Out-Of-Court Debt Restructuring And The Problem Of Holdouts And Free Riders

Thursday, September 19, 2013 - 16:15

Restructuring professionals often promote the benefits of Chapter 11 of the United States Bankruptcy Code for restructuring the debts of insolvent or financially distressed businesses.  Among its virtues, Chapter 11 provides a reasonably well-defined set of rules, a developed body of judicial law interpreting those rules, an automatic stay prohibiting creditors from exercising remedies outside of the bankruptcy process and a central forum (the bankruptcy court) where all parties can be heard and disputes can be resolved either consensually or, when necessary, by decision of a single judge who presides over the entire process. 

One of the most appealing features of Chapter 11 is the ability to bind minority creditors to a restructuring plan that is accepted by a statutorily defined majority.  Section 1122(a) of the Bankruptcy Code permits a proponent of a Chapter 11 plan to place creditor claims into classes of substantially similar claims for purposes of voting on a plan. General unsecured claims can be placed together in a single class regardless of the nature or origin of the claim. For example, an unsecured lender or bondholder may be placed in the same class as landlords and trade vendors. Whether a plan is accepted by creditors is determined by whether the class of claims, as a whole, has voted to accept it.

Section 1126(c) of the Bankruptcy Code provides that a class of claims has accepted a plan if the plan has been accepted by creditors in the class representing at least two-thirds in amount and more than one-half in number of claims held by creditors that vote.  Only claims of creditors that vote are counted for purposes of determining acceptance. Therefore, unlike requirements in other creditor voting contexts, such as where a threshold percentage of debt outstanding is required, a creditor's failure to vote on a Chapter 11 plan will not count as rejection – it simply will not count at all.  As a result, a restructuring plan can be confirmed and become binding on all creditors, even those who object to the plan and those who did not vote on it.  In a sense, class voting under Chapter 11 can replace voting requirements in bond indentures and syndicated credit agreements, thereby making a restructuring more likely when there is a sufficiently large number of holders or lenders that could successfully block restructuring outside of bankruptcy.

In contrast, restructuring debt outside of a bankruptcy case requires coordinating and motivating disparate groups of creditors, careful examination of different default triggers and voting requirements in multiple financing documents, creditors' voluntary forbearance from exercising default remedies, formation of steering committees, governance structures, confidentiality, and generally keeping parties engaged in a restructuring process when they are not forced to.  Among the principal issues that arise in out-of-court restructurings are the problems of holdouts and free riders.  Holdouts are creditors that are in a position to block a restructuring and use that leverage to extract additional value for themselves (i.e., payment in full from the debtor, other creditors or a hedge counterparty).  Free riders are creditors that do not contribute to a restructuring but obtain the benefit of a financially healthier debtor at the expense of those creditors that made concessions.  The two are not mutually exclusive; holdouts that ultimately are unable to prevent a restructuring become free riders when the restructuring is completed. 

There are advantages to out-of-court restructuring over a Chapter 11 case.  It's a much more flexible process that allows the participating parties to define the parameters of the negotiation including what payments the debtor can continue making, disclosure of confidential information limited to just participating creditors, allowance of interest and other amounts that would be subject to disallowance or subordination in a formal bankruptcy case, short-term extendable forbearance instead of a broad stay, avoidance of public reputational damage to the company, and the avoidance of an uncertain judicial process that is adversarial, invites all parties to be heard and is constrained by the availability of court time and other judicial resources. 

An out-of-court restructuring may be initiated by the debtor or by one or more creditors. The debtor may initiate the process by approaching one or more of its largest financial creditors in an effort to engage the creditors in discussion, persuade them that an out-of-court restructuring is desirable to formal bankruptcy and encourage them to marshal other large financial creditors to form a steering committee.  The largest financial creditor usually will chair the steering committee.  There is no need to involve non-financial creditors, and it is often better to permit the debtor to continue paying trade creditors, employees, landlords and other debts in the ordinary course while restructuring discussions are proceeding. 

At the onset of an out-of-court restructuring, the participating creditors must agree to a standstill or forbearance that prohibits each creditor from exercising default remedies or otherwise taking action against the debtor outside of the restructuring process.  Forbearance agreements are short-term to keep pressure on all the parties and allow creditors to abandon restructuring and pursue remedies if progress is not being made at an acceptable pace.  A typical initial forbearance period may be two to three weeks and a second term may be 30 days.  If discussions are going well, the term is extended and the periods between terms may be increased.  Forbearance typically terminates automatically if any creditor (on the steering committee or not) takes action to enforce its rights against the debtor. 

In the context of out-of-court restructuring there are two separate negotiations happening simultaneously:  One is the negotiation between the creditors and the debtor to restructure the debt, and the other is among the creditors inter se.  Financial creditors that participate in restructuring may share an interest in restoring the debtor to financial stability, but they often have different ideas about how to proceed and they are characteristically guarded when it comes to disclosing to each other information about their exposure, the terms of their individual agreements and whether they have credit protection for all or any portion of the debt.  For these reasons, there is a confidentiality agreement between the creditor group and the debtor and a separate confidentiality agreement among the creditors on the steering committee. Steering committees typically engage professionals (in addition to legal counsel), such as accountants and financial advisors, to test the veracity of the financial information being provided by the debtor, as well as to act as a confidential repository of the steering committee members' transaction documents.  In its capacity as confidential document repository, the steering committee's financial advisor has access to information about each creditor's exposure without the creditors having to share the information with each other.  This presumes a high level of trust in the financial advisor to keep the information confidential and not present it in a way that reveals each creditor's position.  If there are a large number of creditors on the steering committee, the financial advisor can present data to the group on an anonymous basis, and it is not readily apparent which creditor correlates to any specific data.  The smaller the group, the easier it is to determine which creditor is which even if the information is presented anonymously. 

In light of the different rights and interests of the individual creditors, the negotiation among the creditors can be more sensitive than the actual restructuring negotiation with the debtor. Different creditors have different relationships with the debtor and therefore may have access to different levels of information. Each creditor may place conditions on any concession it makes in the restructuring on certain concessions being made by other creditors.  If any of the creditors have credit protection – credit insurance or credit default swaps – their interests may conflict with the rest of the group, and they may have incentives to force the restructuring into a form that triggers their rights against hedge counterparties or even push the debtor into formal insolvency. 

The goal of a restructuring is to improve the financial condition of the debtor so that it is able to service its debt.  To achieve that goal, participating creditors have to make concessions, such as reducing the amount of their debt, extending maturities, reducing the amount of periodic payments and spreading out payment dates in a manner that fits the debtor's cash flow projections over a period of time.  The greater the number of creditors participating in the restructuring and making these concessions, the better the debtor's financial condition will be coming out of the restructuring, and the more likely the debtor will be to perform its restructured debt obligations.  At a minimum, the largest creditors would have to participate for the restructuring to work.  But there may be creditors who are aware of the restructuring but deliberately decline to participate so that they can be paid in accordance with their debt instruments without making concessions and enjoy the benefit of a financially healthier debtor.  While it is expected that participating creditors will have to tolerate a certain amount of these "free riders," if there are a significant number, then the restructuring may not succeed. 

Another problem is holdouts: creditors whose participation is necessary to make a restructuring work but who decline to participate in the hope that they will recover payment in full, or at least more than they expect to recover in the restructuring.  If the other creditors do not agree to pay the holdout, the restructuring will fail and the debtor will either liquidate or commence formal bankruptcy proceedings. This is the classic "prisoner's dilemma" in which the holdout must choose between the known recovery from cooperating with the other creditors and the unknown recovery that will either be better if the holdout is paid in full or worse if the restructuring fails and the debtor is forced into liquidation or formal bankruptcy.  The only leverage participating creditors have to persuade a holdout to cooperate is market leverage, such as peer pressure if the participating creditors do other business with the holdout away from the particular restructuring at hand.  Another factor that could persuade a holdout to cooperate is that a holdout in one case may be a participating creditor in another case and need the cooperation of the other creditors in the next restructuring. Persuading a holdout to cooperate often involves elevating the issue to the highest levels of the institutions' senior management.

These are some of the more salient issues that arise in out-of-court restructuring.  These and other factors must be weighed against each other to determine whether a restructuring should be pursued out of court or in a formal bankruptcy proceeding.

Rick Antonoff is a Bankruptcy and Restructuring Partner in the New York office of Clifford Chance.  

Please email the author at rick.antonoff@cliffordchance.com with questions about this article.