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All animals are equal, but some are more equal than others. George Orwell’s line from Animal Farm is an apt description of the power dynamic that has defined the US distressed debt jungle in the past decade. Historically, secured lenders, junior junk bondholders and out-of-the-money equity owners would wage fights over the crumbs of shrunken pie.
More recently, there has been a different trend of so-called creditor-on-creditor violence where, say, large holders of a senior loan try to squeeze extra nickels and dimes from smaller holders in the same class of loan.
The results often seemed outside of norms of law and fairness to many experts but courts had been slow to intervene in the shenanigans. Until now.
Last month, a federal judge in Texas ruled that a bankruptcy plan, for the CVC-backed ConvergeOne, an IT services company that gave a super-majority group of lenders a superior recovery relative to a small dissident group, plainly violated bankruptcy law.
The suddenly impermissible terms of the ConvergeOne restructuring were already widely in use, leaving parties in current restructurings scrambling to reset ongoing negotiations. That may be a sign that the pendulum is swinging back after a period of particularly hardball legal tactics in distressed debt investing.
The current ConvergeOne dispute is influenced in part by Elliott Management, even though the savvy hedge fund is not directly involved. Elliott had pioneered the use of bankruptcy exit financing as a way to wring out excess returns.
A decade ago, during the bankruptcy proceedings of Peabody Energy, Elliott, alongside other major creditors of Peabody, sought to purchase the restructured company’s shares at a sharp discount to fair value for those fellow bondholders who wanted to participate in writing checks for the more than $1bn of new equity.
A small creditor group sued, arguing that too much of the value of the reorganised Peabody was flowing to the Elliott group via the discounted equity purchases and that it was unlawful for one group of bondholders to then get an outsized return relative to non-participants.
An appeals court, however, ruled that the Peabody exit financing transaction was distinct from the narrower reorganisation. As such, there was no requirement for equal economic outcomes within the group. Ever since, majority creditors have attempted to use such exit financings as a way to line their own pockets — and in increasingly aggressive ways.
In the case of ConvergeOne, the small dissident group never got the chance to participate in the discounted exit financing offering, nor the chance to propose a rival deal. In a transaction to wipe out more than $1bn of a loan balance, the debtors’ own public filings showed that the excluded group would get an initial nominal recovery of just 20 cents compared with at least 27 cents for the participating group.
The US district court that heard the ConvergeOne dispute on appeal, said the new equity sale clearly represented differing payouts for the same claim, and not a distinct transaction from the reorganisation, not meeting the previous Peabody.
That leaves the question, though, why bankruptcy courts have been willing to wave through lopsided terms that harm aggrieved minority creditors. Bankruptcy courts are increasingly under pressure to approve pre-packaged Chapter 11 filings quickly. Separately, US debtors are allowed to forum shop when picking a bankruptcy court, leaving judges reluctant to cross powerful law firms.
But district and appeals courts, staffed by generalist judges, are slowly understanding restructuring situations better and are plainly registering their discomfort. Last year, a federal appeals court overturned an ugly intra-class debt swap involving the mattress maker Serta, a ruling that has since led to a reining in of differential payouts in non-bankruptcy workouts.
In the current bankruptcy of First Brands, a majority lender group struck a deal to provide a $1.1bn bankruptcy loan that came with sweeteners attached that were not available to all the group. Experts said that benefits — some extra fees for providing the loan — in this instance were not egregious. But just how the majority lenders try to extract any future special benefits in the ultimate restructuring, is something to watch. As it happens, the judge in the First Brands case, Christopher Lopez, is the jurist who had signed off on the ConvergeOne reorganisation plan that has just been overruled.
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