In the Radnor Holdings Chapter 11 case, Case No. 06-10894 (PJW) (Bankr. D. Del., November 17, 2006), the Delaware Bankruptcy Court has reinforced a secured lender's ability to take reasonable, market-tested actions to protect its position. The court overruled the objections of the official unsecured creditors' committee (the "Committee") to the "stalking horse" credit bid of the debtor's pre-petition secured lenders (hereinafter, the "Lenders"), allowing the Lenders' claims in full and approving the Lenders' credit bid as the highest and best offer for the debtor's assets.
This decision follows two significant Third Circuit opinions which also refused to recast pre-bankruptcy financings in ways that would undo the claims, rights and protections commonly bargained for by lenders and exercised in times of borrower distress. In its January 2006 Submicron Systems Corporation decision, 432 F.3d 448 (3d. Cir. 2006), the Third Circuit upheld the sale of the debtor's assets to a group that included its secured lenders, rejecting recharacterization and equitable subordination as contrary to the parties' intent as evidenced through a common sense evaluation of the facts and circumstances surrounding the transaction. The Third Circuit eschewed a "mechanistic scorecard" in favor of determining the parties' intent through a common sense evaluation of the facts and circumstances surrounding the transaction.
The Third Circuit's Owens Corning decision on substantive consolidation, 419 F.3d 195 (3d Cir. 2005; cert. den. McMonagle v. Credit Suisse First Boston, 126 S. Ct. 1910, 164 L.Ed. 2nd 685, 2006 U.S. LEXIS 3492, 74 U.S.L.W. 3618 (2006), ruled that since the existence of inter-affiliate guarantees of the debtor's bank debt and a material degree of operational coordination and management of the affiliates resulted from arms' length negotiations and were common in lending arrangements, those deal terms alone would not support the pooling of assets and liabilities of affiliated debtors to implement distributions to all creditors of all debtors. The court ruled that substantive consolidation effectively would have punished the lenders for incorporating market-accepted terms into their financing arrangements, where no evidence was adduced of wrongdoing by the lenders.
As in the Third Circuit decisions, the Radnor Holdings court was loathe to upset arms' length negotiated financings absent evidence of actual lender wrongdoing. The Third Circuit's cautionary note in Owens Corning appears to be resounding: "No principled, or even plausible, reason exists to undo [the borrower's] and the Banks' arms-length negotiation and lending arrangement, especially when to do so punishes the very parties that conferred the prepetition benefit - a $2 billion loan unsecured by [the borrower] and guaranteed by others only in part. To overturn this bargain, set in place by [the borrower's] own pre-loan choices of organizational form, would cause chaos in the marketplace, as it would make this case the Banquo's ghost of bankruptcy." 419 F.3d 216
Still, the vaulting ambition of creditors and shareholders seeking litigation leverage in the absence of economic strength threatens to create its own bit of chaos within a particular case, as seen in Radnor Holdings . There, the court's ruling came after nearly two months of extensive pre-trial discovery and eight full days of trial which saw 14 witness testify and admitted more than 350 documents into evidence. Accordingly, Radnor Holdings is instructive as to the impact the pre-petition lender/borrower relationship may have upon the borrower's default and insolvency, and the intense microscope under which such relationship will be examined .
Ten months before the company's Chapter 11 filing, the Lenders invested $120 million in Radnor - $95 million in secured debt and $25 million of preferred equity. The funds were used to retire $70 million of senior secured notes, to refinance or reduce certain other existing indebtedness and to provide Radnor with enhanced liquidity. Under an Investors Rights Agreement entered into in connection with the Lenders' preferred stock, the Lenders were granted (and exercised) the right to appoint one designee to the company's four member board of directors and one board observer.
Shortly after closing, Radnor missed its 2005 EBITDA projections by a significant margin. Six months later, faced with what was believed to be a short-term liquidity issue, the Lenders provided an additional $23 million of secured financing. Notwithstanding this additional liquidity, Radnor's financial condition continued to deteriorate.
Three months after the second financing, Radnor's working capital lenders (not affiliated with the Lenders) cut off funding, resulting in the debtor's August 2006 Chapter 11 filing. At the company's request, the Lenders provided a "stalking horse" bid, which contemplated payment for substantially all of the company's assets though the Lenders' credit bid of a portion of their clams. Accordingly, the company filed for Chapter 11 and, with court authorization, began immediately a bankruptcy auction process, seeking competitive bids against the Lenders' stalking horse bid.
The Committee's Lawsuit
The Committee supported the entry of a bidding procedures order establishing the auction process and scheduling a bankruptcy court hearing to consider the sale of the company to the highest and best bidder. While the Committee waived its right to object to the sale, it preserved its ability to challenge the Lenders' decision to accede to the company's request and make the stalking horse bid for the debtor's assets. The Committee appeared to find the bid particularly objectionable because it contemplated payment of the purchase price through a credit bit, which would leave no recovery for unsecured creditors.
The Committee apparently was convinced that the Lenders' ability to credit bid the full amount of their claim would result in a sale process that would generate no recovery for unsecured creditors. In an attempt to defeat the proposed sale to the Lenders, the Committee filed a lawsuit against the Lenders, seeking to (i) recharacterize as equity or equitably subordinate approximately $128 million of secured loans provided by the Lenders to Radnor within 10 months of the bankruptcy filing (including approximately $20 million provided within 4 months of the filing); (ii) prevent the Lenders from being the "stalking horse" bidder and from credit bidding their secured claims in satisfaction of the purchase price, (iii) disallow the Lenders' claims, and (iv) obtain damages against the Lenders on various theories including breach of loyalty and care, aiding and abetting breach of fiduciary duty and other misdeeds.
The Committee argued that the Lenders had pursued an improper "loan-to-own" strategy designed to overload Radnor with debt that could not be serviced, while using its preferred equity stake to play an active role on the debtor's board, all to facilitate what the Committee asserted was the Lenders' ultimate goal - to obtain ownership of Radnor's assets at depressed values, leaving no recovery for the approximately $150 million of unsecured bond and trade creditors.
The Court Rules In Favor Of The Lenders On All Counts
Ultimately, the Bankruptcy Court ruled for the Lenders on all counts. The Bankruptcy Court closely followed the Submicron Systems decision in ruling against the Committee's recharacterization and equitable subordination claims. The court found that the Lenders' investments were made based upon the debtor's well thought out, albeit optimistic, bottoms-up financial projections, and noted that other potential financing sources existed at the time of the initial lending. The court further found that at the time of the Lenders' initial investments, the parties' intent was clear - the original secured loans were a true debt investment by the Lenders, in contrast to their preferred stock investment. Citing SubMicron , the court ruled that the Lenders' knowledge of Radnor's liquidity crisis at the time of the subsequent April 2006 loan was insufficient to support recharacterization, noting that it was legitimate for an existing lender to extend additional credit to a distressed borrower as a means to protect its existing loans.
The court also held that the Lenders did not exercise control over the debtor's day-to-day operations, because they did not dictate corporate policy or disposition of corporate assets without limits. The court agreed with the Lenders that it is not unusual for lenders to have designees on a company's board, monitor the business and exert influence regarding financial transactions, particularly when a company is distressed. Such typical activities, by themselves, in the absence of objectionable behavior, are not tantamount to control. Similarly, the court found that the Lenders' access to non-public information was insufficient to establish insider status, especially where the same information was shared with other potential bidders.
Other key findings of fact included:
the Lenders conducted their own independent financial, business and legal due diligence and reasonably believed that Radnor could meet its financial projections and the performance covenants contained in the loan documents;
the Lenders' initial loan was supported by adequate collateral appraisals;
the loan terms and investment documents were typical for transactions of that type;
there was no evidence that the Lenders intended to acquire Radnor at the time of the initial or subsequent loan transactions;
the Lenders' transactions did not harm the debtor's creditors; to the contrary, they benefited creditors by reducing the debtor's net debt;
Radnor's decision to obtain an additional loan four months before the bankruptcy filing and to use the loan proceeds to stabilize the business, take advantage of the opportunities presented by new product and improve performance was protected by the business judgment rule;
unsecured bondholders continued to receive interest payments on their loan, and were paid for their consent to the additional loan;
pre-petition, the Lenders gave substantial concessions to the debtor, including entering into a forbearance agreement and agreeing to subordinate a portion of its senior secured debt to the debtor's working capital lender; and
the Lenders had valid business reasons to provide a stalking horse bid, and had been convinced by the company that without such a bid, including overbid protections, the company would face a free-fall bankruptcy and possible Chapter 7 liquidation.
In contrast to all of these facts and considerations, the court found that the Committee failed to produce any evidence in support of its allegations. Accordingly, the court allowed the Lenders' claims in full, and permitted them to credit bid the full amount of their claims.
Implications For Secured Lenders
The Radnor Holdings case reinforces the principle that the rights and remedies of secured lenders should be respected absent evidence of bad faith, improper motive or undue control. In Radnor Holdings , the Lenders or their affiliates held equity interests, had non-controlling board representation and other common investor/lender rights and protections. Central to the court's rulings were its favorable factual findings regarding, among other things, the parties' intent at the time the loans were made that they were to be treated as true secured debt obligations, the lack of control exercised by the Lenders (notwithstanding their minority equity stake, non-controlling board representation and other default rights) and the propriety of the Lenders' workout and credit decisions. Equally significant was the Committee's failure to produce any tangible evidence to support its claims of bad faith, improper motive and undue control by the Lenders - indeed, the facts suggested exactly the opposite.
The Radnor Holdings decision supports a lender's reasonable exercise of its bargained-for rights and market-tested recovery strategies, notwithstanding the range of potential litigation claims that may be investigated and even pursued by disenchanted parties-in-interest. Nonetheless, Radnor Holdings also demonstrates that lenders' pre-bankruptcy credit and recovery decisions likely will continue to come under intense scrutiny by creditors' committees and other parties. As a result, creditor rights and recovery strategies should be pursued with care for the specific facts of the situation at hand. Radnor Holdings is surely not the last case in which unhappy creditors and equity holders will pursue litigation strategies in an attempt to enhance their bargaining leverage.
Michel E. Foreman and Scott K. Rutsky are Partners in Proskauer Rose LLP's Bankruptcy and Reorganization Practice Group. Michael may be reached at (212) 969-3218 and Scott at (212) 969-3983.