‘Stalking-Horse Lenders’ Must Proceed With Caution in Chapter 11 Cases

Acquisition of companies in bankruptcy has become prevalent and perhaps the model in Chapter 11 cases.  But potential purchasers need to be aware of several pitfalls. I will address some of them here, and discuss others during our upcoming Webinar - Chapter 11 Reorganization:  Hot Topics & Industry Perspectives - hosted by LexisNexis on Oct. 19, 2010 (see more info at the end of this post).

We've seen an increase in very quick sales and the emergence of what I call "stalking horse" lenders, operating in a way referred to as the "loan to own" model.  These include situations where the parties either lend into companies with the expectation that they may take them over if there is a default, or specifically purchase debt at various levels of a company's capital structure with the expressed intent of taking  over the debtor company. 

Recently-decided cases indicate a possible  backlash against some of these tactics, presenting a number of risks that  purchasers - particularly stalking-horse lenders or loan-to-own lenders - need to be aware of. 

One important case that will have staying power is In re DBSD North America, Inc.*, 421 B.R. 133 (Bankr. S.D.N.Y. 2009), aff'd 2010 WL 1223109 (S.D.N.Y. Mar. 24, 2010) from the United States Bankruptcy Court for the Southern District of New York,  an opinion written by Bankruptcy Judge Robert E. Gerber.  This, of course, is one of the two most influential bankruptcy courts in the U.S. so I expect the decision to be precedential.  As noted above, Judge Gerber's decisions were affirmed by the District Court and have now been appealed to the Second Circuit Court of Appeals, which will address the issue as one of first impression.

The issue in DBSD involved the debtor's plan of reorganization that was about to be voted on.  A  competitor and potential purchaser of the debtor's assets acquired senior debt at par primarily to defeat the proposed plan of reorganization.  Obviously, by purchasing the debt at par the purchaser signaled that it was not trying to make a profit, necessarily, on the debt.  In other words, this was not a debt arbitrage which is often seen in these cases.  This was found significant by the court.  The potential purchaser was rather open that it wished to defeat the debtor's plan and use its newly acquired senior debt position to take over the company or at least acquire its assets. 

The debtor and others challenged the negative votes of the potential takeover party under Bankruptcy Code section 1126 which permits the court to "designate" claims - meaning prohibit or disallow votes on those claims-- based on the absence of good faith of the voting party.  In this case the court found that the potential purchaser had not acted in good faith and designated its claims, thus disallowing the votes. 

The court took additional steps to make sure disallowing the votes did not derail the debtor's plan.  The court specifically held that even though that creditor inhabited a class by itself,  the  class would nonetheless be treated as voting for the plan or be treated as an empty class so that the plan could be confirmed.. 

The moral here is that court made an important distinction between the acquisition of debt for arbitrage purposes to make a profit or a vote by a creditor simply to protect its position as a creditor, and a takeover motive.  The court harkened back to a well-known case called In re Allegheny Int'l Inc.*, 118 B.R. 282 (W.D. Pa. 1990), where a court many  years ago essentially did the same thing - designated votes in order to prevent a takeover attempt by a potential financial acquirer.  Indeed, Judge Gerber emphasized that the competitor "acted to advance strategic investment interests wholly apart from maximizing recoveries on a long position in debt it holds."

And so in terms of future loan-to-own or debt-acquisition cases, this is something that loan-to-own creditors will have to be very careful about, particularly in the plan context, where their votes could be designated, and their attempts to leverage the situation to take over a company  thwarted by vote designation.  Similar grounds could also be used to, for example, limit credit bidding by loan-to-own creditors for "cause".  More on that at the webinar.

* The case links may be accessed by lexis.com subscribers.  Non-subscribers may obtain Research Value Packages by the day, week, or month

Robert Keach is one of the authors of The Collier Guide to Chapter 11: Key Topics and Selected Industries, the latest addition to the Collier line of bankruptcy products from LexisNexis. Written by over 20 bankruptcy lawyers from leading firms, the Guide takes an in-depth look at the key topics involved in current chapter 11 practice and the special issues that arise in selected industries. It fills the gap between the Code-based coverage of Collier on Bankruptcy and the more general topical approach of the Collier Bankruptcy Practice Guide. Visit the LexisNexis Book Store to learn more.   

Collier Guide to Chapter 11 authors will be participating in a free CLE accredited webinar on Tuesday, Oct. 19, beginning at 2 pm ET. Webinar attendees will receive a 20% discount off the Collier Guide to Chapter 11 after the webinar's completion. During the webinar, you will hear highlights from the new publication that will cover topics including issues affecting reorganizations for the retail industry, treatment of hospitals and health care businesses in Chapter 11 and Debtor-in-Possession (DIP) financing in the aftermath of the credit crisis.

Register for the free webinar today.