Chapter 11 Rights Offerings and Private Placements: How Creditors Can Strike A Windfall.

• Author: Saxon, Shelby V.

ABSTRACT

Debtors-in-possession have increasingly turned to rights offerings and/or private placement sales as an exit financing option in chapter 11 bankruptcy. When timed and executed properly, these offerings can provide a windfall of returns to select creditors. This windfall does not appear to exist outside of chapter 11, as rights offerings and private placements are subject to heightened fiduciary duties without the flexibility of the Bankruptcy Code, notwithstanding objections to many aspects of these sales and their outcomes, courts adjudicating these disputes have found no violations of the Code. The popularity of these offerings within chapter 11 has increased in recent years and courts have consistently confirmed plans that include them.

This Article asserts that courts adjudicating rights offerings disputes have correctly applied the plain language of the Code. However, unbridled financing terms combined with intentional complexity, opaque value incurred, and strategic negotiation methods have created the opportunity for favored groups of creditors to stride a windfall that the drafters of the Code never intended to allow, as this treatment undermines the equitable nature of bankruptcy. While some commentators and at least one judge have discussed rights offering components using reasonability terms, there is currently no express reasonability test applied to rights offerings. This Article argues that a market-based reasonability standard applied to rights offering finance terms would mitigate this windfall yet preserve fair returns for investors willing to take financial risks. This result would more properly balance the equitable goals of bankruptcy, while still allowing for successful debtor exit financing.

INTRODUCTION

In April 2016, Peabody Energy Corporation and its affiliates ("Peabody"), like most American coal companies that had managed to stay afloat, (1) were completely shrouded in debt and facing liquidation. (2) Headquartered in St. Louis, Missouri, Peabody had experienced a steep decline in revenue due to decreased demand for American-produced coal. (3) Shortly after filing for relief under chapter 11 of the Bankruptcy Code (the "Code"), (4) Peabody emerged from what they assert was the most successful coal company reorganization in history. (5) But the former Peabody shareholders and unsecured creditors would likely describe the reorganization as a "vulture capitalist" effort that left them with "no part of the mine but the shaft." (6) Though executives who assist with the reorganization process typically obtain benefits for their risk, the Peabody executives who "go no nearer a coal mine than the [local mall]" struck a windfall through this reorganization that simply seems incompatible with the equitable nature of the Code. (7)

When they entered chapter 11, Peabody hoped a reorganization would allow them to "(1) emerge from bankruptcy with adequate liquidity to weather the volatile business cycles inherent in the coal industry; (2) ensure that following emergence they could pay their debts on time; (3) maximize the size of their estate for their creditors' benefit; and (4) achieve the broadest consensus among creditors possible." (8) Unexpectedly, however, Donald Trump was elected President in the midst of the Peabody reorganization, and with his promise to revitalize certain industries, "[i]t was suddenly possible that the largely bankrupt American coal industry might have more value than previously thought." (9) The prospect of Peabody's highly increased value led to a contest between the prepetition stakeholders that would ultimately determine the new controllers of the reorganized, and now profitable, coal company. (10)

The early stages of this control contest began when a dispute arose between certain secured and unsecured creditors regarding the extent to which Peabody's coal mines served as collateral. (11) The bankruptcy court required all parties involved in the dispute to participate in confidential mediation. (12) Mediation discussions evolved into negotiations on much broader reorganization issues, and resulted in what was termed a "global settlement." (13) However, not all creditors took part in the negotiations leading to the purported "global settlement"--only those involved in the dispute regarding the extent to which the coal mines served as collateral. (14) Peabody structured the entirety of their chapter 11 plan around these settlements. (15) Under this plan, Peabody would raise $1.5 billion of new money by holding two sales: first, a rights offering of common stock and second, an exclusive private placement sale of preferred stock. (16) A group of creditors, termed the Ad Hoc Committee of Non-Consenting Creditors (the "Ad Hoc Committee"), who were not involved in the mediation resulting in the "global settlement," (17) strongly objected to the details of the private placement. (18)

Despite the objections of the Ad Hoc Committee, the Bankruptcy Court for the Eastern District of Missouri confirmed Peabody's plan of reorganization. (19) The Ad Hoc Committee appealed confirmation to the district court, which affirmed the bankruptcy court, approving the plan on the merits. (20) The Ad Hoc Committee appealed confirmation yet again, but in August 2019, the Eighth Circuit affirmed the district court. (21)

To understand the details in the Peabody dispute, it is imperative to take note of both the plan confirmation process and debtor strategies for ensuring confirmation. Under the Code, an entire class is deemed to accept a plan if it is accepted "by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims [within] the class." (22) A judge cannot confirm a plan unless it has been accepted by at least one class of impaired claimholders. (23) Practically, this means that not all creditors within a class will need to accept the plan, even if that creditor will be impaired. (24) Such an arrangement allows for strategic negotiations between the debtor and a specific group of creditors--who will supply the accepting impaired class votes necessary to confirm the plan--over the objection of dissenting creditors. (25)

One increasingly common strategy is for the debtor to offer a Restructuring/Plan Support Agreement (RSA/PSA). When enough parties enter into this agreement, the debtor can be sure it will have the requisite votes for plan approval, "plac[ing] no hurdles in the way of its smooth adoption" during the reorganization process. (26) However, because the debtor does not need 100% of creditors to approve the plan, these agreements tend to benefit those with a seat at the negotiation table at the expense of those not present. (27) The consequences of this arrangement will be discussed in detail in Part II.A.1. (28)

When the plan moves to confirmation before the court, it is still subject to objections from creditors. (29) In addressing any objections, the court, under [section] 1129, (30) must find that the plan was proposed in good faith, is feasible, and complies with all provisions of the Code. (31) If these requirements are met to the satisfaction of the court despite the objections of creditors, the plan will be confirmed through cram-down. (32)

In Peabody, the Ad Hoc Committee objected to plan confirmation, arguing that the plan did not comply with all provisions of the Code because it failed to satisfy the equal treatment of claims standard under [section] 1123(a)(4). (33) Further, the Committee contended that components of the private placement and the negotiations leading to its execution violated the good faith standard required by [section] 1129(a)(3). (34) Despite these objections, the bankruptcy court found that Peabody's plan of reorganization met each of the [section] 1129 requirements. On appeal, both the district court and the Eighth Circuit affirmed. (35)

With its execution of the private placement and final plan confirmation, Peabody effectively sold nearly half of its equity to a select group of creditors at a discount inconceivable outside of the chapter 11 process. (36) On top of the thirty-five percent discount to plan value, backstop parties received a $120 million payment, with options for increases depending on how long it took for the plan to be confirmed. (37) The backstop parties agreed to purchase any securities left unsubscribed after the closing of the rights offering or private placement to ensure that the debtor would still raise the necessary capital. (38) The Ad Hoc Committee determined the total value retained by the Peabody backstop parties to be $160 million beyond that which was retained by any other creditor in the entire case. (39)

What occurred in Peabody is not unlike what has taken place in other successful rights offerings and private placement sales within chapter 11 plans of reorganization. (40) When timed and executed properly, rights offerings participants--particularly backstop parties--can strike a windfall of returns without violating the Code. (41) This windfall may consist of premium fees paid by the debtor, heavily discounted securities, and even a new position as majority shareholder of a now profitable company. (42) The ability to realize such great returns does not appear to exist outside of corporate bankruptcy, as "tak[ing] control rights away from existing shareholders and granting] them to another is subject to heightened fiduciary duties'" outside this flexibility permitted by the Code. (43) However, as the popularity of rights offerings within chapter 11 bankruptcy has increased in recent years and with courts confirming those plans, the creditor windfall has become more apparent. (44)

Consequently, the missed opportunities of creditors excluded from rights offerings have become more apparent as well (45) In response to their losses, these creditors have attempted to find recourse within bankruptcy law (46) The most popular creditor arguments mirror...