/>iA debtor can obtain exit financing by issuing debt or equity, or both. Many debtors feel that they are at the mercy of the credit markets when it comes to negotiating an exit facility. However, with proper foresight and planning, a debtor can substantially improve its prospects for obtaining successful exit financing.
Whenever possible, a corporate borrower should begin working with its restructuring advisers on exit financing even before entering Chapter 11. Many companies have been able to formulate a plan that includes exit financing before commencing the Chapter 11 case, which partially explains the rise in the use of prenegotiated and prepackaged plans under Chapter 11. Such plans can dramatically improve the likelihood that a company will emerge from Chapter 11 and can also minimize the time spent in bankruptcy. If a corporate borrower is in distress but has the cash available to delay a Chapter 11 filing, the borrower can maximize its chances of survival by preparing for the negotiation of an exit facility as early as possible, thereby putting itself in a position to take advantage of the short-term (and perhaps long-term) cycles in the credit markets. Of course, not every distressed borrower has the luxury of time, and many borrowers will find themselves negotiating an exit facility after entering Chapter 11.
Regardless of the amount of time that the borrower has, the financing process will require the debtor to juggle the conflicting interests of the parties involved. For example, a typical shareholder has a long-term perspective and will want to put the company’s cash to work on strengthening the business. On the other hand, prepetition creditors who risk not being paid in full will attempt to grab as much cash as they can, and the idea of investing in the business and using cash for acquisitions or capital expenditures, for example, will not be palatable to them.
Aside from obtaining credit that meets the debtor’s needs and has terms that are feasible for the debtor to fulfill, obtaining the firmest financing commitment possible under the circumstances should be one of the debtor’s primary objectives of the negotiation.
Debt
Issues in Traditional Exit Financing Facilities
The most common and perhaps simplest form of exit financing is the issuance of secured or unsecured debt by entering into an exit facility with one or more lending institutions. When evaluating these options, a debtor must first consider the amount and types of unencumbered assets that will be available post-confirmation and the state of the credit markets at that time.
In many respects, the terms and conditions of an exit financing facility are not much different than those of a traditional credit facility outside of bankruptcy. However, there are some unique considerations to take into account when negotiating an exit finance facility, such as the importance and effectiveness of best efforts and material adverse change clauses. In most lending scenarios, even outside of bankruptcy, a lending commitment comes with conditions that must be fulfilled before the loan is actually made. In the context of exit financing, where many of those conditions involve the bankruptcy case and other contingencies, these clauses are the subject of much negotiation and sometimes litigation.
“Best Efforts” vs. Committed Financing
In a committed financing, the arranging or agent lender commits to fund the entire amount of the loan and assumes the syndication risk itself. Such commitments are relatively rare for Chapter 11 exit financing. It is more common for the arranging lender to commit to fund less than the entire amount of the facility, if anything at all, and pledge its commercially reasonable “best efforts” to syndicate the remainder of the facility so that it is funded on time.
If the financing is committed, then the lender assumes the risk that the credit markets will not be favorable for funding the facility on the effective date of the plan; in a best efforts scenario, the debtor assumes that market risk.
Where a plan is predicated on nothing but a best efforts pledge to syndicate an exit financing, a court may not even set a confirmation hearing, let alone confirm the plan. Among other things, such a plan would not satisfy the feasibility test because there is no certainty at all that the debtor will be able to fund its commitments under the plan.
The benefits for the debtor of committed financing are that the debtor has the certainty of financing, thus making its plan more likely to pass the feasibility test, and also that the interest rate is likely to be capped, so that a debtor can lock in a favorable interest rate.
Of course, committed financing will often carry fees that make it more expensive than a best efforts agreement. In addition, even in a committed financing, the commitment will likely contain a market material adverse change clause or material adverse effect clause, or both. Usually, the market material adverse change clause is rooted in the credit markets and allows the lender to avoid its funding commitment if the credit markets are unfavorable on the proposed funding date. On the other hand, a material adverse effect clause is linked to the debtor’s performance.
High-Yield Debt Offering
In recent years, it has become more common for Chapter 11 debtors to go to the high-yield markets for part or all of their exit financing. Issuances of high-yield debt (also referred to as non-investment-grade debt or speculative-grade debt) are on the rise in exit financing, a trend likely to continue in the near future because of the attractive terms available in that market. Traditional exit financing can be difficult for some debtors to obtain under tightened lending standards. In addition, the prevailing low interest rates for traditional commercial loans are driving investors to the high-yield markets, where there is a much better rate of return. These drivers of supply and demand are the primary reasons for the increase in high-yield exit financing.
Benefits and Considerations
High-yield exit financings provide numerous benefits. For borrowers, the financing is longer in term than that usually provided by traditional lenders and it is often free of maintenance covenants that subject the borrower to periodic financial tests. For lenders, the financing has call protection to protect the upside of the investment and can have a first or second priority lien to protect the downside. Call protection generally prohibits a debt issuer from prepaying the debt early on in the life of the maturity. The financing can either be fully committed or subject to best efforts.
There are some disadvantages to high-yield exit financings. The financing will require an escrow that involves complex negotiations and can make the plan of reorganization somewhat inflexible. In the long term, the call protection provided to the lenders can make it difficult for the reorganized debtor to refinance if the credit markets become more favorable. In addition, the fees and interest related to the length of the escrow period can be considerable.
Bridge Loan as Commitment to Fund High-Yield
Although there are only a handful of examples, it is possible to obtain a commitment for a high-yield exit financing. The commitment is usually in the form of a bridge loan that will be funded in the event that the issuer is unable to raise all of its financing in the high-yield markets. While the fees and costs associated with a bridge loan commitment can be significant, the commitment can be a powerful hedge against the short-term volatility of the high-yield markets and can provide a powerful argument to the court that the plan is feasible.
Typically, the bridge loan will have a maturity of one year and will contain some type of requirement that the reorganized debtor revisit the high-yield markets before maturity. If high-yield notes are not issued post-confirmation, then at maturity the bridge loan will likely roll over to a new note upon maturity.
The bridge loan will carry a commitment fee that is typically funded on the date of financing, whether the financing is completed with the high-yield or the bridge financing. If the high-yield is placed successfully, then this fee should be the only incremental cost of the unused commitment. If the debtor must avail itself of the bridge loan commitment, then there will also be a funding fee. During the life of the bridge loan, the reorganized debtor will incur administrative fees and a rollover fee, if a rollover occurs.
Rationale and Use of Escrow Issuer
Outside of bankruptcy, escrows are not typically employed in a high-yield financing. Instead, the investors simply fund on the closing date. However, if the issuer is a Chapter 11 debtor, then the investors will not release any funds to the debtor until the court approves the high-yield financing and the confirmation order is final and non-appealable. The reason is that if funding is made directly to the debtor and the court does not confirm the plan, then the investors may not be able to retrieve the funding from the bankruptcy estate. On the other hand, a court is far more likely to approve a financing arrangement and confirm a plan if the exit financing is already funded.
The establishment of an escrow issuer is the solution to this issue. The Chapter 11 debtor establishes a nondebtor escrow issuer, which is a bankruptcy-remote entity that will take the funds into escrow and issue the debt to the investors.
The debtor must make a motion to the court and obtain an order from the bankruptcy court before any investors transfer funds to the escrow issuer. For the debtor to succeed in marketing the strategy to potential lenders and in appeasing lender concerns, the order must state: (1) that the issuer is not a debtor; (2) that the proceeds of the high-yield financing are not included as part of the debtor’s bankruptcy estate; and (3) that the escrow entity will not be consolidated with the debtor until the effective date of the plan. When the plan goes effective, the escrow issuer will merge into the reorganized debtor, which will then have access to the funds and assume all of the obligations for the debt.
Required Bankruptcy Court Approvals
Numerous approvals from the bankruptcy court are required before the Chapter 11 debtor can even establish the escrow issuer and the investors will fund. Motions must be filed to obtain the following:
- Confirmation that the escrow issuer will not be a debtor;
- Confirmation that the escrowed funds will not become property of the estate;
- Authorization for assumption and assignment;
- Authorization to enter into related agreements; and
- Authorization to pay related fees and expenses, and afford them administrativ expense priority status.
If the plan of reorganization is prepackaged or prenegotiated, these motions will likely be filed on the first day of the bankruptcy case and will be fully described in the disclosure statement. Declarations are required from management to satisfy the business judgment test required for some of the approvals. Some of the details of these motions may be filed under seal, if the investment bankers consider the information proprietary.
The debtor must coordinate the bankruptcy approvals with the approach to the high-yield markets and vice versa. The following are the major steps in a high-yield issuance:
The debtor must coordinate the bankruptcy approvals with the approach to the high-yield markets and vice versa. The following are the major steps in a high-yield issuance:
- Requests for proposals to lending institutions with high-yield expertise;
- Develop term sheets with interested institution(s);
- Draft commitment papers, if applicable;
- Draft offering memorandum for issuance of high-yield notes (will somewhat resemble
- disclosure statement);
- Draft escrow agreement;
- Obtain bankruptcy court approvals;
- Draft the description of notes, which will contain the essential pricing terms;
- Debtor’s management team embarks on a “roadshow” to make a pitch to potential purchasers of the notes; and
- The high-yield notes get final pricing and close.
Equity
Aside from or in addition to issuing debt, a debtor can raise financing to exit Chapter 11 through the issuance of equity in the reorganized debtor. In the typical scenario, all of the stock issued by the Chapter 11 debtor is extinguished when the plan of reorganization goes effective and the new investor receives stock issued by the reorganized debtor. One of the primary considerations is whether the debtor receives the investment from an insider or a third party.
New Value Plan
Where an insider, such as a current shareholder of the debtor, wants to make a new investment in exchange for equity in the reorganized debtor, then the arrangement must meet the fairly rigid requirements for a new value plan set forth by the Supreme Court in Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 442, 119 S.Ct. 1411 (1999).
In LaSalle, the Supreme Court held that an equity holder of the debtor could not retain that equity by making a new equity investment and taking stock in the reorganized debtor if the opportunity to invest was given only to the debtor’s current equity holders. The Supreme Court reasoned that the exclusive opportunity to invest in the reorganized debtor must be subjected to some type of market test. In practice, this often means that a competing investor should be allowed to propose a competing plan of reorganization.
Since LaSalle, some jurisdictions have adopted a multipart test for determining whether a new value plan passes muster. The test usually provides that the new value must be:
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In money or money’s worth;
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Necessary to the debtor’s reorganization;
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Reasonably equivalent to the interest retained or received by the equity holder; and
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Provided “up front.”
New value plans often lead to litigation between the debtor’s shareholders and creditors, which can delay a debtor’s emergence from Chapter 11. On the other hand, a new value plan might provide a reorganized debtor the only means to confirm a plan if debt financing is insufficient or not available.
Rights Offering
A rights offering is where current stakeholders of the debtor are given the opportunity to purchase equity in the reorganized debtor. While rights offerings have been employed for many years, such offerings are experiencing a resurgence thanks in part to the beleaguered credit markets.
In a rights offering, a class of creditors or equity holders is offered the right to purchase equity in the reorganized debtor at a fixed price. The number and value of the shares that a stakeholder is entitled to purchase is proportionate to its prepetition stake in the debtor.
Benefits, Considerations and Features of Rights Offerings
A rights offering can encourage plan acceptance by providing stakeholders an opportunity to enhance their recoveries through a new investment, at a discount. A successful offering can also give the court and current and prospective stakeholders of the company optimism that the reorganized company will be successful. The debtor’s equity holders can use a rights offering to protect their original investment from total elimination while avoiding the thorny legal issues arising under a new value plan.
Shares in the reorganized debtor are typically sold at a discount from the assumed enterprise value as a means to entice stakeholders to exercise their option and to take advantage of the exemption from securities laws.
The offering may also provide oversubscription rights, where a stakeholder may purchase more than its pro-rata share if the offering is undersubscribed. The plan can also provide for over-allotment rights where a stakeholder can purchase more than its pro-rata share if the offering is fully subscribed, yet there is still additional demand.
Backstop for Rights Offerings
Backstop commitments are more common for rights offerings than for debt issuances. Typically, a creditworthy group of stakeholders that is interested in obtaining much of the reorganized debtor’s equity will commit to purchasing all of the reorganized debtor’s unsubscribed stock. The debtor will pay a commitment fee and will sometimes agree to a breakup fee as well. Again, while such fees can be substantial, the commitment can help ensure that the debtor’s plan passes the feasibility test.
Exemption from Securities Laws
Section 1145
Under section 1145 of the Bankruptcy Code, the securities issued by the reorganized debtor are exempt from the registration requirements of federal and state securities laws. To qualify for this exemption, the securities must be issued: (1) under a plan of reorganization; (2) by the debtor, an affiliate of the debtor, or a successor to the debtor; and (3) in exchange for claims against or interests in the debtor, or principally in exchange for such claims or interests and partially for cash and property.
In order to satisfy the third prong of this test, the offering must be designed to give the stakeholder a distribution on account of its claim or interest, as opposed to having the primary intent of raising fresh capital for the reorganized debtor. To achieve this, the plan usually provides that the right to purchase new securities at a discount is afforded to the stakeholder in exchange for the prepetition claim or interest.
The closer that the share purchase price is to the value of the prepetition claim, the less likely it is that a court or the U.S. Securities and Exchange Commission will consider that the offer to purchase the new security is “principally” in exchange for the prepetition claim.
Section 4(2) of the Securities Act of 1933
The private placement exemption under section 4(2) of the Securities Act of 1933 can also provide an exemption from registration for securities issued by the reorganized debtor under certain conditions. However, the private placement must be limited to accredited investors to qualify for the exemption, and in many cases not all of the stakeholders within a particular class will be accredited investors. Under section 1123(a)(4) of the Bankruptcy Code, all creditors within a class must receive equal treatment; therefore, in many cases it may not be possible to rely on this exemption.
Common Objections to Rights Offerings
Discriminatory Treatment Within a Class
There are certain objections that arise frequently with rights offerings. First, if the plan offers rights to a class of creditors, then all of the creditors within that class must be afforded the same pro-rata share at the same price. In In re Washington Mutual, 442 B.R. 314 (Bankr. Del. Jan. 7, 2011), the debtor’s plan included a $100 million rights offering to a class of claimants but limited the offering to those creditors who held at least $2 million in claims in that class. While the debtor argued that the primary reason for the threshold was administrative convenience in the context of a plan that was distributing $7.5 billion in assets, the United States Bankruptcy Court for the District of Delaware held that section 1123(a)(4) prohibits discriminatory treatment within a class, even if for alleged administrative convenience. The debtor was forced to eliminate the rights offering and present a modified plan.
Protections for Backstop Providers
The parties that backstop the rights offering will often negotiate enhanced protections for themselves as consideration for the backstop, in addition to the commitment and breakup fees. For example, the backstop parties may negotiate a release of the estate’s Chapter 5 avoidance actions against the backstop parties or may include provisions in the backstop agreement that render the “commitment” illusory. Creditors may object to provisions that they believe are unwarranted under the debtor’s circumstances and market conditions.
Market Test and Valuation Issues
Creditors have also objected to a proposed rights offering on the basis that the enterprise value used to calculate the share price was too low. Such an objection is more likely to arise if the debtor does not market test the offering. One way to diffuse such an objection is to conduct an informal auction for the right to be the backstop party. Managed correctly, such an endeavor should not only yield a rights offering with the highest share price, but also with the lowest fees and strongest commitment terms.
