Conversations with banks tend to have a different tone than you are likely used to when they concern troubled portfolio companies. In these situations, the bank is often focused on how the fund is going to backstop the company, and will often ask for the fund to simply put in more equity.
In a nearly ritualistic way, the dance will continue, with the next step having you explain why your formation documents may prohibit an additional investment or why, regardless, an equity infusion isn’t going to happen. The negotiations continue and can spin the situation in a number of different directions. Sometimes, you will end up putting new money in, as junior secured debt or maybe through a last-out participation. Other times, the situation can end in a bankruptcy. And there are a lot of possibilities in between.
The Power To Destroy
During the negotiations, in the background, is the threat (rarely explicitly made) that the company will file bankruptcy if a deal with the banks cannot be made. Bankruptcy won’t always be consistent with the fiduciary duties of the board, but it often is (and sometimes it’s the only way to fulfill those duties). In bankruptcy, everybody loses. Sure, bankruptcy is powerful medicine but like a lot of drugs, the side effects can be nasty. Suffice it to say, it is costly and it nearly will always impact the value of the business in a negative way. The only question is this: To what extent can the impact be limited (the point of so called “first day motions” is largely to try to do this).
What’s our point? It is that, many times, a sponsor’s maximum leverage lays in the threat of bankruptcy. What’s the title of this article about? It refers to a tactic available to banks (and to any lender secured by all the assets of a company) which, until recently, was almost never used.
Banks are in the business of banking, not running companies. And bankers tend to be risk -adverse animals. So, it is not surprising that it is somewhat unusual for a bank to take stock and voting rights as collateral. Nor is it surprising that it is (or, at least until recently, was) nearly unheard of for a bank to actually exercise the voting rights that have been pledged. They—and their even more risk adverse lawyers—fear “lender liability” the way you probably fear having to go back to whatever you did before you were in private equity.
Bankers Gone Wild
But something’s changed. We don’t know what lenders’ lawyers have been drinking lately, but we’ve seen banks exercise the right to vote several times in the past 18 months or so (whereas prior to that, we had never seen a bank actually do it).
The banks that exercised these rights were large national lenders with sophisticated counsel on larger sized credits. While we were surprised to see this happen, we would be extremely surprised if we ever saw a smaller regional bank pull this trigger and even more surprised if a small community bank were to attempt this move.
The set-up for this strategy is made when the loan is first made: Lender makes a loan to borrower secured by all assets of borrower. Owner of borrower (by owner, we mean the holding company that owns the operating company) executes a guaranty in favor of the lender and the guaranty is secured by a pledge agreement of all ownership interests in borrower along with the option for lender to exercise exclusive right to vote all shares in the event of a default. That’s it. A pledge is a pledge is a pledge. If a borrower or shareholder of a company pledges stock and voting rights, the pledge will stick if documented properly.
With this structure in place, as soon as an event of default occurs, the lender may exercise the right to vote all shares and decide to elect an entirely new board of directors. The new board is comprised of hand picked “friends of the lender.” With a new board in place, the owners of borrower cannot file bankruptcy for borrower as typically, only the board of directors can approve such a filing. Additionally, with a new board in place, the board can instruct the company to sell all of its assets, conduct an assignment for the benefit of creditors, or cooperate with the lender and have a UCC sale of all assets. At any of the above mentioned sales, the lender may credit bid its debt and become owner of the assets or the company.
UCC and assignee sales can be done in weeks, not months or even years that Chapter 11 takes. No court is involved. No committees are appointed. For the cost of a few publications and minimal professional fees, the collateral passes hands. The UCC sale will wipe out any junior liens if done properly and everyone can go home happy—except the old board members/owner.
See how much fun this is (for the lender)? No long and expensive bankruptcy. No messy litigation. It’s all good (for the lender). In fact, this structure supports the entry of a temporary restraining order in favor of the lender to keep the owners of borrower from filing a bankruptcy and conversely can withstand a motion for a temporary restraining order filed by a borrower. Additionally, even if you never pull the trigger on this remedy, the looming threat that you might , may just be enough to scare the company into doing what you want. Are there defensive moves to prevent a board takeover? Sure, but you can’t expect us to give you all the answers here…
What about reactive moves? That is, what can a sponsor do after its appointed board members have been replaced upon the bank’s exercise of a pledge right? It’s a difficult situation, to say the least. Lender liability suits are extremely difficult to win. Obtaining temporary restraining orders require proof that there is a substantial likelihood that the old board will win on the merits of its case—which is hard to do with a fully executed pledge agreement staring the judge in the face. Suffice it to say, like many things in life, its better to be proactive and prevent it from happening in the first place.
While these tactics have been rarely used by banks (or other traditional lenders), they have been in the arsenal of loan to own players for quite some time.
What’s Good for the Goose…
If you are not a loan-to-own player, maybe its time to open your heart and mind to becoming one when the right situation presents. If you would be happy to own the underlying company but satisfied just clipping the coupon on the loan if the borrower doesn’t default, it is a great model. And even if you don’t want to take your firm in that direction, putting some of your purchase price in in the form of secured debt will, at least, give you a distinct advantage (at least vis a vis unsecured creditors) should your portfolio company run into trouble later.
When all is said and done, the dollar cost and the brain damage of getting ownership of the business or the assets of the business by using the right to vote can be much less than if the company went through a bankruptcy and was ultimately liquidated through a 363 sale or otherwise. All it takes is a simple pledge of stock/membership interest and a pledge of the right to vote. Are there hiccups that may occur? Sure. In one of the situations we were involved in, where we were brought in by the sponsor after control of a board was stripped from it, the company ended up in bankruptcy any way because a deal could not be cut with the largest unsecured creditor, a noteholder, outside of bankruptcy and the new board (appointed by the bank) and buyer wanted the additional protection of a 363 sale order. Even in the absence of specific road blocks, one would be hard pressed to ever suggest that a bankruptcy does not provide an added layer of protection for a board and a buyer. So, at the end of the day, there will always be a cost/benefit analysis over whether a bankruptcy makes sense.
Regardless, though, even if a bankruptcy is necessary, its going to be a very different bankruptcy if it is one filed by a “disinterested” board whose members were appointed by the bank rather than the board you controlled before it was replaced upon the exercise of a bank’s stock pledge.
Are there other hiccups that could occur? Sure. No plan is bulletproof. You could end up in front of a judge that in a former life was a borrower’s attorney. The former owners could file lender liability claims. Junior creditors can file equitable subordination claims. We could go on.
We never said bankers were stupid. They’re just more risk adverse than you (then again, so are we). Lately, however, the bankers have been stepping out on the same proverbial ledge that funds have been balancing on for years. And now that they are using a newer gun, its time for you to upgrade your body armor.
Jonathan Friedland and William Schwartz are partners with Levenfeld Pearlstein LLC, a law firm based in Chicago. They have represented old boards, new boards, troubled portfolio companies, and buyers of troubled companies in the situation described in this article. Friedland is the principal author of two books published by Thomson/Reuters/West, Commercial Bankruptcy Litigation and Strategic Alternatives for Distressed Businesses. He also chairs the advisory board of DailyDAC, LLC.