Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

In recent months, there have been several bankruptcy court decisions that are significant to secured lenders.  Here's a write-up of some of them, prepared by my bankruptcy colleagues here at Reed Smith.  Some of the issues addressed in these cases include proper perfection of security interests, the rights of second lien holders (also covered in this prior post), the role of stalking horse bidders, and a situation where a 363 asset sale didn't work out as planned for the secured lender.  Happy reading!

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Credit bidding has become a really hot issue recently.   For those of us who don't normally work on bankruptcy matters, the right to credit bid is an important right that secured lenders usually have in a bankruptcy proceeding.  If you're the senior secured lender and you want to buy the company's assets in a bankruptcy sale, you can show up at the auction and, instead of bidding cash, you can place credit bids.  A credit bid is basically an offer to give up part (or all) of the secured claim you have against the company -- i.e., amounts the company borrowed from you and didn't pay back -- in exchange for the assets.  

The senior secured lender's right to credit bid in an asset sale has come under question recently.  In the well-publicized Philadelphia Newspapers (pdf) case, the secured lenders were actually prohibited from credit bidding in the asset sale.  Last week, the lenders bought the company's assets anyway, by paying cash. 

The Philadelphia Newspapers case is significant because it seems to be the first time an appellate court has decided that secured lenders don't have a right to credit bid the amount of their loans in a sale under a Chapter 11 plan of reorganization.  It's important to note that this case was from the Third Circuit, which includes Delaware -- where a lot of companies choose to file for bankruptcy.  That said, it's also important to note that this case applies only to sales under plans of reorganization, and not to "363 sales" (under Section 363 of the bankruptcy code) or UCC Article 9 asset sales outside of bankruptcy.  Still, this changes the game for secured lenders, at least in that part of the country.  A right you would have expected to have in bankruptcy appears to be gone, at least for now.

Several suggestions have been offered for what to do about this.  For example, if you have a borrower in bankruptcy (and if it's not too late), you can try to include provisions in a DIP financing order (or in a cash collateral order) requiring that the secured lenders be given the right to credit bid.  You can also try to require that an asset sale be conducted as a 363 sale and not under a plan of reorganization.   For more details about the Philadelphia Newspapers case (and a longer list of suggestions for what to do), take a look at this summary.

Since credit bidding has been the subject of so many recent bankruptcy cases, we'll continue this thread next time, talking about issues that come up when you have a syndicated loan and want to credit bid for the assets, but not all the lenders agree. 

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With the increase in corporate bankruptcy filings over the past year, there have been some interesting bankruptcy court decisions that affect those of us on the front end in corporate lending.  One recent case took up the question of whether a second lien is truly second -- and whether it is safe to expect that the terms of your intercreditor agreement will be enforced.  

In an intercreditor agreement, the senior lender will usually require that the junior lender waive several of its rights, including

• the right to challenge the validity or priority of the senior lender's liens, and
• the right to oppose a plan of reorganization supported by the senior lender. 

The intercreditor agreement in the ION Media case, as is common for an agreement of this type, included a broad waiver of these and other rights.  In the agreement, the junior creditor agreed that its rights to the company's assets would be junior, and the relative priorities of the lenders' claims would not be affected or impaired by "any nonperfection of any lien purportedly securing" any of the senior obligations.  However, in the bankruptcy case, the junior creditor took issue with these terms, and argued that some of the assets weren't "collateral" as defined in the intercreditor agreement -- so the waiver should not apply.  The bankruptcy court disagreed, deciding instead to enforce the waiver as written. 

When we draft these kinds of waivers in intercreditor agreements, this is exactly the type of situation we are trying to address:  if it turns out that there's a problem with the senior lender's lien (perhaps liens as to some of the collateral don't appear to have been properly perfected, for example), the junior lender is still supposed to remain in the junior position.  These terms help  ensure that the senior lender actually receives the benefit of its senior position.  And this agreed-upon allocation of risk affects many other elements of the lending relationship for both creditors -- including loan pricing.  Junior creditors typically receive significantly higher rates of return than senior lenders, due to the higher level of risk they take on.

Until now, we were pretty sure that all these provisions worked, but we didn't have the benefit of a published case on point.  It is helpful for both junior and senior creditors to have more certainty here.

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On Wednesday, I spoke at an international conference on microfinance.   The conference was a veritable United Nations, with representatives from the microfinance community around the world in attendance.   We even had those little earpieces for language translation.  My role at the conference was to discuss how loans and workouts are done in corporate finance, and whether there are differences in lending to microfinance institutions (covering just the institutional loans this time, not the microloans the institution makes to its individual clients).   I was surprised to find many similar issues, despite the sometimes vastly differing circumstances.  

Is there anything that we, in the corporate finance world, can learn from microfinance lending?  

1.  Use intercreditor agreements.   Workouts involving microfinance institutions highlight the  importance of using intercreditor agreements among lenders.   It's very common for a microfinance institution to have received loans from several different creditors, some domestic and some international, but all without any intercreditor arrangements in place.   One person I met was from a microfinance institution in Eastern Europe that is running into some financial issues.  She's trying to address those issues with ten lenders who each have differing views and approaches.  The lack of a common understanding among the lenders as to what to do in this situation creates problems for the lenders themselves, as well as for the borrower institution. 

2.  Use similar loan documents whenever possible.   When several lenders make loans to a single borrower, it becomes all the more vital that the terms of the loans match up.  Borrowers and senior secured lenders sometimes insist on this approach in corporate lending, but this hasn't happened much (yet) in microfinance.  Microfinance institutions often find themselves with loan documents that contain a wide variety of covenants and terms - each one different from the last.   Several institutional borrowers at the conference mentioned that keeping track of (and complying with) eight or ten different sets of reporting requirements takes up time and resources that would be better spent serving the institution's clients.  Trends toward standardization of loan documents and the increased use of syndicated loan structures may help with this issue over time.

3.  Defined legal structures make a big difference.  Microfinance loan workouts can be significantly complicated by absence of the legal structures that we take for granted in the US and Western Europe.  Several countries don't have Chapter 11-like procedures for bankruptcy -- or if they do, the process isn't always available to microfinance institutions, especially nonprofits.  In many places, it isn't legally possible to obtain a perfected security interest in accounts, which are the primary assets a microfinance institution is likely to have.  Even if you do have a security interest, your priority over other creditors isn't assured.   Also, the entire process can be affected in unexpected ways by local political events and regulatory changes.  Though we are occasionally surprised by bankruptcy court decisions in the US, we benefit from relative certainty as to who has priority and how the legal process will treat our claims.

Borrowers and creditors all over the world, in microfinance and in corporate finance, share many of the same concerns.   We have much to learn from each other.

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This post was written by my partner Ben Brimeyer, a member of the Financial Industry Group in Reed Smith's Chicago office.

In today's challenging economic climate, private equity sponsors are trying to figure out how to fill funding gaps in acquisition financings -- and how to provide additional capital to their troubled portfolio companies.  In lieu of providing additional equity, some sponsors are requesting the ability to participate as a lender in the senior debt facilities of the portfolio company.  Also, on occasion, it's the lenders who need to find someone to take a piece of a new loan, and the equity sponsor is the only one standing by ready to do so.

If the lenders decide to allow the sponsor to become a lender in their debt facilities, what steps should they take to best protect themselves, given the different hats this new lender will be wearing?

Voting rights. Given the sponsor's ability to control the borrower, the sponsor should not have the same set of voting rights available to the other lenders.  The sponsor should have the ability to protect its investment, but should generally be a silent participant, without the ability to interfere with actions the lenders may need to take.  The sponsor’s commitment should be removed from the calculation of required lenders, and the voting terms should provide that the vote of the sponsor won’t be required other than for a very specific set of items (typically 100% vote issues):

• Increase the commitment of the sponsor-lender
• Reduce the interest rate on the sponsor-lender's loans
• Reduce the principal amount owing to the sponsor-lender
• Change the pro rata treatment of the loans
• Subordinate the loans

Information/Meetings. It is important to ensure that the sponsor, as both the equity owner and a lender, does not have the same access to information, rights to attend bank group meetings and ability to require action by the agent as the other lenders have.  In this regard, the sponsor-lender should not be allowed to:

• Require the agent or any lender to take any action or exercise any remedy
• Attend any meeting between the agent and the lenders to which the borrower is not invited
• Receive any information or communication from the agent or any lender that is not sent to or by the borrower (i.e., shared among the lenders only) 
• Provide information obtained in its capacity as a lender to any member of management of the borrower

Bankruptcy. In a bankruptcy, the sponsor-lender’s interests differ significantly from the rest of the lenders, since the sponsor as equity owner receives a different set of rights. To protect the lenders from actions which may be taken by the sponsor-lender in a bankruptcy, the sponsor should agree not to impede any actions being taken by the agent, so long as the sponsor-lender is being treated equally with the other lenders.  The sponsor-lender should also agree that its vote in bankruptcy shall be cast in the same proportion as that by the other lenders, which results in the sponsor essentially being dragged along proportionally to the votes of the other lenders. This is particularly important if the sponsor-lender will hold more than one third of the debt, providing a potential blocking position on issues requiring a lender vote in a bankruptcy.

Allowing the sponsor to participate in the senior loans may be essential to completing a transaction or providing a portfolio company with additional liquidity.  It can be done, but with careful consideration of the challenges it presents to the rest of the lender group.
 

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When closing a leveraged buyout, if the buyer makes its payments to the company’s shareholders through a financial institution - even in an acquisition of a privately held company - those payments may be protected from being clawed back in a bankruptcy. 

The Quality Stores Case

A recent federal case involving Quality Stores Inc. was decided in favor of the shareholders on appeal, permitting them to keep the payments they received for their shares when the company was acquired.  This has long been the case for public company acquisitions, but now the rule has been extended to private companies as well.

The sale price for the Quality Stores acquisition was paid to the shareholders through a financial intermediary, who distributed the cash to the shareholders in exchange for their shares. The court found that use of the financial intermediary for payment and settlement was sufficient to entitle the shareholders to the protections of Section 546(e) of the Bankruptcy Code. This means that the payments cannot be unwound, and the cash cannot be pulled back into the company to be accessed by the company’s creditors.

What This Means For Financial Institutions

On one hand, it seems odd that the mere use of an intermediary would create such a result, when there is nothing else different about this transaction from most others.  Steve Bobo, who is one of my bankruptcy partners here at Reed Smith, has been watching this case for some time.  He recently explained that the exemption exists to protect financial institutions (i.e., the intermediaries) from instability and risk.  But, as Steve also points out, this particular transaction had no economic or substantive difference from any other private LBO.  The shareholders got paid for their stock just like in any other acquisition.

For financial institutions that act as intermediaries in settlements like these, this is good news. There is additional certainty that once you’ve transferred the funds to the shareholders, they can stay there.  However, for financial institutions that act as senior creditors, the fact that these funds cannot be brought back into the bankruptcy estate means there may be less cash from which you can have your loan repaid, and you have less likelihood of recovery.  Whether you cheer or decry this decision depends which side of the table you’re on in any particular deal.

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