Global Private Equity Newsletter - Winter 2016 Edition: Recent Developments in Acquisition Finance

by Dechert LLP

Two recent court decisions may result in a broadening of the range of options available to an equity sponsor in respect of an insolvent portfolio company. The first decision may provide increased flexibility in structuring asset sales in certain chapter 11 settings, by utilizing escrows and other techniques to potentially avoid the need to apply asset-sale proceeds strictly in accordance with creditor priorities under the U.S. Bankruptcy Code. The second decision reinforces the principle that the fiduciary duties of directors of an insolvent Delaware corporation run to the entity as a whole and to all its stakeholders, with the result that, even if the directors adopt a business plan whose downside would be borne by creditors but whose upside largely would be enjoyed by equity holders, they generally will not be viewed as having breached their fiduciary duty to the corporation, so long as the business plan was rationally designed to increase profitability and enterprise value and their decisions were informed and made without improper conflicts of interest.

Towards an “Absolute Priority Rule” that’s Less Absolute?

In ICL Holdings Co. v. United States,1 the U.S. Court of Appeals for the Third Circuit affirmed a lower court decision upholding a sale of substantially all of a bankrupt debtor’s assets in a sale under Section 363(b) of the U.S. Bankruptcy Code. Such asset sales, requiring only court approval, can sometimes provide an expedited route for a chapter 11 debtor, as compared to an asset sale pursuant to a plan of reorganization, which entails additional procedural requirements.

In the case, the court permitted payments under the terms of the asset sale and related settlement to be made to pre-petition unsecured creditors and to certain post-petition administrative claimants, while the claims of certain other post-petition administrative claimants were allowed by the court to go unpaid. Notably, these unpaid claims were pari passu with the other administrative claimants who were paid, and were senior to the pre-petition claimants who were paid, in seeming disregard of the absolute priority rule of the U.S. Bankruptcy Code, under which all post-petition administrative claims of the debtor would ordinarily be paid in full prior to any distribution to pre-petition unsecured creditors.

The debtor, LifeCare Holdings, Inc. (LifeCare), developed and operated long-term acute-care hospitals across the U.S. Beginning in 2012, the company began to experience financial difficulty, which it blamed chiefly on Hurricane Katrina that was asserted to have damaged its facilities, as well as on new federal regulations adopted following Katrina that were claimed to have hindered its growth. Its debt grew increasingly difficult to service, leading to a proposed sale process for the company, which failed to attract sufficient interest. Ultimately the highest and best bid was a US$320 million (of the US$355 million secured debt outstanding) credit-bid from its own senior secured lenders for all of LifeCare’s assets, including its cash. The secured lenders also agreed to separately fund escrow accounts that would be used to pay LifeCare’s legal and professional fees, as well as certain wind-down costs (with any surplus escrow funds being required to be returned to the secured lenders). LifeCare entered into an asset purchase agreement with the secured lender group on this basis and then immediately filed its chapter 11 case, requesting court approval for the asset sale.

The U.S. government and the official committee of unsecured creditors in the case each objected to the sale. The government claimed that the sale would result in an administrative claim for capital-gains taxes payable by the debtor that would be unlikely to be paid once the asset sale was consummated and the debtor was left with no remaining assets. Similarly, the unsecured creditors objected on the basis that they would recover nothing, asserting that the asset sale was not in the best interests of the estate. The purchasing secured creditors settled with the unsecured creditors by agreeing to pay them US$3.5 million, via a deposit of funds in escrow. The government was then left in sole opposition to the sale, arguing that the settlement payment to the unsecured creditors, as well as the escrows for the professional fees and wind-down costs, should all be viewed as part of the purchase price for the assets, and thus considered part of LifeCare’s bankruptcy estate, as proceeds of the asset sale, whose distribution would need to comply with the priorities of the U.S. Bankruptcy Code. The government asserted that such priorities were violated, because it was a post-petition administrative creditor on par with the professionals whose fees were being paid via escrow, and because its claim was in fact senior to the pre-petition claims of the unsecured creditors that were paid via the settlement. The Third Circuit Court of Appeals disagreed.

The court found that the settlement payment of US$3.5 million was a direct payment from the secured lenders to the unsecured creditors and never came into LifeCare’s possession, thus never becoming estate property. As the court stated: “Though it is true that the secured lenders paid cash to resolve objections to the sale of LifeCare’s assets, that money never made it into the estate. Nor was it paid at LifeCare’s direction. In this context, [the court] cannot conclude here that when the secured lender group, using that group’s own funds, made payments to unsecured creditors, the monies paid qualified as estate property.”2

The court also found that the payments required under the terms of the asset purchase agreement itself, including those for LifeCare’s professional fees and wind-down costs, also never became estate property. As the court explained, “the secured lender group purchased all of LifeCare’s assets, including its cash, by crediting US$320 million owed by LifeCare to the secured lenders. Thus, once the sale closed, there technically was no more estate property.”3 The court thus, somewhat counter-intuitively, treated these payments by the secured creditors as having effectively been made to themselves (as owners of all assets purchased from LifeCare, which included all residual cash), rather than having been made to the seller of the assets (LifeCare), and thus characterizing them as never having become part of the selling debtor’s estate, despite the fact that under the sale contract such amounts constituted part of the purchase price paid to the estate. 

What this Means for Sponsors

ICL Holdings may provide a path for debtors and secured creditors seeking to bypass certain priority claimants that otherwise may be in line to receive proceeds of a sale of assets in a chapter 11 case. The court seemed willing, at least in this case, to ignore the fungibility of money and to distinguish between purchase consideration paid by a buyer of assets directly to a third party, on the one hand, and payments made by the buyer directly to the selling debtor and then paid in turn by the debtor to the third party, on the other. The court appeared eager to afford flexibility to the debtor and secured creditors in structuring the asset sale and related payments so as to respect the structuring of the transaction under which the relevant funds were never received directly by the debtor, and thus to characterize such payments as never having become estate property.

It may be that this decision will be limited in its impact and followed only in situations presenting similar fact patterns, namely in contexts involving substantial pressure on all parties to quickly effectuate an asset sale (given that the ICL court may have had no palatable alternative, as a liquidation of the debtor’s hospitals might have led to sudden and numerous patient discharges at a time of deep administrative insolvency of the debtor; closing of the debtor’s hospital facilities may have been the only alternative to approval of the asset sale transaction in question).

The question remains as to how much leeway a bankruptcy court within the Third Circuit might allow going forward, given this decision. That the Third Circuit includes Delaware makes this question all the more important. Would a lower court follow ICL’s reasoning to allow, for example, under any set of facts, receipt of substantial value by pre-petition equity holders of a debtor, while pre-petition unsecured debt remains unpaid, if the payments are so structured so as to be “direct” to the former equity holders and designed to never to pass through the estate? Such a result would seem exceedingly doubtful, as ICL could immediately be distinguished on the ground that no payments to equity holders were at issue in the case. The flexibility afforded by a court in following the reasoning of ICL would presumably be tempered by the overall fairness of the terms of a particular Section 363(b) sale and the relevant facts, to ensure that the result not be overly offensive to the expectations of various stakeholders. Yet, the ICL court seemingly was signaling some additional measure of flexibility.

It is reasonable to anticipate that, in light of ICL, the trend to use Section 363(b) sales to expedite reorganizations will continue to accelerate, certainly within the Third Circuit. Unsecured creditors may be advantaged as well, as they may have increased incentives to raise objections to a proposed asset sale, in the hopes of receiving a negotiated payment that may include amounts that otherwise, under the Bankruptcy Code’s priority rules, may have gone to certain administrative creditors. The possibility that a court will uphold a structured distribution to pre-petition unsecured creditors from funds that otherwise would have gone to pay an administrative claimant is likely to be the most direct potential result of the ICL decision, and the deviation from the Bankruptcy Code’s priority rules that a court in the Third Circuit may be most inclined to countenance under the right set of circumstances. 

Supporting Director Discretion in Maximizing Enterprise Value

A recent decision by the Delaware Court of Chancery confirms the broad discretion of the directors of a distressed Delaware corporation in determining the best future strategic course for the business. So long as creditors’ bargained-for contractual covenants are not violated and the directors have fulfilled their duties of care and loyalty to the corporation, they will have broad latitude in adopting business plans that maximize value for all stakeholders. Even when the entity is in the "zone of insolvency" or even if it is insolvent, its directors will be allowed broad discretion in pursuing rational business plans seeking to maximize equity value, even through strategies that could put the remaining value of the entity at risk, a risk borne predominantly or totally by creditors in a distressed context.

Quadrant v. Vertin4 involved Athilon Capital Corp. (Athilon), a seller of credit protection to financial institutions in the credit default swap market, which wrote credit default swaps on senior tranches of debt portfolios. Its credit default swap business struggled in the wake of the financial crisis of 2008. By 2010, Athilon had become arguably insolvent on a GAAP basis, and its board of directors decided to implement a modified business plan, involving investments in an expanded class of assets. Athilon had sufficient assets to satisfy the holders of the company’s senior bonds, if it had chosen to liquidate at such time. There were no provisions in its charter or any other governing documents prohibiting a change in business strategy or requiring a liquidation. Quadrant Structured Products Company, Ltd. (Quadrant) purchased certain of the senior and junior bonds in 2011 and filed suit in the fall of 2011 challenging the payment by Athilon of certain ordinary course fees to an affiliated asset manager, interest paid on certain notes held by Athilon affiliates, and the change in business strategy on the grounds of breach of fiduciary duty. Quadrant brought a derivative claim on behalf of Athilon against Athilon’s board of directors, asserting that the directors had breached their fiduciary duty to Athilon, among other claims.

Quadrant had acquired Athilon’s bonds at a substantial discount, hoping that Athilon would liquidate and pay par or close to par on the outstanding bonds or that Quadrant could force the liquidation. Quadrant also asserted that adoption of Athilon’s new business strategy jeopardized Quadrant’s potential recovery and thus, it asserted, constituted a breach by Athilon of its duty of good faith and fair dealing owed to Quadrant, even if the same did not violate the terms of any specific contractual covenants running in Quadrant’s favor under its bond indenture with Athilon. Quadrant alleged further that Athilon’s prior elective payments of cash interest on its junior debt (which was held by its sponsor and included a PIK-toggle feature that Athilon had declined to exercise) had drained cash from Athilon. In later filings, Quadrant also claimed that Athilon’s purchase in 2013 from its sponsor, at or below fair value, of certain of its junior debt had improperly siphoned off cash from Athilon, which more properly should have been directed towards satisfying Quadrant’s bonds. Finally, Quadrant asserted various fraudulent transfer theories, on the basis that liquidity was improperly drained from Athilon, either intentionally to defeat debtholders’ claims or otherwise improperly.

The court found as a technical matter that Quadrant lacked standing to bring a breach of fiduciary duty claim against Athilon’s directors, since at the time such claim was brought Athilon was in fact solvent, and rejected Quadrant’s other claims as well. In sweeping dictum, the court declared that “[g]enerating returns for equity holders is the opposite of a fiduciary wrong; it is the purpose of a for-profit entity.”5 The court cited the prior Delaware Supreme Court decision in Gheewalla6 for the principle that, when creditors of an insolvent corporation assert a breach by its directors of their fiduciary duty to the company, the directors’ duty is owed to the entity as a whole and to all its stakeholders, and not to its creditors alone.

The court also stated that Quadrant had “failed to prove any entitlement to relief under what should be its primary source of protection: the express terms of the Senior Indenture.”The court noted that creditors may protect themselves through the terms of their negotiated agreements with borrowers. Had the indenture in question, for example, included a covenant limiting Athilon’s ability, while Quadrant’s bonds were outstanding, to make payments on or to acquire its junior debt, or to make payments on its debt owed to affiliates, then Quadrant would have had the contractual protections it was asking the court impose for its benefit. In rejecting Quadrant’s fraudulent transfer claims, the court noted that Athilon had purchased the junior notes in question from its sponsor at or below fair value, and had not acted with intent to defraud creditors. 

What this Means for Sponsors

Quadrant reiterates the applicability of the kind of broad protection afforded by the business judgment rule in respect of the fiduciary duties owed by directors of a Delaware corporation that is in the zone of insolvency or even insolvent. So long as the directors have made informed decisions with no improper conflicts of interest, and the entity has not breached its contractual covenants or engaged in fraudulent transfers, their business decisions should not be second-guessed by a court, as long as they are reasonably designed to increase the value and success of the business.


1) In re ICL Holding Co., 802 F.3d 547 (3d Cir. , 2015).

2) Id. at 555.

3) Id. at 557.

4) Quadrant Structured Prods. Co. v. Vertin, No. 6990-VCL, 2015 Del, Ch. Lexis 266 (Del. Ch. Oct. 20, 2015).

5) Quadrant Structured, 2015 Del. Ch. 266, at *4.

6) North Am. Catholic Educ. Programming Found. Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).

7) Quadrant Structured, 2015 Del. Ch. 266, at *43.


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Dechert LLP

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