Willoughby Law Group, PLLC
Copyright 2010 – All Rights Reserved
Distressed Investors Beware: Use of voter designation and cramdowns to dilute the leverage traditionally enjoyed by strategic buyers of senior secured debt.
One of the fastest and most effective ways to acquire a distressed company is to purchase its senior secured debt. This senior position not only places the acquirer at the top of the capital stack, but its also provides the most flexibility and control, in terms of dictating the liquidation of the company or sale of the assets, either inside or outside of a bankruptcy. In fact, this strategy forms the backbone of the business model of many investment funds and hedge funds that buy debt at deep discounts as a primary acquisition strategy.
However, when the debt piece transfers to a holder that has more of a strategic mindset than the typical lender, this can often create “misalignment” with the traditional notions of maximizing the value of the estate (for all stakeholders). To explain, a strategic buyer of debt typically does not want to be a ”lender” (except to become an owner) or take a long-term debt position. Therefore, such a buyer would presumably object to any reorganization plan that would extend its position as a creditor (even though this might enhance the value of the estate and also the debtor’s chances of accomplishing a successful reorganization). This exact type of conflict was highlighted in the recent Chapter 11 case of DBSD North America.
To explain the “context” of this opinion, this was a chapter 11 case where a bankrupt business (the “debtor in possession”) is either reorganized or sold as part of a plan of reorganization. In those cases, the holder of the senior secured debt must typically approve the plan of reorganization, although it certain cases it can be approved over the creditor’s objection if it provides the creditor the “indubitable equivalent” of its claim (i.e. the proverbial “cram down,” which is separate body of law unto itself). However, in either case, the Senior Secured Lender typically holds a lot of leverage in a bankruptcy court.
In the DBSD case, the acquirer of the senior secured debt was actually a competitor of the Debtor. The competitor acquired the debt in an effort to accomplish a takeover of the Debtor, DBSD. The plan proposed to essentially refinance and extend the senior secured piece, with PIK (equity) dividends in lieu of interest, and with a first lien on the reorganized debtor’s assets (with the notable exception that the debtor’s only liquid assets, auction rate securities, were excluded from the collateral package). The competitor, who had purchased the senior debt at par (i.e. “100 cents” or “no discount”), objected to the plan because it essentially thwarted its acquisition strategy.
The United States Bankruptcy Court for the Southern District of New York took the highly unusual position of “designating” the competitor’s rejected plan vote under Section 1126(e) of the Bankruptcy Code. This rarely used provision allows the court, upon request of a party in interest, to “designate” (essentially, disallow) the vote of any entity “whose acceptance or rejection of the Plan was not in good faith.” In the DBSD case, the court determined that “good faith” was lacking because the competitor was a “strategic buyer” and not simply a creditor voting to further its interest of being repaid. Not only did the court designate the vote as in favor of the plan, the court also went on to hold that the proposed plan treatment could also be approved over the competitor’s objection by way of satisfying the “cramdown” standard of “indubitable equivalent” under 1129(b)(2)(A)(iii) of the Code.
The matter was appealed to the United States Court of Appeals for the Second Circuit. Originally, the Second Circuit issued a stay of the Plan’s effectiveness to “preserve the status quo pending the outcome of the appeal.” However, in summary order issued on December 6, 2010 (with opinion to follow in due course) the 2nd Circuit upheld the vote designation and its resultant, hyper-aggressive treatment to the strategic buyer of the secured debt.
Obviously, this ruling could send a chilling effect through the distressed investing community because it could take away some of the “strategic leverage” traditionally enjoyed by the acquirer of the senior secured debt. However, it is doubtful whether other courts will follow this opinion routinely, because this was a case of “first impression” and the court’s analysis was tied heavily to the specific facts of the case.
More importantly, however, the cramdown aspects of the holding could have equally significant, if not greater, impact to distressed investment funds. After all, the court’s holding that a 1 year note with a blanket security could be swapped for a 4 year loan with a neutered collateral package (and still pass muster under the indubitable equivalent standard) could significantly alter the leverage dynamic and lead to more aggressive cramdown attempts within the confines of a bankruptcy reorganization. We will have to wait on the formal opinion to determine whether this aspect of the holding is specifically endorsed and affirmed by the Second Circuit.
A copy of the second circuit’s summary order can be found at: http://bit.ly/e0Y71A