Rights Offerings, Backstop Commitments and Private Placements—Understanding Pacific Drilling and the Eighth Circuit’s Peabody Decision
Debtors are increasingly financing their emergence from bankruptcy through rights offerings subject to backstop commitments from a subset of their impaired creditors. While bankruptcy courts regularly confirm reorganization plans that include this form of exit financing, two recent cases challenged its compatibility with the Bankruptcy Code. Although both cases ultimately approved the financings in question, the decisions provide guidance to debtors and creditors seeking court approval of backstop commitments and other exclusive financing opportunities going forward.
I. Background: Scrutiny for Backstop Commitments and Other Exclusive Financing Opportunities
Broadly speaking, a rights offering is a type of exit financing in which a debtor’s existing creditors are offered the opportunity to invest new money in the reorganized debtor, often at a discount to the value attributed to the reorganized debtor in the plan of reorganization. Debtors sometimes favor rights offerings over alternative forms of financing because they provide valuable new equity financing, and a subset of participating creditors will often agree to guarantee that financing by making a “backstop” commitment—i.e., the promise, in exchange for a fee, to purchase any remaining equity if the offering is undersubscribed. The agreement to enter into the backstop commitment is also often accompanied by the backstopping creditors’ agreement to vote in favor of the plan of reorganization, which may ensure the favorable vote of the participating creditors’ class. The opportunity to invest in the reorganized debtor at a discount may also be attractive to existing creditors, who are already familiar with the debtor’s business (and who may have adopted a bullish view of the debtor’s future prospects in the bankruptcy case). And backstopping opportunities may be attractive to creditors whose bankruptcy claims are impaired, because the fees they earn for their backstop commitments can help offset the impairment on their claims.
The demand for rights offerings as a means of raising valuable exit financing, and the concomitant practice of entering into backstop commitments to guarantee that financing, shows no signs of abating. Two recent cases, however, suggest that the fees and other benefits paid to backstopping creditors may be subject to heightened judicial scrutiny or challenge in the future. Backstopping creditors and debtors should thus take steps to demonstrate that the fees and other benefits paid to the backstopping creditors are provided on account of the creditors’ new money commitment rather than their prepetition claims, and are generally consistent with the market for comparable financings.
II. Pacific Drilling: A Bridge Too Far?
On November 12, 2017, Pacific Drilling S.A. and its related debtors filed for bankruptcy in the Southern District of New York. See Case No. 17-13193 (MEW) (Bankr. S.D.N.Y.). On September 18, 2018, Judge Michael Wiles considered an uncontested motion seeking approval of an equity commitment relating to a $500 million equity raise in which: (1) holders of unsecured claims would have the right to purchase $350 million of equity in the reorganized company at a 46.9% discount to plan value through a rights offering; and (2) an ad hoc group of lenders and noteholders, and existing majority shareholder Quantum Pacific Group, would have the right to purchase $100 million and $50 million of equity, respectively, at the same discount in a private placement. Under the proposed equity commitment, the ad hoc group of lenders and noteholders, which had also entered into a restructuring support agreement with the debtors, would backstop the rights offering in exchange for the $100 million private placement and a fee of 8% of the full $500 million equity raise, payable in equity of the reorganized debtor. See id. (Dkt. 535).
Notwithstanding the absence of any objections, Judge Wiles declined to approve the equity commitment at the September 18, 2018 hearing. Judge Wiles noted at the hearing that while “it is entirely reasonable and appropriate to raise financing on market terms and to pay reasonable commitment fees for that financing,” “it’s quite clear you’re not supposed to give disproportionate treatment or different treatment to people just because they hold more claims than other people [do] … [or] just to get their support for a plan.” Id., Sept. 18, 2018 Hrg. Tr. at 86 (Dkt. 622). Judge Wiles expressed concern that the 8% backstop fee “doesn’t seem to bear any relationship to the actual risk” associated with it, and appeared to be “a plum opportunity that’s been given to a special group of large creditors” supporting the plan “on a basis that’s not equal to other similarly situated creditors.” Id. at 87-88. Judge Wiles also took issue with the $100 million private placement, questioning whether it was “really a disguised overallocation of rights in a rights offering,” and stating that if it was directly related to the backstopping creditors’ current bankruptcy claims, then the debtors would have “an equal treatment problem that’s deadly to [the] plan.” Id. at 26, 83. Judge Wiles expressed skepticism that the equity commitment was in fact a stand-alone financing unrelated to the ad hoc group’s current claims, because it was not subject to market testing, and was “specifically designed to prohibit anybody else from even making another proposal.” Id. at 27.
Judge Wiles deferred consideration of the equity commitment to September 25, 2018, when the debtors presented a revised equity commitment agreement. Id. (Dkt. 609). The revised agreement eliminated the $100 million private placement, and revised the 8% backstop fee so that it would apply only to the uncommitted portion of the rights offering, with a 5% fee applying to the remainder. Id. (Dkt. 607 at 5). Noting once again the absence of objections, Judge Wiles approved the equity commitment at a September 25, 2018 hearing, but stated that he was doing so “not without a great deal of misgivings”—particularly with respect to the backstop fee, which Judge Wiles found to be likely unwarranted, and to potentially constitute “just an extra payment and an extra recovery rather than a real standalone financing term.” Id., Sept. 25, 2018 Hrg. Tr. at 17, 28 (Dkt. 634). Near the end of his remarks, Judge Wiles expressed “hope that in the future when these structures are presented, parties will explore in more detail the issues and concerns that I have raised.” Id. at 29.
III. The Peabody Case: The Eighth Circuit’s Decision
The Peabody Energy Corporation (“Peabody”) bankruptcy case raised issues similar to those addressed by Judge Wiles in Pacific Drilling. The Peabody plan of reorganization provided for exit financing commitments of $1.5 billion in new money, consisting of $750 million to be raised through a private placement of preferred equity sold at a 35% discount to the agreed-upon value in the plan (the “Private Placement”) and $750 million to be raised through a rights offering of common stock sold at a 45% discount to the agreed-upon value in the plan (the “Rights Offering”). Initially, the Debtors limited participation in the Private Placement to a small group of Second Lien and Class 5B Noteholders (the “Consenting Noteholders”), who held approximately 40% of such claims and who had participated in the mediation that had resulted in the Plan. The Consenting Noteholders agreed: (1) to provide a full backstop of the Rights Offering and Private Placement (the “Backstop Commitment”) and; (2) to sign a Plan Support Agreement (“PSA”) agreeing to support the Plan subject to bankruptcy court approval (the “Support Commitment” and together with the Backstop Commitment, the “Commitments”).
Ultimately, the Plan was revised to grant the Consenting Noteholders the exclusive right to purchase the first 22.5% of preferred equity in the Private Placement. Next, other Second Lien and Class 5B Noteholders willing to sign onto the Commitments, together with the Consenting Noteholders, had the exclusive right and obligation to purchase their pro rata share of the next 5% of preferred equity. Then, a third group of noteholders that subsequently signed onto the Commitments were permitted to join the other participating noteholders to purchase their pro rata share of the remaining 72.5% of preferred equity. “The Plan provided that [f]or the avoidance of doubt, any Preferred Equity purchased … in the Private Placement … shall be solely on account of the new money provided in the Private Placement and not on account of any purchaser’s [bankruptcy claims].” In re Peabody Energy Corp., 582 B.R. 771, 776-77 (E.D. Mo. 2017) (quotation marks omitted).
Approximately 95% of Second Lien and Class 5B Noteholders signed onto the Commitments and participated in the Private Placement. A small group of noteholders who did not participate in the mediation (the “Ad Hoc Group”) objected to the Plan, arguing that the Private Placement: (1) violated Bankruptcy Code § 1123(a)(4) by treating claims in the same class unequally; (2) violated the good faith requirement in Bankruptcy Code § 1129(a)(3) by failing to maximize the value of the debtors’ estate; and (3) violated Bankruptcy Code § 1125(b) by improperly soliciting creditor votes in favor of the Plan. Case No. 16-42529-399 (Bankr. E.D. Mo) (Dkt. 2649). The Bankruptcy Court overruled these objections and confirmed the Plan on March 17, 2017, and the District Court affirmed that decision on December 29, 2017. See id. (Dkt. 2763); In re Peabody Energy Corp., 582 B.R. at 783-84.
The Ad Hoc Group appealed the District Court’s decision to the Eighth Circuit, arguing again that the Private Placement resulted in unequal treatment of similarly situated non-participating creditors on account of their claims, and violated the Bankruptcy Code’s good faith requirement by offering a substantial portion of the reorganized debtors’ equity at an indisputably below-market price and conditioning the opportunity to receive that discount on an agreement to vote in favor of the Plan. (The Ad Hoc Group did not pursue its argument that the Plan violated § 1125(b) of the Bankruptcy Code at this phase of the case.) The debtors responded by arguing that: (1) the right to participate in the Private Placement was granted not on account of creditors’ prepetition claims, but rather in exchange for their Backstop Commitment; and (2) the good faith requirement is met when “there is a reasonable likelihood that the plan will achieve a result consistent with the standards prescribed under the Code,” and that the Plan satisfied this standard, given that the Rights Offering and Private Placement, together with the Plan’s other terms, allowed Peabody to succeed as a going concern while maximizing recoveries for creditors who otherwise might have received nothing. Ad Hoc Comm. of Non-Consenting Creditors v. Peabody Energy Corp., No. 18-1302 (8th Cir. Apr. 16, 2019), audio available at http://media-oa.ca8.uscourts.gov/OAaudio/2019/4/181302.MP3.
Furthermore, during oral argument the Eighth Circuit panel raised potential concerns similar to those articulated by Judge Wiles in Pacific Drilling, including whether the additional value conferred on participating creditors was truly provided in exchange for new value and whether conditioning additional payments on plan support constitutes bad faith or “vote buying.” Id. Notwithstanding these questions, however, on August 9, 2019, the Eighth Circuit affirmed the lower courts’ decisions, holding that the right to participate in the Private Placement did not constitute “unequal treatment” in violation of Bankruptcy Code § 1123(a)(4) because the opportunity “was not ‘treatment for’ the participating creditors’ claims,” but rather was “consideration for valuable new commitments made by the participating creditors,” including the promise to support the plan and to backstop the Private Placement and Rights Offering. In re Peabody Energy Corp., No. 18-1302, 2019 WL 3756884, at *5 (8th Cir. Aug. 9, 2019). With respect to the question of good faith, although the court found it “troubling that creditors wishing to take part in the Private Placement had to elect to do so before approval of all the agreements and the disclosure statement,” it nevertheless concluded that it lacked “a definite and firm conviction that a mistake ha[d] been committed” by the Bankruptcy Court under a “clear error” standard of review, in light of countervailing factors that included: (1) broad acceptance of the Plan by all twenty classes; (2) participation in the Private Placement by 95% of unsecured creditors; (3) the high cost of delayed plan consummation; and (4) the potential for plan sabotage and market risk absent the Support Commitment. Id. at *6-7 (quotation marks omitted).
The Eighth Circuit’s Peabody decision may largely put to rest speculation that Judge Wiles’s concerns in Pacific Drilling signaled the dawning of a new era in which proposed backstop commitments and exclusive financing opportunities would be subjected to more rigorous scrutiny. It is notable, however, that while the courts in both Pacific Drilling and Peabody ultimately approved the financings in question, they also involved instances where the financings were challenged by only a small group of creditors (Peabody), or not challenged at all (Pacific Drilling). This may indicate a recognition by the restructuring community that creditors who are willing to become restricted to negotiate a plan with the debtor may be entitled to some compensation for that work, and that the opportunity to participate in a backstop or private placement may be an appropriate way to provide such compensation. It remains to be seen, however, whether other courts in the Southern District of New York or elsewhere will heed Judge Wiles’s caution, especially in the event that a proposed financing is subject to objection from a material portion of the creditor body.