Private Equity 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]) Providence Equity Partners and Ayala Corporation, in connection with the business 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 capital structure could be attacked by other Investments, 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 50(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 loan 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 loans 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 05 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 Undercapitalization. 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 008 issue of Private investment 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 05 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,