Please note that the below article, prepared by Daphne Coelho-Adam of Seward & Kissel LLP, appeared in the August 6 online edition of Law360.
A few years ago, rights offerings were a rarely employed means of financing an emergence from bankruptcy. However, a combination of the credit crunch and the increased entry of funds, more likely to take in equity from a borrower, into the loan market has resulted in the rise of rights offerings as a means for borrowers to raise capital to emerge from bankruptcy. Recently, many plans of reorganization have included some type of rights offering, replacing the more common issuance of bond debt. Despite criticisms that rights offerings are not a preferable means for a borrower that can utilize leverage to finance its emergence from bankruptcy, we can nonetheless expect to see more of them in the future. LyondellBasell Industries, Cooper-Standard Automotive Inc., GSI Group Inc. and Trident Resources Corp. represent just a few borrowers who have recently employed rights offerings to finance their emergence from bankruptcy.
This trend along with the rise of Collateralized Loan Obligations (“CLO”) participation in the secondary market has given rise to a number of distinct settlement issues that can significantly delay settlements and possibly limit a buyer’s ability to receive the entire package of benefits that might come out of a restructuring. These delays also increase counterparty risk and transaction costs and counterparties should take a strategic view when looking at credits with rights offerings. The settlement process in LyondellBasell provides a helpful illustration of a number of these issues.
LyondellBasell emerged from bankruptcy at the end of April following a 15- month restructuring. In connection with the restructuring, the company issued, among other things, Class A stock, which was issued as a direct proceed of the bankruptcy to senior secured claimholders in satisfaction of their claims. In addition, LyondellBasell decided to use a rights offering to finance its emergence, issuing approximately 263.9 million shares of Class B stock. Unlike the Class A stock, the rights offering for the Class B stock was voluntary. Therefore, a claimholder needed to directly subscribe for the shares, funding the purchase price at the time of subscription. Under the terms of the plan, only certain senior secured lenders were eligible to participate in the offering. As those lenders sold those rights in the secondary market, a problem emerged due to the participation of CLOs, causing loan market participants to rush settlement of outstanding loan trades with CLO counterparties, fearing that a CLO lender would not be able to purchase the Class B stock and deliver it downstream to buyers.
A CLO, though it may be able to hold stock, is often, by its nature and the terms of its organizational documents, prohibited from purchasing a defaulted asset, therefore barring its ability to participate in a rights offering. The issue generally centers on the CLO’s ability to actually fund the stock purchase. A party with an outstanding loan purchase from a CLO, therefore, risked not receiving its ratable shares of Class B stock, and faced a reduced return on its purchase. In order for a buyer to guarantee receipt of Class B stock from a CLO, the parties had to settle the assignment of the loans before the record date for the rights offering, thereby earning the buyer record lender status to subscribe directly for the stock. Unfortunately, given the myriad of issues (ranging from a CAM exchange to a high volume of open trades) obstructing trade settlement in Lyondell, many parties were left with open trades once the record date arrived. CLOs were thus forced to find ways to subscribe for and deliver the Class B stock. For open trades involving multiple parties where the CLO was not the record holder, multilateral nettings provided a simple solution. However, for CLOs that were the record lender, other solutions had to be found. A popular solution that emerged was for the CLO lender to complete the subscription documents, but set up or designate a third party to receive the purchase funds from the CLO’s buyer and then have the funds wired directly from the third party to the subscription agent. This required the subscribing CLO to clearly indicate to the agent on the subscription documents where the wire or wires, in the case of multiple counterparties, would be coming from. The clear risk was that the subscription agent might not be able to match the wire with the subscriber. If the subscription agent could not identify the relevant subscription funds, then the subscription faced rejection due to lack of funding and Class B stock would not be issued. This risk, however, for most parties was tolerable given the alternative of a CLO not subscribing at all.
Similarly, if a CLO was the purchaser in an unsettled loan trade, although the seller may have been able to subscribe, the CLO may not have been able to fund. In such cases, CLOs could set up third parties to hold the funds and wire them to the seller for payment of the subscription price. Since the plan required that the rights to participate in the offering travel with the loans, such that a seller could not agree to sell the subscription rights separately from the loans, parties were concerned about the implications of not transferring the Class B stock.
To address all these concerns, in addition to the standard loan documentation, parties in the loan market entered into side letter agreements to cover the rights and obligations associated with the subscription for and delivery of the Class B stock. In light of the above, for CLOs and their counterparties, it was essential to make clear how the rights offering would be handled, how the funds would be wired and adjust any representations and language to identify any third parties with obligations.
Given the rise in CLO participants in the loan market and the likelihood that more borrowers will employ rights offerings, loan market participants should be aware of their open trades and counterparty risk any time a borrower files for bankruptcy. CLOs especially should take heed and monitor their open trades for any credit for which a borrower is in bankruptcy. A CLO investor should consider multilateral nettings to avoid having to subscribe for or hold such stock altogether. In the event settlement on assignment or multilateral netting is not possible, CLOs, their investment managers and counsel should have alternate plans for settlement in place. Depending on the individual concerns and structural restrictions of a particular CLO, third party funding may be an option. If there are any impediments, CLOs should be sure to raise any alternate protective language at the time of trade and negotiate any alternative terms of settlement in the trade confirmation. Ultimately, CLOs should be aware of the impact a rights offering may have on their investment strategy and return when participating in the loan market.
Daphne Coelho-Adam is a corporate finance associate at Seward & Kissel LLP, a leading firm in the area of secondary market trading of distressed, par and near par loans and claims trading.
