Private Equity Alert Sept 09

8/14/2019 Private Equity Alert Sept 09

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Private EquityAlert

September 2009

Weil News

n WeilGotshaladvisedeTelecare

anditscontrollingstockholders,

ProvidenceEquityPartnersand

AyalaCorporation,inconnection

withthebusinesscombination

oeTelecarewithStreamGlobal

Services

n WeilGotshaladvisedMacquarie

Groupinconnectionwithits$428

millionacquisitionoDelaware

Investments,adiversiedasset

managementrm

n WeilGotshaladvisedCCMP

CapitalandBancrotPrivate

Equityinconnectionwiththe

250millionsaleoNowacoto

Bidvest

n WeilGotshaladvisedGMT

CommunicationsPartnerson

theacquisitionotheRoadsideAssetsoTitanOutdoorAdver-

tisingLimited

n WeilGotshaladvisedHMCapital

inconnectionwithitsacquisition

oEarthboundFarms

n WeilGotshaladvisedShowtime

ArabiaanditsparentKipcoGroup

inconnectionwithitsmerger

withOrbitGroup,creatingthe

leadingpay-TVplatorminthe

MiddleEastandNorthArica

Equitable(In)subordinationConsiderationsor

SponsorsLendingtoPortolioCompanies

By Ron Landen ([email protected]), Rose Constance

([email protected]) and Joe Basile ([email protected])

Private equity sponsors are increasingly providing additional capital to their

portolio companies either to address liquidity issues at those companies or as part

o a negotiated debt restructuring. From a sponsors point o view, it is otenpreerable to invest that additional capital in the orm o debt rather than equity.

However, in structuring that transaction sponsors should be aware that the priority

o this debt in a portolio companys capital structure could be attacked by other

creditors i that portolio company ends up in bankruptcy under the theories o

equitable subordination or recharacterization. It is important that sponsors

structure any such investments to reduce the risk o a successul attack on the

priority status o their debt.

Equitable Subordination

Section 50(c) o the Bankruptcy Code provides that bankruptcy courts may

exercise principles o equitable subordination to subordinate all or part o one

claim to another claim. Conceptually, this gives the bankruptcy court power todemote a higher priority claim to a lower priority claim under certain circum-

stances. In some instances, this can convert an otherwise rst priority secured

claim into a general unsecured claim ranking pari passu with all other general

unsecured claims. Although the statutory authority or equitable subordination is

clear, the application is not. However, there are some general principles that can

be applied as a guide in properly structuring a credit arrangement.

Generally, the courts consider three actors in determining whether to equitably

subordinate a claim. These actors are (i) whether the creditor was engaged in

inequitable conduct, (ii) whether the misconduct injured other creditors or gave

an unair advantage to the creditor in question and (iii) whether subordination

would be consistent with the provisions o the Bankruptcy Code. Importantly,insiders are typically held to a higher standard than are unaliated third party

lenders because insiders oten have (and exercise) infuence over management o

the company. This means that a sponsor who is also an equity holder needs to

use extra caution when loaning money to a portolio company. The misconduct

o a creditor does not need to be tied to such creditors claim it can arise out o

other actions by the claimant. In an equitable subordination analysis, the court

considers whether a creditor engaged in inequitable conduct and applies subordi-

nation as a remedy only to the extent necessary to counteract any damage to

other creditors.


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Private EquityAlert September 2009

Weil, Gotshal & Manges llp

The recent bankruptcy case involving

Schlotzkys, Inc. provided a good

illustration o how courts apply these

principles. In that case, the two

largest shareholders each made

separate loans to the company in an

eort to resolve a liquidity crisis. Therst loan was secured by substantially

all o the companys intellectual

property and was structured on arms-

length terms. The second loan, made

seven months later, was secured by

the same collateral package; however,

the bankruptcy court more closely

scrutinized this transaction because it

was approved in a hurried, last

minute board meeting where

management reported that the

company could not make payroll

payments without the loan.

proceeds o the second loan were used

to pay unsecured creditors and

equitable subordination is remedial,

not penal, equitable subordination

was not appropriate. As to the rst

loan, the Court o Appeals ruled that

there was no evidence o misconduct,

so that loan also should not have

been subordinated.

Recharacterization

Recharacterization o a claim occurs

where a bankruptcy court uses its

equitable powers under Section 05 o

the Bankruptcy Code to convert an

otherwise valid debt claim into an

equity interest. Recharacterization is

a highly unusual remedy, but that

does not mean that sponsors can

Bankruptcy Code, recharacterize debt

claims as equity interests.

Courts that consider themselves to

have the power to recharacterize debt

claims as equity interests will exercise

that power when, despite the labelplaced by the parties on the particular

transaction, the true nature o the

transaction is, in the courts view, the

creation o an equity interest. In

pursuing the quest to nd the true

nature o a transaction, most

bankruptcy courts apply a multi-acto

test where no single actor is determi-

native. The actors normally

considered by courts include the

ollowing:

n Undercapitalization. Many courts

view thin or inadequate capital-

ization as strong evidence that

investments are in act capital

contributions rather than loans.

n Inability to obtain similar outside

fnancing. Diculty in obtaining

outside nancing on similar terms

or o-market credit terms may lead

to a determination that the

nancing was in act a capital

contribution rather than a loan.

n Presence or absence o fxed terms

and obligations and ability to

enorce payments. The absence o a

xed maturity date, interest rate

and obligation to repay principal

and interest at xed times is an

indication that the investments

may be capital contributions and

not loans. Similarly, i the

instrument does not entitle the

holder to enorce payment o

principal and interest when due, the

investment is more likely to be

characterized as a capital contri-

bution and not as a loan. Loans

that require a sinking und or are

structured as a demand note

payable upon the holders request

are more likely to be treated as debt

and not equity.

Sponsors should structure loans to portfolio companies to

minimize the risk that other creditors could attack the priority

of those loans under the theories of equitable subordination

or recharacterization.

In pursuing the equitable subordi-

nation claim, the unsecured creditors

o the company attempted to showthat the loans contributed to a

deepening insolvency o the company

(see the August 008 issue o Private

Equity Alert or urther discussion o

this legal theory). The bankruptcy

court ound that both loans should be

subordinated, holding that the

inequitable conduct consisted o a

combination o the last minute board

meeting in which no alternatives were

discussed (even though all non-

interested directors approved the

loan), a very avorable security

package and a modication o the

shareholders personal guarantees.

The bankruptcy courts ailure to

conclude that the loans resulted in

harm to the unsecured creditors led to

a reversal o the bankruptcy court on

the second loan. The Court o

Appeals concluded that because the

ignore the risk that their loans may be

recharacterized as equity. The

recharacterization analysis diersrom that o equitable subordination

in that it considers whether or not an

investment is actually equity instead

o debt. I the answer is yes, then the

eect o the recharacterization is to

subordinate the investment to all

other valid debtor claims and to

provide or repayment o the

investment only to the extent that

there is recovery to equityholders.

Although some courts have taken the

position that bankruptcy courts lack

the power to recharacterize debt

claims as equity interests, the

majority o courts that have

considered the question have deter-

mined that bankruptcy courts may, in

the exercise o their inherent powers

as courts o equity and the powers

granted by Section 05 o the


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n Source o repayments. Some courts

have said that i the expectation o

repayment depends solely on the

borrowers earnings, the transaction

has the appearance o a capital

contribution.

n Failure o the debtor to repay on

the due date or to seek

postponement. I the debtor simply

ails either to repay the investment

on the nominal due date or to seek

postponement, some courts have

said that the investment looks more

like a permanent capital contri-

bution than a loan.

n Identity o interest between the

creditor and the stockholder. I

stockholders make investments in

proportion to their respective

ownership interests, the transaction

has the appearance o a capital

contribution. In a requently cited

recharacterization case, a

bankruptcy court said that it

considered this to be the most

critical actor in its determination.

n Security. The presence o a security

interest and related documentation

is strong indication o a loan and

the absence o security cuts

somewhat in avor o a capital

contribution.

n Extent o subordination. The

subordination o an advance to the

claims o other creditors indicates

that the investment was a capital

contribution and not a loan.

n Participation in management. I

the terms o the transaction give the

investor the right to participate in

the management o the business,

the investment is more likely to be

characterized as a capital contri-

bution and not as a loan.

n Treatment in the business records.

At least one court has said that the

manner in which the investment is

treated in the business records o

the debtor is a actor that is relevant

to the characterization issue.

It is important to note that almost all

the reported decisions in which

bankruptcy courts have concluded that

a right that the parties have called aclaim is in act an equity interest have

involved loans made to a debtor by a

controlling stockholder, director,

ocer or other insider. However, the

possibility o recharacterization should

not by itsel discourage sponsors rom

lending money to their portolio

companies as this remedy is not oten

sought by claimants or granted by

bankruptcy courts and there are steps a

sponsor can take to reduce its risk.

Steps that Reduce Risk of

Equitable Subordination and

Recharacterization Risk

There are some general guidelines that

sponsors can ollow to help minimize

the risk o equitable subordination or

recharacterization. The most

important guidance is to treat any

sponsor loan to a portolio company

as i it is a third party loan being

provided on customary market terms,

including interest rate, payment

terms, ees and other terms. The

obvious challenge is nding

customary terms in an illiquid market.

Also, the sponsor should take extra

care to ensure that the proper internal

governance procedures are ollowed

by the portolio company to avoid

any implication o misconduct,

impropriety or control by the sponsor.

To minimize subordination risk,

sponsors should anticipate liquidityproblems as early as possible to allow

their portolio companies to

adequately consider alternatives. This

means avoiding any last minute

decisions where the only alternative

to an emergency unding transaction

is a liquidation or bankruptcy. Also, a

potent deense to any equitable

subordination claim is that the

unsecured creditors were either not

harmed or helped by the additional

nancing. Finally, an insider should

avoid loaning money to any portolio

company that the insider knows is

undercapitalized or insolvent.

Sponsors should take care to observe

the ormalities typically associated with

debt transactions among unrelated

parties. Consideration should be given

to the name o the instrument, which

should indicate that the instrument is

valid, enorceable and is proper

evidence o indebtedness. I possible,

the instrument should include xed

interest rates, xed maturity dates and

detailed payment schedule.

Additionally, the instrument shouldinclude rights or the sponsor to enorce

repayment. Moreover, courts will note

whether the portolio company actually

made the required payments ater

execution o the instrument and, i it

did not, what steps the sponsor took to

enorce repayment.

Ideally, any debt instrument should

not reerence any related equity

ownership or provide that the loan is

provided in respect o such equityownership. I possible, the debt

should be secured. I the debt is

unsecured, the court will be more

likely to consider the investment to be

debt i the parties include a sinking

und or other similar mechanism in

the instrument.

The sponsor should also make an

eort to distinguish the investment

rom characteristics more commonly

associated with equity investments.

Repayment provisions that are tied to

the companys perormance, especially

i the advance is unsecured, will

indicate to a court that the parties

intended the investment to be a

capital contribution. To the extent

possible, the parties should make an

eort to avoid having investments

made in perect proportion to the

sponsors equity ownership. I


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accurate, the instrument should also

make clear that the investment is

intended to nance the companys

daily operating expenses, as opposed

to the purchase o capital assets,

which courts consider a purpose more

indicative o an equity contribution.

Additionally, the instrument should

not grant management or other rights

to control the operations o the

business to the sponsor.

Even where the parties involved are

not insiders, these principles may be

applied. A recent bankruptcy court

case applied the remedy o equitable

subordination to a secured $

million claim by Credit Suisse against

the estate o Yellowstone Mountain

Club. The court ound that although

Credit Suisse was not an aliate o

Yellowstone (which is typically the

case when equitable subordination is

applied), the court ound a level o

misconduct suciently egregious to

warrant subordination o Credit

Suisses claim. According to the court,

Credit Suisses desire or lending ees

contributed signicantly to the

demise o Yellowstone. Although thisappears to be an unusual ruling, it

emphasizes that all creditors should

be cognizant o the risks involved and

take steps to mitigate those risks.

Conclusion

In the current environment, it is

increasingly likely that sponsors may

consider lending money to struggling

portolio companies. With some

additional care and consideration, asponsors risk o its debt claim being

equitably subordinated or recharac-

terized as equity can be reduced

signicantly. Since each o these

remedies is in urtherance o the

courts equitable powers, however, the

court still has ultimate discretion over

whether to employ these remedies or

the benet o other creditors.

Letters o intent or memoranda ounderstanding are requently used in

private equity transactions to

evidence the preliminary under-

standing o a potential transaction

beore the parties commit signicant

time and resources to the transaction.

Oten such documents are prepared

and negotiated by deal proessionals

based on the precedent rom the last

deal or another similar deal with

limited or no review by outside

counsel. A recent case suggests thatthis approach is not without risks and

that careul drating o letters o

intent and memoranda o under-

standing is important.

In the case oVacold LLC v. Cerami, a

decision by the United States Court o

Appeals, nd Circuit, the court held

that some preliminary agreements,

such as letters o intent or memoranda

o understanding, may bind the

parties and require them to completethe contemplated transaction even i

the parties are unable to reach

agreement on denitive documents

or the transaction. The court

considered the language o the

agreement, the context o the negotia-

tions between the parties, and the

existence o open terms in deter-

mining whether the preliminary

agreement in question was binding on

the parties. The court concluded that

a preliminary agreement that clearly

maniests the intention o the parties

to be bound will obligate the parties

to ully proceed with the transaction.

The court presented several actors

that, i present, could result in a

preliminary agreement binding the

parties to complete the transaction,

including:

n

the ailure to drat an expressedreservation o the right not to be

bound in the absence o a denitive

written agreement;

n the partial perormance o the

agreement;

n the parties reaching agreement on

all o the material terms o the

transaction; and

n the transaction is the type that is

usually committed to a more ormaland denitive agreement.

As a result, when drating a letter o

intent, memorandum o under-

standing or other similar preliminary

agreement it is imperative or private

equity sponsors to always consider that

such an agreement may bind them to

more than they may have intended i

they are not vigilant when negotiating

and drating the documentation.

The ollowing are tips or privateequity sponsors to consider when

preparing letters o intent,

memoranda o understanding or other

similar documents in order to mitigate

the risk that they will become bound

to complete a transaction when it was

not the sponsors intention to do so:

n Use unambiguous language or the

title o the document. Use a title

or the preliminary agreement

containing words such as proposal,letter o intent or memorandum o

understanding. A document entitled

letter agreement may be inter-

preted as maniesting the intent o

the parties to be bound. However,

one should not rely alone on the

title o a document to maniest the

intent o the parties not to be

bound by such agreement.

LettersoIntentandAvoidingtheUnintended

By Michael Szlamkowicz ([email protected]) and Alex Radetsky

([email protected])


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www.weil.com


PrivateEquityAlertispublishedbythePrivateEquityGroupoWeil,Gotshal&MangesLLP,

767FithAvenue,NewYork,NY10153,+1-212-310-8000.ThePrivateEquityGroupspracticeincludes

theormationoprivateequityundsandtheexecutionodomesticandcross-borderacquisitionand

investmenttransactions.Ourundormationpracticeincludestherepresentationoprivateequity

undsponsorsinorganizingawidevarietyoprivateequityunds,includingbuyout,venturecapital,

distresseddebtandrealestateopportunityunds,andtherepresentationolargeinstitutional

investorsmakinginvestmentsinthoseunds.Ourtransactionexecutionpracticeincludesthe

representationoprivateequityundsponsorsandtheirportoliocompaniesinabroadrangeo

transactions,includingleveragedbuyouts,mergerandacquisitiontransactions,strategicinvestments,

recapitalizations,minorityequityinvestments,distressedinvestments,venturecapitalinvestmentsandrestructurings.

Editor:DougWarner([email protected]),+1-212-310-8751

DeputyEditor:MichaelWeisser([email protected]),+1-212-310-8249

2009.Allrightsreserved.Quotationwithattributionispermitted.Thispublicationprovidesgeneralinormationandshouldnotbeusedortakenaslegaladviceorspecicsituationsthatdependontheevaluationopreciseactualcircumstances.TheviewsexpressedinthesearticlesrefectthoseotheauthorsandnotnecessarilytheviewsoWeil,Gotshal&MangesLLP.Iyouwouldliketoaddacolleaguetoourmailinglistoriyouneedtochangeorremoveyournameromourmailinglist,pleaselogontohttp://www.weil.com/weil/[email protected].

n Include a conspicuous disclaimer that the document is not intended to be

binding. In order to strongly indicate the intention o the parties not be bound

by a preliminary agreement, a conspicuous disclaimer within the document

should indicate that the understandings contained therein are or discussion

purposes only and do not constitute a binding agreement (except, o course, with

respect to certain provisions which the parties may intend to be binding, such as

exclusivity and condentiality) but merely express a summary o current discus-sions with respect to the transaction and that any terms discussed in the

document shall only become binding upon the negotiation and execution o

denitive agreements.

nIndicate terms that remain open. Including a list or a discussion o terms that

remain open strongly indicates that the parties do not intend or the preliminary

agreement to be denitive or binding and that a denitive agreement is

necessary in order to bind the parties to complete the transaction. It is recom-

mended that parties include clear and unambiguous language that species that

the parties do not intend to be bound until (a) the private equity sponsor

completes the due diligence process to its satisaction, (b) the investment

committee o the private equity sponsor approves, in its sole discretion, anypotential transaction and (c) the parties enter into a denitive written agreement

to complete the transaction.

Letters o intent, memoranda o understanding and similar preliminary documents

are important components o private equity deals. However, sponsors need to be

aware o the risks that such preliminary documents may be deemed binding. There

is also a risk in some jurisdictions that a court may impose a good aith duty o

negotiation on the parties and require them to work together to negotiate den-

itive agreements or a transaction. By ollowing the practice tips identied above

and having counsel careully review all preliminary documents, private equity

sponsors can lay out the intent o the parties while still avoiding the unintended.

Documents

Private Equity Alert Sept 09