Alert

September 2009 Equitable (In)subordination − Considerations for Sponsors Lending to Portfolio Companies Weil News n Weil Gotshal advised eTelecare By Ron Landen ([email protected]), Rose Constance and its controlling stockholders, ([email protected]) and Joe Basile ([email protected]) Partners and Ayala Corporation, in connection with the combination Private equity sponsors are increasingly providing additional capital to their of eTelecare with Stream Global portfolio companies either to address liquidity issues at those companies or as part Services of a negotiated debt restructuring. From a sponsor’s point of view, it is often n Weil Gotshal advised Macquarie preferable to invest that additional capital in the form of debt rather than equity. Group in connection with its $428 However, in structuring that transaction sponsors should be aware that the priority million acquisition of Delaware of this debt in a portfolio company’s could be attacked by other , a diversified asset creditors if that portfolio company ends up in bankruptcy under the theories of management firm equitable subordination or recharacterization. It is important that sponsors n Weil Gotshal advised CCMP structure any such investments to reduce the risk of a successful attack on the Capital and Bancroft Private Equity in connection with the priority status of their debt. €250 million sale of Nowaco to Bidvest Equitable Subordination n Weil Gotshal advised GMT Section 510(c) of the Bankruptcy Code provides that bankruptcy courts may Communications Partners on exercise principles of equitable subordination to subordinate all or part of one the acquisition of the Roadside claim to another claim. Conceptually, this gives the bankruptcy court power to Assets of Titan Outdoor Adver- demote a higher priority claim to a lower priority claim under certain circum- tising Limited stances. In some instances, this can convert an otherwise first priority secured n Weil Gotshal advised HM Capital in connection with its acquisition claim into a general unsecured claim ranking pari passu with all other general of Earthbound Farms unsecured claims. Although the statutory authority for equitable subordination is clear, the application is not. However, there are some general principles that can n Weil Gotshal advised Showtime Arabia and its parent Kipco Group be applied as a guide in properly structuring a credit arrangement. in connection with its merger with Orbit Group, creating the Generally, the courts consider three factors in determining whether to equitably leading pay-TV platform in the subordinate a claim. These factors are (i) whether the creditor was engaged in Middle East and North Africa 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 subordi- nation as a remedy only to the extent necessary to counteract any damage to other creditors.

 Private Equity Alert September 2009

The recent bankruptcy case involving proceeds of the second were used Bankruptcy Code, recharacterize debt Schlotzky’s, Inc. provided a good to pay unsecured creditors and claims as equity interests. illustration of how courts apply these equitable subordination is remedial, Courts that consider themselves to principles. In that case, the two not penal, equitable subordination have the power to recharacterize debt largest shareholders each made was not appropriate. As to the first claims as equity interests will exercise separate to the company in an loan, the Court of Appeals ruled that that power when, despite the label effort to resolve a liquidity crisis. The there was no evidence of misconduct, placed by the parties on the particular first loan was secured by substantially so that loan also should not have transaction, the “true nature” of the all of the company’s intellectual been subordinated. transaction is, in the court’s view, the property and was structured on arms- creation of an equity interest. In length terms. The second loan, made Recharacterization seven months later, was secured by pursuing the quest to find the “true Recharacterization of a claim occurs the same collateral package; however, nature” of a transaction, most the bankruptcy court more closely where a bankruptcy court uses its bankruptcy courts apply a multi-factor scrutinized this transaction because it equitable powers under Section 105 of test where no single factor is determi- was approved in a hurried, last the Bankruptcy Code to convert an native. The factors normally minute board meeting where otherwise valid debt claim into an considered by courts include the management reported that the equity interest. Recharacterization is following: company could not make payroll a highly unusual remedy, but that n . Many courts payments without the loan. does not mean that sponsors can view thin or inadequate capital- ization as strong evidence that Sponsors should structure loans to portfolio companies to investments are in fact capital minimize the risk that other creditors could attack the priority contributions rather than loans. of those loans under the theories of equitable subordination n Inability to obtain similar outside or recharacterization. financing. Difficulty in obtaining outside financing on similar terms In pursuing the equitable subordi- ignore the risk that their loans may be or off-market credit terms may lead nation claim, the unsecured creditors recharacterized as equity. The to a determination that the of the company attempted to show recharacterization analysis differs financing was in fact a capital contribution rather than a loan. that the loans contributed to a from that of equitable subordination deepening insolvency of the company in that it considers whether or not an n Presence or absence of fixed terms (see the August 2008 issue of Private is actually equity instead and obligations and ability to Equity Alert for further discussion of of debt. If the answer is yes, then the enforce payments. The absence of a this legal theory). The bankruptcy effect of the recharacterization is to fixed maturity date, interest rate court found that both loans should be subordinate the investment to all and obligation to repay principal subordinated, holding that the other valid debtor claims and to and interest at fixed times is an inequitable conduct consisted of a provide for repayment of the indication that the investments combination of the last minute board investment only to the extent that may be capital contributions and meeting in which no alternatives were there is recovery to equityholders. not loans. Similarly, if the discussed (even though all non- instrument does not entitle the interested directors approved the Although some courts have taken the holder to enforce payment of loan), a very favorable security position that bankruptcy courts lack principal and interest when due, the package and a modification of the the power to recharacterize debt investment is more likely to be shareholders’ personal guarantees. claims as equity interests, the characterized as a capital contri- The bankruptcy court’s failure to majority of courts that have bution and not as a loan. Loans conclude that the loans resulted in considered the question have deter- that require a sinking fund or are harm to the unsecured creditors led to mined that bankruptcy courts may, in structured as a demand note a reversal of the bankruptcy court on the exercise of their inherent powers payable upon the holders’ request the second loan. The Court of as courts of equity and the powers are more likely to be treated as debt Appeals concluded that because the granted by Section 105 of the and not equity.

Weil, Gotshal & Manges llp  Private Equity Alert September 2009

n Source of repayments. Some courts the debtor is a factor that is relevant unsecured creditors were either not have said that if the expectation of to the characterization issue. harmed or helped by the additional repayment depends solely on the financing. Finally, an insider should It is important to note that almost all borrower’s earnings, the transaction avoid loaning money to any portfolio the reported decisions in which has the appearance of a capital company that the insider knows is bankruptcy courts have concluded that contribution. undercapitalized or insolvent. a right that the parties have called a n Failure of the debtor to repay on claim is in fact an equity interest have Sponsors should take care to observe the due date or to seek involved “loans” made to a debtor by a the formalities typically associated with postponement. If the debtor simply controlling stockholder, director, debt transactions among unrelated fails either to repay the investment officer or other insider. However, the parties. Consideration should be given on the nominal due date or to seek possibility of recharacterization should to the name of the instrument, which postponement, some courts have not by itself discourage sponsors from should indicate that the instrument is said that the investment looks more lending money to their portfolio valid, enforceable and is proper like a permanent capital contri- companies as this remedy is not often evidence of indebtedness. If possible, bution than a loan. sought by claimants or granted by the instrument should include fixed bankruptcy courts and there are steps a interest rates, fixed maturity dates and n Identity of interest between the sponsor can take to reduce its risk. detailed payment schedule. creditor and the stockholder. If Additionally, the instrument should stockholders make investments in Steps that Reduce Risk of include rights for the sponsor to enforce proportion to their respective Equitable Subordination and repayment. Moreover, courts will note ownership interests, the transaction Recharacterization Risk whether the portfolio company actually has the appearance of a capital There are some general guidelines that made the required payments after contribution. In a frequently cited sponsors can follow to help minimize execution of the instrument and, if it recharacterization case, a the risk of equitable subordination or did not, what steps the sponsor took to bankruptcy court said that it recharacterization. The most enforce repayment. considered “this to be the most important guidance is to treat any critical factor in its determination”. Ideally, any debt instrument should sponsor loan to a portfolio company not reference any related equity n Security. The presence of a security as if it is a third party loan being ownership or provide that the loan is interest and related documentation provided on customary market terms, provided in respect of such equity is strong indication of a loan and including interest rate, payment ownership. If possible, the debt the absence of security cuts terms, fees and other terms. The should be secured. If the debt is somewhat in favor of a capital obvious challenge is finding unsecured, the court will be more contribution. customary terms in an illiquid market. likely to consider the investment to be Also, the sponsor should take extra n Extent of subordination. The debt if the parties include a sinking care to ensure that the proper internal subordination of an advance to the fund or other similar mechanism in governance procedures are followed claims of other creditors indicates the instrument. by the portfolio company to avoid that the investment was a capital any implication of misconduct, The sponsor should also make an contribution and not a loan. impropriety or control by the sponsor. effort to distinguish the investment n Participation in management. If from characteristics more commonly To minimize subordination risk, the terms of the transaction give the associated with equity investments. sponsors should anticipate liquidity investor the right to participate in Repayment provisions that are tied to problems as early as possible to allow the management of the business, the company’s performance, especially their portfolio companies to the investment is more likely to be if the advance is unsecured, will adequately consider alternatives. This characterized as a capital contri- indicate to a court that the parties means avoiding any last minute bution and not as a loan. intended the investment to be a decisions where the only alternative capital contribution. To the extent n to an emergency funding transaction Treatment in the business records. possible, the parties should make an is a liquidation or bankruptcy. Also, a At least one court has said that the effort to avoid having investments potent defense to any equitable manner in which the investment is made in perfect proportion to the subordination claim is that the treated in the business records of sponsors’ equity ownership. If

Weil, Gotshal & Manges llp  Private Equity Alert September 2009 accurate, the instrument should also make clear that the investment is Letters of Intent and Avoiding the Unintended intended to the company’s daily operating expenses, as opposed By Michael Szlamkowicz ([email protected]) and Alex Radetsky ([email protected]) to the purchase of capital assets, which courts consider a purpose more Letters of intent or memoranda of n the failure to draft an expressed indicative of an equity contribution. understanding are frequently used in reservation of the right not to be Additionally, the instrument should private equity transactions to bound in the absence of a definitive not grant management or other rights evidence the preliminary under- written agreement; to control the operations of the standing of a potential transaction n the partial performance of the business to the sponsor. before the parties commit significant agreement; Even where the parties involved are time and resources to the transaction. not insiders, these principles may be Often such documents are prepared n the parties reaching agreement on applied. A recent bankruptcy court and negotiated by deal professionals all of the material terms of the case applied the remedy of equitable based on the precedent from the last transaction; and deal or another similar deal with subordination to a secured $232 n the transaction is the type that is limited or no review by outside million claim by Credit Suisse against usually committed to a more formal counsel. A recent case suggests that the estate of Yellowstone Mountain and definitive agreement. this approach is not without risks and Club. The court found that although that careful drafting of letters of Credit Suisse was not an affiliate of As a result, when drafting a letter of intent and memoranda of under- Yellowstone (which is typically the intent, memorandum of under- standing is important. standing or other similar preliminary case when equitable subordination is agreement it is imperative for private applied), the court found a level of In the case of Vacold LLC v. Cerami, a equity sponsors to always consider that misconduct sufficiently egregious to decision by the United States Court of such an agreement may bind them to warrant subordination of Credit Appeals, 2nd Circuit, the court held more than they may have intended if Suisse’s claim. According to the court, that some preliminary agreements, they are not vigilant when negotiating Credit Suisse’s desire for lending fees such as letters of intent or memoranda and drafting the documentation. contributed significantly to the of understanding, may bind the demise of Yellowstone. Although this parties and require them to complete The following are tips for private appears to be an unusual ruling, it the contemplated transaction even if equity sponsors to consider when emphasizes that all creditors should the parties are unable to reach preparing letters of intent, be cognizant of the risks involved and agreement on definitive documents memoranda of understanding or other take steps to mitigate those risks. for the transaction. The court similar documents in order to mitigate considered the language of the the risk that they will become bound Conclusion agreement, the context of the negotia- to complete a transaction when it was In the current environment, it is tions between the parties, and the not the sponsor’s intention to do so: increasingly likely that sponsors may existence of open terms in deter- n Use unambiguous language for the mining whether the preliminary consider lending money to struggling title of the document. Use a title agreement in question was binding on portfolio companies. With some for the preliminary agreement the parties. The court concluded that additional care and consideration, a containing words such as proposal, a preliminary agreement that clearly sponsor’s risk of its debt claim being letter of intent or memorandum of manifests the intention of the parties equitably subordinated or recharac- understanding. A document entitled to be bound will obligate the parties terized as equity can be reduced “letter agreement” may be inter- to fully proceed with the transaction. significantly. Since each of these preted as manifesting the intent of remedies is in furtherance of the The court presented several factors the parties to be bound. However, court’s equitable powers, however, the that, if present, could result in a one should not rely alone on the court still has ultimate discretion over preliminary agreement binding the title of a document to manifest the whether to employ these remedies for parties to complete the transaction, intent of the parties not to be the benefit of other creditors. including: bound by such agreement.

Weil, Gotshal & Manges llp  Private Equity Alert September 2009

n Include a conspicuous disclaimer that the document is not intended to be Beijing binding. In order to strongly indicate the intention of the parties not be bound Steven Xiang +86-10-8515-0558 by a preliminary agreement, a conspicuous disclaimer within the document Boston should indicate that the understandings contained therein are for discussion James Westra purposes only and do not constitute a binding agreement (except, of course, with +1-617-772-8377 respect to certain provisions which the parties may intend to be binding, such as Budapest exclusivity and confidentiality) but merely express a summary of current discus- David Dederick +1-361-302-9100 sions with respect to the transaction and that any terms discussed in the Dallas document shall only become binding upon the negotiation and execution of Glenn West definitive agreements. +1-214-746-7780 Frankfurt n Indicate terms that remain open. Including a list or a discussion of terms that Gerhard Schmidt remain open strongly indicates that the parties do not intend for the preliminary +49-69-21659-700 agreement to be definitive or binding and that a definitive agreement is Hong Kong necessary in order to bind the parties to complete the transaction. It is recom- Akiko Mikumo +852-3476-9008 mended that parties include clear and unambiguous language that specifies that Peter Feist the parties do not intend to be bound until (a) the private equity sponsor +852-3476-9100 completes the due diligence process to its satisfaction, (b) the investment London committee of the private equity sponsor approves, in its sole discretion, any Michael Francies +44-20-7903-1170 potential transaction and (c) the parties enter into a definitive written agreement Marco Compagnoni to complete the transaction. +44-20-7903-1547

Letters of intent, memoranda of understanding and similar preliminary documents Munich Gerhard Schmidt are important components of private equity deals. However, sponsors need to be +49-89-242430 aware of the risks that such preliminary documents may be deemed binding. There New York is also a risk in some jurisdictions that a court may impose a good faith duty of Thomas Roberts negotiation on the parties and require them to work together to negotiate defin- +1-212-310-8479 Barry Wolf itive agreements for a transaction. By following the practice tips identified above +1-212-310-8209 and having counsel carefully review all preliminary documents, private equity Doug Warner sponsors can lay out the intent of the parties while still avoiding the unintended. +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, Providence 767 Fifth Avenue, New York, NY 10153, +1-212-310-8000. The Private Equity Group’s practice includes David Duffell +1-401-278-4700 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 Shanghai fund sponsors in organizing a wide variety of private equity funds, including , , Steven Xiang distressed debt and real estate opportunity funds, and the representation of large institutional +86-21-6288-1855 investors making investments in those funds. Our transaction execution practice includes the Silicon Valley representation of private equity fund sponsors and their portfolio companies in a broad range of Craig Adas transactions, including leveraged , merger and acquisition transactions, strategic investments, +1-650-802-3020 recapitalizations, minority equity investments, distressed investments, venture capital investments Warsaw and restructurings. Pawel Rymarz Editor: Doug Warner ([email protected]), +1-212-310-8751 +48-22-520-4000 Deputy Editor: Michael Weisser ([email protected]), +1-212-310-8249 Washington, DC Robert Odle +1-202-682-7180 ©2009. All rights reserved. Quotation with attribution is permitted. This publication provides general information Wilmington 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 E. Norman Veasey views of Weil, Gotshal & Manges LLP. If you would like to add a colleague to our mailing list or if you need to +1-302-656-6600 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]. www.weil.com

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