As default rates continue to rise, many junior capital lenders are finding their debt positions “under water” or “out of the money.”
In many cases, the underlying financial condition of the borrower is so poor that its equity becomes worthless. In these situations, the inevitable workout and restructuring discussions lead the junior capital lenders down one of two paths. First, the lenders can take an aggressive position to gain leverage in the restructuring, which may cause a liquidation or sale of the company in an effort to receive, in many cases, pennies on the dollar. Second, the lenders can become the owners of the business by negotiating a conversion of their outstanding debt into equity in an attempt to generate greater long term returns. In certain situations, lenders are forced to go simultaneously down both paths with an eye towards the more desired outcome. This article investigates the twists, turns and roadblocks that junior capital lenders must navigate as they consider the possibility of transitioning from lender to owner.
By converting their debt to equity, junior capital lenders typically become the majority or sole equity owners of the underlying companies. The lenders effectively take over the role reserved for the original equity sponsors, and they become the owners of the business. The goals vary by company and lender, ranging from a short-term goal of creating sufficient enterprise value to allow for an exit at or above the amount of their original investment to a longer term view of thinking and behaving like an equity investor seeking equity-like returns. Through their newfound equity positions, the lenders would typically control the board of directors and set the business plan. By restructuring the company’s capital structure and reducing its debt service obligations, the lender cleans up the balance sheet with the goal of providing the borrower with the liquidity needed to survive and continue operations.
There are a number of legal and practical considerations for junior capital lenders to consider when becoming controlling equity sponsors. The most prevalent and significant issues fall into four general categories: (1) the significant dilution of existing equity holders (2) the taking of equity rights by the junior capital lenders (3) the legal implications of taking control of the equity and (4) the business implications of taking control of the equity.
1. Dilution Of Existing Equity Positions. • Equity Wipe-Out. In most debt/equity conversion transactions, existing equity owners are either wiped-out entirely or diluted considerably. The full wipe-out typically occurs in those cases when either the lender can effectuate the conversion without the consent of the equity holder (bankruptcy or foreclosure), the equity sponsor has no leverage at all as a result of its equity being so far under water, or, is seeking a clean walk-away. In the cases where equity holders are allowed to retain a sliver of equity, it is typically in exchange for their consent and cooperation in the recapitalization. The retained equity provides the original equity sponsors with some hope, however limited, for a future return on their investment. One of the key considerations is the impact of existing anti-dilution and pre-emptive rights provisions. In essentially all circumstances, these existing provisions need to be waived, amended or deleted entirely in order to effectuate the desired equity allocations among the stockholders who retain a going-forward interest in the company.
• Change Of Control. Most debt/equity conversions are so dilutive to existing stockholders that they may trip “change of control” provisions under contracts with customers, suppliers and employees, real estate leases, other debt-instruments, stock option plans or other company documents, such as director and officer insurance policies. All of the parties involved must consider which, if any, change of control provisions are impacted as they may result in unexpected outcomes, such as termination of important contracts, acceleration of indebtedness, vesting of outstanding options or the cancellation of insurance policies.
2. Taking Of Rights By Junior Capital Lenders.
• Governance. Ironically, the package of rights typically enjoyed by the lenders who receive equity kickers and the original equity sponsors are flipped on their head in the recapitalization. The diluted equity sponsors are relegated to hoping to receive certain minority rights—limited information rights and potentially piggy-back registration rights. Conversely, as the new majority equity owners, the junior capital lenders have their choice of rights—negative covenants, approval rights over transfers, board representation/control, pre-emptive rights, etc.
• Type of Security. Junior capital lenders must determine the type of equity security their debt will convert to. The most common options are straight convertible preferred stock, participating preferred stock and convertible preferred stock with a multiple liquidation preference. With straight convertible preferred, on liquidation the holder has the choice of taking the greater of (a) its original investment amount plus, in many cases, an accruing dividend (usually 8 percent) and (b) the value of the common stock into which the preferred is convertible. With participating preferred stock, on liquidation the holder has the choice of taking the sum of (a) its original investment amount plus, in many cases, an accruing dividend (usually 8 percent) and (b) the value of the common stock into which the preferred is convertible. With convertible preferred with a multiple liquidation preference, on liquidation the holder has the choice of taking the greater of (a) a multiple of its original investment amount (typically 2x or 3x) plus, in many cases, an accruing dividend (usually 8 percent) and (b) the value of the common stock into which the preferred is convertible. In most cases, the junior capital lender will choose to structure its equity as preferred equity to achieve priority over the remaining equity holders.
3. Legal Implications Of Taking Control Equity Positions.
• Consents, Waivers and Releases. As with many financings, a debt-to-equity conversion frequently requires consents from other lenders, holders of previously issued preferred stock or other parties. For example, a class or series vote may be required under state law or the terms of existing preferred stock to create a new class or series of preferred stock, particularly if the new securities will rank pari passu with or senior to the existing securities. The lender must make its investment conditioned on the company obtaining waivers from existing stockholders of anti-dilution and preemptive rights, and possibly amendments to the terms of existing securities or agreements. It is also worthwhile to try to obtain a release and acknowledgement from as many of the current stockholders of the company as possible. The danger of proceeding without a release is that, at a later time when the company has appreciated significantly in value (e.g., at an IPO or sale), a stockholder may bring an action against the company (and potentially against the investors that participated in the recap) claiming that its position was unnecessarily diluted.
• Fiduciary Duties. Existing lenders with representatives on the board of (or who control) the company who intend to participate in the transaction have a conflict of interest with respect to authorizing the transaction. Stockholders who subsequently challenge these lender recapitalizations often focus on the conflict the board faces in approving the transaction. Accordingly, junior capital lenders must walk a fine line. They must pay particular attention to the process by which the board approves a recapitalization to ensure the members of the board have adequately discharged their fiduciary duties but at the same time not exercise too much control so as to expose themselves to lender liability claims. Ideally, the recapitalization should be authorized by directors who do not have a conflict of interest (if there are enough of them to constitute a quorum). Absent a quorum of disinterested directors, the full board should delegate the decision to authorize the transaction to a special committee of disinterested directors. In any case, all material terms of the proposed financing should be carefully considered by the board (or special committee), and counsel should assist the board in fully and accurately reflecting its deliberations in meeting minutes to establish a written record. Obtaining a fairness opinion is an additional tool to reduce the likelihood of future attacks, although in many cases the time and money involved in obtaining such an opinion will make this impractical. While these strategies alone will not satisfy the board’s fiduciary obligations (particularly where the level of dilution to existing stockholders is very high), they help establish the overall fairness of the transaction and may make stockholders less likely to sue. In situations where the lender does not have a board representative, the fiduciary duty risk is significantly tempered.
• Indemnification. Given the heightened risk of third-party suits following a debt to equity conversion, it is also appropriate to seek indemnification from the company against third-party claims resulting from the conversion. In addition, the lender will want to make sure it is satisfied with the company’s level of Directors & Officers, or D&O, insurance and that all of its board nominees enter into a director indemnification agreement with the company. In reviewing D&O policies, it is important to note the specific policy exclusions since often the risks that lenders are trying to protect against may be carved out from coverage.
4. Business Implications Of Taking Control Equity Positions.
• Employee Retention/Morale. A significant issue for the board and management to consider in the context of a debt-to-equity conversions is the effect of the transaction on the morale of employees generally, but in particular, those with equity in the company. Debt-to-equity conversions typically become public within a private company and option holders quickly realize that their equity is out of the money. It often will be appropriate to take steps to re-incentivize key employees through re-pricing their existing equity (to the extent it doesn’t create adverse tax or accounting consequences) or issuing them additional new equity at the new lower price. As noted above, a significantly dilutive recap can inadvertently provide some psychological benefit to employees holding options that have vesting accelerated due to a technical change of control in the down-round. While these options are no doubt still out of the money, the employees often perceive that that they have “earned” the equity and a resulting benefit.
• De-leveraging the Balance Sheet. With all the issues and complexities of converting debt to equity, why are more lenders taking advantage of this tactic? At the conclusion of the conversion, it often significantly decreases the debt burden on the company and allows it to focus resources on problem-solving—purchase of inventory, capital expenditures, reducing payables. Sometimes this conversion is the only relief that is available to save the viability of the business. A change in the balance sheet as well as direction of the ownership philosophy is an important step for junior capital lenders to begin to see a potential return on their investment in the future.
As junior capital lenders face troubled portfolio companies they need to consider whether conversion from debt to equity is a viable and worthwhile option. Part of that analysis requires a review of the myriad of legal and document issues. This has become more of an effective tool for junior capital lenders so long as they proceed methodically and cautiously through the issues and process.
Steven M. Ellis is a partner in Proskauer Rose’s corporate department, head of the Boston office, co-head of the Distressed Debt Group and Junior Capital Group, and co-chair of the Corporate Finance Group. Reach him at firstname.lastname@example.org. Alexander B. Temel is a partner in the Corporate Department and is a member of the M&A/Private Equity Group. Reach him at email@example.com..