By David N. Griffiths and Alexander P. Cohen (Weil, Gotshal & Manges)
Summary
1. Sponsors should be aware of recent situations in which lenders have exercised voting rights given to a collateral agent through proxies in credit documents aiming to take control of distressed boards following events of default.
2. These board “flips” can box in sponsors, who are left with equity-in-name-only (without any voting rights), and can prevent a chapter 11 filing to restructure a portfolio company’s debt.
3. Sponsors should be careful when a portfolio companies show signs of financial distress, operating the business without a forbearance in place with lenders following an event of default puts the business at risk and will likely close doors to some restructuring options.
Background
Distress happens, even at portfolio companies that once appeared financially solid. When it does, the portfolio company, its sponsor, and its lenders often enter into restructuring discussions in search of a consensual path forward, typically under the terms of a forbearance agreement.
Recently, however, some lenders (particularly in the middle-market private credit space) have sought to short-circuit the traditional restructuring process. Rather than negotiate with their borrower (and its sponsor) on the terms of a forbearance or more holistic capital structure solution, certain middle-market private credit lenders have turned to previously underutilized provisions in security documents—the exercise of voting rights given to a collateral agent through a voting proxy as part of the pledge of a borrower’s equity, otherwise known as Pledged Equity Proxy Rights.
In a traditional secured financing, a parent holding company—which owns the equity of a borrower entity lower in the corporate structure—will pledge the borrower’s equity to secure the loan. As part of that pledge, the holding company often grants a contractual proxy to the collateral agent. Other than to the extent agreed in the credit documents, that pledge should not affect the holding company’s ability to vote the pledged equity prior to the occurrence of an event of default—the holding company acts as a traditional corporate parent as long as it complies with credit documents.
But, when a proxy is granted as part of the collateral package, the occurrence of an event of default often will empower the collateral agent to exercise the rights of a borrower’s shareholders to appoint board members (i.e., the Pledged Equity Proxy Rights) if so directed by the required lenders. If that happens, the collateral agent can exercise such Pledged Equity Proxy Rights to remove existing directors and “flip” the board, installing directors friendly to lenders instead. Further, if the company has also pledged equity of any of the borrower’s subsidiaries (which often happens), the collateral agent can remove and replace directors at those subsidiary boards as well. Credit documents vary on how much notice is required prior to the exercise of such Pledged Equity Proxy Rights, with a trend, at least in private credit deals, toward no notice requirement at all following the occurrence of an event of default.
Once lenders have control of a borrower’s board, they can replace officers, hire advisors, and otherwise direct the governance of the company, notwithstanding a sponsor’s equity ownership.
Practical Consequences
Beyond the obvious consequence, a “flip” can exacerbate issues faced by an already distressed company. With the loss of control of the borrower’s board (and perhaps the boards of subsidiaries as well), a sponsor loses significant leverage in restructuring discussions with lenders. Filing for voluntary bankruptcy relief requires proper corporate authorization, and, without control of the borrower’s board, the sponsor loses the ability to file its portfolio company for chapter 11 and, with it, the threat of filing, which itself can be a powerful tool in restructuring negotiations.
Though relatively little case law exists on these issues, at least one court, the United States Bankruptcy Court for the District of Delaware in In re CII Parent, Inc., No. 22-11345 (LSS) (Bankr. D. Del. Apr. 12, 2023), held that a proper pre-bankruptcy exercise of Pledged Equity Proxy Rights by lenders to effectuate a board “flip” was enforceable and could not be unwound in a bankruptcy case of the borrower’s corporate parent. There, the debtor-parent argued that the agent violated the automatic stay provisions of the Bankruptcy Code by exercising control over bankruptcy estate property (i.e., the pledged equity in the debtor’s subsidiaries). The court disagreed, holding that the proxy decoupled the voting rights from the ownership of the equity, the agent complied with the credit documents in exercising the rights granted under the proxy, and nothing in the Bankruptcy Code prohibited the lenders’ pre-bankruptcy actions. Therefore, the debtor could not recover control of its pledged subsidiaries in its bankruptcy cases. In effect, the company lost the ability to file itself and its subsidiaries for bankruptcy protection and use the bankruptcy cases to restructure its debt.
A change in the board composition of a borrower (which often is an operating entity) also may trigger “change of control” default and/or notice provisions in material contracts and leases. A “flip,” therefore, could result in counterparties tightening trade terms or terminating contracts altogether. Further, if a company has other funded debt obligations, it may also trigger direct defaults or cross-defaults under those credit documents, which may strain intercreditor relations. Either of the foregoing could result in a liquidity crunch—especially if the other funded debt is in the form of a revolver or similar instrument—or exercise by such parties of self-help remedies.
Takeaways
As soon as a portfolio company shows signs of financial distress, professionals (like Weil) should be engaged to review the credit documents and determine potential exposure and mitigation strategies. If problems continue and a portfolio company is teetering on the edge of a default, the portfolio company and sponsor should prioritize negotiating for a forbearance (or similar agreement) with lenders. A sponsor should also be careful not to rely on handshake deals and relationships with lenders when its portfolio company faces a potential default. In the world of private credit and direct lending, we have seen an uptick in aggressive tactics (like board flips) that may have been less palatable to a traditional credit syndicate. And, if restructuring discussions stall with a default looming, the Company’s board should consider its strategic alternatives—including a potential voluntary bankruptcy filing—to protect control of the company
Click here to read the full article.
Leave a Reply