Early Stage Capital Raising Trends in Chapter 11 Reorganizations

Editor’s Note: See Professor Kenneth Ayotte’s recent Roundtable article on sub rosa DIP loans here.

By Judge Robert D. Drain, Shana A. Elberg, Evan A. Hill, and Jaclyn F. Kleban (Skadden, Arps, Slate, Meagher & Flom LLP)

Rights offerings have become a key, yet sometimes controversial, tool for companies in chapter 11. They may address liquidity needs, help demonstrate plan feasibility, and facilitate plan negotiations. However, objectors may argue that the rights offering is not properly valued, unfairly discriminates against similarly situated creditors, or otherwise have unfair terms or are not in good faith.

We examine two related trends on the topic of equity offerings in bankruptcy, focusing on two S.D.N.Y. cases: In re LATAM Airlines Group S.A.¹ and In re SAS AB.²

(1) Equity Options at the DIP Stage. Recently, parties have proposed DIP loans that provide the option to convert into equity of the reorganized debtor. Such terms provide the debtor with exit financing without refinancing the DIP loan at confirmation and afford the DIP lender the potential benefit of increased equity value in the post-emergence, deleveraged company. That said, the terms may be rejected if they appear to effectively set terms of a chapter 11 plan at the outset of the case without the protections of the confirmation process.

• In LATAM, Judge James L. Garrity, Jr. denied a proposed equity conversion aspect of a DIP agreement because it constituted a sub rosa plan that would improperly allocate a right to the reorganized debtor’s equity without a valuation or the other protections available in the plan confirmation process.
• In SAS, Judge Michael E. Wiles approved a DIP facility with an equity conversion aspect because (1) after negotiating, no parties objected to the arrangement, and (2) the option to convert the DIP loan into equity was revocable by the debtor (subject to a fee). However, Judge Wiles questioned whether the equity option granted in the DIP facility was commensurate with the benefits that the loan provided to the debtors.

(2) Fair Market Value Evidence. Courts have long recognized that a fair market test is the best way to value an asset for purposes of a rights offering. In practice, however, potential “market” alternatives are often skewed, or do not arise at all, because of the high entry costs that true third parties face in competing with a DIP loan offered by existing lenders whose right to adequate protection of their collateral supports their objection to being primed by a third party. Thus, courts may need to look at valuation evidence in the absence of competing bids in order to determine the fairness of the proposed transaction.

At plan confirmation in LATAM,³ Judge Garrity approved a modified rights offering after taking considerable valuation evidence. Of note was the parties’ acknowledgment that their evidence and analysis of assertedly comparable rights offerings were in material respects novel. Notwithstanding several courts’ prior approval of rights offerings/backstops in conjunction with plan confirmations, LATAM is the first case to our knowledge where a bankruptcy judge looked closely at the terms of assertedly comparable past rights offerings/backstops and proposed comparative valuation methodologies to determine the fair value of proposed backstop fees and discounts to “plan” equity value in such a rights offering.

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Footnotes:

1. No. 20-11254 (JLG), 620 B.R. 722 (Bankr. S.D.N.Y. 2020).
2. No. 22-10925 (MEW), 644 B.R. 267 (Bankr. S.D.N.Y. 2022).
3. No. 20-11254 (JLG), 2022 Bankr. LEXIS 1725 (Bankr. S.D.N.Y. June 18, 2022), aff’d, 643 B.R. 756 (S.D.N.Y. 2022).