Creditors renegotiating debt terms should keep a watchful eye on the potential bankruptcy implications of the proposed restructuring, lest the troubled borrower eventually wind up in bankruptcy.
In exchange for certain concessions designed to alleviate the borrower’s financial distress, lenders to troubled borrowers often try to enhance the prospects for full, albeit delayed, repayment by adding co-obligors through affiliate or other third-party guaranties, taking more collateral, and seeking to limit management flexibility in a way that may maximize lender recovery at the expense of other creditors.
However, aspects of the new deal could be unwound by a court if the borrower subsequently files for bankruptcy. Upon filing for bankruptcy, a debtor enjoys certain protections, including an automatic stay under section 362(a) of the US bankruptcy code that enjoins most creditor enforcement activities. Further, under the bankruptcy code, debtors are granted broad powers to reject executory contracts and unexpired leases and to claw back or negate certain transfers made on account of pre-existing obligations or for less than reasonably equivalent value within a certain time period before bankruptcy. In addition, the bankruptcy code grants courts the power to subordinate the claims of a creditor to the claims of other creditors notwithstanding the contractual or statutory priority of such claims.
Accordingly, when negotiating an out-of-court restructuring, lenders should anticipate what may occur if the restructuring fails and the debtor files for bankruptcy.
This article discusses what savvy lenders should know when negotiating for credit enhancements and other lender protections in an out-of-court restructuring.
Promise Not to File
Lenders in debt restructurings often require the borrower to promise that it will not subsequently file for bankruptcy protection. The bankruptcy courts have uniformly refused to enforce covenants not to file, on the basis of furthering public policy in favor of unfettered access to bankruptcy relief.
The bankruptcy laws are designed to promote fairness and facilitate equality of distribution among similarly situated creditors. They establish a priority scheme that sets the order for making distributions to the different types of creditors. They also provide that certain transfers during the runup to bankruptcy may be unwound or “avoided” because they demonstrate a preference toward the recipient creditor at the expense of other creditors.
Lenders should be aware that a transfer that is made by an insolvent company within 90 days of its bankruptcy filing may be set aside by the bankruptcy court. The 90-day period is extended to one year if the creditor is considered an “insider” in relation to the debtor. This could happen if the creditor received more before filing than it otherwise would if it stood in line with the other creditors in a typical bankruptcy proceeding.
A “transfer” includes every mode of disposing of property or an interest in property, including the granting of a security interest. The bankruptcy code does not limit the avoidance of preferential transfers to any specific type of creditor or transfer.
The intention of the parties in making the transfer is irrelevant.
Creditors need to think carefully about whether the restructuring creates payments or deemed payments that could be unwound by a bankruptcy court in the future. Sometimes, as part of a workout, a creditor will require a debtor to make a meaningful payment on the outstanding debt in exchange for a relaxation of terms for the remaining obligation. This payment could be clawed back if the debtor then declares bankruptcy within 90 days. In addition, the grant of new or additional security for an existing loan may be later avoided because, at the end of the day, the additional security will allow the lender to receive more than it otherwise would have in the bankruptcy case.
However, not all preferential transfers are susceptible to being unwound. A creditor has defenses to prevent a preference from avoidance in cases where the creditor is not just restructuring, but extending new or additional credit.
Another important planning point is the substitution of collateral of equal value is generally not avoidable as a preference. Moreover, the granting of an additional lien is not a preference where the lender provides additional loans after the security interest is granted. Lenders must be careful that the restructuring documentation is drafted so as not inadvertently to restart the 90-day or one-year preference period as it relates to preexisting collateral security.
In addition to preferential transfers, the bankruptcy laws permit the avoidance of “fraudulent conveyances.”
In general, a transfer, or an obligation incurred, may be avoided as a fraudulent conveyance in two situations. One is where the debtor made the transfer or incurred the obligation with an actual intention to hinder, delay or defraud creditors. In other words, one must prove actual fraud on some of the debtor’s other creditors. The other is where the debtor received less than reasonably equivalent value for the transfer or new obligation.
In addition, it must also be shown either that the debtor was insolvent at the time of the transfer or the incurrence of the obligation (or becomes insolvent as a result of the transfer or obligation), it retained an unreasonably small amount of capital for the business in which it was engaged, or the debtor intended to incur, or believed it would incur, debts that would be beyond its ability to repay.
Fraudulent transfers made within one year of the bankruptcy may be recovered under federal law. Earlier fraudulent transfers may be recovered under state law depending on the relevant state law reach-back periods.
Lenders should be aware that loan guarantees may be affected by the fraudulent conveyance rules. It is common in out-of-court restructurings for lenders to require a third-party guarantee in exchange for concessions made by the lender. Most often, such guarantees are provided by an affiliate of the borrower. Inter-company guarantees, and other third-party guarantees for that matter, raise fraudulent conveyance concerns because the guarantor may not receive an exchange of reasonably equivalent value in exchange for the guarantee. Reasonably equivalent value does not require that there be an exchange of exactly the same value; it requires substantially equal value.
The guarantees that are least likely to be unwound are those for which the lender can show the guarantor received a tangible benefit. In general, downstream guarantees — that is, from a parent for a subsidiary’s debt — are not avoidable as a fraudulent conveyance because the parent typically benefits from the guarantee in the form of the credit extended to the subsidiary. However, both upstream — that is, from a subsidiary for the parent’s debt — and cross-stream — from a subsidiary for a sister subsidiary’s debt — guarantees are susceptible to avoidance as fraudulent conveyances because the benefit is not always as clear; reasonably equivalent value is not always given to the subsidiary guarantor. Moreover, guarantees extended in the restructuring context may be subject to avoidance on the basis that no new loans were extended and, accordingly, the guarantor did not receive reasonably equivalent value in exchange for the guarantee.
Lenders should also recognize that credit enhancements provided by the borrower’s affiliates in the form of guarantees and collateral security may blur the separateness of the individual firms within the consolidated enterprise in a way that may promote an argument for substantive consolidation in a subsequent bankruptcy of the borrower or its affiliates. In other words, the more that affiliates of the borrower are involved in pre-bankruptcy restructurings, the more likely those affiliates — and their assets — are to be pulled into a subsequent bankruptcy proceeding of the borrower. Bankruptcy courts have the power to ignore the separation between corporate entities that are under common control by pooling the assets of affiliated entities and requiring all creditors to look to the common pool of assets for payment on their claims. The power to consolidate may significantly affect the rights of debtors and creditors and is therefore used sparingly. Therefore, lenders may wish to be particularly skeptical of the ultimate value extended by third parties in workout situations. While lenders should continue to require credit enhancement through inter-company guarantees and collateral grants, they should do so fully aware of their potential vulnerability in a subsequent bankruptcy case.
A final area of caution: A creditor’s claim may be subordinated in bankruptcy to the claims of other creditors under the common law doctrine of equitable subordination. The doctrine has been codified in section 510(c) of the US bankruptcy code. It authorizes a court to subordinate a creditor’s claim to the claims of other creditors in response to certain misconduct that results in harm to the other creditors.
While the bankruptcy code authorizes the equitable subordination of claims, it is silent about when equitable subordination is appropriate. Courts have almost uniformly held that three conditions must be satisfied. First, the creditor must have engaged in some inequitable conduct. Inequitable conduct may in fact be lawful, but regardless of its legality shocks “good conscience.” An example is secret and unjust enrichment caused by unconscionable double dealing.
Second, the misconduct must have resulted in injury to other creditors or confer an unfair advantage to the creditor whose claim is to be equitably subordinated. This factor is satisfied — for example — if the misconduct led to an increase in the misbehaving creditor’s claim or a reduction to the distributions received by other creditors.
Finally, equitable subordination of the claim must be consistent with the principle in the bankruptcy code that there should be equal distribution among similarly-situated creditors. Given its underlying purpose, equitable subordination is remedial in nature and is not intended to punish creditors and, therefore, claims are generally subordinated only to the extent necessary to address a clear harm to innocent creditors.
Collection activity, and by extension efforts to enhance the ultimate collectibility of a loan through restructuring, may under certain circumstances subject a lender to a challenge under equitable subordination. Where a creditor exercises undue control over the debtor’s decision making process, a creditor may be accountable for his actions under a fiduciary standard. However, this should only be a problem in very unusual circumstances. Lenders should not feel constrained to act meekly when negotiating a restructuring.
While we do not advocate that lenders forego the credit enhancements traditionally sought in the context of out-of-court restructurings or tread lightly when dealing with a delinquent borrower, it is important that lenders, when negotiating restructuring agreements, remain mindful of the various bankruptcy risks that may arise if the restructuring does not achieve its intended consequence. Some types of rights for which a lender might negotiate in a debt restructuring are less likely to be set aside in a subsequent bankruptcy than other rights. It is useful to keep in mind the distinction.