Editor: Last month we interviewed two of your partners, Evan Flaschen and Gregory Nye, who are involved in leveraged finance and restructuring. How do your two specialties complement their work?
Carey: For several years I have been working with Evan, because my traditional expertise in front-end high yield transactions and services in general complement his bondholder representations. I am not a bankruptcy lawyer literally, but I do complex indenture analysis as well as exchange and tender offers, for instance. Primarily, the people I represent have changed from traditional debt issuers and investment banks to hedge funds and ad hoc committees of bond holders.
Joachim: My practice is a leveraged finance practice. I represent banks, hedge funds, other financial institutions, and the proprietary trading desks of investment banks in connection with leveraged finance transactions, acquisition financing, and sometimes distressed and rescue financing. My historical background is that of a bankruptcy lawyer. My finance practice came about as a result of gaining expertise in structuring transactions to avoid some of the pitfalls that occur when a transaction is heading into a restructuring context. The attraction of Bracewell was in linking up with Evan Flaschen and Greg Nye as traditional restructuring lawyers as well as with Mark Palmer and his team whose practice includes private equity, M&A, and the equity side of the practice that focuses on distressed and special situation transactions. When you look at the business of a hedge fund, private equity fund or an investment bank's special situations trading desk, other than the regulatory compliance issues, our practices at Bracewell cover and service every single aspect of this business - ranging from M&A transactions, distressed M&A, equity transactions, leveraged loan transactions, high yield transactions, mezzanine loans, senior secured financings, restructurings and bankruptcy matters. In that way our three teams - Evan's, Mark's and my team are very unique in servicing so many areas on the legal landscape. Collectively, we are loosely and unofficially calling the three groups the Private Clients Group.
Editor: It seems as though you have a seamless working relationship.
Joachim: Absolutely. One of the benefits for us is the fact that we have worked with Evan and Greg for awhile. We also have known Mark Palmer. There are great synergies among our three practices.
Carey: We are able to service a distressed debt fund entirely within our group. Evan by background is a bankruptcy and restructuring attorney. If a distressed fund has either public bonds or mezzanine loans, I would serve that need and Mark Joachim would provide the bank debt and second lien expertise. If the fund wished to equitize the debt or make it part of their portfolio, Mark Palmer would provide his expertise.
Editor: Mark, I understand that you have experience in representing first lien holders or second lien holders in a leveraged finance situation. What are some of the terms in the inter-creditor agreement that you strive to obtain for the second lien holder?
Joachim: I have been involved from the outset with the development of the second lien market when only one or two funds were active. They were able to exact strong terms reflecting the rights of second lien holders. Now that the market is larger and these transactions are done by many more institutions, including investment banks and traditional banks, the market has normalized to some extent. The key for second lien holders is to retain all the rights of a creditor in a bankruptcy context. In contrast to traditional mezzanine debt and subordinated debt, the big difference is that second lien debt is actually an agreement between two creditors as to how the proceeds of collateral will be distributed. Other than that, the second lien holder is a creditor on par with the first lien holder. It has all the same rights except the right to attack the first lien. It is not subordinating its debt but only its rights with respect to the collateral, if and when it is liquidated. In a bankruptcy a second lien holder should be able to maintain voting rights and the ability to pursue rights and remedies subject to some stand-still period.
Editor: How do first lien holders avoid a "cram-down" that could deprive them of some of their rights under an indenture?
Joachim: Under Section 1129 of the Bankruptcy Code in order to cram down a creditor, i.e., to approve a plan over their objection, you have to be "fair and equitable" as to the objecting class. This relates to first and second liens which will make the next restructuring cycle interesting because a lot of debt that used to be unsecured bond debt which was easy to cram down is now second lien secured debt which is harder to cram down. In order to cram down any secured creditor you have to give that creditor the "indubitable equivalent" of their claim, a term not defined in the Bankruptcy Code so it is a flexible concept. Most people think that it means that you have to give them a security that has the same rights as the debt security that they had pre-bankruptcy. It has to be a debt security that would trade in the market at par if there were a market for such securities.
Editor: Bob, I understand that you have a great deal of experience in interpretation of complex indenture provisions. Why is there such ambiguity?
Carey: For instance, a couple of the change-in-control provisions in merger covenants are triggered when a company sells all or substantially all of its assets. If you look at any prospectus or offering memo, there will be language interpreting what that phrase means. What it boils down to is that there is no black and white test of that phrase, so parties interpret it differently in the context of any one transaction. And even among different jurisdictions, that phrase is interpreted slightly differently. For example, New York and Delaware interpret it differently.
The rest of the ambiguity I would attribute to a couple of things. One is that indentures are complex and weighty documents. If you compare high yield as opposed to investment grade, the language has been crafted over time to include a broad variety of carve-outs and interrelated covenants. The ambiguity comes because in the real world companies take actions of varied sorts which may or may not fit easily into the indenture provisions. Indenture provisions must be crafted broadly to provide the company flexibility, but they also need to prohibit "leakages" outside the credit. Depending on a company's performance, an action that it takes may or may not be permitted by the indenture: two people can have different interpretations on whether an action is permitted or not.
Second, hedge funds are increasingly debt holders which are much more activists than front-end buyers, such as mutual funds, would be. Many of these hedge funds in their quest for earnings are buying debt to make quick returns so they are very focused on all of the company's actions. With these complex transactions, both issuers and funds hire expensive lawyers to review the indenture, and reasonable minds can differ. This is where I become involved.
Editor: Back in the 1980s Professor Altman at NYU provided statistics as to the number of high yield corporate financings that ended up in bankruptcy court which was a very low percentage. Has there been a marked difference in that small percentage today?
Joachim: Our record low debt default rate is based on the strength of the economy and the unprecedented amount of liquidity that is in the market. There is an old adage that money cures all problems. You can have a distressed company not performing well but if it has access to the capital markets and to liquidity through private equity or hedge funds, it is possible to avoid default even if there are operational issues. Until we hit a point in the economy where there is true credit tightening and difficulty in obtaining liquidity, it is going to be hard to say how many of these high yield and second tier issues will end up in default. At the moment the ability to find capital is helping people avoid those defaults. There may be a looming default in a high risk venture but the debtor can get replacement money or go to high yield holders who waive the default and reset the covenants.
Carey: The nature of securities offerings and high yield offerings is that the underwriters negotiate with the issuers, and if there is a sponsor, with the sponsors, but the distressed debt holders do not negotiate the covenants. They buy the paper without becoming involved in negotiating or analyzing the covenants. When there is a problem, they call us.
Editor: How are lenders, private equity and venture funds protecting themselves today against defaults in terms of covenants?
Joachim: From the lender's perspective it is difficult to obtain overly burdensome protection because the market is such that another lender will not insist upon those credit protections. All you can do is be smart about your due diligence and structuring. That means having the right internal people and hiring the right lawyers to structure the deal. In the case of private equity, they are using their increased leverage in this market to go in the other direction: they will avoid default by insisting upon terms such as an equity cure, the right to put in more money to cure a default. Historically, lenders would have said no to that proposal because if a company should be liquidated in order to get the lender paid out, it is to counter the lender's interest. It is forcing the lender to be a partner with private equity and stay in the game.
The other problem is the concept of covenant light. Because of the increased liquidity and leverage that the private equity firms have, private equity firms are insisting that lenders agree on covenant light transactions. That means that the covenants are in the document but they do not have application until a trigger occurs which is usually a liquidity test. Those are some of the things that private equity firms are doing to make sure that if there are hiccups in the business, they can stay in control of the situation and keep the lender at bay.
Editor: Mark, how do you protect a DIP lender to ensure it gets the "first money out"? Does it always have priority?
Joachim: In most transactions it is intended to have first priority. There are transactions where people believe that there is difficulty priming the existing first lien. In those deals, a lender may come in and do debt behind the first lien. If you think about it, those transactions are done only by parties like private equity that have another interest in the capital structure. By definition you can prime someone if you can adequately protect them, because the theory is that their debt is money-good.
Typically a DIP loan, other than this one exception, is intended to be a first lien. The magic of DIP lending has to do with what the DIP order says. The DIP credit agreement is something I have a lot of experience with both on the borrower side, as a bankruptcy attorney, and from the lender side in representing clients in DIP transactions. With a DIP credit agreement you really need to marry the finance world to the bankruptcy world. At the end of the day, your DIP credit agreement should coincide with the DIP order to be fully covered.
When our practice does DIP transactions, Evan's group and my group work together closely with my group working on the credit documents and Evan's group, with a real understanding of DIP orders and bankruptcy court orders, assisting the lender to get the best terms possible. Unless your attorney knows about DIP orders and how those orders work, lenders may not be fully protected.
Editor: Do you find that in structuring deals for institutional clients your knowledge of the possible alternative of a future bankruptcy is a help or a hindrance?
Joachim: We have all spent a fair amount of time on both sides of the cycle. Because we have a good understanding of the fact that our clients only make money if they close deals and are only happy if they are making money, we walk that thin line between cautioning clients about the risks involved but also understanding that all risks can be quantified with some precision and are worth taking for the right rewards, although bankruptcy courts are unpredictable. Our clients are some of the smartest hedge funds and investment banks in the country. For that reason they all understand how to work with their lawyers and other advisors in assessing risks and what reward premium should be obtained in exchange for that risk. I would never tell a client not to do a transaction. I would tell them the risks and let them decide. Clients should have the right team advising them on the risks and benefits of the transaction. We will help them assess that and help figure out what the rewards should be in exchange for taking that risk.