DIP Financing Agreement Initially Rejected as Sub Rosa Chapter 11 Plan
Postpetition financing provided by pre-bankruptcy shareholders or other "insiders" is not uncommon in chapter 11 cases as a way to fund a plan of reorganization and allow old shareholders to retain an ownership interest in the reorganized entity. The practice is typically sanctioned by bankruptcy courts under an exception—the "new value" exception—to the "absolute priority rule," which prohibits shareholders and junior creditors from receiving any distribution under a plan on account of their interests or claims unless senior creditors are paid in full or agree otherwise.
Such a proposed financing arrangement was the subject of a ruling recently handed down by the U.S. Bankruptcy Court for the Southern District of New York. In In re LATAM Airlines Grp. S.A., 2020 WL 5506407 (Bankr. S.D.N.Y. Sept. 10, 2020), the court held that the debtor demonstrated that secured financing provided by its existing shareholders was necessary, that the terms of the loan were fair, and that the lenders were acting in good faith. However, the court initially refused to approve the proposed financing agreement, finding that the agreement was a prohibited "sub rosa" chapter 11 plan because it provided that the debtor could elect to repay the shareholder loan with discounted stock in lieu of cash and effectively prevented confirmation of any plan other than the debtor's. However, after the parties modified the financing agreement to remove the equity election feature, the bankruptcy court approved the financing.
LATAM
In May 2020, LATAM Airlines Group S.A. and certain affiliates (collectively, "LATAM"), Latin America's leading airline group, filed for chapter 11 protection in the Southern District of New York after losing 95% of its passenger business due to travel restrictions imposed during the COVID-19 pandemic.
LATAM's prepetition efforts to secure government financial assistance were unsuccessful. Accordingly, upon the filing of its chapter 11 case, LATAM sought bankruptcy court approval of a $2.45 billion debtor-in-possession ("DIP") financing agreement with a Tranche A lender and two of its existing shareholders—Qatar Airways Investments (U.K.) Ltd ("Qatar") and Costa Verde Aeronautica S.A. ("Costa Verda")—as Tranche C lenders (an alternative super-priority DIP loan facility proposal with a Tranche B loan was abandoned). The Tranche A lender had no relationship with LATAM prior to the bankruptcy cases. Together, Qatar, Costa Verda, and their affiliates held approximately 32% of LATAM's common stock. Delta Airlines, Inc. ("Delta") acquired approximately 20% of the common stock of LATAM's parent corporation in connection with a 2019 tender offer and an ensuing joint venture agreement.
The Tranche A loan ($1.3 billion) was to bear interest at an adjusted LIBOR rate plus an applicable margin and would be secured by a senior lien on LATAM's unencumbered assets and a junior lien on its encumbered assets. The delayed-draw Tranche C loan (up to $900 million plus an additional $250 million increase commitment) was to bear payment-in-kind interest at the initial rate of 14.5% and was to be secured by a lien junior to the lien of the Tranche A lender. Both loans were to be conferred with super-priority administrative expense status. LATAM had the right to prepay the Tranche A loan, but not the Tranche C loan.
The Tranche C loan facility provided that, in lieu of repaying the loan in cash, LATAM had the option to repay the loan by giving the Tranche C lenders restricted equity in the reorganized company at a 20% discount to plan value (a discount valued at approximately $283 million). According to LATAM, this "modified equity subscription election" was a valuable asset, particularly if it did not have sufficient cash to pay off the Tranche C loan at the end of the case. The proposed DIP financing agreement further provided that confirmation of a non-LATAM-approved chapter 11 plan was an event of default.
LATAM's official unsecured creditors' committee, an ad hoc bondholder group, and Knighthead Capital Management LLC ("Knighthead" and collectively, the "objectors"), the last of which was a bondholder and a jilted competing DIP lender, objected to the Tranche C loan. They argued that the shareholders were getting a "sweet" deal because they were LATAM's largest shareholders and that the court should deny the motion because LATAM failed to demonstrate the "entire fairness" of the "insider" loan. They also argued that the loan was both overpriced and not the product of good faith, arm's-length negotiations.
In addition, the objectors contended that the equity election was really a means for LATAM's major shareholders to ensure that they would retain their equity interests in the reorganized company at the potential expense of unsecured creditors. They also argued that the credit agreement violated the "absolute priority rule" because old shareholders would receive stock while unsecured creditors would not be paid in full under any plan proposed by LATAM. Finally, the objectors claimed that the Tranche C loan facility amounted to a prohibited sub rosa chapter 11 plan.
The Bankruptcy Court's Ruling
The bankruptcy court initially denied the DIP financing motion.
At the outset of its opinion, the court concluded that, as required by section 364(c) of the Bankruptcy Code, LATAM demonstrated that it: (i) was unable to obtain unsecured credit allowable as an administrative expense; (ii) had an urgent need for financing; and (iii) was appropriate for LATAM to seek approval of the full $2.45 billion DIP loan facility.
Whether the Financing Was Fair and Reasonable. However, in examining whether the proposed financing was "fair and reasonable," the bankruptcy court concluded that the business judgment standard customarily used in this context did not apply. The court explained that, when a proposed transaction with a debtor involves "insiders," courts apply "heightened" or "rigorous" scrutiny in assessing the bona fides of the transaction. LATAM, 2020 WL 5506407, at *27 (citing Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holdings Unsecured Claims (In re Papercraft Corp.), 211 B.R. 813, 823 (W.D. Pa. 1997), aff'd, 160 F.3d 982 (3rd Cir. 1998); In re MSR Hotels & Resorts, Inc., 2013 WL 5716897, at *1 (Bankr. S.D.N.Y. Oct. 1, 2013)). Although the term "insider" is defined in section 101(31) of the Bankruptcy Code, the court noted, the statutory definition is not exclusive and has been interpreted broadly to include anyone "who has a sufficiently close relationship with the debtor that his conduct is made subject to closer scrutiny than those dealing at arm's length with the debtor." Id. at *28 (citations and internal quotation marks omitted).
If a transaction involves an insider, the court explained, the insider bears the burden of showing the "entire" or "inherent" fairness of the transaction at issue. Id. at *27 (citing WHBA Real Estate Ltd. P'ship v. Lafayette Hotel P'ship (In re Lafayette Hotel P'ship), 227 B.R. 445, 454 (S.D.N.Y. 1998); In re L.A. Dodgers LLC, 457 B.R. 308, 313 (Bankr. D. Del. 2011); Papercraft, 211 B.R. at 823). Even a minority shareholder can be considered an insider in this context if it exercises influence and control over the corporation through other means, including board seats or exclusive access to confidential information. Id. (citing Nisselson v. Softbank AM Corp. (In re Marketxt Holdings Corp.), 361 B.R. 369, 387-88 (S.D.N.Y. 2007)).
According to the bankruptcy court, the Tranche C lenders and Delta—which was "instrumental" in negotiating the terms of the transaction—were "insiders" of LATAM. These shareholders collectively owned or controlled 51% of LATAM's common stock and designated six of LATAM's nine board members. Moreover, although it was undisputed that the Tranche A lender was not a LATAM insider, the court applied heightened scrutiny to the proposed Tranche A loan as well, reasoning that the two loan facilities were "intertwined" and the "terms of the Tranche C Facility were essential in raising the Tranche A DIP Facility."
To demonstrate that LATAM satisfied the "entire fairness" standard, the court noted, LATAM had to show that the proposed financing agreement, including the Tranche A facility and the Tranche C facility, "results from fair dealing and reflects a fair price." Initially, the court rejected the objectors' argument that LATAM lacked good faith in seeking approval of the financing. According to the court, the evidence showed that LATAM made an informed judgment in rejecting financing from other sources and had "good reasons" for approaching its major shareholders for a DIP loan.
Next, the court concluded that the terms of the proposed financing amounted to a "fair price" under the circumstances and that LATAM's efforts to obtain DIP financing amounted to a "fair process" that included extensive due diligence and negotiations, extensive marketing procedures, and the consideration of multiple competing offers. The court rejected the objectors' argument that LATAM's admitted failure to market the Tranche C facility prepetition precluded a finding that the process was entirely fair. According to the court, LATAM engaged in a robust marketing process postpetition and demonstrated that there were good reasons for it not to go to the market with the DIP financing proposal prior to filing for bankruptcy, including: (i) "a DIP underwritten by its major shareholders would enhance the potential for governmental support and send a strong signal to the market that their equity holders had confidence in the [LATAM's] business"; and (ii) it was impractical to go to the market because LATAM did not have adequate collateral to fully secure a $2 billion loan.
The court also rejected the objectors' argument that the price and terms of the Tranche C facility were not "entirely fair" because the pricing was excessive, and the terms, including the lack of any prepayment right, broadly deviated from market standards, in an attempt to entrench management, impair creditor protections, and impinge on the court's authority. According to the court, because LATAM was not obligated to draw down the full amount of the delayed-draw Tranche C facility, a prepayment right was of "diminished" importance. Moreover, the court explained, even after thoroughly testing the market postpetition, LATAM was unable to secure alternative financing on more favorable terms (either by increasing the Tranche A facility or otherwise) to address its liquidity needs in the current crisis. In addition, the bankruptcy court found that the pricing of the Tranche C loan was "negotiated to incorporate the respective parties' risks and rewards" and accordingly found that the DIP financing agreement, including the Tranche A loan and the Tranche C loan, resulted "from fair dealing and reflects a fair price."
Good Faith Lenders?Next, the bankruptcy court found that both the Tranche A lender and the Tranche C lenders were entitled to the protections of section 364(e) of the Bankruptcy Code, which moots any appeal of an unstayed order approving financing from a good faith lender. The court rejected the objectors' argument that the Tranche C lenders did not act in good faith because: (i) they were LATAM insiders; and (ii) they "intentionally pursued a transaction … that, on its face, subverts the principles of absolute priority and constitutes a sub rosa plan." The court dismissed the insider argument as meritless. Also, it explained that, because LATAM maintained that the Tranche C loan represented an investment of new money, was not a sub rosa plan and did not violate the absolute priority rule, the Tranche C lenders were "not seeking relief that is improper under settled law." Finally, given the absence of any evidence indicating that the Tranche C lenders misused their status as shareholders, engaged in fraud or collusion, or tried to take gross advantage of other bidders, the court ruled that the Tranche C lenders were entitled to a good faith lender designation under section 364(e).
The Absolute Priority Rule and the New Value Exception.According to the objectors, the proposed DIP financing violated the "absolute priority rule" codified in section 1129(b)(2) of the Bankruptcy Code because, "on account of their status as shareholder," the proposed financing: (i) gave existing shareholders—the Tranche C lenders—the exclusive option to acquire the equity of the reorganized LATAM at a discount; and (ii) extended to all other shareholders the option to acquire all of the new equity in the reorganized LATAM at plan value. The bankruptcy court acknowledged that, even though the proposed DIP financing was not part of a chapter 11 plan, the absolute priority rule was "triggered" because the "Tranche C DIP Facility is at least partly being extended and repaid to the Tranche C Lenders (and other shareholders) on account of their pre-existing equity holdings."
However, the court concluded that the financing transaction satisfied the "new value" exception to the rule, which permits a shareholder to retain equity, or a junior creditor to receive a distribution under a plan, despite less than full payment of senior creditors, provided the shareholder or junior creditor contributes new capital to the restructured enterprise. First, the court noted, there was no dispute that the up to $1.15 billion to be loaned by the Tranche C lenders was "new, substantial money." Next, the court found that the $1.15 billion Tranche C facility was "reasonably equivalent" to the value retained and "necessary" because: (i) the loan was negotiated at arm's length and underwent an extensive postpetition market test without producing any viable competing offers; and (ii) the total pricing of the loan, including the equity conversion feature, reflected the value of the risk undertaken by the Tranche C lenders.
Undone by a Sub Rosa Plan?Despite all its prior findings, the court ultimately denied the financing motion because it concluded that the equity subscription provision in the Tranche C facility represented a prohibited sub rosa chapter 11 plan. It explained that certain events that precede (or supersede) confirmation of chapter 11 plan, such as a global settlement among major stakeholders, a sale of substantially all of the debtors assets, or a comprehensive agreement in anticipation of a "structured dismissal," may be a de facto chapter 11 plan without providing all parties with the same protections as the plan confirmation process. Such sub rosa plans are prohibited "based on a fear that a debtor-in-possession will enter into transactions that will, in effect, 'short circuit the requirements of Chapter 11 for confirmation of a reorganization plan.'" LATAM, 2020 WL 5506407, at *54 (citing Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452, 466 (2d Cir. 2007); Pension Benefit Guar. Corp. v. Braniff Airways, Inc. (In re Braniff Airways, Inc.), 700 F.2d 935, 940 (5th Cir. 1983)); accord In re Miami Metals I, Inc., 603 B.R. 531, 536 (Bankr. S.D.N.Y. 2019). According to the court, a proposed DIP loan may be rejected as a sub rosa plan "if the terms of the loan include concessions to creditors or parties in interest that are unauthorized under, or in conflict with, provisions under the Bankruptcy Code." LATAM, 2020 WL 5506407, at *56 (citing Resolution Tr. Corp. v. Official Unsecured Creditors Comm. (In re Def. Drug Stores, Inc.), 145 B.R. 312, 317 (B.A.P. 9th Cir. 1992); In re Belk Props., LLC, 421 B.R. 221, 225-26 (Bankr. N.D. Miss. 2009); In re Chevy Devco, 78 B.R. 585, 589 (Bankr. C.D. Cal. 1987)).
In this case, the court found, LATAM was not asking the court to approve a transaction that would merely bring it one step closer to plan confirmation but "to approve a transaction that will fix now, some of the terms of a plan yet to be filed." If approved, the court noted, the Tranche C facility would lock into place the 20% discount to plan value on the stock to be issued at LATAM's option to the Tranche C lenders in satisfaction of the loan. The court wrote that, because it was not market tested, "[t]here is no way of knowing now whether that discount is appropriate … [and] neither the Debtors' decision to make that election, nor the 20% discount, will be subject to creditor comment or Court review." For this reason, the court initially denied approval of the Tranche C loan because it "short circuit[ed]" the chapter 11 plan review process "by establishing plan terms sub rosa."
In addition, the bankruptcy court ruled that the DIP financing agreement "establishe[d] plan terms sub rosa" by providing for the distribution of stock in the reorganized LATAM to existing equity holders "on account of" their status as shareholders without market testing.
Finally, the court found that the provision in the DIP financing agreement providing that the confirmation of a non-LATAM-approved chapter 11 plan was an event of default was further evidence that the agreement was a sub rosa plan. According to the court, the DIP financing agreement "effectively lock[ed] up any future plan of reorganization to be only the Debtors' plan providing for the equity conversion."
Postscript
Shortly after the bankruptcy court handed down its ruling, the lenders and LATAM submitted a revised DIP financing agreement without the equity subscription election and with terms modified to remedy the concerns expressed by the court in its decision. In addition, Knighthead affiliates were permitted to subscribe up to $425 million to the Tranche A and Tranche C loans. The court approved the revised DIP financing agreement on September 19, 2020. See In re LATAM Airlines Grp. S.A., No. 20-11254 (JLG) (Bankr. S.D.N.Y. Sept. 19, 2020) (Doc. No. 1091).
Outlook
LATAM is a cautionary tale for shareholders or other insiders attempting to parlay chapter 11 plan financing into a continuing ownership interest in a reorganized company. According to the bankruptcy court, even if such financing is necessary to the success of the case and on otherwise fair terms, it cannot dictate the terms of a chapter 11 plan or otherwise subvert the plan confirmation process.
A version of this article was previously published by Lexis Practice Advisor. It has been reprinted here with permission.
