Private Equity Alert Sept 09

Private Equity Alert September 2009 Weil News Weil Gotshal advised eTelecare and its controlling stockholders, Providence Equity Partners and Ayala Corporation, in connection with the business combination of eTelecare with Stream Global Services

n

Weil Gotshal advised Macquarie Group in connection with its $428 million acquisition of Delaware Investments, a diversified asset management firm

n

Weil Gotshal advised CCMP Capital and Bancroft Private Equity in connection with the €250 million sale of Nowaco to Bidvest

n

Weil Gotshal advised GMT Communications Partners on the acquisition of the Roadside Assets of Titan Outdoor Advertising Limited

n

Weil Gotshal advised HM Capital in connection with its acquisition of Earthbound Farms

n

Weil Gotshal advised Showtime Arabia and its parent Kipco Group in connection with its merger with Orbit Group, creating the leading pay-TV platform in the Middle East and North Africa

n

Equitable (In)subordination − Considerations for Sponsors Lending to Portfolio Companies By Ron Landen ([email protected]), Rose Constance ([email protected]) and Joe Basile ([email protected]) Private equity sponsors are increasingly providing additional capital to their portfolio companies either to address liquidity issues at those companies or as part of a negotiated debt restructuring. From a sponsor’s point of view, it is often preferable to invest that additional capital in the form of debt rather than equity. However, in structuring that transaction sponsors should be aware that the priority of this debt in a portfolio company’s capital structure could be attacked by other creditors if that portfolio company ends up in bankruptcy under the theories of equitable subordination or recharacterization. It is important that sponsors structure any such investments to reduce the risk of a successful attack on the priority status of their debt.

Equitable Subordination Section 510(c) of the Bankruptcy Code provides that bankruptcy courts may exercise principles of equitable subordination to subordinate all or part of one claim to another claim. Conceptually, this gives the bankruptcy court power to demote a higher priority claim to a lower priority claim under certain circumstances. In some instances, this can convert an otherwise first priority secured claim into a general unsecured claim ranking pari passu with all other general unsecured claims. Although the statutory authority for equitable subordination is clear, the application is not. However, there are some general principles that can be applied as a guide in properly structuring a credit arrangement. Generally, the courts consider three factors in determining whether to equitably subordinate a claim. These factors are (i) whether the creditor was engaged in inequitable conduct, (ii) whether the misconduct injured other creditors or gave an unfair advantage to the creditor in question and (iii) whether subordination would be consistent with the provisions of the Bankruptcy Code. Importantly, insiders are typically held to a higher standard than are unaffiliated third party lenders because insiders often have (and exercise) influence over management of the company. This means that a sponsor who is also an equity holder needs to use extra caution when loaning money to a portfolio company. The misconduct of a creditor does not need to be tied to such creditor’s claim – it can arise out of other actions by the claimant. In an equitable subordination analysis, the court considers whether a creditor engaged in inequitable conduct and applies subordination as a remedy only to the extent necessary to counteract any damage to other creditors.



Private Equity Alert

The recent bankruptcy case involving Schlotzky’s, Inc. provided a good illustration of how courts apply these principles. In that case, the two largest shareholders each made separate loans to the company in an effort to resolve a liquidity crisis. The first loan was secured by substantially all of the company’s intellectual property and was structured on armslength terms. The second loan, made seven months later, was secured by the same collateral package; however, the bankruptcy court more closely scrutinized this transaction because it was approved in a hurried, last minute board meeting where management reported that the company could not make payroll payments without the loan.

September 2009

proceeds of the second loan were used to pay unsecured creditors and equitable subordination is remedial, not penal, equitable subordination was not appropriate. As to the first loan, the Court of Appeals ruled that there was no evidence of misconduct, so that loan also should not have been subordinated.

Recharacterization Recharacterization of a claim occurs where a bankruptcy court uses its equitable powers under Section 105 of the Bankruptcy Code to convert an otherwise valid debt claim into an equity interest. Recharacterization is a highly unusual remedy, but that

Courts that consider themselves to have the power to recharacterize debt claims as equity interests will exercise that power when, despite the label placed by the parties on the particular transaction, the “true nature” of the transaction is, in the court’s view, the creation of an equity interest. In pursuing the quest to find the “true nature” of a transaction, most bankruptcy courts apply a multi-factor test where no single factor is determinative. The factors normally considered by courts include the following: n

does not mean that sponsors can

Sponsors should structure loans to portfolio companies to minimize the risk that other creditors could attack the priority of those loans under the theories of equitable subordination or recharacterization. In pursuing the equitable subordination claim, the unsecured creditors of the company attempted to show that the loans contributed to a deepening insolvency of the company (see the August 2008 issue of Private Equity Alert for further discussion of this legal theory). The bankruptcy court found that both loans should be subordinated, holding that the inequitable conduct consisted of a combination of the last minute board meeting in which no alternatives were discussed (even though all noninterested directors approved the loan), a very favorable security package and a modification of the shareholders’ personal guarantees. The bankruptcy court’s failure to conclude that the loans resulted in harm to the unsecured creditors led to a reversal of the bankruptcy court on the second loan. The Court of Appeals concluded that because the

Bankruptcy Code, recharacterize debt claims as equity interests.

n

ignore the risk that their loans may be recharacterized as equity. The recharacterization analysis differs from that of equitable subordination in that it considers whether or not an investment is actually equity instead of debt. If the answer is yes, then the effect of the recharacterization is to subordinate the investment to all other valid debtor claims and to provide for repayment of the investment only to the extent that there is recovery to equityholders. Although some courts have taken the position that bankruptcy courts lack the power to recharacterize debt claims as equity interests, the majority of courts that have considered the question have determined that bankruptcy courts may, in the exercise of their inherent powers as courts of equity and the powers granted by Section 105 of the

n

Undercapitalization. Many courts view thin or inadequate capitalization as strong evidence that investments are in fact capital contributions rather than loans. Inability to obtain similar outside financing. Difficulty in obtaining outside financing on similar terms or off-market credit terms may lead to a determination that the financing was in fact a capital contribution rather than a loan. Presence or absence of fixed terms and obligations and ability to enforce payments. The absence of a fixed maturity date, interest rate and obligation to repay principal and interest at fixed times is an indication that the investments may be capital contributions and not loans. Similarly, if the instrument does not entitle the holder to enforce payment of principal and interest when due, the investment is more likely to be characterized as a capital contribution and not as a loan. Loans that require a sinking fund or are structured as a demand note payable upon the holders’ request are more likely to be treated as debt and not equity.

Weil, Gotshal & Manges llp



Private Equity Alert

n

n

n

n

n

n

n

Source of repayments. Some courts have said that if the expectation of repayment depends solely on the borrower’s earnings, the transaction has the appearance of a capital contribution. Failure of the debtor to repay on the due date or to seek postponement. If the debtor simply fails either to repay the investment on the nominal due date or to seek postponement, some courts have said that the investment looks more like a permanent capital contribution than a loan. Identity of interest between the creditor and the stockholder. If stockholders make investments in proportion to their respective ownership interests, the transaction has the appearance of a capital contribution. In a frequently cited recharacterization case, a bankruptcy court said that it considered “this to be the most critical factor in its determination”. Security. The presence of a security interest and related documentation is strong indication of a loan and the absence of security cuts somewhat in favor of a capital contribution. Extent of subordination. The subordination of an advance to the claims of other creditors indicates that the investment was a capital contribution and not a loan. Participation in management. If the terms of the transaction give the investor the right to participate in the management of the business, the investment is more likely to be characterized as a capital contribution and not as a loan. Treatment in the business records. At least one court has said that the manner in which the investment is treated in the business records of

September 2009

the debtor is a factor that is relevant to the characterization issue. It is important to note that almost all the reported decisions in which bankruptcy courts have concluded that a right that the parties have called a claim is in fact an equity interest have involved “loans” made to a debtor by a controlling stockholder, director, officer or other insider. However, the possibility of recharacterization should not by itself discourage sponsors from lending money to their portfolio companies as this remedy is not often sought by claimants or granted by bankruptcy courts and there are steps a sponsor can take to reduce its risk.

Steps that Reduce Risk of Equitable Subordination and Recharacterization Risk There are some general guidelines that sponsors can follow to help minimize the risk of equitable subordination or recharacterization. The most important guidance is to treat any sponsor loan to a portfolio company as if it is a third party loan being provided on customary market terms, including interest rate, payment terms, fees and other terms. The obvious challenge is finding customary terms in an illiquid market. Also, the sponsor should take extra care to ensure that the proper internal governance procedures are followed by the portfolio company to avoid any implication of misconduct, impropriety or control by the sponsor. To minimize subordination risk, sponsors should anticipate liquidity problems as early as possible to allow their portfolio companies to adequately consider alternatives. This means avoiding any last minute decisions where the only alternative to an emergency funding transaction is a liquidation or bankruptcy. Also, a potent defense to any equitable subordination claim is that the

unsecured creditors were either not harmed or helped by the additional financing. Finally, an insider should avoid loaning money to any portfolio company that the insider knows is undercapitalized or insolvent. Sponsors should take care to observe the formalities typically associated with debt transactions among unrelated parties. Consideration should be given to the name of the instrument, which should indicate that the instrument is valid, enforceable and is proper evidence of indebtedness. If possible, the instrument should include fixed interest rates, fixed maturity dates and detailed payment schedule. Additionally, the instrument should include rights for the sponsor to enforce repayment. Moreover, courts will note whether the portfolio company actually made the required payments after execution of the instrument and, if it did not, what steps the sponsor took to enforce repayment. Ideally, any debt instrument should not reference any related equity ownership or provide that the loan is provided in respect of such equity ownership. If possible, the debt should be secured. If the debt is unsecured, the court will be more likely to consider the investment to be debt if the parties include a sinking fund or other similar mechanism in the instrument. The sponsor should also make an effort to distinguish the investment from characteristics more commonly associated with equity investments. Repayment provisions that are tied to the company’s performance, especially if the advance is unsecured, will indicate to a court that the parties intended the investment to be a capital contribution. To the extent possible, the parties should make an effort to avoid having investments made in perfect proportion to the sponsors’ equity ownership. If Weil, Gotshal & Manges llp



Private Equity Alert

accurate, the instrument should also make clear that the investment is intended to finance the company’s daily operating expenses, as opposed to the purchase of capital assets, which courts consider a purpose more indicative of an equity contribution. Additionally, the instrument should not grant management or other rights to control the operations of the business to the sponsor. Even where the parties involved are not insiders, these principles may be applied. A recent bankruptcy court case applied the remedy of equitable subordination to a secured $232 million claim by Credit Suisse against the estate of Yellowstone Mountain Club. The court found that although Credit Suisse was not an affiliate of Yellowstone (which is typically the case when equitable subordination is applied), the court found a level of misconduct sufficiently egregious to warrant subordination of Credit Suisse’s claim. According to the court, Credit Suisse’s desire for lending fees contributed significantly to the demise of Yellowstone. Although this appears to be an unusual ruling, it emphasizes that all creditors should be cognizant of the risks involved and take steps to mitigate those risks.

Conclusion In the current environment, it is increasingly likely that sponsors may consider lending money to struggling portfolio companies. With some additional care and consideration, a sponsor’s risk of its debt claim being equitably subordinated or recharacterized as equity can be reduced significantly. Since each of these remedies is in furtherance of the court’s equitable powers, however, the court still has ultimate discretion over whether to employ these remedies for the benefit of other creditors.

September 2009

Letters of Intent and Avoiding the Unintended By Michael Szlamkowicz ([email protected]) and Alex Radetsky ([email protected]) Letters of intent or memoranda of understanding are frequently used in private equity transactions to evidence the preliminary understanding of a potential transaction before the parties commit significant time and resources to the transaction. Often such documents are prepared and negotiated by deal professionals based on the precedent from the last deal or another similar deal with limited or no review by outside counsel. A recent case suggests that this approach is not without risks and that careful drafting of letters of intent and memoranda of understanding is important. In the case of Vacold LLC v. Cerami, a decision by the United States Court of Appeals, 2nd Circuit, the court held that some preliminary agreements, such as letters of intent or memoranda of understanding, may bind the parties and require them to complete the contemplated transaction even if the parties are unable to reach agreement on definitive documents for the transaction. The court considered the language of the agreement, the context of the negotiations between the parties, and the existence of open terms in determining whether the preliminary agreement in question was binding on the parties. The court concluded that a preliminary agreement that clearly manifests the intention of the parties to be bound will obligate the parties to fully proceed with the transaction. The court presented several factors that, if present, could result in a preliminary agreement binding the parties to complete the transaction, including:

n

n

n

n

the failure to draft an expressed reservation of the right not to be bound in the absence of a definitive written agreement; the partial performance of the agreement; the parties reaching agreement on all of the material terms of the transaction; and the transaction is the type that is usually committed to a more formal and definitive agreement.

As a result, when drafting a letter of intent, memorandum of understanding or other similar preliminary agreement it is imperative for private equity sponsors to always consider that such an agreement may bind them to more than they may have intended if they are not vigilant when negotiating and drafting the documentation. The following are tips for private equity sponsors to consider when preparing letters of intent, memoranda of understanding or other similar documents in order to mitigate the risk that they will become bound to complete a transaction when it was not the sponsor’s intention to do so: n

Use unambiguous language for the title of the document. Use a title for the preliminary agreement containing words such as proposal, letter of intent or memorandum of understanding. A document entitled “letter agreement” may be interpreted as manifesting the intent of the parties to be bound. However, one should not rely alone on the title of a document to manifest the intent of the parties not to be bound by such agreement.

Weil, Gotshal & Manges llp



Private Equity Alert

n

n

Include a conspicuous disclaimer that the document is not intended to be binding. In order to strongly indicate the intention of the parties not be bound by a preliminary agreement, a conspicuous disclaimer within the document should indicate that the understandings contained therein are for discussion purposes only and do not constitute a binding agreement (except, of course, with respect to certain provisions which the parties may intend to be binding, such as exclusivity and confidentiality) but merely express a summary of current discussions with respect to the transaction and that any terms discussed in the document shall only become binding upon the negotiation and execution of definitive agreements.

Indicate terms that remain open. Including a list or a discussion of terms that remain open strongly indicates that the parties do not intend for the preliminary agreement to be definitive or binding and that a definitive agreement is necessary in order to bind the parties to complete the transaction. It is recommended that parties include clear and unambiguous language that specifies that the parties do not intend to be bound until (a) the private equity sponsor completes the due diligence process to its satisfaction, (b) the investment committee of the private equity sponsor approves, in its sole discretion, any potential transaction and (c) the parties enter into a definitive written agreement to complete the transaction.

Letters of intent, memoranda of understanding and similar preliminary documents are important components of private equity deals. However, sponsors need to be aware of the risks that such preliminary documents may be deemed binding. There is also a risk in some jurisdictions that a court may impose a good faith duty of negotiation on the parties and require them to work together to negotiate definitive agreements for a transaction. By following the practice tips identified above and having counsel carefully review all preliminary documents, private equity sponsors can lay out the intent of the parties while still avoiding the unintended.

September 2009

Beijing Steven Xiang +86-10-8515-0558

Boston James Westra +1-617-772-8377

Budapest David Dederick +1-361-302-9100

Dallas Glenn West +1-214-746-7780

Frankfurt Gerhard Schmidt +49-69-21659-700

Hong Kong Akiko Mikumo +852-3476-9008 Peter Feist +852-3476-9100

London Michael Francies +44-20-7903-1170 Marco Compagnoni +44-20-7903-1547

Munich Gerhard Schmidt +49-89-242430

New York Thomas Roberts +1-212-310-8479 Barry Wolf +1-212-310-8209 Doug Warner +1-212-310-8751

Paris David Aknin +331-44-21-9797

Prague Karel Muzikar +420-2-2140-7300

Private Equity Alert is published by the Private Equity Group of Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, +1-212-310-8000. The Private Equity Group’s practice includes the formation of private equity funds and the execution of domestic and cross-border acquisition and investment transactions. Our fund formation practice includes the representation of private equity fund sponsors in organizing a wide variety of private equity funds, including buyout, venture capital, distressed debt and real estate opportunity funds, and the representation of large institutional investors making investments in those funds. Our transaction execution practice includes the representation of private equity fund sponsors and their portfolio companies in a broad range of transactions, including leveraged buyouts, merger and acquisition transactions, strategic investments, recapitalizations, minority equity investments, distressed investments, venture capital investments and restructurings.

Providence David Duffell +1-401-278-4700

Shanghai Steven Xiang +86-21-6288-1855

Silicon Valley Craig Adas +1-650-802-3020

Warsaw

Editor: Doug Warner ([email protected]), +1-212-310-8751

Pawel Rymarz +48-22-520-4000

Deputy Editor: Michael Weisser ([email protected]), +1-212-310-8249

Washington, DC

©2009. All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations that depend on the evaluation of precise factual circumstances. The views expressed in these articles reflect those of the authors and not necessarily the views of Weil, Gotshal & Manges LLP. If you would like to add a colleague to our mailing list or if you need to change or remove your name from our mailing list, please log on to http://www.weil.com/weil/subscribe.html or e-mail [email protected].

Wilmington

Robert Odle +1-202-682-7180 E. Norman Veasey +1-302-656-6600

www.weil.com

Weil, Gotshal & Manges llp