The Peabody Award: Exclusive Opportunism in Bankruptcy
We asked our expert Contributors to weigh in on Exclusive Opportunism – the trend of preserving exclusive financial opportunities for select creditors without offering that opportunity to all creditors of the relevant class — all in exchange for voting in favor of the debtor’s plan. While the Peabody case seemed an outlier at the time, it has since become the go-to strategy for debtors making it the namesake for this inaugural award.
A list of recent cases is below:
In re Peabody Energy Corp. (EDMS 2017)
Favored creditors given exclusive right to purchase 22.5% of $750 million private placement.
In re LATAM Airlines Grp. S.A. (SDNY 2022)
Favored creditors given exclusive right to purchase 50% of $3.269 billion private placement
In re Grupo Aeromexico, SAB (SDNY 2022)
Favored creditors given exclusive right to purchase $580 million of $720 million rights offering
In re Pacific Drilling (SDNY 2018)
Favored creditors given exclusive right to purchase 20% of $500 million exit financing
TPC Group Inc. (Del 2022)
Favored creditors given exclusive opportunity to purchase 45% of $450 million exit financing
From my perspective, two legal pillars frame the issue. The first is the statute itself. The Bankruptcy Code specifies that a Chapter 11 plan “shall” – i.e., must – “provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment of such particular claim or interest.” 11 U.S.C. § 1123(a)(4). The second is the U.S. Supreme Court. In construing the Code, it has held that the exclusive right to invest in the reorganized debtor, to finance its emergence from bankruptcy granted under a Chapter 11 plan, is a form of property – i.e., that exclusive right can amount to “treatment” under the plan, and if that preferential treatment afforded one party in interest but not another is contrary to the requirements for confirmation, the plan cannot be confirmed. Bank of America Nat. Trust and Savings Assoc. v. 203 N. Lasalle St. P’ship, 526 U.S. 434 (1999).
To be sure, the plan in Lasalle offered the debtor’s shareholders, not a subset of creditors in the same class, the exclusive right to invest in the reorganized debtor. And the question in Lasalle was whether the plan violated the “absolute priority rule” under Section 1129(b) after a senior class of impaired creditors voted to reject the plan, not whether the plan violated the “same treatment” requirement for claims in the same class under Section 1123(a)(4). But there is nothing in the Supreme Court’s analysis in Lasalle that makes me think the case would have come out differently if the issue had arisen in the context of the “same treatment” requirement under Section 1123(a)(4). Instead, as I read the decision, it holds that offering one party in interest (whether it is a creditor or an interest holder) the exclusive right to purchase equity in the reorganized debtor is a form of “property.” It therefore stands to reason that such an offer (or a similar offer to invest in equity or debt) can be “treatment” under a plan. Accordingly, in my view, offering some but not all creditors in the fulcrum class the right to invest in the reorganized debtor (or the right to backstop an offering) under a plan can violate the “same treatment” requirement for confirmation.
Some of the arguments to the contrary that have been made by parties in leading cases seem to me to miss the mark. For example, debtors will sometimes argue that they are offering the subset of creditors additional equity (or debt), not in consideration for the discharge of those creditors’ claims, but rather in exchange for those creditors’ agreement to help fund the debtors’ reorganization by investing in the reorganized debtor. But the debtor and shareholders made essentially the same argument in Lasalle, and the Supreme Court rejected it. The question is not whether the new equity (or debt) is in exchange for the creditors’ new money – it is; instead, the question is whether the option offered some but not all creditors in the same class to invest is in consideration of that subset of creditors’ claims (and in exchange for those creditors’ agreement to support the debtor’s plan).
So, too, I don’t see why it should make a difference if the debtor seeks approval for the investment agreement with the subset of creditors in advance of plan confirmation. If that agreement is offered only to that select group of creditors, not to all creditors in the class, and it is offered to the favored creditors in order to obtain their support for the plan, it seems to me just as problematic whether, as a matter of timing and process, the offer is made in advance of or contemporaneous with plan confirmation. Whether by invoking the sub rosa plan doctrine or by applying a different legal rubric, bankruptcy courts do not typically allow debtors prior to plan confirmation to make any distribution in respect of an impaired claim, let alone to offer one set of creditors preferential treatment over another, similarly situated group.
All this said, I also don’t think that every plan in which some, but not, all creditors in the same class get to invest in equity or debt issued by the reorganized debtor at emergence is unconfirmable. For one thing, if the debtor offers the same opportunity to all creditors in the class and some elect to accept it whereas others do not, the disparate elections should not matter. The “treatment” – the opportunity to invest – is the same, and the plan should pass muster under both Section 1123(a)(4) and Lasalle. Indeed, Lasalle strongly suggests that if the debtor goes to market and simply accepts the highest bid for the equity it will issue upon its emergence from bankruptcy, the plan will be confirmable even if the highest bidder happens to be the existing equity holders (or a subset of creditors in the fulcrum class). In this regard, a debtor could in effect conduct an auction open to all creditors in the class (as well, potentially, as third parties) and take the highest and best offer; in such a situation, no subset of creditors is receiving the “exclusive” right to invest or different “treatment” on their claims.
Even if the debtor does not offer all creditors in the class the right to invest and does not otherwise “market test” the opportunity, the debtor might have legitimate reasons for so proceeding, such that providing that opportunity to a subset of creditors in the class should not be viewed as offering them superior “treatment” on their claims as compared to the treatment afforded the other members of the class. For example, the debtor might anticipate needing to lock-up a commitment to fund the plan for a long period, during which market conditions could change. In such a situation, the debtor might have legitimate concerns that one group of creditors would present less “execution risk” as the “plan sponsor” than a different group might. So, too, a debtor might have a legitimate concern that one group of creditors might be a better “business partner” than another group following plan confirmation. For instance, if the plan funding is going to be in the form of debt, not equity, the debtor might conclude that one group is more likely to work “constructively” with the reorganized debtor if it trips a covenant in the future.
If the reason for the disparate opportunity to provide exit financing afforded different groups of creditors is not to “buy” their support for the plan by affording the favored group an attractive investment not afforded the rest of the class, a court might be able to conclude that the disparate opportunity does not amount to different “treatment” on the creditors’ claims. But even if this is right as a matter of law, the debtor (or other plan proponent) bears the burden to prove that it has satisfied the requirements for plan confirmation, so it would need to show as a factual matter that a legitimate reason exists for why it is affording some, but not all, members of the class the opportunity to invest. And, in my view, a bankruptcy court should have a healthy degree of skepticism about such a claim where the group that is offered the exclusive investment opportunity “just so happens” to have the votes to deliver the class and the group that is excluded does not.
One final point: Both on the law and the facts, I don’t think a debtor can justify affording some creditors in the affected class an exclusive investment opportunity by saying that, unfortunately, this is the price the debtor has to pay to obtain those creditors’ support so that the debtor can emerge from bankruptcy. On the law, the Bankruptcy Code specifies that a plan can be confirmed “only if” it “complies with the applicable provisions” of the Code, one of which is that the plan “shall” provide the same treatment to all creditors in the same class (unless the subset receiving worse treatment so agrees). 11 U.S.C. §§ 1129(a)(1); 1123(a)(4). Congress could have provided otherwise, but it did not. On the facts, if a debtor is worth more reorganized than liquidated, then all creditors in the fulcrum class should support the debtor’s reorganization even if none can obtain a “premium” over others in the class. To provide a simple example, assume that, if all creditors in the class are afforded the same treatment, they will receive 50 cents on the dollar if the debtor is reorganized, but only 40 cents on the dollar if instead the debtor is liquidated. Yes, a subset of large and powerful creditors in the class might prefer to negotiate a sweetheart deal for themselves where they get 55 or 60 cents on the dollar under the debtor’s plan of reorganization, while other, less powerful creditors in the same class get less. But if that option is not on the table, because the bankruptcy court holds that it runs afoul of the Code, the powerful creditors should still support the debtor’s reorganization since it will provide them a higher recovery than the debtor’s liquidation will – 50 cents on the dollar is better than 40. There is every reason to think, therefore, that application of the “same treatment” requirement of Section 1123(a)(4) will, in most (if not all) cases, not stand in the way of the debtor’s reorganization and, indeed, may make such a reorganization simpler, quicker and less expensive by eliminating or at least reducing litigation over whether disparate treatment is, or is not, permissible
In recent years, a troubling pattern has emerged in how debtors obtain support for plans of reorganization. Increasingly, debtors make, in effect, a side payment to a subset of creditors in the form of an exclusive opportunity to participate in equity or debt financing on favorable terms.
This benefits the controlling coalition at the expense of creditors who are not part of it and creates perceived, if not actual, conflicts for management teams (and their advisors). Exclusive opportunism goes hand in hand with other hostile out-of-court restructuring tactics that pit similarly situated creditors against one another. These transactions – whether inside or outside of bankruptcy – strain intercreditor dynamics, creating new fault lines and amplify distributional concerns among similarly situated creditors.
These hostile restructurings have captured the attention of influential trade associations and creditor advocacy groups and resulted in a flurry of litigation and media focus. To date, most of the consternation has been directed toward out-of-court “uptier” transactions, whereby distressed borrowers buy more time and runway by offering a subset of creditors the opportunity to jump ahead of other pari-passu creditors. Similarly, debtors engage in exclusive opportunism in bankruptcy by “buying” support from a subset of creditors for the debtors’ favored plan in exchange for the exclusive opportunity to receive valuable consideration without offering the same to other similarly situated creditors.
Exclusive opportunism has been justified as an inextricable part of a holistic bargain, usually embodied within the terms of a restructuring support agreement, and provided — not on account of a claim — but on account of a separate new money commitment. This claimed distinction was considered and squarely rejected in Bank of America Nat. Trust and Savings Assoc. v. 203 N. LaSalle St. P’ship, 526 US 434 (1999) (“LaSalle”), where the Supreme Court held that exclusive investment opportunities to existing stakeholders to buy discounted equity cannot constitute legitimate consideration for a new money commitment. The Court relied on the remedy of a market test to satisfy itself that an exclusive opportunity would result in full value to the estate. The rationale of LaSalle remains fully applicable to exclusive opportunism in its present form.
Until recently, courts (most notably in the Peabody Energy bankruptcy case) have failed to question these hostile transactions for fear of upsetting an interdependent restructuring transaction. But exclusive opportunism has come under renewed judicial scrutiny. Both Bankruptcy Judge Wiles in the Pacific Drilling case and Judge Goldblatt in TPC Group questioned whether these strategies comport with the Code’s requirements. Judge Goldblatt observed of the exclusive opportunism in that case:
And at some level it does seem as if, for example, the Supreme Court’s decision in 203 North LaSalle is highly relevant to that question and that, when you’re asked is the reason a party, a creditor or interest holder receiving certain treatment on account of their claim or interest, on the one hand, or on account of a plan transaction on the other, that the way that’s answered is by market testing. And I’ve got some concerns that these transactions here aren’t market tested, which, if right, would counsel in favor of the view that it’s actually consideration being given on account of the claims, which would give rise to claims of discriminatory treatment.
In re TPC Group Inc., Case No. 22-10493 (CTG), Transcript of Hearing, at 189 (Bankr. Del. July 29, 2022).
Courts should be concerned about exclusive opportunism – whether inside or outside of bankruptcy – because they strain intercreditor dynamics, create new fault lines and amplify distributional concerns among similarly situated creditors. These transactions violate fundamental norms (most specifically, vote buying) and may cause dangerous ripple effects in the capital markets.
There are a variety of remedies available to address exclusive opportunism, including separate classification and the market-test approach suggested by the Supreme Court in LaSalle. A more effective response for courts would be to require that exclusive opportunities be opened up to an entire class of creditors. This solution is consistent with the relative priorities of the parties, avoids bifurcating the new money component from plan support or separately classifying claims (thereby risking plan failure) and avoids rent seeking. While some could argue that this could come at the expense of debtors forced to make up for lost consideration to the favored class, as the ultimate control parties, the residual owners are best placed to bear that burden. This approach would help restore the relative priority of the parties and restore the Supreme Court’s decision in LaSalle to its rightful place.
Payment of backstop fees, like many of the other non-statutory creatures of restructuring that the Creditor Rights Coalition has explored (third party releases, independent directors, etc.), is a valuable tool for debtors that is also subject to abuse.
On the one hand, obtaining a backstop commitment (whether from an existing creditor or a third-party) to fully subscribe a rights offering better ensures full subscription, and thus provides debtors with a more certain path to confirmation. That backstop commitment has independent value to the debtor, and cannot be obtained without compensating the backstop party for the financial risk associated with making such a commitment. On the other hand, backstop fees have been used to provide majority groups of creditors with outsized consideration at the expense of minority creditors who are not offered the same opportunity, which implicates Section 1123(a)(4)’s prohibition on different treatment of claims in the same plan class.
In situations where an RSA provides for payment of backstop fees to creditors who provide both (1) a backstop commitment and (2) an agreement to vote their existing claim in favor of a chapter 11 plan, it is difficult to determine what portion of the backstop fees are attributable to the value of the backstop commitment itself versus the commitment to support the debtor’s treatment of the existing claim under the plan.
From a legal standpoint, the cleanest solution to the above dilemma would be to require debtors to offer all creditors of a given class the opportunity to participate in the backstop, but imposing that requirement would undoubtedly diminish the appetite of larger creditors to provide any upfront backstop commitment under an RSA, thereby depriving the debtor of an important and valuable restructuring tool. Given that reality, one theoretical legal solution would be to use the market test requirement imposed by 203 N. LaSalle as a guide to isolating the “new value” attributable to the backstop. This would involve requiring a debtor to shop the backstop opportunity to third parties who are not creditors and thus indifferent to treatment of their claim under a plan. But running such a process for backstop fees may not be practicable for a variety of reasons including timing concerns, securities law compliance, and the risk that non-creditors will attribute lower value to the new securities than creditors who have skin in the game.
Alternatively, the Supreme Court could, with appropriate input, prescribe a new bankruptcy rule, similar to FINRA Rule 5100 (which governs underwriting terms and arrangements), establishing guidelines (whether presumptive or fixed) for bankruptcy courts (and parties-in-interest) to determine if particular backstop fees are reasonable or unreasonable. While not a perfect solution to isolate the value of the backstop commitment, such a bankruptcy rule could at least minimize the abuse that can result when no guardrails exist.
Over the past decade, or so, we have seen situations in Chapter 11 cases where groups of creditors contracted with debtors for the exclusive right to provide new money on extremely favorable terms, with significant “backstop” fees paid in connection therewith, and other creditors in the same class were excluded from participating in such investments. E.g., Peabody Coal, CHC Helicopter, Pacific Drilling, Momentive and most recently, LATAM Airlines and TPC Group.
The specific mechanics of these transactions vary but they generally arise in DIP loans (e.g. Toys R Us), or in exit financings to be implemented under a reorganization plan. In connection with plan exit financings, such exclusive new money arrangements have typically been tied to restructuring support agreements (RSA’s) under which the new money investors – – which, significantly, have the size to control the vote of their class and deliver acceptance of the debtors proposed plan – – receive very favorable returns on their new investments. Similarly situated creditors that are not invited to participate in the exclusive new money investment, do not get to participate in the favorable new investment – – except where they put up a successful fight to be included, as, for example, we recently saw in the TPC Group case, where Cerberus Capital was initially excluded.
Below is a high level summary of some of the issues relating to such exclusive investment opportunities by creditors in Chapter 11 cases, which will likely be resolved on a case by case basis depending on the specific facts and circumstances presented and the strength and approach of the excluded creditors opposing such transactions. Generally, assuming the debtor can show that the new exclusive financing has been appropriately market tested, or adequately “shopped,” and that the financing is necessary for the reorganization to succeed, courts will have a hard time rejecting them if plan confirmation can’t otherwise be achieved. Objecting parties’ best response to these exclusive financing opportunities is to propose a more favorable financing package which, they would argue, should be embraced by the debtor as a better deal. But, if excluded creditors proposing the competing financing cannot deliver the class, it may be difficult to prove that the alternative financing package is a “higher and better” financing package.
Violation of Section 1123(a)(4)
Objecting parties have argued that such exclusive financing arrangement violate section 1123(a)(4) of the Bankruptcy Code, which requires that a plan “provide the same treatment for each claim or interest of a particular class.” It is often said that while claimants in a class need not receive the exact same recovery, at the very least all claimants in a class must have the same opportunity for recovery. Several courts have seemed responsive to such arguments.
For example in Pacific Drilling, Judge Wiles rejected an uncontested motion to approve an equity commitment agreement that would have provided lenders that agreed to backstop a $500 million rights offering with an 8% backstop fee and a “private placement” opportunity to purchase $100 million of reorganized equity at a 46.9% discount to plan value. The Court explained that those exclusive opportunities gave rise to “an equal treatment problem that’s deadly to your plan, and I mean deadly.” Judge Wiles explained: “The theory of the Bankruptcy Code is that when the big creditors sit in a room and negotiate a deal, the little creditors who are in the same boat get the same deal. The Bankruptcy Code does not permit the unequal treatment of creditors in the same class; it also does not permit the payment of extra compensation to large creditors in exchange for their commitment to vote for a plan.” Judge Wiles further stated that “the problem with special allocations in rights offerings, or with private placements that are limited to the bigger creditors who sat at the negotiating table, or big backstop fees that are paid to the bigger creditors who sat at the negotiating table but that are not even open to other creditors (and in particular to other creditors in the same class), is that it is far too easy for the people who sit at the negotiating table to use those tools primarily to take for themselves a bigger recovery than smaller creditors in the same classes will get.”
In Momentive, Judge Drain rejected an agreement that would have provided a 5% fee to backstop a $600 million rights offering priced at a 15% discount to plan value. Judge Drain explained that he did not “have sufficient evidence that a right that is being offered to all other members of the class for merely the fifteen-percent discount is not fair without another five-percent recovery which the rest of the class is not being offered.” On the other hand, in LATAM Airlines, Judge Garrity recently approved an exclusive financing arrangement under which the exclusive commitment creditor group, which controlled the class vote, received far superior treatment under their exclusive new money investment compared with recoveries of excluded creditors in the same class, including substantial backstop fees even on their own commitments. In LATAM Airlines, Avenue Capital was among the excluded creditors.
Violation of LaSalle
Objecting parties have also argued that exclusive financings offered to select groups with class control violate LaSalle because a bona fide market test is lacking. In Bank of America Nat. Trust and Savings Assoc. v. 203 N. LaSalle St. P’ship, 526 US 434 (1999) (“LaSalle”), the U.S. Supreme Court held that, in a plan not accepted by all impaired creditors, exclusive investment opportunities granted to existing stockholders to buy discounted equity could not constitute legitimate consideration for a new money investment if such investment opportunity is on account of, or in consideration for, the existing equity interests. That would violate the absolute priority rule. The Supreme Court found that a market test was necessary to prove that an exclusive new money investment opportunity was not given to equity on account of their existing equity interests. In other words, roughly, the exclusive opportunity had to be appropriately marketed – – so as to ensure it was the equivalent of a new money market-priced investment and not on account of an existing claim or interest. Courts have applied the same rule to creditor claims. That seems like an obvious conclusion, and that is why in response to an exclusive new money investment granted to a select few, the objecting parties’ typical tactic would be to propose a more favorable financing package which, they would argue, should be embraced by the debtor as a better deal. If, however, the group of creditors granted the exclusive investment opportunity can deliver the votes to have the debtor’s plan accepted, and the excluded creditors proposing the competing financing cannot, is the exclusive financing package a “higher and better” financing package?
In TPC Group, which was ultimately resolved consensually by allowing Cerberus and others to participate, Judge Goldblatt, prior to the consensual resolution, commented on whether the exclusive offer was market tested, and therefore not given to the exclusive group of creditors solely on account of their existing claims and ability to deliver plan acceptance: “[A]t some level it does seem as if, for example, the Supreme Court’s decision in 203 North LaSalle is highly relevant to that question and that, when you’re asked is the reason a party, a creditor or interest holder receiving certain treatment on account of their claim or interest, on the one hand, or on account of a plan transaction on the other, that the way that’s answered is by market testing. And I’ve got some concerns that these transactions here aren’t market tested, which, if right, would counsel in favor of the view that it’s actually consideration being given on account of the claims, which would give rise to claims of discriminatory treatment.”
It is not clear what the future holds for these exclusive financing arrangements. What appears clear, however, is that: groups of investors will seek to maximize their recoveries, even if similarly situated creditors are excluded; debtors will do whatever is necessary to confirm a plan; excluded creditors will oppose being left out; and bankruptcy courts will tend to remain in the business of confirming plans.