Anticipating a possible bankruptcy
By Joseph H. Smolinsky
A Standard & Poor’s report in late November said that $90 billion in short- and medium-term debt will come due from US merchant power companies in the next four years.
Many merchant power companies are in workout or refinancing talks with their lenders. Some bankruptcies are expected. What can a lender do to protect its interests? Starting even before a loan is made, there are several steps a lender can take to protect itself against the possibility of a borrower bankruptcy.
Both during a workout preceding bankruptcy and in making a new loan, the lender should evaluate what might happen in bankruptcy to contracts that the borrower has with third parties.
Once a borrower has filed for bankruptcy, section 365 of the bankruptcy code permits the borrower to pick and choose among its unexpired leases and contracts. It can select which contracts to assume (adopt) and which to reject (disavow).
Generally a borrower may assume a contract if, at the time of assumption, the borrower cures past defaults under the agreement and demonstrates its financial ability to perform its obligations under the agreement going forward. A borrower has the power to reject a contract if it is burdensome to the borrower’s business and, in the borrower’s business judgment, it is appropriate to do so. If a contract is rejected, then it is deemed to be a court-authorized breach of the contract and remedies of the counterparty to the contract will be restricted to a prepetition general unsecured claim for damages. In contrast, if a borrower assumes a contract and then subsequently breaches it, the counterparty will have a claim for damages that is not limited by the bankruptcy laws.
Another possibility is that a borrower can assign most of its leases and contracts, on a nonrecourse basis, to third parties. This is true even for contracts that include antiassignment clauses. The effect of such an assignment is to release the borrower from all further liability and to transfer all past and future obligations to the new contract party. In fact, a number of reorganizations have been funded by the borrower’s ability to assign below-market leases and other types of agreements for fair market value.
A lender should consider the impact of the possible rejection of key contracts in making its credit evaluation of the borrower. It should consider not only the possibility of the borrower’s bankruptcy, but also that of the counterparty. Are there sweetheart agreements with affiliates or longterm, below-market contracts that could be rejected were the counterparty to file for bankruptcy? If so, a lender should insist on seeing a revised business plan that takes into account the loss of these valuable contract rights.
A lending decision should take into consideration the borrower’s affiliates. A bankruptcy court under certain circumstances has the power to pool and merge the assets and liabilities of all affiliates affected by a bankruptcy. Through this remedy, known as “substantive consolidation,” all affiliates of the borrower in the substantively consolidated group are treated as if they were a single corporate and economic entity.
The consolidated assets create a single fund from which all claims against the consolidated companies are to be satisfied. Consequently, a creditor of one of the substantively consolidated companies is treated as a creditor of the whole group of companies, and issues of individual corporate ownership of property and individual corporate liability on debts and other obligations are ignored.
A lender to one member of a group of companies should evaluate the risks of substantive consolidation if the borrower files for bankruptcy. In a worst-case scenario, a lender could lose its place in line for collateral to a prior lender to another affiliate that relied on the affiliate’s ownership of the collateral in making the prior loan.
If the borrower is a newly-formed entity wholly owned by a controlling affiliate, then a lender making a new loan should ordinarily require the formation of the borrower as a bankruptcy-remote, special-purpose vehicle.
The loan documents and corporate charter would ensure that the vote of an independent director is needed to commence a bankruptcy case for the borrower and would further ensure that commingling of assets and other factors favoring substantive consolidation are not present. For those borrowers that have been in existence long enough to have a history, the lender should survey transactions and business practices between the borrower and its affiliates to evaluate whether the relationships are kept at arms’ length.
The lender can request legal opinions or officers’ certificates to support the borrower’s representations with respect to such matters. In evaluating a potential loan, a lender should also be aware that substantive consolidation will eliminate eliminate duplicative claims that a lender has against more than one debtor in the group, as well as an inter-company claims between the members of the group.
Research how the borrower obtained its assets. A bankruptcy court can unwind a transaction made by the borrower up to a year prior to its bankruptcy filing (or longer under applicable state law) if the court finds it to be a “fraudulent conveyance.”
A fraudulent conveyance is a transfer of property by a borrower for which the borrower received less than fair consideration at a time when the borrower was insolvent, was unable to pay its debts as they came due, or was left with unreasonably small capital to conduct its business. It is worthwhile for a lender to a newly-formed borrower to review the transactions under which the borrower received or will receive its assets to determine whether the transactions could be subject to avoidance as fraudulent conveyances.
The lender should also review transactions with affiliates to ensure that large claims are not likely to be brought against the borrower if one or more affiliates were to file for bankruptcy.
Plan ahead to avoid being cast as an “insider” of the borrower. Although rarely successful, a borrower, its shareholders or other creditors may sue a lender on the theory that the lender was at least partly responsible for the debtor’s financial difficulties. Such “lender liability” actions may arise where a creditor exercises significant control over its borrower, either by actively managing the borrower’s day-to-day affairs or by holding a significant equity stake in the borrower.
The theory behind such suits is that the creditor has become the principal and the borrower, over which the creditor has control, its agent. Even where a lender is not exercising pervasive control over the borrower, lender liability has been alleged where funding is terminated based on a “material adverse change” provision or upon default under a nonmonetary covenant in a loan agreement. Thus, lenders should be careful to document material defaults and seek legal counsel prior to termination of funding – for any reason –- to avoid liability.
Review the borrower’s proposed bankruptcy petition and related papers before they are submitted to the court. A voluntary chapter 11 bankruptcy case formally begins with the borrower filing a petition for reorganization and other documents required by the bankruptcy code and rules. The borrower will have to address significant issues before it submits a single piece of paper. For example, it will have to gather volumes of information, decide which affiliates — foreign and domestic — will join in the filing, and choose the proper venue in which to file the case. It is not uncommon for a borrower to begin working with its creditors on a post-petition financing facility while the borrower prepares to file. In such situations, it is reasonable and common practice for a lender to review all proposed filings prior to the commencement of the case.
Gather evidence about the value of the borrower’s overall collateral package for its loan even before the debtor files for bankruptcy. The bankruptcy code precludes a borrower from using “cash collateral” for any purpose without the express cross corporate guarantees given by one member of the group for another member’s obligations.
It will also consent of its secured creditor or an order of the bankruptcy court. “Cash collateral” refers to certain types of property pledged by the debtor as security for a debt. The types of property include cash, negotiable instruments, documents of title, securities, deposit accounts and proceeds of items such as accounts receivable.
A debtor cannot use any cash collateral until its lender consents or the court approves such use. A debtor may not have a source of liquid funds with which to run its business other than the cash collateral.
Accordingly, a borrower may seek an emergency order from a bankruptcy court permitting the use of cash collateral over a secured creditor’s objection. A bankruptcy court will override a creditor’s objections and permit the borrower to use cash collateral when the borrower can show that its use of the funds will not jeopardize the secured creditor’s ability to recover on its debt.
Proceedings on this issue are often conducted on an expedited and emergency basis because the survival of the borrower may depend on its immediate ability to obtain use of the cash collateral. For this same reason, courts are often willing to give great deference to the borrower’s evidence that the secured creditor will not be harmed by the borrower’s use of the cash. Thus, even prior to filing, a lender should be ready to defeat the borrower’s request by arming itself with strong evidentiary support on valuation of all its collateral (including expert testimony).
Don’t depend on insurance proceeds. A borrower in bankruptcy must maintain adequate insurance at all times, including casualty insurance, worker’s compensation and unemployment insurance and general public and product liability insurance.
Once a borrower has filed for chapter 11, the law precludes an insurer from refusing to renew a borrower’s insurance policy if premiums are current. Despite the fact that a lender may have negotiated to the contrary in a loan agreement, insurance proceeds received post-petition from a casualty loss may not be required to be turned over to the lender for application to the loan balance. As with other cash collateral, the borrower may be allowed to use the funds if it can demonstrate that the lender is adequately protected.
However, depending on the jurisdiction, there may be ways to limit the borrower’s access to the funds. Prior to the debtor’s bankruptcy filing, a lender can take steps to put itself in a better position when the “automatic stay” kicks in. As soon as a borrower files its chapter 11 petition, claims against the borrower are put on immediate hold.
This “automatic stay” stops almost all litigation, collection efforts, lien enforcement efforts and foreclosure-related actions. The scope of the automatic stay is extremely broad — it applies to virtually every type of action, whether formal or informal, against a borrower or its property. It is designed to provide a borrower with a breathing spell from its creditors and give it some immediate relief from the financial pressures that necessitated the bankruptcy filing.
It gives the borrower the opportunity to address business problems and formulate a plan of reorganization to satisfy its creditors’ claims. However, the automatic stay benefits creditors as well. It prevents the arbitrary disposition of the borrower’s property to creditors utilizing “self-help” remedies or racing to the courthouse to enforce state law rights (“grab-law”). The stay promotes equality of distribution of a borrower’s assets by assuring that the borrower’s business and property and the payment of its creditors are administered in an orderly fashion.
A lender can take steps prior to the borrower’s filing that will enhance its position with respect to the subsequent imposition of an automatic stay. For example, it can make sure that funds the borrower receives from selling any property used as collateral for the lender’s loan are segregated in a blocked account to prevent use of the funds without satisfying the requirements for use of cash collateral. In addition, a lender can require the borrower to keep all funds in the lender’s banks so that the lender can impose an administrative freeze on them, which may not be prevented by the automatic stay.
It is also useful for a lender to keep in mind that by entering into a financing agreement after the borrower’s filing or consenting to the use of cash collateral, a lender can require an automatic lifting of the automatic stay in the event of future default by the borrower.
Know your rights if a sale of the borrower’s assets is contemplated as part of the bankruptcy. In a chapter 11 bankruptcy case, the sale of the borrower’s operating business may be accomplished either by selling substantially all of the borrower’s assets under section 363 of the bankruptcy code, or by confirming a plan of reorganization that provides for such a sale. The sale of stock in a non-bankrupt subsidiary can also be accomplished in either manner.
Typically a sale under section 363 is preferred by purchasers because it is faster and can be accomplished early in the bankruptcy case. In addition, the sale removes the proposed purchaser from the disputes that usually arise between a borrower and its various creditors. A creditor will have significant input into the timing and manner in which the borrower conducts its sale. The language in the financing documents relating to the application of sale proceeds is very important as well, particularly when the borrower sells its assets in pieces.
A lender should pay careful attention to such documents. Plus, a pre-petition lender will have rights to object to a sale of substantially all the borrower’s assets if the sale proceeds are not sufficient to satisfy all obligations under the loans.