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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Bankruptcy Court Considers Whether Key Employee Incentive Plan Milestones Can Be Lowered Without Triggering The Restrictions On Retention Plans

One of the significant changes made by the Bankruptcy Code amendments that took effect in October 2005 was the imposition of severe restrictions on "key employee retention plans," known in the bankruptcy world as KERPs.  In this post I’ll discuss how several courts have handled these issues in the year and a half since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, became effective. The most recent decision, issued late last week by the Delaware Bankruptcy Court in the Nellson Nutraceutical case, gives debtors added flexibility when trying to craft plans consistent with these new restrictions.

Changes Aimed At Curbing KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. The restrictions apply only to insiders; no similar limitations have been placed on payment of retention bonuses and severance to non-insiders.

The New Law’s High Hurdles. To give you a flavor of the restrictions BAPCPA added to Section 503(c) of the Bankruptcy Code, a debtor company must now prove the following before it can gain approval for payment of a retention bonus to an insider:

  • the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;
  • the services provided by the person are essential to the survival of the business; and

  • either

  • the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or
  • if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred.

The requirement of a bona fide job offer in particular has led some to observe that if an officer of a company in Chapter 11 really had such an offer he or she would probably just take it, mooting the entire retention issue. In any event, these provisions have had their desired effect. It is now rare to find a debtor proposing a KERP that seeks to make retention payments to officers or other insiders.

Debtors Opt For Plan B. Despite these restrictions, debtors still usually want to keep their key officers and may worry that they will leave for more stable companies absent some incentives to remain with the debtor. So what are debtors doing? Since October 2005, they have shifted gears and are proposing not retention plans but incentive plans instead. To date, only a few decisions, discussed below, have addressed what is necessary for an incentive plan to pass muster. In other instances, incentive plans have been approved with little or no opposition. Perhaps the earliest such approval came in May 2006 when Judge Burton R. Lifland approved one in the Calpine Corporation Chapter 11 case.

The Dana Corporation Case. The first significant contested plan motion came shortly after the Calpine incentive plan’s approval. Dana Corporation, whose Chapter 11 case was also pending before Judge Lifland, filed a motion seeking approval of a plan similar to that approved in the Calpine case. After considering objections filed by various creditors and others, however, in September 2006 Judge Lifland refused to approve Dana Corporation’s proposed plan, finding that it was a prohibited retention plan. For an excellent and entertaining discussion of the circumstances leading to denial of that first effort in the Dana Corporation case, including why the Calpine plan was approved while the first Dana plan was not, be sure to read Steve Jakubowski’s detailed post on the Bankruptcy Litigation Blog.

A few months later, on Dana Corporation’s second try, Judge Lifland approved the revised incentive plan. In his second ruling, he found that with certain modifications the debtor’s revised proposals met the sound business judgment test required for approval. In addition, he ruled that the new plan incentivized the key officers "to produce and increase the value of the estate" and, because the benchmarks in the plan were difficult targets to reach and not easy "lay-ups," the proposal was an actual incentive plan and not a retention plan in disguise.

Evaluating Incentive Plans. In evaluating whether the Dana plan represented the exercise of sound business judgment, Judge Lifland considered the following factors:

  • Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance? (emphasis added)
  • Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities and earning potential?
  • Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
  • Is the plan or proposal consistent with industry standards?
  • What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?
  • Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

These factors provide useful guidance not only to bankruptcy courts but also to boards of directors of financially troubled companies, whether in or out of bankruptcy, when considering proposals for retention or incentive plans.

The Global Home Products Decision. In March 2007, Judge Kevin Gross of the Delaware Bankruptcy Court approved two incentive plans in the Global Home Products case. In that decision, as the Delaware Business Bankruptcy Report described here, the court followed the analysis Judge Lifland used in the Dana Corporation case and approved the two incentive plans. Specifically, Judge Gross found that the plans were true incentive plans, which he called "pay for value" plans and were not KERPs, or "pay to stay" plans. For this reason, Judge Gross evaluated the plans under the business judgment standard of Section 363 of the Bankruptcy Code, holding that the strict Section 503(c) limitations simply did not apply.

The Nellson Nutraceutical Decision. On May 24, 2007, Judge Christopher S. Sontchi of the Delaware Bankruptcy Court issued a decision in the Nellson Nutraceutical Chapter 11 case approving revisions to a previously-approved incentive plan. There, the debtors’ first incentive plan provided for certain performance milestones based on target levels of EBITDA, or earnings before interest, taxes, depreciation, and amortization. Unfortunately, the debtors did not achieve those EBITDA milestones and sought to lower them to align with what they considered to be more realistic performance goals. After receiving testimony that the debtors had made similar reductions in bonus targets in the past, Judge Sontchi concluded that the debtors’ current proposal was in the ordinary course of business and involved a good faith business judgment.

On the issue of whether Section 503(c)’s retention payment restrictions applied, Judge Sontchi found that the lowering of the incentive plan milestones did not turn the plans into retention plans. He held that if the primary purpose of a plan is to incentivize insiders and other employees, rather than merely retain them, it remains an incentive plan:

Under the facts of this case, although the modification of the 2006 bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable.

*     *    *

The [United States Trustee] argues with some force that if an incentive plan is based on achievement of EBITDA targets and those targets are not achieved, yet the bonus is still received, that the plan cannot be an incentive plan but must, in fact, be solely a retention plan.

*   *    *

While the Court agrees that the payment of bonuses under the modified 2006 [plan] has some retentive effect, the Court disagrees with the [United States Trustee’s] argument that its sole or primary purpose is retention. Consistent with the Debtors’ pre-petition practice, the 2006 [plan] must be considered as a whole. It consists of two parts: the establishment of ‘aspirational goals’ in the early part of the year; and a review at the end of the year to consider whether those goals have been met and, if not, why. In this case, the Debtors did just that and determined that the 2006 [plan] served its purpose by motivating the employees to do a ‘great job’ in connection with the matters that those employees could reasonably be expected to influence. As such, the Debtors seek to award bonuses at a reduced level to compensate the employees for their success (albeit somewhat limited) in 2006 and to motivate the employees in 2007.

Finally, Judge Sontchi held that Section 503(c)(3)’s additional limitations, which among other things prohibit transfers to insiders that are "outside of the ordinary course of business and not justified by the facts and circumstances of the case," by its terms apply only to payments outside of the ordinary course of business. Given his earlier holding that the debtors’ plans and their modifications were made in the ordinary course of business, Judge Sontchi concluded that Section 503(c)(3)’s requirements did not apply at all.

Conclusion. BAPCPA has effectively ended the use of KERPs for officers and other insiders of a debtor. However, more than a year and a half after BAPCPA became effective, bankruptcy courts in New York and Delaware, and perhaps elsewhere, are willing to approve incentive plans for insiders. The Nellson Nutraceutical decision goes further and, in the right circumstances, will allow the incentive plan’s performance milestones themselves to be lowered without jeopardizing the "incentive" character of the plan. This area of the law is plainly evolving, so stay tuned for more developments.

Business Bankruptcy Issues Recent Developments

California Bankruptcy Court Answers Open Question From Supreme Court’s Travelers Decision: Can Post-Petition Attorney’s Fees Be Added To Unsecured Claims?

In March, the U.S. Supreme Court overruled the so-called Fobian rule in the Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. decision. (Click here for a copy of the decision.) That rule, named for decision by the United States Court of Appeals for the Ninth Circuit in a case called In re Fobian, 951 F.2d 1149 (9th Cir. 1991), had barred unsecured creditors from recovering as part of their unsecured claim attorney’s fees incurred post-petition litigating bankruptcy issues.

The Open Question. As discussed in a post on the Travelers decision, although the Supreme Court dispatched the Fobian rule, it did not decide whether an unsecured creditor could actually recover its attorney’s fees. Left unresolved, among other issues, was whether Section 506(b) of the Bankruptcy Code, which expressly allows attorney’s fees to oversecured creditors, precludes recovery of post-petition attorney’s fees as part of an unsecured claim.

The Question Gets Asked Post-Travelers. In the In re Qmect, Inc. Chapter 11 cases pending in the U.S. Bankruptcy Court for the Northern District of California, an unsecured creditor sought allowance of post-petition attorney’s fees, incurred litigating bankruptcy issues, as part of its unsecured claim against debtors who were individual guarantors of its debt owed by the corporation. The creditor had prevailed in an adversary proceeding on its guaranty (an appeal is pending) and sought post-petition attorney’s fees as part of its judgment.

After first denying the creditor’s request without prejudice last November, the Bankruptcy Court asked for supplemental briefing on the issue after the Travelers decision was decided. In the debtors’ supplemental brief, they argued that Section 506(b) of the Bankruptcy Code implicitly provides for the disallowance of post-petition attorney’s fees as part of unsecured claims (as opposed to secured claims). In the creditor’s supplemental brief, it argued that all of the other circuits that have addressed the issue agree that such fees are recoverable and that there is nothing in Section 502(b) or Section 506(b) that prohibits their recovery. Both the debtors and the creditor filed reply briefs as well, further arguing their contentions.

California Bankruptcy Court Gives An Answer. On May 17, 2007, in perhaps the first post-Travelers decision to rule on the issue, Judge Leslie Tchaikovsky held that an unsecured creditor was entitled to include post-petition attorney’s fees incurred litigating bankruptcy-related issues in its unsecured claim, where the parties’ underlying contract provided for recovery of attorney’s fees. In its Memorandum of Decision re Motion for Post-Petition Attorneys’ Fees, the Bankruptcy Court held that (1) the creditor’s post-petition attorney’s fees qualify as a "claim" under Section 101(5) of the Bankruptcy Code, and (2) none of the exceptions in Section 502(b) of the Bankruptcy Code apply to require disallowance of the fees as part of the claim.

The Court’s Analysis. In elaborating on the second holding, the Bankruptcy Court explained as follows:

The only category [of Section 502(b)’s exceptions] that arguably supports the disallowance of an unsecured claim for post-petition attorneys’ fees is 11 U.S.C. § 502(b)(1): i.e., that ‘such claim is unenforceable against property of the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured….’ 11 U.S.C. § 502(b)(1). The debtor contends that this category applies to post-petition attorneys’ fees because 11 U.S.C. § 506(b) renders the claim for post-petition attorneys’ fees unenforceable against the debtor and property of the debtor. Section 502(b)(1) refers to ‘applicable law,’ not ‘applicable nonbankruptcy law.’ Thus, Section 506(b) qualifies as ‘applicable law.’ Section 506(b) provides as follows:

(b) To the extent that an allowed secured claim is secured by property, the value of which is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and reasonable fees, costs or charges provided for under which such claim arose.

Thus, according to the debtor, by providing that a secured claim shall be allowed reasonable fees to the extent the claim is secured by property, the Bankruptcy Code is implicitly saying that fees are not available to an unsecured creditor. The Court finds this reading of 11 U.S.C. §§ 502(b) and 506(b) too strained to be persuasive. First, 11 U.S.C. § 506 is entitled ‘Determination of Secured Status.’ A statute so entitled would not be a logical place to provide for the disallowance of an element of an unsecured claim. If Congress, in enacting the Bankruptcy Code, had wanted to disallow claims for post-petition attorneys’ fees, the logical place for it to have done so was surely in 11 U.S.C. § 502(b). Moreover, 11 U.S.C. § 506(b) does not distinguish between pre-petition and post-petition attorneys’ fees. Thus, if 11 U.S.C. § 506(b) is read as an additional ground for objecting to claims, arguably, an unsecured creditor would be prohibited from including its pre-petition attorneys’ fees in its claim as well as its postpetition fees.

(Footnotes omitted.) After being unable to find any Court of Appeals decision decided under the Bankruptcy Code directly addressing the issue, the Bankruptcy Court then examined the policy argument underlying the debtors’ objection:

The strongest rationale for implying a prohibition on the inclusion of post-petition attorneys’ fees in a unsecured creditor’s pre-petition claim is that, unless the debtor is solvent, the unsecured creditor’s augmented claim will diminish the dividend to other unsecured creditors. However, a similar effect flows from allowing secured creditors to include their post-petition attorneys’ fees in their secured claims. While equality of distribution is one of the basic tenets of bankruptcy law, another important policy in bankruptcy is the preservation of nonbankruptcy legal rights except to the extent necessary to facilitate the purpose of the bankruptcy proceeding. Absent a clear provision of the Bankruptcy Code modifying a creditor’s nonbankruptcy legal rights, the Court concludes that those rights should be deemed to be left intact.

Now What? If the Bankruptcy Court’s decision is followed by other courts, the main question left open in Travelers will have been answered. However, this decision raises some additional issues:

  • Will the potential allowance of post-petition attorney’s fees for bankruptcy-related issues impact a debtor’s reorganization prospects?
  • What procedures will debtors propose for managing the process as unsecured creditors amend their claims to add attorney’s fees incurred in protecting their rights during the course of a bankruptcy case?
  • Will individual unsecured creditors become more active in Chapter 11 cases, particularly in those cases in which a large distribution is likely?
  • What standards will bankruptcy courts use to assess the reasonableness of an unsecured creditor’s post-petition attorney’s fees for bankruptcy-related issues?  
  • Will claims buyers pay more for unsecured claims based on contracts providing for recovery of post-petition attorney’s fees now that bankruptcy-related fees are recoverable?
  • Will creditors be more insistent on including attorney’s fees provisions in contracts?

It will be interesting to see how these issues unfold as the impact of this decision, and those of other courts facing this issue, are felt. Stay tuned.

Business Bankruptcy Issues Recent Developments

A Second District Court Decides Whether A Trademark License Can Be Assumed In Bankruptcy

Once again, a district court has faced the issue of whether a non-exclusive trademark license can be assumed by a debtor in possession. Before the November 2005 decision in In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), no court had directly addressed that question. The decision in the N.C.P. Marketing case, now on appeal to the Ninth Circuit, held that trademark licenses are personal and nonassignable, absent a provision in the trademark license to the contrary, and in a hypothetical test jurisdiction such as the Ninth Circuit, they cannot be assumed by the debtor in possession. For a more detailed discussion on the N.C.P. Marketing case, you may find this post of interest. For an analysis of some recent trends on the broader topic of assumption of IP licenses, try this post.

The Wellington Vision Case. Earlier this year, a second district court, this time the U.S. District Court for the Southern District of Florida, faced the same question in an appeal in the In re Wellington Vision, Inc. Chapter 11 bankruptcy case.

  • Pearle Vision sought relief from the automatic stay to terminate a franchise agreement with Wellington Vision, arguing that Wellington could not assume the agreement because it Included a non-exclusive license of Pearle Vision trademarks.
  • The U.S. Bankruptcy Court for the Southern District of Florida granted the motion for stay relief by this two-page order, holding that the inclusion in the franchise agreement of a trademark license made the agreement, under federal trademark law, non-assignable absent consent by Pearle Vision.

Appeal To The District Court. Wellington Vision filed an appeal from the Bankruptcy Court’s decision.

  • In its opening brief, Wellington argued that (1) Pearle Vision had failed to establish that the franchise agreement included a trademark license, (2) a provision in the franchise agreement allowing for assignments on consent that cannot be unreasonably withheld meant that the parties had opted out of applicable law, and (3) Section 365(c)(1) of the Bankruptcy Code only prohibits assumption or assignment by a trustee, not by a debtor in possession, citing the Footstar case.
  • Pearle Vision argued in its answer brief that "applicable law" is the federal Lanham Act, which makes trademark licenses personal and non-assignable, and that Section 365(c)(1) creates a hypothetical test and precludes assignment or assumption of the license.
  • Wellington’s reply brief asserted that the District Court should not apply Section 365(c)(1) to debtors in possession and further that it should hold that this license was assignable by its terms.

The District Court’s Decision On Appeal. On February 20, 2007, Judge Alan S. Gold of the U.S. District Court for the Southern District of Florida affirmed the Bankruptcy Court’s decision in this 14-page decision. The District Court first held that the franchise agreement expressly included a non-exclusive license to certain Pearle Vision trademarks, making the Lanham Act the "applicable law" to be considered under Section 365(c)(1). It then held that the agreement’s provisions contemplating assignment under certain conditions did not constitute consent to any specific assignment or an "opt out" of the Lanham Act’s general restrictions on assignment, distinguishing In re Quantegy, 326 B.R. 467 (Bankr. M.D. Ala. 2005), relied on by Wellington. Finally, the District Court held that Section 365(c)(1) did apply to debtors in possession and not just to trustees, citing the Eleventh Circuit’s decision in City of Jamestown v. James Cable Partners, L.P., 27 F.3d 534 (11th Cir. 1994).

No Further Appeal Has Been Filed. Unlike the N.C.P. Marketing case, the District Court’s decision in this case will not be appealed. While the appeal was pending, the Wellington case was converted to a Chapter 7 case. Also, within the past two months litigation between Pearle, Wellington, and a guarantor of certain debt owed to Pearle was settled, resolving the issues decided by the District Court.

Trademark Owners Win Another One. Although it did not cite the N.C.P. Marketing decision, the Wellington Vision court becomes only the second district court to address the assumability of trademark licenses — and the second to hold that they are not assumable when the hypothetical test applies. This is more good news for trademark owners, who typically want as much control as possible over licenses to their marks, but bad news for debtors, who face the prospect of losing valuable trademark licenses (and franchise agreements including them) if they file bankruptcy. Stay tuned for more developments on this issue, including the Ninth Circuit’s decision in N.C.P. Marketing, which is likely still months away.

Special thanks to Warren Agin of the Tech Bankruptcy blog, whose post entitled The Descent Into Darkness Continues, first discussed the Wellington Vision case. The title of that post also gives you a sense of how many bankruptcy lawyers feel about the hypothetical test, its application to IP licenses, and its impact on debtors. 

Business Bankruptcy Issues Recent Developments

Are We In A Global Financial Bubble?

The San Francisco Business Times reports in a new article that the CEOs of Bank of America and GMO, a global investment management firm, have both commented recently about what they see going on in the financial and asset markets. Their views are similar to those expressed by the CEO of a major private equity fund, as reported here.

The San Francisco Business Times article quotes Ken Lewis of Bank of America as stating, "We need a little more sanity in a period in which everyone feels invincible and thinks this time is different," and "[w]e are close to a time when we’ll look back and say we did some stupid things." A Bloomberg article on his remarks can be found here.

Jeremy Grantham, CEO of GMO, went further and said he believes we are in the first "global bubble" in everything from stocks to junk bonds to land in Panama. His definition of a bubble is also interesting: "Perfect conditions create very strong ‘animal spirits’ reflected statistically in low risk premium," and "[w]idely available cheap credit offers investors the opportunity to act on their optimism." A version of his comments, published in the Financial Times and available courtesy of MSNBC.com, can be found here.

I can vividly recall a comment made by a highly respected senior corporate attorney shortly before the dot com bubble burst in early 2000. Although he didn’t use the term bubble, his description of the way venture funds were rapidly investing in companies and how, in turn, the public equity markets were snapping up shares in IPOs, still rings in my ears: "In thirty years of practice, I have never seen anything like it."

Jeremy Grantham of GMO reminds us that "Every bubble has always burst." It’s still hard to tell whether this period is a really a bubble or something short of it, and the recent comments from CEOs and others may be aimed at reducing some of the froth in various asset classes. However, if we actually are in another bubble there’s little reason to think the outcome will be "different this time." If so, at some point we may see a new wave of restructurings and Chapter 11 filings.

Business Bankruptcy Issues Recent Developments

Third Circuit Shoots Down Plan Confirmation, Finding Improper Gerrymandering

In an interesting decision issued last month in a case called In re Machne Manachem, Inc., the Third Circuit upheld a district court’s decision to reverse confirmation of a Chapter 11 plan of reorganization. The decision stemmed from steps taken to obtain votes required for approval of the plan. Before discussing the details, a bit of background on bankruptcy plans and the rules governing voting is in order.

Classes And Plans Of Reorganization. Bankruptcy plans must classify creditors and equity holders into various classes, usually based on the type of debt or equity security they hold or on other characteristics of their claims or interests. Each secured creditor is typically put in a separate class or subclass, bondholders may be put in a separate class based on the bond issue involved, general unsecured creditors may be grouped together in one class, and the claims held by insiders are occasionally put in a separate class.

Voting Requirements For Plans. The Bankruptcy Code spells out the voting rules for Chapter 11 plans of reorganization.

  • Under Section 1129(a)(10) of the Bankruptcy Code, at least one "impaired" class must vote to accept a plan. In the bankruptcy world, "impaired" means that under the plan the holder of the claim or interest will receive treatment that is different (usually worse) than what it would get outside of bankruptcy. This may involve stretching out repayment terms over time, paying less than 100 cents on the dollar, or canceling all shares of prepetition stock.
  • To accept a plan, the tally of votes from the impaired class must meet or exceed two thresholds. Two-thirds in dollar amount and a majority in number of those creditors voting must accept the plan.
  • If these tests are satisfied, as happened in the Third Circuit case, and if other requirements are met, the debtor may be able to "cram down" the plan on the rest of the creditor body, even if other creditors voted to reject the plan. 

A Case Of Gerrymandering. In this case, the plan got the required votes from the impaired class. So what prompted the Court of Appeals to throw out the plan? In short, the Court found that by purchasing a select set of impaired claims, an insider of the debtor gerrymandered the vote in favor of the debtor’s plan. The Court ruled that the insider’s purchase of four claims in the only impaired class that accepted the plan was done to win the vote of that class. Once they were purchased, those claims were shifted out of the key class and into another class where their votes would not matter. This conduct, the Court held, was improper and "undermined the critical confirmation requirements of the bankruptcy code."

  • Although there was little evidence either way, the Court seem concerned that the vote in that one critical accepting class — 7 claims accepting and 4 claims rejecting — could have ended up as 7 claims accepting and 8 claims rejecting if the four purchased claims had stayed in the original class.
  • The Court also found troubling that the purchased claims received less than 100 cents on the dollar, which was the treatment the proposed plan provided for the rest of the creditors in the key class.

Conclusion. Classifying claims into classes for Chapter 11 plans and the voting process are critical aspects of the reorganization process in a business bankruptcy case.  From time to time objecting creditors may accuse the debtor or other plan proponent of gerrymandering those classes to win confirmation, but when the Third Circuit issues a decision finding that improper gerrymandering actually took place, it’s a case worth reading.  Special thanks to the Delaware Business Bankruptcy Report for first posting on the case.

Business Bankruptcy Issues Recent Developments

A Debt Bubble In Private Equity Deals?

The New York Times DealBook blog has another interesting post on the debt being used to finance private equity deals. This one is entitled "Is Private Equity Riding A Debt Bubble?" It discusses a recent article in the Boston Globe which, among other things, quotes the CEO of a major private equity firm as using the term "debt bubble" to describe the current situation in the debt market.

The Boston Globe article points to low interest rates, large loans relative to the acquired company’s cash flow, and the lack of covenants — sometimes known as "covenant lite" loans — as driving the phenomenon. Some deals are also being structured with so-called toggle notes, giving the borrower the option to make "payment in kind" or PIK payments — additional debt instead of cash — although at a higher interest rate. The absence of significant covenants led the quoted CEO to ask, "How do you default?" 

This DealBook post follows one from last week, reported here, discussing the rising risk level of the debt behind private equity deals. If these generous lending terms are putting us in a "debt bubble," would an economic hard landing burst the bubble and lead to even more defaults, restructurings, and bankruptcies? Time will tell. 

Business Bankruptcy Issues Recent Developments

Are Risk Levels Rising For The Debt That’s Financing Private Equity Deals?

The New York Times DealBook blog has an interesting post about the risks posed by all the debt that helps fund the many private equity buyouts these days. It points to two articles in the UK press on the topic.

The first article, in the Financial Times, discusses comments by Larry Fink, the CEO of BlackRock, about how increasing levels of debt, lowered risk premiums, and less restrictive lending standards in connection with today’s private equity deals may end up creating "tomorrow’s problem." A major downturn in the economy could transform buyout debt into distressed debt.

The second article, in The Guardian, reports on the Bank of England’s warning about "how quickly credit quality can deteriorate following a period of lax credit standards." Sir John Gieve, one of the Bank of England’s deputy governors, is quoted as saying that the "rapid growth in credit risk transfer markets is also making more participants dependent on continuous market liquidity and could amplify the impact of a sharp reversal in credit spreads from their current low levels."

In addition, an increasing amount of corporate debt now involves second lien loans, and out-of-court restructurings and bankruptcy cases could be noticeably more complex.  Although neither article suggests that defaults are about to spike, the perspectives offered about how quickly that could change — if economic conditions turn for the worse — makes for interesting reading.