Grant, a member of the Distressed Debt Investors Club, pens a piece on the advanced distressed debt concept of pre-petition debt reinstatement. Enjoy!
Some companies currently experiencing financial distress raised large amounts of debt capital on significantly easier terms during the last decade’s “credit bubble” than they could obtain today.
Consequently, debtors currently contemplating or undergoing restructurings sometimes seek to keep existing pieces of debt in place rather than (a) replacing that debt with a new, more expensive facility with potentially tighter covenants or (b) giving concessions to existing creditors who now hold a below-market instrument. “Reinstatement”, or keeping pre-petition financing in place, is contemplated under the Title 11 of the US Code (the “BRC”). Per BRC §1124, for debt to be reinstated it must be unimpaired, meaning the debtor must cure its defaults (with the exception of certain technical defaults such as “ipso facto” clauses declaring the debtor’s bankruptcy to be a default in se) and restore the creditor’s legal, equitable and contractual rights prior to default.
In situations where junior creditors and/or equity holders attempt to impose reinstatement on a senior class, some professionals use the descriptive term “cram up” to distinguish this procedure from the process under which a class is forced to accept a plan in a “cram down” under BRC §1129(b)(2).
Reinstatement and “cram-up” were hot topics in the closely-followed, intensively litigated Chapter 11 bankruptcy of Charter Communications, et al (“Charter”). In late 2008, Charter engaged a Lazard team to engage in intensive pre-bankruptcy planning and negotiations with creditors to avoid a “free-fall” bankruptcy. The ensuing pre-negotiated plan (the “Plan”) included complex arrangements designed to keep $11.8B Charter senior debt unimpaired, and reinstated on Plan confirmation. Importantly, the senior creditors did not participate in the pre-bankruptcy negotiations. Not surprisingly, therefore, the senior creditors objected vociferously to the “cram-up” element of the Plan. While the senior creditors were “paid everything that they are owed under the existing facility and have even received default interest during the [Charter] bankruptcy cases”, they “openly admit that their goal here is to obtain an increased interest rate that reflects what would be charged for a new loan in the current market for syndicated commercial loans.” The senior lenders therefore objected to the Plan and challenged reinstatement by calling attention to a number of alleged defaults under the credit agreement.
On November 17, 2009, Judge James M. Peck rendered a landmark decision ordering the reinstatement of the senior debt. His full opinion can be found here: http://www.kccllc.net/documents/0911435/0911435091117000000000001.pdf.
For those seeking full understanding of the Charter reinstatement, a careful read of Judge Peck’s opinion will prove not only essential but also pleasant: he delivers his conclusions in plain, well-written English. The rest of this article will attempt to summarize his key findings:
One tenet of the senior creditors’ argument revolved around a specific covenant in the credit agreement, Section 8(g)(v), regarding the debtor’s “prospective” ability to pay its debts as they came due. Judge Peck rejected the senior creditors’ argument that (a) Section 8(g)(v) was “forward looking” and (b) Charter defaulted when drawing down an additional $250M under the senior credit facility because it relied on good faith on financial advisors to calculate “surplus”(essentially a valuation test) in making the drawdown. The Judge therefore repudiated the senior creditors’ allegation of a default under Section 8(g)(v) of the credit agreement.
The senior creditors also alleged the Plan caused a change of control, which also would have triggered a default. Judge Peck noted the change of control issue was a “challenging problem” for reinstatement, but ruled against the senior creditors and determined no change of control would occur on confirmation of the Plan. Prior to bankruptcy, Charter had been backed by billionaire Paul Allen. The credit agreement’s definition of “change of control” incorporated the condition that no change of control would occur if Allen held a voting percentage of at least 35%. The Plan incorporated some clever structuring with Allen. Allen would receive nothing for his pre-petition equity; but would receive $375M to retain his voting participation at 35%. Lazard and Charter designed this arrangement specifically to avoid a change of control for two reasons: to (a) effect reinstatement of senior debt and (b) preserve tax benefits. Interestingly, Judge Peck found Charter received an estimated net present value of (a) $3.5B from reinstatement of the senior debt vs. replacing the senior debt with a new facility at market rates, plus (b) $1.14B of tax savings from the preservation of NOLs. Effectively the Plan contemplates the capture by Allen and Charter of billions in value at the expense of the senior creditors and the IRS. Nevertheless, Judge Peck ruled that Charter’s arrangement with Allen did not constitute a breach of the change of control provision, principally because the provision contemplated voting control as opposed to economic control. Judge Peck furthermore rejected the senior creditors’ argument that three bondholders (Apollo, Crestview and Oaktree) working together were a “group” under Section 13(d) of the Securities Exchange Act because the three bondholders did not have an explicit agreement to act as such. Therefore the actions of these bondholders, in Judge Peck’s opinion, did not trip the change of control provision.
The senior creditors also argued that the bankruptcy of some of the holding companies within the Charter structure triggered a cross-default, and acceleration, of a borrowing entity that did not itself enter bankruptcy. The senior creditors argued that this default was not an “ipso facto” clause because it dealt with the cross default of a different entity that went bankrupt in the structure and not the borrowing entity itself. Judge Peck also rejected this argument, ruling Charter to be an “integrated enterprise” and citing documents and behavior patterns that indicate the senior creditors consistently treated the separate entities within Charter as such. Accordingly, Judge Peck ruled the cross-default and acceleration covenant indeed to be an invalid “ipso facto” clause.
Again, the above is a short summary of Judge Peck’s conclusions, and reading his opinion is a great window onto how a bankruptcy judge analyzes issues. With the dollars and principles involved, this matter involved fierce litigation: the first couple pages of the opinion list myriad professionals at some of America’s most prominent corporate and bankruptcy law firms. For the distressed debt investment professional, careful consideration of how courts will rule on reinstatement issues can have drastic implications in assessing value, especially if credit markets do not return to the frothy levels of a few years ago and debtors fight to keep below-market debt instruments in place post-emergence.