Rights Offerings in Bankruptcy: More Than New Capital, Journal of the Association of Insolvency & Restructuring Advisors, reprinted in Jones Day Business Restructuring Review
Over the past decade, rights offerings have become a valuable and frequently used source of exit financing for chapter 11 debtors. The increased use of rights offerings is, in part, a result of the increased participation of nontraditional, sophisticated lenders in the bankruptcy process. Rights offerings are often beneficial to all parties involved. The debtor can obtain access to new capital without resorting to secured financing, and creditors or prebankruptcy equity security holders can preserve their investments in the debtor and obtain enhanced recoveries by investing at a discount to the perceived value of the reorganized company. Moreover, a successful rights offering can provide a signal to the market that there is healthy optimism about the success of the reorganized company.
In addition to providing reorganized debtors with access to new capital, rights offerings are increasingly being used as a tool to effectuate other agendas in a bankruptcy case, including the resolution of valuation disputes and allocating control of the new company.
The Basics of Rights Offerings
In bankruptcy, a rights offering allows a debtor to offer creditors or equity security holders the right to purchase equity in the postemergence company, usually at a healthy discount to the assumed value of the reorganized enterprise. The class of creditors or equity security holders solicited for participation is generally offered the right to purchase its pro rata share (i.e., the same percentage that its current holdings represent) of the equity available under the offering. Rights offerings typically involve a solicitation of the eligible creditors or equity security holders either in connection with solicitation of the reorganization plan or following confirmation of a plan, but prior to consummation of the plan and emergence from bankruptcy. Because the new equity typically is sold at a discount to assumed value, the parties often have a strong incentive to participate in the offering to avoid dilution, provided that they believe the offering price does in fact represent a discount to the value of the reorganized entity.
To guarantee that the reorganized debtor’s capital needs are met, rights offerings are usually backstopped by a third party that agrees to purchase any unsubscribed shares. Because the debtor’s plan of reorganization is normally premised upon raising the financing contemplated by the rights offering, obtaining a backstop commitment is typically critical to establish the feasibility of the plan at confirmation and to avoid the possibility of a substantial loss of time and expense soliciting and confirming a plan that is thereafter never consummated because sufficient funds have not been raised. Because there is always the inherent risk that the backstop party could be required to purchase a much larger number of unsubscribed shares than the party desires, backstop parties typically require payment of a backstop fee, often ranging from 3 to 7 percent of the total offering. The backstop party will also typically want assurance, through an "overallotment right" or otherwise, that it will have the opportunity to purchase a certain minimum number of shares. To ensure its protection, the backstop party will require that, prior to proceeding with any solicitation of the rights offering, the debtor seek court approval of the backstop agreement, including the backstop fee. The backstop party can often end up with a controlling, or at least very influential, equity block. To obtain the most favorable terms, debtors often shop the backstop right, sometimes through an informal auction process.
One of the most heavily negotiated terms of the backstop agreement will be a "material adverse change" provision. Often there are months between the time the backstop agreement is signed and the consummation of the rights offering, and it can be challenging to define, and reach agreement on, what unexpected adverse developments might permit the backstop party to terminate the backstop commitment.
A rights offering may include "oversubscription" or overallotment rights. Oversubscription rights allow existing creditors or equity holders to purchase more than their pro rata shares if unsubscribed securities are available, while overallotment rights permit holders to purchase additional securities even when the offering is fully subscribed. The use of oversubscription/overallotment rights in connection with backstop rights provides debtors with substantial flexibility in the offering process, facilitating the debtor’s ability to achieve the optimal capital and ownership structure upon emergence from bankruptcy.
Another benefit of rights offerings in bankruptcy is the potential to exempt the new securities from registration with the Securities and Exchange Commission ("SEC"). Registration is typically lengthy and expensive, but Bankruptcy Code section 1145 permits a debtor to issue securities in the reorganized company without registration if certain conditions are met. To rely on the securities-law exemption under section 1145(a)(1), the new offering of securities must be issued: (i) under a plan of reorganization; (ii) by the debtor, an affiliate of the debtor, or a successor to the debtor; and (iii) in exchange for claims against or interests in the debtor, or "principally" in exchange for such claims or interests and partly for cash or property. Section 1145(a)(2) also provides an exemption for offerings of securities through warrants, options, rights to subscribe, or conversion privileges when the original security is issued in compliance with section 1145(a)(1).
To qualify for the exemption when securities are exchanged for cash or property in addition to claims or interests, the debtor in possession must be careful to ensure that the transaction does not appear to be primarily an effort to raise fresh capital—in other words, the claims or interests exchanged for the right to participate, not the new money raised, must be the central aspect of the rights offering. Under the statute, the exemption is unavailable if the amount of cash or property given by a claimant transforms the transaction into something other than securities issued "principally in exchange" for the claims or interests, sometimes referred to as the "principally/partly" test. This test raises the question: How much cash or property is too much in a section 1145(a) transaction?
The text of section 1145, "principally in exchange," could be read to require simply that the exchange of property and cash be less than the amount of the surrendered claim or interest. SEC no-action letters, however, have suggested that "principally in exchange" may require a lower ratio of cash to claim or interest value. For instance, in Bennett Petroleum Corporation, the SEC agreed that the exemption applied to a plan of reorganization where the debtor exchanged new preferred stock for old common stock plus cash. The exchange was structured to provide a cash amount equal to 75 percent of the value of the interests being surrendered (e.g., cash of $75 million compared to old stock tendered with a value of $100 million).
Similarly, in Jet Florida System, Inc., the SEC requested further information regarding a plan under which the unsecured creditors received new common stock and subscription rights, among other things, in exchange for their claims. The SEC agreed to take no enforcement action with respect to the application of the exemption after the debtor established that the value of the claims exchanged by the creditors was substantially greater than the $2.40 subscription price. As in Bennett Petroleum, the ratio of cash value to the value of claims exchanged for the new securities was approximately 75 percent. The SEC no-action letters appear to provide a safe harbor at 75 percent for meeting the principally/partly test; however, a rights offering could have a ratio of more than 75 percent (e.g., $95 million in cash raised compared to stock surrendered with a value of $100 million) and still potentially satisfy the requirements of section 1145.
Section 1145, by its own terms, does not exempt transfers to underwriters. As a result, shares purchased by the backstop party are typically not exempt from registration under section 1145. Thus, to issue new securities to the backstop, the debtor usually relies on a private-placement exemption. Additionally, if the backstop seeks to sell its shares to the public at some point in the future, the backstop may separately require the reorganized company to go through the registration process after the offering has been completed.
Use of Rights Offerings in Recent Cases and Related Issues
Among other uses, rights offerings can be an effective tool for junior creditors or equity security holders to bolster their position on valuation by demonstrating a willingness and financial commitment to invest new money premised on a higher valuation—i.e., put their money where their mouths are.
For instance, a proposed rights offering backed by certain equity holders was utilized in the GSI Group, Inc., case: (i) to convince the debtors to abandon a plan negotiated with certain noteholders and premised on a lower valuation; and (ii) ultimately to reach a consensual plan on much more favorable terms for equity holders. In GSI Group, Inc., the debtors commenced their chapter 11 cases with a prenegotiated plan supported by the holders of the debtors’ $210 million in unsecured notes. The prenegotiated plan contemplated that the noteholders would receive $95 million in new notes and approximately 80 percent of the equity in the reorganized entity and that existing shareholders would receive approximately 20 percent of the new equity. Following several weeks of litigation over valuation and the debtors’ subsequently proposed modifications to the plan to improve the treatment of equity holders, the equity committee proposed an alternative plan premised on a rights offering with a higher enterprise value than the plan the debtors and noteholders were seeking to cram down. The rights offering under the alternative plan was to be backstopped by one of the shareholders on the committee, and the alternative plan proposed to pay down a substantial portion of the notes in cash and reinstate the balance of the notes. Initially, the parties could not come to an agreement on a consensual plan because a subgroup of noteholders wanted a share of the upside in the reorganized company, as opposed to cash and new notes, and there was a fundamental disagreement over the enterprise value of the reorganized entity and thus the value of the new equity to be distributed under the plan.
Ultimately, the valuation dispute was resolved through the creative use of the backstop right coupled with a potential overallotment right. Under the consensual plan, the noteholders agreed to backstop the offering and the equity committee agreed that the noteholders would have the right to purchase a certain minimum amount of the new equity—even if the offering was fully subscribed. Because it was anticipated that a portion of the existing equity holders would elect not to participate in the offering, much of the allotment guaranteed to the backstopping noteholders was expected to come from equity holders that elected not to participate in the offering. Following the completion of the rights offering under the plan, existing equity holders retained approximately 86 percent of the stock in the reorganized company, and the noteholders received, among other things, the cash proceeds from the rights offering and new secured notes. As anticipated, the guaranteed minimum equity for the noteholders was fulfilled in part from existing equity holders that chose not to participate, reducing the dilution of the participating equity holders that believed the shares were worth substantially more than the subscription/conversion price.
Because participation in a rights offering is often viewed as a valuable right, issues have arisen in recent cases over the ability to participate, including whether similarly situated creditors or shareholders are receiving equal treatment under a plan.
For instance, in the chapter 11 case of Dana Corp., the debtor reached agreements with its unions and with a financial sponsor for exit financing. Under those agreements, the financial sponsor would backstop a rights offering for new preferred stock that would include, among other things, consent rights for certain transactions. To make its corporate governance manageable, Dana needed to limit the ultimate number of new preferred stockholders. In addition, to reach the desired result and provide assurance that the preferred stock offering would not be materially undersubscribed, the financial sponsor negotiated to limit participation in the offering to sophisticated parties, which would provide greater certainty of participation. To effectuate this plan, Dana developed certain objective criteria for claimants eligible for participation, including a requirement that they hold claims aggregating a certain minimum amount. Ineligible creditors and the creditors’ committee objected on the basis that the participation right was valuable and was being provided on account of the eligible creditors’ claims, thereby resulting in unequal treatment of unsecured creditors. Dana contended, among other things, that the creditors purchasing the preferred stock were not receiving that right on account of their claims and that the smaller ineligible creditors were likely to benefit in any event because larger holders were likely to seek to buy smaller claims at a premium if they wanted to participate. The issue was eventually settled through the provision of an additional settlement fund in which ineligible creditors would have the right to share under certain circumstances, and Dana raised new capital through an offering without creating an unworkable governance structure for the reorganized company.
A similar issue regarding the ability to participate arose in the chapter 11 case of Visteon Corp. In Visteon, the debtors proposed a plan that contemplated, among other things, a $950 million rights offering to unsecured noteholders, which was oversubscribed by more than $110 million, and a $300 million direct-purchase commitment from certain noteholders. An ad hoc group of shareholders (representing about 20 percent of the outstanding shares) objected to plan confirmation on the basis that unsecured creditors were receiving more than 100 percent on their claims based on the value of the equity being distributed and thereby setting up a complex valuation dispute at confirmation. To resolve the objection and avoid the cost and delay of the valuation trial, the debtors proposed to reimburse the ad hoc shareholder group for the professional fees the group had incurred. In addition, to further entice the ad hoc group to drop its objection and vote in favor of the plan, the noteholders agreed to permit the shareholders in the group to participate to a very limited degree in the direct-commitment portion of the rights offering. No other shareholders were given this right to participate. Because the equity class as a whole would not have voted in favor of the plan without the support of the ad hoc group, the settlement avoided cramdown and the valuation trial.
The U.S. Trustee and certain shareholders objected to the plan and settlement on the basis that (i) the settlement amounted to a purchase of the ad hoc group’s votes; and (ii) the plan did not provide equity holders equal treatment as required under section 1123(a)(4) of the Bankruptcy Code because the ad hoc group was receiving different and more favorable treatment than other similarly situated shareholders. The debtors argued that the participation right was not part of the plan treatment, but rather an agreement by the investor noteholders to share a portion of their equity purchase commitment to avoid what might otherwise be an expensive valuation dispute that could result in a material delay, potentially putting the investor noteholders’ equity at risk. The court overruled the objections.
Rights offerings were successfully used to effectuate confirmation of a plan in each of these cases. Rights offerings can also be used, however, to disadvantage certain parties. For instance, investment funds may have internal restrictions that prevent them from investing additional funds in a rights offering. To the extent that part of the real value given in exchange for a claim or interest is the right to participate in the offering, such parties can be diluted to their disadvantage. Rights offerings could be proposed as leverage against such parties in the context of restructuring negotiations.
Over the past few years, rights offerings have become an increasingly important tool for reorganizing debtors. Because of their inherent flexibility and value, rights offerings can be used to resolve disputes and benefit certain parties over others, in addition to raising new money for the reorganized company. Practitioners should be aware that offerings can be used both offensively and defensively, and they should remain cognizant of the increased creative use of the rights-offering process to best protect the client’s position.
Bennett Petroleum Corporation, SEC No-Action Letter, 1983 WL 28907 (Dec. 27, 1983).
Jet Florida System, Inc., SEC No-Action Letter, 1987 WL 107448 (Jan. 12, 1987).
A version of this article was published in the November/December 2010 edition of the AIRA Journal. It has been reprinted here with permission.