Litigation Risks In Debt Exchanges

Debt market participants call it “The Wall.”

Over the next several years, some $1.5 trillion of real estate and leverage buyout debt will come due. Efforts to manage this wall are well under way, and some considerable relief has already been achieved, through negotiated restructurings, including high-yield exchanges, partial refinancings and “amend to extend” accommodations. Nevertheless, the ability to refinance the remaining wall of debt maturities may prove to be more challenging than in the past. And in recent months and years, tender offers and new-for-old debt exchange offers have in some circumstances given rise to litigation. Below is a rundown of some of the more significant cases, and the early lessons that they give rise to.

Apollo’s Realogy

A number of courts have already been asked to address complex and highly technical contractual issues arising in the context of real estate and portfolio company refinancing transactions. Just over a year ago, in December 2008, the Delaware Chancery Court entered judgment for a creditor, and against Realogy, a portfolio company of Apollo Management, in connection with Realogy’s effort to use a senior credit facility’s incremental term loan to refinance junior lenders. In subsequent cases, courts have refused to forbid proposed exchange offers. Other cases remain pending.

The two decided cases arising out of exchange offers that are largely viewed by commentators as the leading cases resulted in opposite outcomes. In Bank of New York Mellon v. Realogy Corp., the Delaware Chancery Court entered judgment in favor of toggle note-holders in connection with a proposed debt exchange transaction in which Realogy sought to exchange unsecured notes for new secured term loans. Specifically, Realogy offered up to $500 million in new second-lien term loans, under the “accordion feature” of the senior credit agreement, in exchange for certain unsecured notes at a substantial discount to face value. Toggle note-holders, who were senior or pari passu in the capital structure to certain of the noteholders invited to participate in the exchange offer, but who were not invited to participate, sued to enjoin, or prohibit, the exchange offer, contending that the terms of the accordion prohibited new indebtedness that provided “greater security” than the debt being refinanced.

Realogy, for its part, defended the exchange offer on the grounds that the incremental term loans were issued in compliance with the provisions of the credit agreement. It further argued that, although the incremental term loans were secured, a provision in the definition of “Refinancing Indebtedness” expressly permitted unsecured debt to refinanced with secured debt so long as the additional liens did not otherwise run afoul of the credit agreement’s restrictive covenants.

The Delaware Chancery Court rejected Realogy’s position, holding that in order for the “Refinancing Indebtedness” definition to make sense, it had to be read as prohibiting liens for the new debt above and beyond any liens for the original debt. Otherwise, the specific provisions in the definition, prohibiting the issuance of incremental loans providing “greater security” to any debt being refinanced, would be entirely superseded by the provision of the credit agreement permitting other debt to be secured.

The court’s decision and reasoning in Realogy received immediate attention from the private equity community and its advisers. The decision was a reminder that many courts—and certainly the Delaware Chancery Court, where legal issues arising in the context of exchange offers are more likely to be litigated—are capable of very sophisticated analysis of complex credit agreements, and may very well impute meaning to the terms of the contract not otherwise conveyed by the strict words of the contract.

A challenge to an exchange offer involving Neff Corp. resulted in a different outcome. In Springfield Associates, LLC v. Neff Corp., second-lien secured bank lenders unsuccessfully brought suit to prohibit Neff from completing an exchange offer allowing certain unsecured noteholders the opportunity to exchange their unsecured notes for secured first-lien incremental term loans under the accordion feature of the first-lien credit agreement. Plaintiffs second-lien lenders, who were to become subordinate to the noteholders accepting the offer, sued to enjoin the exchange offer.

The second-lien lenders alleged that the proposed exchange violated their credit agreement and the intercreditor agreement. Plaintiffs also claimed that the offer constituted a breach of fiduciary duty owed to the Neff creditors because Neff was allegedly insolvent and inadequately capitalized at the time of the offer. Neff defended on the straightforward ground that the incremental term loan was approved by a majority of the existing first-lien lenders and was within the basket for unrestricted accordion lending under the first-lien credit agreement.

The New York Supreme Court accepted Neff’s interpretation of the credit agreement and intercreditor agreement and rejected the second-lien creditor’s extra-contractual claims of breach of fiduciary duty. On that basis, the court declined to enjoin the exchange offer, and the offer closed in 2009. The Neff case, like Realogy’s, demonstrates that, except in extraordinary circumstances, creditors hold contractual rights that will be enforced strictly according to their terms. Purported rights beyond the terms of the operative credit agreements, whether predicated on claims of breach of fiduciary duty or otherwise, will not prevail except in extraordinary circumstances.

Pending Cases

There are several pending cases that will continue to shape the law governing exchange offers, and to give market participants more data upon which to assess risks attendant to exchange offers.

By way of example, in a case involving Freescale Semiconductor, senior secured lenders brought suit alleging that Freescale breached its credit agreement when it issued approximately $924 million in incremental term loans as part of a debt exchange offer. The plaintiffs, senior secured lenders to Freescale, with loans totaling approximately $500 million, allege that the Freescale credit agreement prohibited the company from issuing incremental term loans if any of Freescale’s warranties were not “true and correct in all material respects on and as of the date of such Credit Extensions.” The senior secured lenders further alleged that Freescale had suffered a “Material Adverse Effect” as a result of its financial difficulties, and therefore had breached the no-MAE representation in the credit agreement.

In Murchison v. GMAC LLC, the plaintiffs are individual “non-qualified institutional buyers” of unsecured GMAC notes that ranked equally with all other GMAC unsecured, unsubordinated debt. In November, 2008, GMAC undertook a series of exchange offers allowing certain noteholders to exchange their notes for cash, new notes, or preferred stock. The offer was limited to non-qualified institutional buyers and to certain individual buyers defined by the terms of the offers as “qualified buyers” in or outside the United States. Plaintiffs were not given the opportunity to participate in the exchange offer.

After the exchange offer closed, plaintiffs brought suit seeking damages and alleging (1) that the offer breached the indentures governing their notes because it issued notes that were new guaranteed notes without equally and ratably securing their notes, (2) that the exchange offer would render GMAC unable to pay the notes when they came due; (3) that the exchange offer subordinated Plaintiffs’ notes to those of the offerees; and (4) that the offer violated the Trust Indenture Act of 1939, which requires that a bond issuer obtain a bondholder’s consent before impairing the bondholders rights, that a bond issuer honor a bond indenture, and that a bond trustee act as “a prudent man.” In addition to naming GMAC as a defendant, the plaintiff noteholders also named the members of the board of GMAC, as aiders and abetters, and the private equity firm Cerberus Management, as a control person of GMAC.

In Murchison v. Harrah’s Entertainment Inc., the same plaintiff who brought the GMAC action brought suit against Harrah’s Entertainment. As in GMAC, the plaintiffs were non-qualified institutional buyers of unsecured Harrah’s notes. In November of 2008, Harrah’s offered to exchange the unsecured notes held by non-qualified institutional noteholders for new senior notes secured by Harrah’s’ assets. Over the course of the case, the plaintiffs have alleged that Harrah’s breached the indentures governing the unsecured notes because, among other reasons, (1) Harrah’s’ offer was improperly limited to non-qualified institutional buyers and certain non-U.S. investors; (2) Harrah’s triggered a default under the provision because Harrah’s was unable to repay its debts as they become due as a result of offer; (3) Harrah’s effectively subordinated the old notes without the consent of the plaintiff bondholders, as required; and (4) the offer violated the Trust Indenture Act of 1939 prohibiting impairing the rights of bondholders without their consent.

Key Takeaways

The law and interpretation of contractual provisions governing the rights and obligations of the relevant parties in the context of exchange offers is evolving and potentially subjective, making it difficult to determine with precision the circumstances under which exchange offers will be permitted. As the trend toward de-leveraging continues, debtors and creditors must keep a few key points in mind.

Portfolio companies need to know their creditors and motives. Just as with shareholder activism, different creditors take different approaches to restructuring transactions. And the same creditor may take different positions depending on the motives and economic incentives in a particular set of circumstances. Having command over those incentives will drive much of the analysis in handicapping litigation risk in context of potential restructuring.

Intent of the parties may be unclear. If nothing else is taken from the cases decided to date, they confirm that the rights and obligations of parties to credit agreements are driven principally, and in many cases, exclusively, by the terms of the operative contracts. Yet, in many cases, no one predicted at the time the agreements were negotiated that the parties would pursue exchange offers and other restructurings on such a novel and market-wide basis. In the absence of clear intent, there is a risk that courts will impute a “mutual intent” at odds with the strict words in the agreement in order to achieve what that court may view as the equitable result. It is, therefore, critical to stress test operative credit agreements in the context of any restructuring transaction, to identify any potential ambiguity, and to weigh risks accordingly.

Extra-contractual theories are less likely to prevail. Extra-contractual rights are narrowly circumscribed. Fiduciary duties are generally not owed to bondholders, and so-called implied covenants of good faith and fair dealing are not likely to be read into complex credit agreements. Thus, when either a portfolio company or bondholders are handicapping the likelihood of success in defending or challenging an exchange offer, it may be prudent to discount the likely force of off-contract theories.

Establish and protect privileges as you consider options. In restructurings that lead to litigation, certain creditors will aggressively seek internal communications among the debtor, its affiliates and representatives. Thorny and complex privilege questions may arise. Heading into a restructuring, it is critical, therefore, to protect any and all potentially applicable privileges, including attorney-client, work product, joint defense, and business strategy privileges.

Christopher G. Green and Peter L. Welsh are partners in the Securities Litigation Group at Ropes & Gray LLP, where their practices focus on transactional and securities litigation, corporate governance litigation, investment management and financial services litigation, and director and officer representations. They can be reached at and