A key consideration for investors in securities of bankrupt issuers is the extent to which the securities received upon consummation of a Chapter 11 plan will be freely transferable. While the trading restrictions may not change an investor’s determination to, for instance, participate in a backstop arrangement, or to receive an amount of securities that would result in potential affiliate status, the investor’s compliance and back-office functions will be responsible for monitoring reporting and implementing trades, and the potential slip-ups are many and varied. This article provides a high-level overview of recurring situations with which every investor in distressed securities should be familiar.
Section 1145 and Its Availability
Section 1145 is an exemption from the registration requirements of Section 5 of the Securities Act of 1933, under which it is unlawful to offer or sell any security unless a registration statement is in effect with respect to the security, or an exemption from registration is available. It also provides an exemption from the registration requirements of state securities laws. Technically, these exemptions apply only to the issuance of securities by the debtor. However, under Section 1145(c), securities issued in reliance on Section 1145 have the status of securities issued in a public offering. As a consequence, creditors of the debtor that receive these securities can resell them, the same as if they received the securities in an offering registered with the SEC.
In many cases, securities issued under a bankruptcy plan will comply with the requirements of Section 1145, which are principally as follows:
The securities are issued under plan of reorganization.
The securities are issued by a debtor or a successor to a debtor.
The securities are issued entirely or principally in exchange for a claim against a debtor.
The importance of the exemption afforded by Section 1145 can hardly be overstated: it permits debtors to issue securities in connection with a plan to a wide range of creditors without the time and expense of an SEC registration process.
When Section 1145 Is Unavailable
While debtors are typically able to rely on Section 1145 for the issuance of at least a portion of the securities issued in connection with a reorganization plan, there are several situations that are not covered by the statute’s exemptions.
Prepackaged plans. A situation that commonly runs afoul of the “plan requirement” of Section 1145 is when a debtor is fortunate enough to file for Chapter 11 reorganization with a prepackaged plan. In this case, a debtor is deemed to have offered the securities outside of the plan process, since it negotiated the prepackaged plan prior to filing. As a result, Section 1145 is unavailable to the debtor for the securities issued under the plan. The debtor will need to institute procedures to limit the issuance of securities under the prepackaged plan — and depending on the procedures, the offering as well — to accredited investors and otherwise comply with an exemption from the registration requirements, most frequently in reliance on Section 4(a)(2) of the Securities Act.
Rights offerings. Rights offerings, typically accompanied by a backstop arrangement to ensure the offering is successful in raising the desired amount of capital, are a near-ubiquitous feature of the modern bankruptcy process for debtors of any meaningful size. Rights offerings must be viewed through the so-called “principal/partly” test, under which new securities must be issued principally in exchange for a claim against a debtor. The amount of capital to be raised, and the discount to plan value at which the securities can be purchased, will determine whether an entire rights offering will be exempt under Section 1145, or whether the rights offering must be bifurcated between a component that qualifies under Section 1145 and a component that must be conducted pursuant to a private placement exemption.
Backstops. Securities issued in connection with backstop commitments will not qualify under Section 1145, because these securities will not be issued in exchange for a claim. Accordingly, the issuance of securities pursuant to backstop arrangements — whether in the form of fees or simply on account of the backstop function whereby securities not purchased in the rights offering are acquired — will need to be done pursuant to a private placement exemption.
The Resale of Securities by a Creditor
In general, the extent to which securities acquired in connection with a plan are freely transferable will track the availability of the Section 1145 exemption to the debtor. As such, securities issued in exchange for debt securities or other claims against the debtor, as well as securities issued upon subscription for rights in rights offerings that qualify under Section 1145, will be freely transferable, while securities issued upon subscription for rights in nonqualifying offerings and pursuant to backstop arrangements will be “restricted securities” and not freely transferable. Also, securities that would otherwise qualify under Section 1145 are not freely transferable in the hands of an affiliate of the reorganized debtor.
What are the restrictions on affiliates? Securities that qualify for Section 1145 treatment and are freely transferable in the hands of nonaffiliates are “control securities” in the hands of affiliates. This means that the securities must either be (i) sold in private transactions, which can result in a discount because the purchaser will acquire “restricted securities” that are subject to a holding period; (ii) sold pursuant to Rule 144, in which case all requirements of the rule other than the holding period apply — most important, the volume restrictions, but also public availability of information regarding the reorganized debtor, the manner of sale (through a broker or to a market maker) and the filing of Form 144; or (iii) registered by the reorganized debtor for resale, which can be a time-consuming process and take several months post-closing to be completed, even for a willing issuer that has agreed to registration rights.
Who is an affiliate? The determination of whether a former creditor is an affiliate of the reorganized debtor can be complex and uncertain, but frequently is driven by factors such as the beneficial ownership level of the holder and its relationship with members of the board of the reorganized debtor. In particular, in cases where the reorganized debtor will be issuing convertible preferred stock or convertible debt, it is important for an investor to understand the securities law calculations of beneficial ownership early in the reorganization process, as they may result in an equity ownership level well above calculations made on an economic basis.
What are the disclosure obligations of affiliates? The disclosure obligations of affiliates will turn on whether the reorganized debtor will be a reporting issuer under the Securities Exchange Act of 1934. If it is, holders of 5% or more of an issuer’s equity securities will be required to file reports under Section 13(d) of the Exchange Act — on Schedule 13G or 13D, generally depending on whether the holders have passive or activist intentions — and holders of 10% or more of an issuer’s equity securities will also be required to report their holdings and transactions under Section 16(a) of the Exchange Act. In addition, 10% holders will generally be subject to the “short swing” recapture provisions of Section 16(b), which provide for disgorgement of profits on any “matching” transactions within a six-month period. As a result, it is important for investors to coordinate early with their internal compliance functions and, frequently, outside securities counsel, which may be different than counsel advising on the restructuring.
Investors will frequently receive a mix of securities in a reorganization, some of which may be freely transferable and some of which may not be. All securities received by affiliates of a reorganized debtor will be subject to transfer restrictions, but some may be subject to a holding period, while others may be immediately salable under Rule 144. Moreover, due to the potential vagaries of the SEC’s beneficial ownership calculations, investors that are not affiliates, and who may not even view themselves as 5% or 10% holders, may nevertheless be required to file reports under Section 13(d) and/or Section 16. These issues should be discussed with restructuring counsel, securities counsel and an investor’s in-house compliance department during the reorganization process, to ensure that investors understand the status of the securities received and any reporting or other requirements.