the senior lender engaged in egregious behavior such as orchestrating an inadequate sales process.
Rather than pursue a section 363 sale of the business to the senior lender or other bidder favored by management, the debtor may propose a plan of reorganization supported by the senior lender which provides little or no value to junior creditors. This risk will be exacerbated if the debtor and senior lender negotiate a prepack where the duration of the Chapter 11 case is often measured in weeks, not months or years. Thus, in a prepack, creditors who are out of the money as of the petition date are unlikely to find themselves in the money by plan confirmation. Nevertheless, junior creditors can avail themselves of one or more of the following strategies: try to find an alternative transaction that creates more value to enhance their recoveries; investigate alternative sources of recovery, such as litigation claims, and insist that such claims be transferred to a litigation trust for the benefit of junior classes; consider bringing an action against the borrower’s board of directors for breach of fiduciary duty to dissuade the directors from going ahead with a plan that unfairly wipes out junior classes and gives too much value to senior classes; consider the filing of an involuntary petition before the prepack’s pre-petition plan solicitation process can be completed; try to buy a blocking position in the fulcrum security or any other class that is impaired under the plan if the plan proponent needs the acceptance of that class; sell their position to a distressed investor who is better able to bear the risks and costs of a fight; mount a valuation fight at the hearing on confirmation of the plan; negotiate for warrants or other consideration; and negotiate for and participate in a rights offering.
Even if the senior lender’s liens are not subject to attack, creditors who cannot expect any recovery from the company’s assets should insist that litigation claims be pursued for their benefit by an appropriate estate representative such as an official committee, bankruptcy trustee or plan administrator. For instance, if a dividend recap or other transaction involving insiders was effectuated at a time when the company was insolvent, or if the transaction caused insolvency, then it can likely be avoided as a fraudulent conveyance and directors may have exposure for having approved the transaction. A dividend or stock redemption that occurred while the company was insolvent should be avoidable as a fraudulent conveyance so long as the claim is not time-barred. Experts should be retained to evaluate the solvency of the company at the time of the transaction. Creditors should also ascertain whether directors and officers liability coverage is available, and the terms of any such policies, as well as what due diligence directors undertook before approving the transaction.
Finally, enterprising parties may wish to make lemonade out of lemons by buying the fulcrum security and using it to take control of the debtor’s business at a bargain price. If the senior secured debt can be purchased at a discount from a holder who is experiencing lender fatigue, then (in the absence of unusual circumstances discussed above) the buyer of the senior debt can credit bid at a section 363 sale using the face amount of the secured debt, even though purchased at a discount. This will likely chill the bidding and give the credit bidder a tremendous advantage over other potential buyers. In short, junior creditors who are proactive can minimize their losses and may even be able to garner significant returns if the right debt in over-leveraged companies can be purchased at an appropriate discount.
For More Information
For more information on how these issues may affect your rights, please contact Nicholas F. Kajon at 212.537.0403.
This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.