Corporate Bankruptcy and Restructuring 2018-2019

The last year saw two competing narratives in the world of corporate bankruptcy and restructuring. On the one hand, overall default rates in the U.S. remained relatively low, against the backdrop of a strong U.S. economy and (for most of the year) robust credit markets. But at the same time, the U.S. retail sector faced significant distress, as a series of major retailers were forced into chapter 11 and/or liquidation. And as 2018 progressed, broader signs of stress also began to emerge. As discussed in our recent memo, Acquisition Financing Year in Review: From Break-Neck to Brakes-On, debt issuance declined sharply in the fourth quarter, and the prices of high-yield bonds came under heavy pressure.

As we look ahead to 2019, with rising interest rates, a domestic economy that is potentially slowing, and choppy credit markets, borrowers and creditors alike are apt to face new challenges. As in prior years, companies in distress, including retailers, will pursue out-of-court solutions before resorting to bankruptcy, and companies that cannot avoid bankruptcy will seek to mitigate risk by pursuing quick transactions, including sales under section 363 of the Bankruptcy Code. In all cases, however, the ability to execute and preserve value will depend on adaptability to the current environment. We discuss below important themes from 2018 and thoughts on the year ahead.

The Retail Sector and the Limits of Chapter 11

In 2018, a significant number of large brick-and-mortar retailers—including Sears, Nine West, Claire’s, David’s Bridal, Mattress Firm, and Brookstone—filed for chapter 11 protection. This week, two more retailers—ShopKo and Gymboree—have filed. Although each case has its own story, the volume and size of these cases reflect an environment in which retailers are being squeezed by online competition, and cannot survive absent significant changes to their business.

In many situations, however, a traditional chapter 11 case does not provide an adequate solution for retailers. Chapter 11 provides important tools to retailers, including the ability to procure post-petition financing and to reject unfavorable leases. But even with those tools, retailers in chapter 11 have had difficulty staving off competitors, reassuring customers, and funding the significant expenses of the chapter 11 process. A basic lesson from recent cases is that, as far in advance as possible—and well in advance of significant maturities—retailers and their creditors should aggressively consider all alternatives to chapter 11. If a filing proves necessary, the downside risks can, in some cases, be mitigated through a quick sale (see the next section) or a pre-negotiated plan, but they cannot be eliminated.

The Toys “R” Us case encapsulates the risks presented to retailers in chapter 11. In that case, the debtors were able to procure over $3 billion in post-petition financing prior to their filing, seemingly providing a soft landing into bankruptcy. Nonetheless, what followed was a terrible holiday season—as competitors courted customers and customers stayed away—leading to unsustainable cash burn and the wind down of the U.S. business. Ultimately, vendors in the U.S. received only partial payment on their post-bankruptcy claims, and secured lenders saw their collateral depleted. While other retail debtors faced similar challenges in 2018, some debtors achieved different outcomes either through quick asset sales (e.g., the sale by Nine West of its intellectual property) or by proposing a prepackaged plan (e.g., Mattress Firm). In early 2019, one debtor (ShopKo) obtained financing for an expedited chapter 11 process under which, if a going-concern transaction is not consummated within 90 days, the debtor will “toggle” to a liquidation and sale.

Section 363 Sales: To Be or Not to Be a Stalking Horse

In 2018, major debtors such as Nine West, Synergy Pharmaceuticals, The Weinstein Company, The Rockport Company, Bon-Ton Stores, and Appvion (among others) all took advantage of section 363 of the Bankruptcy Code. Section 363 is a powerful provision under which the debtor, upon court approval, may sell property “free and clear” of liens and liabilities. As shown in 2018, section 363 is an especially valuable tool for companies, including many retailers, that simply cannot bear the risk of a “free fall” chapter 11.

In the context of a section 363 sale, it is common for debtors to reach agreement with a “stalking-horse bidder” before or soon after the bankruptcy filing, ensuring stability during the sale process and setting a floor for other bids. Both strategic and financial investors are often presented with the question of whether to act as a stalking horse. Doing so has advantages: more time for due diligence; setting the baseline terms for the purchase agreement; the opportunity to build relationships with the company; and the ability to procure court-approved bid protections, such as a break-up fee and expense reimbursement.

But there are also disadvantages: the stalking-horse bidder, even after reaching agreement with the company and post-petition financing sources, faces the risk of being “re-traded” by a creditors’ committee or other objectors, including on substantive points such as deal milestones and bid protections. These objections can often be addressed through negotiation or (if necessary) by the court. But there has also been a troubling trend in recent cases whereby objecting creditors, in an effort to secure a marginally lower break-up fee or a slower schedule (among other things), have sought intrusive discovery of stalking-horse bidders, requiring the stalking-horse bidder to manage and finance an expedited litigation before the auction even starts.

In this environment, potential stalking-horse bidders must be prepared to deal with the multiple stakeholders in a chapter 11 process, including committees, and to hold firm against overreaching demands that increase cost or defy commercial expectations.

Out-of-Court Restructurings: Renewed Clarity

Given the cost and risks associated with chapter 11 cases, bankruptcy remains a last resort for most companies in financial distress. In 2018, bolstered by an important recent legal decision and generally favorable credit markets, companies were able to implement a variety of strategies, including exchange offers, to achieve balance-sheet restructurings out of court.

We previously wrote about the Second Circuit’s decision in Marblegate Asset Management, LLC v. Education Management Corp., which resolved an issue that had caused significant uncertainty for out-of-court debt restructurings. In Marblegate, the court held that the Trust Indenture Act, which states that the “right … to receive payment” cannot be “impaired” without a bondholder’s consent, only prohibits nonconsensual amendments to an indenture’s “core payment terms” (e.g., the amount owed and maturity dates). The Marblegate decision foreclosed arguments that an out-of-court transaction violates the TIA if it has a negative practical effect on holdouts or other nonparticipants in a restructuring transaction. The decision thus restored much-needed certainty to issuers and creditors in developing out-of-court solutions to distressed situations, including solutions that reward participation and deter holdouts.

Following Marblegate, and with markets remaining strong through much of 2018, borrowers have successfully executed debt exchanges to push off maturities and improve their balance sheets (e.g., Murray Energy’s extension of its bond maturities through a discount exchange of existing secured notes for new, longer-dated notes with higher lien priority). Borrowers have also used more creative approaches to restructure their debts without filing for bankruptcy (e.g., API Thermasys’ recently announced consensual foreclosure transaction, executed in cooperation with a majority of its senior lenders and all of its junior creditors).

In 2019 and beyond, we expect borrowers to continue to pursue out-of-court solutions wherever possible, including through structures that incentivize participation and deter holdouts.

“Momentive-Proof” Make Wholes

Over the last several years, there has been substantial litigation regarding “make whole” premiums—namely, provisions in loan documents that require an additional payment to the lender upon an optional redemption or other repayment prior to the scheduled maturity. A major point of contention relates to whether premiums that would be payable to lenders outside of bankruptcy in the event of an early repayment are payable when, under the governing loan documents, the debt maturities have been accelerated due to a bankruptcy filing.

Different federal appellate courts have reached different conclusions on this issue. In the Momentive case, as explained in our prior memo, Restructuring and Finance Developments: Rights of Secured Creditors in Chapter 11—The Momentive Decision, the Second Circuit held that the automatic acceleration of secured loans as a result of a chapter 11 filing meant that the loans were not being redeemed at the debtor’s option, but instead were being repaid post-maturity, meaning that the make whole was not payable. The Momentive decision departed from the Third Circuit’s 2016 decision in Energy Future Holdings, which, as discussed in our memo, Restructuring and Finance Developments: Redemption Premiums in Bankruptcy—The Third Circuit’s Decision in EFH, held that the debtors’ decision to refinance secured debt in bankruptcy was a voluntary “redemption” subject to a make whole under New York law.

These divergent decisions, each applying New York law, have led to further litigation and uncertainty. At the same time, however, the Momentive decision has spawned a trend in which lenders to distressed companies have inserted “Momentive-proof” language in their loan documents—stating expressly that a make whole will be payable regardless of acceleration and regardless of bankruptcy. While Momentive-proof language does not remove all issues regarding the enforceability of a make whole in bankruptcy, it does provide a contractual mechanism to avoid the split in authority described above and to mitigate bankruptcy risk for lenders to distressed companies.

Bankruptcy Code “Safe Harbors”

As discussed in a prior memo, Supreme Court Limits the Scope of Bankruptcy Code’s Safe Harbors, in February 2018, the Supreme Court issued a decision that will increase the risk of fraudulent transfer litigation directed at leveraged buyouts and other financial transactions, adopting the narrower of two readings of the Bankruptcy Code’s “safe harbors.” The Bankruptcy Code allows certain transfers by a debtor to be “avoided” and recovered for the benefit of creditors, but establishes safe harbors to shield financial market transactions from avoidance. One safe harbor, section 546(e), protects “settlement payments” and transfers in connection with a “securities contract,” if made “by or to (or for the benefit of)” a “financial institution” or other specified market participants.

In Merit Management Group, LP v. FTI Consulting, Inc., the Supreme Court unanimously held that, in applying the safe harbor, a court should analyze the “overarching transfer” that the trustee seeks to avoid, rather than component transactions among financial intermediaries. Thus, where the overarching transfer involves parties that are not covered by the safe harbor, the component transactions—even if they occur among financial institutions—do not matter.

Prior to Merit Management, many courts applied the safe harbors to financial transactions, including payments to shareholders in an LBO, based on the involvement of financial institution intermediaries. After Merit Management, the presence of such intermediaries will not necessarily suffice for safe harbor protection, increasing the risk of bankruptcy litigation challenging such transactions (including LBOs) after the fact.