When a private equity portfolio company faces distress, private equity firms and restructuring professionals work together to identify strategic alternatives. These may include asset sales, internal restructurings, refinancings, debt exchanges and other types of workouts that are intended to create enough time and liquidity to support a turnaround effort. In the last several years, however, that work has become more challenging, particularly in light of some recent court activity that makes out-of-court restructurings more difficult and, in some instances, presents liability risks for directors, officers and private equity sponsors.
Does this mean that out-of-court restructuring is no longer a viable option for distressed portfolio companies? Of course not. Many factors can come into play in any deal, and the consummation of an out-of-court workout may be business-optimal and the right thing to do. Moreover, private equity firms and their professionals can reduce execution risk and mitigate the risk of liability when pursuing out-of-court restructurings by: understanding the potential risks in a given transaction; employing commercially practical strategies in light of such risks; and adhering to smart and careful corporate governance principles. This article seeks to provide a road map for improved execution of workout transactions by briefly summarizing the recent court activity relating to out-of-court restructurings and pointing out some key best-practices in light of recent developments.
Current Court Activity Relating to Workout Transactions
In 2015, decisions issued by the U.S. District Court for the Southern District of New York in cases involving transactions by Education Management Corporation1 and Caesars Entertainment Corporation2 broadly interpreted minority bondholder protections under Section 316(b) of the Trust Indenture Act of 1939 (the TIA) and, as a result, cast doubt on out-of-court debt restructurings previously thought to be allowed under that statute.
Section 316(b) provides that the right of any holder to receive payment of principal and interest and to institute suit for enforcement of such payment “shall not be impaired or affected without the consent of such holder.” Restructuring professionals, and the broader lending community, traditionally understood this provision to stand for the non-controversial concept that “core terms” like principal, interest rate, and maturity cannot be changed without 100% bondholder consent. The Education Management and Caesars decisions, however, imply a broader view that would require 100% consent from bondholders even for amendments that leave these core terms legally intact but impair the practical likelihood that the debt will be repaid. In those cases, transactions that were otherwise permitted under the terms of the applicable indentures, such as the release of affiliate or parent guarantees and the transfer of assets to a newly formed entity, were found to violate Section 316(b).
Since the Education Management and Caesars decisions (which are currently on appeal), minority bondholders have filed several copycat class action lawsuits in the Southern District of New York attacking exchange offers by financially challenged companies, particularly when the offer was only open to qualified institutional buyers (“QIBs”) and not retail investors. Recently, the U.S. District Court for the Southern District of New York dismissed one such lawsuit against Cliffs Natural Resources Inc. by distinguishing the Education Management and Caesars cases, noting that the transaction at issue (an offer for QIBSs to exchange unsecured bonds for secured bonds) did not dispose of any assets, amend any terms of the indenture, or modify or remove any guaranty3. This ruling, while comforting, likely will not be the last on the subject, and litigation involving Section 316(b) will likely continue to develop.
In addition to TIA litigation, an important cautionary note was sounded this past spring when an examiner appointed in the Caesars bankruptcy cases issued an 1,800 page report analyzing several complex restructuring transactions consummated by Caesars Entertainment Operating Company and certain of its affiliates in the years before their bankruptcy, identifying numerous weaknesses in the execution of those transactions and flagging many areas of potential liability for the parties involved. The Caesars transactions had extended maturities, amended credit agreements, reduced debt and transferred assets to affiliates either directly or indirectly controlled by their parent company and/or its private equity sponsors. With respect to some of these actions, the examiner’s report concluded not only that the company likely could unwind the transaction, but that there were likely actionable claims against several parties, including the parent company and its directors and sponsors, for (1) actual or constructive fraudulent transfers, (2) breach of fiduciary duty and (3) aiding and abetting breach of fiduciary duty. Those parties disputed the examiner’s conclusions and subsequently entered into a settlement in connection with Caesars’ chapter 11 plan of reorganization, which remains subject to bankruptcy court approval.
Each of these scenarios – the cases spawning TIA litigation and the other Caesars transactions – involved unique factual circumstances that may not be directly replicated. Nonetheless, they demonstrate the current litigious environment surrounding out-of-court restructurings, and together they have created uncertainty that increases both execution risk and litigation risk in workouts.
Best Practices for De-Risking Workout Transactions
In light of the recent developments, private equity firms and their professionals should consider employing the following practices (among others) to help determine the correct structure for pending workout transactions, and ultimately help insulate those transactions from challenge:
- Establishing a Robust Decision-Making Process. When considering a restructuring transaction, parties should create a thorough record that documents in detail both management’s and the board’s deliberations and the business rationale for the deal, including the impact of the transaction on each applicable entity (as well as that entity’s creditors, if it is insolvent). Conflicts of interest should be fully disclosed and considered and, where appropriate, transactions should be approved by disinterested, independent directors or special committees. Boards of directors should consider, and seek advice from professionals regarding, whether private transactions should be subject to a market check in which other parties have an opportunity to participate.
- Understanding and Carefully Evaluating Insolvency. It is critical that parties truly understand whether a company is solvent at the time a restructuring is consummated, as solvency may implicate both director duties and the practical ability to close the deal. A company must pass three tests to be considered solvent: (1) does the fair value of its assets exceed its debts (the “balance sheet test”), (2) can it pay its debts as they become due in the ordinary course of business (the “cash flow test”) and (3) does it have adequate capital for the business that it operates (the “capital adequacy test”). All three tests must be passed, and parties should be careful to avoid alternative rationales, such as equating solvency with a lack of a “going concern” qualification in a borrower’s financials.
- Avoiding Mistaken Identity of Interest. In order to follow correct board process and create a record that will demonstrate, even in hindsight, that directors acted appropriately, the transaction must be considered on an entity-by-entity basis and must be approved using appropriate corporate process for each entity that will participate. Where a parent corporation and its subsidiary are solvent, there is generally an identity of interest because actions that benefit the subsidiary also benefit the parent through improved enterprise value. In that case, a streamlined approval mechanism and combined board record can often be used. However, if the subsidiary becomes insolvent, this identity of interest disappears. The directors and officers of the insolvent subsidiary still owe their primary fiduciary duties to the subsidiary, but the creditors of the insolvent subsidiary, not the parent or its shareholders, are the residual stakeholders, and such creditors may assert derivative claims on behalf of the subsidiary for breach of fiduciary duty. The interests of the insolvent subsidiary’s creditors may not always be aligned with the interests of the solvent parent and its shareholders, and the board records should reflect that these considerations were taken into account.
- Avoiding Over-Reliance on Fairness Opinions. Boards should obtain professional advice when analyzing restructuring transactions, including consideration of the fairness of the deal, viable alternatives, potential risks, and the likelihood of achieving the desired result. However, parties should recognize that formal “fairness opinions” or “solvency opinions,” in and of themselves, may not insulate transferees of assets from liability, or directors and officers if the “entire fairness” standard applies to review of the decision-making process (i.e., directors and officers are found to be conflicted, thus requiring scrutiny beyond the normal business judgment rule). In any event, fairness or solvency opinions should be prepared by fully informed advisors and then tested to confirm they are based upon reasonable projections and methodologies.
- Remaining Mindful of TIA Compliance Opinion Issues. Decision-makers evaluating a transaction should act early to identify and resolve any roadblocks that may occur, such as difficulty in obtaining legal opinions needed for closing. The recent TIA decisions have unsettled practitioners’ prevailing understanding of Section 316(b) of the TIA and, in some cases, caused hesitation among law firms to provide certain legal opinions that are necessary in debt exchanges. To address this issue, 28 law firms published a collaborative white paper in April 2016 intended to provide guidance for opinion givers4. Pursuant to the white paper, absent unusual circumstances, a law firm should be able to give a clean legal opinion to a trustee in connection with proposed amendments to one or more “non-core” terms (i.e., not payment terms) of an indenture, including amendments to material covenants, either: (1) outside the context of a “debt restructuring” or (2) in the context of a debt restructuring where the opinion givers have receive satisfactory evidence that the issuer will likely be able to make all future payments of principal and interest to non-consenting noteholders when due after the proposed transaction. What exactly constitutes a “debt restructuring” and what factual evidence can support an issuer’s ability to make payments when due may vary from case to case, but as evidenced by Education Management and Caesars, opinion givers will pay particular attention to transactions that involve the release of material guarantees or substantial collateral, or transfer of significant assets to entities that will not provide ongoing credit support to dissenting bondholders.
Workouts continue to present difficult challenges for private equity sponsors and their portfolio companies seeking solutions to financial distress. And yet such transactions are often preferable to more costly and protracted in-court alternatives. Given the current legal landscape, private equity firms and their portfolio companies should actively consult their professional advisors to help them proactively mitigate risks and see the deal through.
1 Marblegate Asset Mgmt., LLC v. Education Mgmt. Corp., 111 F. Supp. 3d 542 (S.D.N.Y. 2015).
2 BOKF, N.A. v. Caesars Entertainment Corp., 144 F. Supp. 3d 459 (S.D.N.Y. 2015); MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entertainment Corp., 80 F. Supp. 3d 507 (S.D.N.Y. 2015).
3 Waxman v. Cliffs Natural Res., No. 16 Civ. 1899, 2016 U.S. Dist. Lexis 168933, at *18 (S.D.N.Y. Dec. 6, 2016)
4 Debevoise & Plimpton LLP is among the law firms that authored the TIA white paper and was involved at all stages of its negotiation and drafting.