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Private Equity Alert Sept 09

Private Equity Alert Sept 09

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Published by Dan Primack
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Published by: Dan Primack on Sep 02, 2009
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Private Equity
Alert
September 2009Weil News
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WeilGotshaladvisedeTelecareanditscontrollingstockholders,ProvidenceEquityPartnersandAyalaCorporation,inconnectionwiththebusinesscombinationoeTelecarewithStreamGlobalServices
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WeilGotshaladvisedMacquarieGroupinconnectionwithits$428millionacquisitionoDelawareInvestments,adiversiedassetmanagementrm
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WeilGotshaladvisedCCMPCapitalandBancrotPrivateEquityinconnectionwiththe
250millionsaleoNowacotoBidvest
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WeilGotshaladvisedGMTCommunicationsPartnersontheacquisitionotheRoadsideAssetsoTitanOutdoorAdver-tisingLimited
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WeilGotshaladvisedHMCapitalinconnectionwithitsacquisitionoEarthboundFarms
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WeilGotshaladvisedShowtimeArabiaanditsparentKipcoGroupinconnectionwithitsmergerwithOrbitGroup,creatingtheleadingpay-TVplatormintheMiddleEastandNorthArica
Equitable(In)subordination−ConsiderationsorSponsorsLendingtoPortolioCompanies
 By Ron Landen ( ronald.landen@weil.com ), Rose Constancerose.constance@weil.com ) and Joe Basile (  joseph.basile@weil.com )
Private equity sponsors are increasingly providing additional capital to theirportolio companies either to address liquidity issues at those companies or as parto a negotiated debt restructuring. From a sponsor’s point o view, it is otenpreerable to invest that additional capital in the orm o debt rather than equity.However, in structuring that transaction sponsors should be aware that the priorityo this debt in a portolio company’s capital structure could be attacked by othercreditors i that portolio company ends up in bankruptcy under the theories o equitable subordination or recharacterization. It is important that sponsorsstructure any such investments to reduce the risk o a successul attack on thepriority status o their debt.
Equitable Subordination
Section 50(c) o the Bankruptcy Code provides that bankruptcy courts mayexercise principles o equitable subordination to subordinate all or part o oneclaim to another claim. Conceptually, this gives the bankruptcy court power todemote a higher priority claim to a lower priority claim under certain circum-stances. In some instances, this can convert an otherwise rst priority securedclaim into a general unsecured claim ranking pari passu with all other generalunsecured claims. Although the statutory authority or equitable subordination isclear, the application is not. However, there are some general principles that canbe applied as a guide in properly structuring a credit arrangement.Generally, the courts consider three actors in determining whether to equitablysubordinate a claim. These actors are (i) whether the creditor was engaged ininequitable conduct, (ii) whether the misconduct injured other creditors or gavean unair advantage to the creditor in question and (iii) whether subordinationwould be consistent with the provisions o the Bankruptcy Code. Importantly,insiders are typically held to a higher standard than are unaliated third partylenders because insiders oten have (and exercise) infuence over management o the company. This means that a sponsor who is also an equity holder needs touse extra caution when loaning money to a portolio company. The misconducto a creditor does not need to be tied to such creditor’s claim – it can arise out o other actions by the claimant. In an equitable subordination analysis, the courtconsiders whether a creditor engaged in inequitable conduct and applies subordi-nation as a remedy only to the extent necessary to counteract any damage toother creditors.
 
Private Equity
Alert
September 2009
Weil, Gotshal & Manges
llp
The recent bankruptcy case involvingSchlotzky’s, Inc. provided a goodillustration o how courts apply theseprinciples. In that case, the twolargest shareholders each madeseparate loans to the company in aneort to resolve a liquidity crisis. Therst loan was secured by substantiallyall o the company’s intellectualproperty and was structured on arms-length terms. The second loan, madeseven months later, was secured bythe same collateral package; however,the bankruptcy court more closelyscrutinized this transaction because itwas approved in a hurried, lastminute board meeting wheremanagement reported that thecompany could not make payrollpayments without the loan.proceeds o the second loan were usedto pay unsecured creditors andequitable subordination is remedial,not penal, equitable subordinationwas not appropriate. As to the rstloan, the Court o Appeals ruled thatthere was no evidence o misconduct,so that loan also should not havebeen subordinated.
Recharacterization
Recharacterization o a claim occurswhere a bankruptcy court uses itsequitable powers under Section 05 o the Bankruptcy Code to convert anotherwise valid debt claim into anequity interest. Recharacterization isa highly unusual remedy, but thatdoes not mean that sponsors canBankruptcy Code, recharacterize debtclaims as equity interests.Courts that consider themselves tohave the power to recharacterize debtclaims as equity interests will exercisethat power when, despite the labelplaced by the parties on the particulartransaction, the “true nature” o thetransaction is, in the court’s view, thecreation o an equity interest. Inpursuing the quest to nd the “truenature” o a transaction, mostbankruptcy courts apply a multi-actortest where no single actor is determi-native. The actors normallyconsidered by courts include theollowing:
n
Undercapitalization
. Many courtsview thin or inadequate capital-ization as strong evidence thatinvestments are in act capitalcontributions rather than loans.
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 Inability to obtain similar outside fnancing 
. Diculty in obtainingoutside nancing on similar termsor o-market credit terms may leadto a determination that thenancing was in act a capitalcontribution rather than a loan.
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 Presence or absence o fxed termsand obligations and ability toenorce payments
. The absence o axed maturity date, interest rateand obligation to repay principaland interest at xed times is anindication that the investmentsmay be capital contributions andnot loans. Similarly, i theinstrument does not entitle theholder to enorce payment o principal and interest when due, theinvestment is more likely to becharacterized as a capital contri-bution and not as a loan. Loansthat require a sinking und or arestructured as a demand notepayable upon the holders’ requestare more likely to be treated as debtand not equity.
Sponsors should structure loans to portfolio companies tominimize the risk that other creditors could attack the priorityof those loans under the theories of equitable subordinationor recharacterization.
In pursuing the equitable subordi-nation claim, the unsecured creditorso the company attempted to showthat the loans contributed to adeepening insolvency o the company(see the August 008 issue o PrivateEquity Alert or urther discussion o this legal theory). The bankruptcycourt ound that both loans should besubordinated, holding that theinequitable conduct consisted o acombination o the last minute boardmeeting in which no alternatives werediscussed (even though all non-interested directors approved theloan), a very avorable securitypackage and a modication o theshareholders’ personal guarantees.The bankruptcy court’s ailure toconclude that the loans resulted inharm to the unsecured creditors led toa reversal o the bankruptcy court onthe second loan. The Court o Appeals concluded that because theignore the risk that their loans may berecharacterized as equity. Therecharacterization analysis diersrom that o equitable subordinationin that it considers whether or not aninvestment is actually equity insteado debt. I the answer is yes, then theeect o the recharacterization is tosubordinate the investment to allother valid debtor claims and toprovide or repayment o theinvestment only to the extent thatthere is recovery to equityholders.Although some courts have taken theposition that bankruptcy courts lackthe power to recharacterize debtclaims as equity interests, themajority o courts that haveconsidered the question have deter-mined that bankruptcy courts may, inthe exercise o their inherent powersas courts o equity and the powersgranted by Section 05 o the
 
Private Equity
Alert
September 2009
Weil, Gotshal & Manges
llp
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Source o repayments
. Some courtshave said that i the expectation o repayment depends solely on theborrower’s earnings, the transactionhas the appearance o a capitalcontribution.
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 Failure o the debtor to repay onthe due date or to seek postponement 
. I the debtor simplyails either to repay the investmenton the nominal due date or to seekpostponement, some courts havesaid that the investment looks morelike a permanent capital contri-bution than a loan.
n
 Identity o interest between thecreditor and the stockholder 
. I stockholders make investments inproportion to their respectiveownership interests, the transactionhas the appearance o a capitalcontribution. In a requently citedrecharacterization case, abankruptcy court said that itconsidered “this to be the mostcritical actor in its determination”.
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Security 
. The presence o a securityinterest and related documentationis strong indication o a loan andthe absence o security cutssomewhat in avor o a capitalcontribution.
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 Extent o subordination
. Thesubordination o an advance to theclaims o other creditors indicatesthat the investment was a capitalcontribution and not a loan.
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 Participation in management 
. I the terms o the transaction give theinvestor the right to participate inthe management o the business,the investment is more likely to becharacterized as a capital contri-bution and not as a loan.
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Treatment in the business records
.At least one court has said that themanner in which the investment istreated in the business records o the debtor is a actor that is relevantto the characterization issue.It is important to note that almost allthe reported decisions in whichbankruptcy courts have concluded thata right that the parties have called aclaim is in act an equity interest haveinvolved “loans” made to a debtor by acontrolling stockholder, director,ocer or other insider. However, thepossibility o recharacterization shouldnot by itsel discourage sponsors romlending money to their portoliocompanies as this remedy is not otensought by claimants or granted bybankruptcy courts and there are steps asponsor can take to reduce its risk.
Steps that Reduce Risk ofEquitable Subordination andRecharacterization Risk
There are some general guidelines thatsponsors can ollow to help minimizethe risk o equitable subordination orrecharacterization. The mostimportant guidance is to treat anysponsor loan to a portolio companyas i it is a third party loan beingprovided on customary market terms,including interest rate, paymentterms, ees and other terms. Theobvious challenge is ndingcustomary terms in an illiquid market.Also, the sponsor should take extracare to ensure that the proper internalgovernance procedures are ollowedby the portolio company to avoidany implication o misconduct,impropriety or control by the sponsor.To minimize subordination risk,sponsors should anticipate liquidityproblems as early as possible to allowtheir portolio companies toadequately consider alternatives. Thismeans avoiding any last minutedecisions where the only alternativeto an emergency unding transactionis a liquidation or bankruptcy. Also, apotent deense to any equitablesubordination claim is that theunsecured creditors were either notharmed or helped by the additionalnancing. Finally, an insider shouldavoid loaning money to any portoliocompany that the insider knows isundercapitalized or insolvent.Sponsors should take care to observethe ormalities typically associated withdebt transactions among unrelatedparties. Consideration should be givento the name o the instrument, whichshould indicate that the instrument isvalid, enorceable and is properevidence o indebtedness. I possible,the instrument should include xedinterest rates, xed maturity dates anddetailed payment schedule.Additionally, the instrument shouldinclude rights or the sponsor to enorcerepayment. Moreover, courts will notewhether the portolio company actuallymade the required payments aterexecution o the instrument and, i itdid not, what steps the sponsor took toenorce repayment.Ideally, any debt instrument shouldnot reerence any related equityownership or provide that the loan isprovided in respect o such equityownership. I possible, the debtshould be secured. I the debt isunsecured, the court will be morelikely to consider the investment to bedebt i the parties include a sinkingund or other similar mechanism inthe instrument.The sponsor should also make aneort to distinguish the investmentrom characteristics more commonlyassociated with equity investments.Repayment provisions that are tied tothe company’s perormance, especiallyi the advance is unsecured, willindicate to a court that the partiesintended the investment to be acapital contribution. To the extentpossible, the parties should make aneort to avoid having investmentsmade in perect proportion to thesponsors’ equity ownership. I 

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