The Gift of Exit Financing

Exit financing reproduces the benefits of hostile restructurings in Chapter 11 bankruptcy cases.  In the current era of fractured secured debt holdings and loose loan covenants, borrowers play lenders against each other by offering non-prorata benefits in return for new loans and extended maturities.  Exit financing follows the same playbook in bankruptcy.  Chosen constituencies (often the largest lenders and private equity sponsors) receive lucrative private placement rights and backstop fees in consideration for their plan support and fresh capital.  The case study of ConvergeOne highlights the symmetries between hostile restructurings and unmarketed exit financing. 

Reflecting the evolution of capital markets, exit financing giveaways have replaced gifting as the preferred method to procure plan support in large Chapter 11 cases.  Traditionally, old equity holders were the default source for fresh capital to fund debtors’ exits from bankruptcy.  Creditors like banks and trade vendors shunned these investment opportunities because their primary business was not running the debtors’ businesses, and, in the case of banks, they faced regulatory barriers to equity ownership.  Meanwhile, secured creditors whose claims might be partially equitized could still benefit from old equity’s expertise and support.  Indeed, it was rational for secured creditors to gift new equity to old shareholders.  However, the Supreme Court rejected gifting as an end-run on the absolute priority rule because it bypassed intermediate creditors who hold a higher priority right to distributions than old equity.  Nonetheless, gifting enjoyed a resurgence in the 1990s and early 2010s until circuit courts again rejected it.  Fast-forward to the present day, private credit funds and hedge funds are both willing and able to invest in reorganized debtors’ equity.  All the better that subscription rights are often significantly discounted.  Exit financing has opened a new front in bankruptcy’s forever war with gifting. 

Exit financing is more defensible than gifting because it provides benefits beyond buying approval for the proposed plan.  Debtors often require fresh capital to emerge from bankruptcy.  Administrative expenses must be paid while new working capital supports the reorganized debtor’s operations.  Equity is often preferable to debt as a funding source because it makes the reorganized debtors’ financial structure more feasible.  Exit financing can also be used to satisfy fulcrum security holders’ claims, which can consolidate equity ownership and simplify corporate governance.  Although parties trumpet these values, exit financing also provides opportunities for gamesmanship akin to gifting. 

The Supreme Court’s assessments of new value contributions, a subspecies of exit financing, equip bankruptcy courts with the tools for unmasking exit financing giveaways.  Long ago, the Supreme Court explained that distributing discounted reorganized equity to chosen creditors violated the fundamental horizontal equity principle: creditors with equal priority receive equal distributions on account of their claims.  However, creditors could receive equity distributions if the consideration the creditors provided was reasonably equivalent to the new equity’s value—the famous (or infamous) new value corollary. Likewise, equity could not be granted to old equity unless old equity’s consideration satisfied the new value corollary. The Supreme Court updated the new value corollary in 203 N. LaSalle Street to require public marketing as the test for reasonable equivalence.  Applying these teachings while also incorporating the Bankruptcy Code’s cramdown power, non-consensual exit financing must be publicly marketed.

Both the proposed solutions to restrain the strategic use of exit financing, rules of thumb and improved monitoring have severe shortcomings.  The former proved inadequate in high-profile cases like Peabody Energy, where three courts rubber-stamped the giveaway.  Given the flexible venue rules, debtors and their allies can pinpoint jurisdictions where informal guardrails will likely be ignored.  The appointment of a monitor or special master may improve courts’ analyses, but if the data used is faulty (which it is for the traditional measures of negotiation quality and comparative transactions), then the ultimate decision will still be unreliable. 

My article identifies why publicly marketed sales are the best choice for policing exit financing.  Pervasive control can only be separated from the exit financing terms through market testing.  The two current default evaluation methods, assessing the quality of negotiations and reviewing comparative transactions, both fall short.  The leverage exit financing counterparties have over management is simply too strong.  Debtors’ boards are beholden to private equity sponsors who control their careers, while lenders hold the votes necessary to allow an exit from bankruptcy.  Meanwhile, precedent transactions commonly do not reflect arm’s length bargaining.  This is because a debtor’s management is often motivated to appease counterparties (the same reason the quality of negotiations cannot be trusted). Fundamentally, exit financing should be conducted akin to whole-firm asset sales through publicly marketed sales.  A case study of the Hertz bankruptcy case demonstrates how initially, the unmarketed exit financing benefited current creditors who controlled the debtors’ confirmation prospects.  The pivot to a publicly marketed process culminated in an auction that dramatically improved recoveries.  Exposing the reorganized equity to a competitive sale process is not only what the Supreme Court requires, but it also decouples parties’ leverage over the planning process from the reorganized equity sale process.

The author’s article, which is the basis of this blog post, is available here.

Robert W. Miller is an Assistant Professor at the University of South Dakota Knudson School of Law.