Recent Developments in Acquisition Finance

Several recent court decisions will potentially impact the way equity sponsors handle certain matters regarding their portfolio company investments. The first is a decision of a New York bankruptcy court involving the right of a holder of distressed debt to credit-bid the full face amount of the debt in a bankruptcy auction, a right that may be especially important in the context of a loan-to-own acquisition strategy. The decision bucks the recent trend of decisions in the area and may prove helpful to those pursuing such a strategy. The second, a Delaware Chancery Court decision applying New York law, deals with instances in which the controlling affiliate of an entity, such as a sponsor in respect of its portfolio company, could potentially be found to be legally bound by the terms of a contract entered into by the portfolio company to which the sponsor is not a party. 

In re Aéropostale, Inc. – Giving Credit where Credit is Due? 

In the Summer 2014 edition of this newsletter, we discussed two bankruptcy court decisions¹ which limited a secured creditor’s right to credit bid the full face amount of its secured debt in an auction of its collateral in a bankruptcy setting. The cases, Fisker and Free Lance-Star, were decisions of the Delaware and Virginia bankruptcy courts, respectively. They had signaled a potential new trend in which bankruptcy courts were willing to limit a secured creditor’s right at auction to credit bid the full amount of its debt, in order to remove the chilling effect the credit-bidding right can have on fostering a robust auction, at least where the secured creditor was found to have performed some wrongful action in respect of the auction process -- but perhaps even absent any misconduct by the secured party as well. 

The debtors in Fisker had obtained a loan from the United States Department of Energy (DOE), which was ultimately sold by DOE to Hybrid Tech Holdings, LLC (Hybrid) on a distressed basis for a fraction of its original principal amount. The debtors subsequently filed for bankruptcy and sought approval from the bankruptcy court for a private sale of their assets to Hybrid for a payment to be made by Hybrid entirely via a partial offset against the full face amount of the debt it held. 

The unsecured creditors committee in the bankruptcy case objected to the proposed private sale to Hybrid and asked the court to hold a public auction of the debtors’ assets and to limit the amount of Hybrid’s maximum credit bid to the far smaller amount it had paid to acquire the debt. The request was made under Section 363(k) of the Bankruptcy Code, under which a court may, “for cause,” limit the right of a secured party to credit bid its debt. The committee argued that capping Hybrid’s credit bid would stimulate a more competitive bidding environment and elicit higher cash bids for the collateral at auction. The committee also argued that Hybrid had attempted improperly to rush the debtor’s sale process. 

The court held that Hybrid’s ability to credit bid would indeed be so limited as requested by the committee, stating that the court was entitled to do so in order to “foster a competitive bidding environment.”² The court also noted that the proposed private sale had been expedited by the secured party in a manner “inconsistent with the notions of fairness in the bankruptcy process,”³ and that there was therefore sufficient “cause” to cap the credit-bid right. 

Shortly following the Fisker decision, the court in Free Lance-Star addressed a similar issue involving whether a secured creditor’s actions relating to the auction process for its collateral constituted “cause” that would allow the court to limit its right to credit bid. In that case the debtor had borrowed money, securing the loan with certain real and personal property. The purchaser of the secured debt, after default, asked the debtor to file a Chapter 11 case and to sell to it substantially all of its assets within the context of the case. 

The debtor asserted that sufficient “cause” existed for the court to limit the secured creditor’s credit-bid right. It asserted that the secured creditor had pressured it to agree to an expedited bankruptcy and sale process, and that the secured creditor had interfered with and impeded the pre-auction marketing of its assets. The debtor also submitted evidence that the competitive bidding process would be significantly enhanced if the secured party’s credit bid were capped. 

As in Fisker, the court agreed, holding that the credit bid right may be limited “for cause” in order to foster a more robust and competitive bidding environment. 

The Free Lance-Star court pointed to certain actions of the secured creditor as inequitable, including that it had pressured the debtor to begin an expedited bankruptcy process immediately after its purchase of the loan, and its insistence on shortening the sale process and including an explicit reference to its full credit bidding rights in all of the debtor’s marketing materials for the assets to be auctioned. 

Together, the decisions in Fisker and Free Lance-Star could potentially be read broadly enough to support the view that the chilling effect of the credit-bid right on an auction process could, even without more, constitute sufficient “cause” to justify limiting the credit bid right in appropriate cases. Such an interpretation would run contrary to the established principle that a secured creditor may credit bid its entire claim amount, notwithstanding the awareness of all parties that this ability can discourage rival bidding. This is why the Fisker and Free Lance-Star decisions drew considerable attention. 

But a recent decision of the U.S. Bankruptcy Court for the Southern District of New York discussed below, In re Aéropostale, Inc.,⁴ has bucked this trend, explicitly holding that a chilling effect alone is not sufficient to limit credit bidding rights “for cause” under Section 363(k) of the U.S. Bankruptcy Code. 

Competing Underlying Rationales 

Although the cases at issue do not state so explicitly, what seems to underlie them and their divergent outcomes are dueling views as to whether the ability of a secured creditor to credit bid the full face amount of its claim amounts to a windfall to the secured creditor to the extent that the face amount of its claim exceeds a fair valuation of its collateral. 

The traditional approach, favoring unrestricted credit bidding, seems to view it as the bargained-for right of the secured creditor, since, after all, prior to the debtor’s insolvency, isn’t that precisely what the creditor negotiated for in obtaining collateral securing the full amount of its debt? This approach disfavors depriving the secured creditor of a portion of what it had bargained for -- whether the creditor wishing to credit bid is the originating secured creditor or its remote assignee. The Fisker and Free Lance-Star approach -- or at least what amounts to a broad reading of those decisions -- instead seems to divide an undersecured creditor’s claim into secured and unsecured portions for credit-bidding purposes, much as the U.S. Bankruptcy Code itself does in determining claims allowability generally.⁵ The secured portion of the claim equals the value of the collateral, while the unsecured portion equals the balance of the claim. Credit bidding of the “unsecured portion” is thus viewed as improperly promoting it to secured status, inasmuch as it offsets an auction bid on a dollar-for-dollar basis (rather than at a lesser recovery rate for a typical unsecured claim), thereby enriching the secured party at the expense of the debtor and unsecured creditors. This concern would be exacerbated if the creditor wishing to credit bid is an assignee that purchased the secured debt at a steep discount, and also, needless to say, if the secured creditor were found to have engaged in misconduct in connection with the auction process. These factors would militate against allowing value to move in this way from the debtor and unsecured creditors to the secured creditor in question. 

Bucking the Trend 

In Aéropostale, the bankruptcy court addressed the issue of whether the potential chilling effect of credit bidding on an auction process, by itself, can constitute sufficient “cause” to warrant limiting a secured creditor’s credit-bidding rights under Section 363(k) of the U.S. Bankruptcy Code. 

In 2014, Aéropostale, Inc., an apparel retailer, was in need of liquidity and entered into a US$150 million secured term loan agreement with affiliates of Sycamore Partners (Term Lenders). The term loan agreement included a liquidity covenant and required Aéropostale to enter into a sourcing and manufacturing agreement with an affiliate of the Term Lenders, under which the affiliate would have the right, upon a breach by Aéropostale of the liquidity covenant, to modify payment terms in any way the affiliate chose “in the exercise of it[s] reasonable credit judgment.”⁷

Due to declining sales, Aéropostale breached the liquidity covenant in February of 2016, upon which the Term Lenders’ affiliate, under the sourcing and manufacturing agreement, modified Aéropostale’s payment terms thereunder and began requiring advance payment in full in cash on all future orders. Shortly thereafter Aéropostale filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. In the ensuing bankruptcy auction of Aéropostale’s assets, which constituted collateral for all amounts owing to the Term Lenders under the term loan agreement, Aéropostale filed a motion with the bankruptcy court seeking to disqualify the Term Lenders from credit bidding at the auction “for cause,” under Section 363(k) of the U.S. Bankruptcy Code. 

Aéropostale alleged that the Term Lenders had engaged in inequitable conduct and that “bidding on the sale of their assets will be chilled by the Term Lenders’ ability to credit bid.” 

First, addressing the allegations of inequitable conduct, the court found no misconduct by the Term Lenders that would justify a limitation on their credit bidding right. The court noted that there were “no allegations of collusion, undisclosed agreements, or any other actions designed to chill the bidding or unfairly distort the sale process,”⁸ nor any “allegations that the Term Lenders have engaged in any unfair advantage over the sale process ….”⁹ The court noted as well that in fact the Term Lenders had been “relatively cooperative with the process by, among other things, agreeing to the payment of an expense reimbursement request to a potentially interested bidder and agreeing to a one-week extension of the sale process.”¹⁰

Having found no inequitable conduct, the court then addressed Aéropostale’s assertion that allowing the Term Lenders to credit bid would have a chilling effect on the auction. In doing so, the court methodically noted that each of the cases cited by Aéropostale in support of its motion to restrict credit bidding due to concerns about its chilling effect on the auction process had not in fact relied on the presence of credit bidding alone, but had featured in each instance additional facts that supported limitation of the right. In discussing Fisker and Free Lance-Star, the Aéropostale court stressed the inequitable conduct of the secured creditors in those cases that had dampened competitive bidding.¹¹

The Aéropostale court summed up its discussion by noting that it was “unaware of any cases where the chilling of bidding alone is sufficient to justify a limit on a credit bid.”¹² The court also cited the recently released Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11,¹³ in which the Commission had noted that “all credit bidding chills an auction to some extent,” but that it “did not believe that the chilling effect of credit bids alone should suffice as cause under section 363(k).”¹⁴

What this Means for Sponsors 

Aéropostale could be viewed as simply another bankruptcy court decision and, for that matter, one with no authority to reverse or overrule a decision of another bankruptcy court in another jurisdiction. Yet, the decision is significant because the Aéropostale court was presented with an opportunity to follow and broaden the trend of Fisker and Free Lance-Star, which had seemed to demonstrate a certain judicial sympathy for limiting the credit-bidding right. Those decisions were not entirely clear as to whether the chilling effect alone would have been enough for the court to limit the credit-bidding right as it had. The court in Aéropostale could have followed suit and restricted the credit-bid right as well, notwithstanding the absence of creditor misconduct. Yet, not only did the Aéropostale court decline to do that, but it explicitly rejected such an expansion and proceeded systematically to analyze the relevant precedents in concluding that nowhere was the chilling effect, without more, made the basis for restricting credit-bid rights. Because of the clarity and thoroughness of the court’s analysis and rationale for its decision, the Aéropostale case is likely to be persuasive for other courts that will consider the issue going forward, even absent further action by higher courts on appeal. 

Therefore, buyers of distressed secured debt wishing to exercise their full credit bidding rights in a bankruptcy auction should be able to rest a bit easier now. Needless to say, however, caution should continue to be exercised, as far as is practicable, to minimize any conduct that might later be deemed inequitable and as providing potential grounds for limiting credit-bidding rights, such as auction arrangements coordinated with or imposed on a debtor that tend to diminish the participation or interest level of other potential bidders for the assets in question. 

Obligation through Association: Take my Affiliate … Please! 

An equity sponsor may from time to time, for a variety of reasons, lend money to its portfolio company either directly or through an affiliate. If the portfolio company has other debt for borrowed money extended to it by third parties, the sponsor financing will often be subordinated to the portfolio company’s third-party debt. When the portfolio company repays the sponsor loan, to the extent payoff is allowed under any applicable subordination terms, loan payoff documentation customarily would evidence the repayment. The form of documentation used can have unintended consequences of which sponsors should be mindful. 

The Delaware Court of Chancery’s recent decision in Geier v. Mozido, LLC¹⁵ provides an example of why caution needs to be exercised when documenting a payoff and release, particularly where affiliated entities are on both sides of a transaction. 

The plaintiff in Geier, Philip Geier (Geier), joined the board of Mozido, LLC (Mozido) in March of 2012 in exchange for an option agreement giving him the right to acquire up to 1% of the equity in Mozido for US$135,000 (Option Agreement), a fraction of its presumed fair market value. Shortly thereafter, Michael Liberty (Liberty), founder and vice chairman of Mozido, asked Geier to make a US$3 million bridge loan to help Mozido meet its short-term cash needs. Ultimately Geier agreed, and caused the Philip H. Geier Irrevocable Trust and The Geier Group, LLC (collectively, Geier Entities) to lend US$3 million for 90 days to Mobile Money Partners, LLC (Mobile Money), a Liberty affiliate. The loan was personally guaranteed by Liberty and by another board member of Mozido. 

After Mobile Money defaulted on the loan, the Geier Entities initiated litigation in New York against Mobile Money and the two guarantors to enforce the loan. Philip Geier, individually, was neither a lender nor a party to the litigation. The defendants acknowledged their liability on the bridge loan and agreed to repay it with the proceeds of a new equity investment in Mozido that they would procure. The new investment was in fact procured and the Geier Entities were repaid on the bridge loan from the proceeds. The defendants executed a settlement agreement relating to their respective contribution obligations for the bridge loan repayment. In connection with the settlement, a release agreement was executed (Release Agreement) and Mozido was restructured. Under the restructuring, most of Mozido’s assets were transferred to its newly formed subsidiary, Mozido, Inc. (Mozido Subsidiary). The Mozido Subsidiary also assumed certain liabilities of Mozido, but not Philip Geier’s options.¹⁶

The Release Agreement was titled “General Release” and, under its terms, each of the Geier Entities, having already been repaid in full on the bridge loan, released Mobile Money, Mozido and the Mozido Subsidiary from any and all further claims of any kind. The Release Agreement was executed on behalf of each of the Geier Entities by Hope Smith, as a trustee of the Geier Trust and manager of the Geier Group. Philip Geier himself was not a party or signatory to the Release Agreement. The Release Agreement, by its terms, provided that Mobile Money, Mozido and the Mozido Subsidiary were also being released from any and all further claims against them held by any “affiliates” of the Geier Entities. Philip Geier, individually, if an “affiliate” of the Geier Entities, could thus technically be included as a releasor under the terms of the agreement despite his not being party to the agreement, with the potential result that he would be releasing Mozido and the Mozido Subsidiary from any and all obligations under his Option Agreement. The Mozido Subsidiary in fact had not assumed any obligations under the Option Agreement in connection with the restructuring noted above. 

An earlier draft of the Release Agreement had specifically included Philip Geier individually as a party to the agreement and had included a carve-out for his rights under the Option Agreement. The final, executed version of the Release Agreement, however, did not include him as a party and, correspondingly, the carve-out for his Option Agreement had been removed as well. To the extent that evidence external to the four corners of the executed Release Agreement would be relevant, then, there seemed to be this significant piece of evidence supporting the contention that, were Philip Geier to be included within the group of releasors under the agreement, the parties intended that his Option Agreement be excluded from the scope of the release. 

In October 2014, Philip Geier, after unsuccessfully attempting to exercise his rights under the Option Agreement, filed suit against Mozido and the Mozido Subsidiary in the Delaware Court of Chancery, giving rise to the action under discussion. Mozido and the Mozido Subsidiary filed a motion to dismiss, on the ground that Philip Geier’s claims under the Option Agreement were released under the Release Agreement, since he is an affiliate of the Geier Entities that signed the release and thus bound by the broad release of claims in favor of Mozido and the Mozido Subsidiary under the terminology of the Release Agreement. 

Even assuming Philip Geier were deemed an affiliate of the Geier Entities, could his claims under the Option Agreement have been released without his having been party to the Release Agreement? 

The Court’s Analysis 

The court rejected Philip Geier’s contention that the Release Agreement should be understood within the larger context of the settlement agreement relating to the bridge loan, in connection with which the release had been signed. Geier contended that the context demonstrated that the release was intended to deal only with claims relating to the bridge loan, which had been made by the Geier Entities as lenders, and who were the actual releasing parties under the Release Agreement. 

The court disagreed, explaining that New York law governed the Release Agreement, and that “[t]he usual rules governing the interpretation of contracts under New York law also apply to general releases.”¹⁷ As such, the court declined to consider extrinsic evidence, such as the context within which the agreement was executed, when it found the language of the Release Agreement to be clear and unambiguous within the four corners of the agreement.¹⁸ Noting that the Release Agreement itself referenced no other agreements, the court added that “contracts should be read separately unless their ‘history and subject matter show them to be unified.’”¹⁹ Thus, the court did not consider either the other agreements in connection with which the Release Agreement had been signed or earlier drafts of the Release Agreement. 

Finally, the court determined that, as co-trustee of the Geier Trust and as chairman of the Geier Group, and as the one who had decided to cause the Geier Entities to make the bridge loan, Philip Geier was in control of, and thus an “affiliate” of the Geier Entities.²⁰ The court added in dictum that, “[e]ven if Geier did not ‘control’ the Geier Trust or the Geier Group, the only reasonable construction of ‘affiliate’ would still apply to Geier in his individual capacity. Geier indisputably had a ‘close connection’ and ‘association’ with both Geier Trust as a co-trustee and Geier Group as Chairman.” The court noted additionally that general releases are to be construed broadly under New York law.²¹

Accordingly, the court held that, because the Release Agreement had not expressly carved out the Option Agreement or limited the release to claims related to the bridge loan, it should be read broadly, and as also releasing the Option Agreement rights of Philip Geier, as an affiliate of the named releasing parties, notwithstanding that Philip Geier had not signed the document.²²

What this Means for Sponsors 

The Geier decision might be viewed as something of an outlier to be limited to its specific facts, so that it should have relevance as precedent only where a controlling party has caused its controlled entities to enter into a general release purporting to release claims of affiliates as well, and including no conditions or limits of any kind. The general release then could also be found, presumably on an implicit agency theory, to bind the controlling party as an “affiliate,” even if not an actual party to the release. The decision may then be viewed as a warning to equity sponsors to avoid general releases by a portfolio company, whether in the financing context or otherwise, that purport to release claims of affiliates of the portfolio company as well. By tailoring the language of any release to address the specific matter at issue -- at the very least in respect of any referenced non-party affiliates of the releasing parties -- sponsors should be able to avoid unintended releases that otherwise may inadvertently result, as in Geier. 

The dictum in Geier went further, however, and seemingly would allow even non-controlling affiliates to be bound in such a case. Because the court found Philip Geier to be in control of the Geier Entities, the statements in the decision relating to what the outcome might have been if Philip Geier had been a non-controlling affiliate should be viewed as mere dictum, and without precedential effect for future cases. The dictum is troubling since non-controlling affiliates are (by definition) removed from decision-making at the entity purporting to bind them under the factual scenario under discussion. One suspects that this dictum may have been intended by the Geier court to apply only in respect of its determination as to whether Philip Geier was an “affiliate” of the Geier Entities, and not to its further determination that he was in fact bound by the terms of the Release Agreement to which he was not a party. Assuming that is the case, the decision is easier to digest and comports better with other recent cases addressing similar issues.²³

We look forward to updating you on additional developments in the next issue. 

Footnotes

_{1) In re Fisker Auto. Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014) (“Fisker”) and In re Free Lance-Star Publ’g Co., 512 B.R. 798 (Bankr. E.D. Va. 2014) (“Free Lance-Star”). 
2) Free Lance-Star, 512 B.R. 801.
3) Fisker, 510 B.R. 60-61.
4) 555 B.R. 369 (Bankr. S.D.N.Y. 2016).
5) See Section 506(a)(1) of the U.S. Bankruptcy Reform Act of 1978, as amended.
6) Aéropostale, Inc., 555 B.R. 380.
7) Id. at 416-17.
8) Id. at 416.
9) Id.
10) Id.
11) Id. at 417.
12) Id.
13) Id. at 418.
14) Id.
15) No. 10931, 2016 WL 5462437 (Del. Ch. Sept. 29, 2016).
16) Answering Brief in Opposition to Defendant’s Motion to Dismiss, Geier v. Mozido, LLC, No. 10931, 2016 WL 1167605, at *31 (Del. Ch. Mar. 22, 2016).
17) In re Clinton St. Food Corp., 254 B.R. 523, 534 (Bankr. S.D.N.Y. 2000).
18) Mozido, LLC, 2016 WL 5462437, at *3.
19) Id. at *5.
20) Id.
21) Id.
22) Id.
23) See, e.g., Carlyle Inv. Mgmt. L.L.C. v. Moonmouth Co. S.A., No. 7841, 2015 WL 5278913 (Del. Ch. Sept. 10, 2015) and Garriot v. O’Neil Condo. Assoc., No. 152530/14, 2015 WL 5728245 (N.Y. Sup. Ct. N.Y. Cty. Sept. 23, 2015).}

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