Several recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions, and also provide guidance to those considering a loan-to-own or related acquisition strategy, in order to help avoid potential pitfalls.
Revised Leveraged Lending Guidance
Three Federal agencies (Federal Reserve Board, FDIC and OCC) issued updated Leveraged Lending Guidance (Guidance) for the financial institutions they regulate in March 2013, revising their original 2001 guidance. Depending upon how the Guidance will be implemented by these agencies, it could lead to important changes in the way acquisition financings are arranged and underwritten. Some changes are already being felt in the market.
In identifying loans likely to be criticized by the regulators, the Guidance points generally to loans to entities whose leverage multiples are above 6 times earnings or which cannot reasonably be projected to be able to repay from its core cash flows at least half of its total debt or all of its senior secured debt within five to seven years, and to covenant-light loans (i.e., loans without periodic financial maintenance covenants).
Many currently outstanding loans covered by the Guidance do indeed fall into one of the categories noted above, and therefore appear targeted for criticism under the Guidance, with still-unknown consequences for regulated institutions and their customers.
Because the Guidance frowns equally on both the origination and holding of criticized loans, some of the traditional arrangers of leveraged loans subject to the Guidance have begun to reconsider involvement in transactions involving criticized loans. The range of methods regulators may employ in enforcing compliance with the Guidance is not yet known, and has exacerbated the issue for regulated institutions.
The Guidance, conversely, has created opportunities for unregulated institutions, not subject to the Guidance, to step into these roles in certain situations. There has been a substantial increase in the volume of leveraged lending by non-bank financial institutions, especially in leveraged lending transactions falling into the criticized categories under the Guidance. The long-term impact of these changes is not yet clear, and in the short term there is a concern that they could potentially reduce the overall availability of credit for certain highly leveraged transactions.
Maximum leverage multiples under the Guidance have also led to some interesting terms in loan documentation. In attempting to follow the letter if not the spirit of the Guidance, some deals have featured unconventionally liberal add-backs to EBITDA calculations in loan agreements in order to achieve formal compliance with the limits on leverage multiples under the Guidance. The reality in such a situation may be that, had more historically customary definitions been employed, the leverage multiples in question would have been significantly higher, and subject to criticism under the Guidance. The Guidance, in not addressing EBITDA parameters but setting a leverage-multiple threshold for loans of concern, left open such avenues, at least until clarified via regulatory rule-making or other official guidance.
Finally, because the Guidance deals with leveraged loans, it may potentially encourage buyers to structure leveraged transactions with a greater portion of the debt taking the form of bonds rather than bank loans, assuming agreeable capital market conditions. Historically, bonds were generally more expensive than bank loans, but their pricing differential has narrowed. To the extent the Guidance will increase the cost of leveraged loans for particular deals, bonds could become a more attractive potential alternative in certain circumstances.
Limits on Credit Bidding
On another front, several recent bankruptcy court cases are relevant to buyers of distressed loans who may be contemplating a potential credit-bid of the loans in the context of a loan-to-own strategy in a bankruptcy setting.
In re Fisker Holdings, Inc.,1 a 2014 Delaware bankruptcy court case, provides support to those who may wish to challenge a secured creditor’s ability to credit-bid the full face amount of its debt in a bankruptcy auction.
The debtors in Fisker manufactured hybrid automotive vehicles and obtained a loan from the United States Department of Energy (DOE) in the principal amount of $168.5 million, which loan was ultimately sold by DOE to Hybrid Tech Holdings, LLC (Hybrid) on a distressed basis for $25 million. The debtors subsequently filed for bankruptcy and sought approval from the bankruptcy court for a private sale of their assets to Hybrid for $75 million, payment to be made by Hybrid via a partial offset against the $168.5 million face amount of debt it held.
The unsecured creditors committee in the bankruptcy case objected to the proposed private sale to Hybrid and asked the court to hold a public auction of the debtor’s assets and to limit the amount of Hybrid’s maximum credit bid to the amount it had paid for the debt. This request was made under Section 363(k) of the Bankruptcy Code, under which a court may, “for cause,” limit the right of a secured party to credit bid.
The unsecured creditors committee based its argument on the premise that capping Hybrid’s credit bid would stimulate a more competitive bidding environment and elicit higher cash bids at auction. The committee also argued that some of the assets to be sold were not in fact subject to Hybrid’s valid and perfected liens, and argued further that Hybrid had attempted improperly to rush the debtor’s sale process.
The court held that Hybrid’s credit bid would indeed be limited to $25 million, stating that a court is entitled to deny or limit the right of a secured creditor to credit bid in order to “foster a competitive bidding environment,” noting that in this case all parties had stipulated that there would be no other bidders at auction if Hybrid’s credit bid were not capped. The court also noted that the proposed private sale had been expedited in a manner that was “inconsistent with the notions of fairness in the bankruptcy process,”2 and that there was therefore sufficient “cause” to cap the credit bid right. The Court did not explicitly state that it was limiting Hybrid’s credit bid to the price it had paid for the loans, although effectively that is what it did.
Shortly following the Fisker decision, another bankruptcy court case also denied a secured creditor the right to credit bid the full amount of its claim. In In re Free Lance Star Publishing Co.,3 a Virginia bankruptcy court addressed the issue of whether a secured creditor’s improper conduct constituted “cause” that would allow the court to limit its right to credit bid.
In that case Free Lance-Star Publishing Co. (Free Lance) had borrowed money from a lender, securing the loan with certain real and personal property. Free Lance made required payments on the loan but breached certain loan covenants, after which DSP Acquisition, LLC (DSP), which had purchased the loan, asked Free Lance to file a Chapter 11 case and sell to DSP substantially all of its assets within the context of the chapter 11 case.
Free Lance asserted that sufficient “cause” existed for the court to limit DSP’s credit bid right. It asserted that DSP did not have a valid and perfected lien on all of the assets to be auctioned, that DSP had pressured Free Lance to agree to an expedited bankruptcy and sale process, and that it had interfered with and impeded Free Lance’s pre-auction marketing of its assets. Free Lance also submitted evidence that the competitive bidding process would be significantly enhanced if DSP’s credit bid were capped.
As in Fisker, the court agreed, holding that the credit bid right may be limited for “cause” in order to foster a more robust and competitive bidding environment in a case in which a secured creditor does not hold a valid and perfected lien on all assets to be auctioned and where the creditor “chilled the bidding process by inequitably pushing the debtor into bankruptcy.”
The court pointed to certain actions of DSP as inequitable, including that DSP began to pressure Free Lance to begin an expedited bankruptcy process immediately after DSP’s purchase of the loan and that DSP had insisted on shortening the sale process and had demanded that Free Lance include explicit reference to DSP’s full credit bidding rights in all its marketing materials for the auction. DSP’s inequitable conduct “frustrate[d] the competitive bidding process,” which dampened enthusiasm in the auction and depressed potential interest in the assets. The court ultimately limited DSP’s credit bid to the value of its perfected liens, as opposed to the larger face amount of its claim.
Of note is that the above two cases arose in different jurisdictions, each running contrary to the more established principle that a secured creditor has the right to credit bid its entire claim amount, notwithstanding the awareness of all parties that this ability may well discourage rival bidders.
Although they do not say so explicitly, the Fisker and Free Lance decisions seem to view the right of a secured creditor to credit bid the full face amount of its claim as potentially akin to a windfall that may accrue to a secured creditor to the extent that the face amount of its claim exceeds a fair valuation of its collateral.
Viewed another way, these two courts seem effectively to divide an undersecured creditor’s claim into secured and unsecured portions for credit-bidding purposes, much as the Bankruptcy Code does for claims allowability generally.4 The secured portion of the claim will equal the value of the collateral and the unsecured portion will equal the balance of the claim. These two courts seemed to imply that the credit bidding of the “unsecured portion” could unfairly promote it to secured status, perhaps because it would offset an auction bid on a dollar-for-dollar basis rather than at the lesser recovery rate to which an unsecured claim would otherwise be entitled in the case, thus transferring value from the debtor and unsecured creditors to the secured party. In dividing an undersecured claim in this way, a recent purchase price paid to acquire a distressed loan may be a convenient proxy for the value of the collateral securing it, thereby avoiding the need for potentially lengthy proceedings to determine its value. The Fisker court may be viewed as inclining toward such an approach.
In light of this, secured creditors desiring to credit bid in a bankruptcy auction may expect to face challenges from unsecured creditors committees and debtors to their ability to credit bid the full face amount of their claims, on a theory that “cause” exists to limit the right, based on alleged improper conduct by the secured party.
Purchasers of distressed secured debt wishing to preserve their credit bidding rights in a future bankruptcy auction should therefore exercise caution and minimize, as far as is practicable, any conduct that might later be deemed to provide grounds to limit their rights. The courts in both Fisker and Free Lance stressed that the secured creditors had interfered with the auction process in ways that dampened prospects for a robust bidding environment. Both courts also indicated that promoting a competitive sale process in itself potentially may justify limiting the right, so the future impact of these cases and their implications for secured creditor rights and conduct are not at this time fully clear. At any rate, secured parties should avoid making arrangements with a debtor that result in a sale of collateral to it in a way that deprives other potential buyers of any opportunity to consider whether to participate in an auction for the assets, or that are otherwise calculated to diminish potential third-party interest in the assets.
Rights of Loan Purchasers in Bankruptcy of Borrower
In another recent bankruptcy court case whose rationale could potentially affect those pursuing a loan-to-own or related strategy, In re Meridian Sunrise Village, LLC,5 the U.S. District Court for the Western District of Washington affirmed a decision prohibiting a buyer of distressed secured loans from voting on the borrower’s plan of reorganization in its chapter 11 case. The court adopted a narrow reading of the term “financial institution” and held that certain loan assignees that were distressed debt investors were not financial institutions, and therefore not eligible assignees under the loan agreement entitled to exercise the rights of lenders in the bankruptcy case. The court did not void the loan transfers, but simply refused to allow the transferees to exercise rights of lenders in the chapter 11 case.
In 2008, Meridian Sunrise Village, LLC (Meridian) borrowed $75 million from U.S. Bank, which subsequently assigned portions of the loan to other banks. The loan agreement required that an eligible assignee be a “commercial bank, insurance company, financial institution or institutional lender” (emphasis added). Meridian later defaulted on its loans and filed a chapter 11 case. In the course of the case, one of the lenders sold its loan to NB Distressed Debt Limited Fund and certain of its affiliates (collectively, NB). Meridian objected to the transfers, arguing that NB was not a “financial institution” and thus not an eligible assignee under the loan agreement. Meridian asked the bankruptcy court to prohibit the distressed funds from exercising their rights as lenders in the case. The bankruptcy court agreed and ruled in favor of Meridian.
On review, the District Court affirmed, reasoning that the term “financial institution” could not be read so broadly as to include any fund or other entity that manages money, since to do so would be to permit assignments to “virtually any entity that has a remote connection to the management of money.” 6 The District Court noted that the distressed fund assignees were not in the business of making loans, and gave additional grounds for its decision based on the conduct of the parties, such as the lenders’ prior requests to the borrower to waive the eligible assignee requirements, which indicated to the court that the lenders had understood the assignee qualification requirements in the same way that Meridian did.
If followed by other courts, the holding in Meridian could potentially, in cases involving similar requirements for eligible assignees, significantly detract from the rights of purchasers of distressed loans in bankruptcy cases. The Meridian decision, however, seems to have been based on particular aspects of Washington State law, which differ from the law in New York and many other jurisdictions in significant ways. For example, the Washington court considered the parties’ loan negotiations history in determining the proper meaning of provisions of the loan agreement. Under New York law, a court likely would not have considered the prior negotiations in light of the unambiguous language of the loan agreement, as well as due to New York’s policy favoring the free alienability of property rights. The impact of the Meridian decision thus is likely to be limited, even in cases in which the relevant credit agreement language employed is similar.
We look forward to updating you on additional developments in the next issue.