06 Jun Shields Up! (Q1-23)

The present economic cycle distinguishes itself from previous credit crises due to the influence of unforeseeable elements that are driving inflationary pressures. Consequently, lenders find themselves navigating an extended period of ambiguity. Instead of encountering a swift surge of defaults, we anticipate a turbulent environment that demands the collective willingness of all involved parties to adapt terms and effectively address distress.

Nevertheless, it is crucial to recognize that restructuring endeavors must carefully account for the interests of diverse stakeholders who possess varying levels of risk tolerance. Achieving successful renegotiations and adept deal management necessitates the involvement of experienced lenders equipped with astute decision-making capabilities and a knack for generating innovative solutions. This includes a willingness by private credit managers to readily consider swapping debt for equity when they possess confidence in the borrower’s long-term value proposition.

In our Q3-2020 President’s Letter, we discussed the Companies’ Creditors Arrangement Act (the “CCAA”), Canada’s main statute for restructuring insolvent corporations. Crucial to the proper functioning of the CCAA is the court-appointed monitor, a trustee and insolvency professional that functions as the court’s independent advisor on the fairness and soundness of any proposal or plan. The monitor’s primary duty is to act in the best interests of all stakeholders, striving to maximize value for each party involved, irrespective of whether this entails facilitating a restructuring plan or overseeing an asset liquidation. A chronic issue in the use of the CCAA to authorize sales of substantially all of a debtor’s assets is undervaluation. Despite the objective to generate prices equal to fair market value, our experience is that sales processes conducted in insolvency proceedings produce below market prices, especially when they occur during a recession or financial crisis.

There are several reasons for the systematic undervaluation of assets during insolvency driven sales processes (“IDSPs”). The absence of so many features that buyers in normal, negotiated sales process have come to expect virtually ensures that below-market prices will prevail. The flaws pervade the process. IDSPs are forced sales and when they occur during economic downturns can become fire sales. In normal, voluntary sales processes, a financial advisor or investment banker will prepare a detailed information package about the business and assets for distribution to prospective buyers. The package will include detailed background and performance information about the business and assets, market and competitive data, customer and supplier disclosure, and forward-looking information about asset potential and plans. Bidders normally can visit the business, inspect the condition of the assets, and perform other customary due diligence. None of these features are present in IDSPs.

Unlike normal sales processes, IDSPs receive little publicity and the responsible monitors, who want to minimize costs, will usually provide only the legally required notice. The purchase agreement entered into by the buyer will not be tailored to the buyer’s specific needs and will not contain any representations or warranties about the assets’ condition or performance. The buyer will have no recourse to the debtor or monitor. IDSPs are typically conducted with strict and hurried timelines and completed within weeks rather than months for normal sales processes. All of this reduces the number of buyers and lowers the sales price.

Perhaps the biggest barrier to attracting multiple attractive bids in IDPSs is the secured lender’s asymmetric funding advantage due to its ability to “credit bid” for the assets that comprise its collateral. Third-party bidders must pay in cash. Credit bidding is a powerful tool granted to secured lenders under bankruptcy and insolvency regimes, enabling them to utilize their secured claim as a form of currency during auctions of the debtor’s collateral. In the U.S. and Canada, the secured lender has the ability to offset their claim’s full-face amount against the purchase price of the collateral. This mechanism empowers the secured lender to acquire the debtor’s assets, which are subject to their lien, in exchange for a complete or partial cancellation of the debt, effectively allowing them to secure the assets without making any direct cash payments.

Credit bidding serves as a crucial defensive mechanism for lenders, effectively safeguarding the value of their collateral amidst the backdrop of deteriorating asset prices. By utilizing credit bidding, secured lenders can protect their interests and ensure the preservation of asset value during the sale process. Without the ability to credit bid, there is a risk that the collateral securing a lender’s claim may be undervalued and sold at a discounted price, either intentionally or unintentionally. Debtors are incentivized to sell collateral at reduced prices to insiders, “white knights”, or other third parties if they believe such sales will result in favorable treatment from these buyers in the future. If the collateral is undervalued and sold below its fair market value, secured lenders may find a significant portion of their secured claim treated as unsecured, potentially yielding only a fraction of its value in the bankruptcy estate.

Credit bidding ensures that the secured lender receives the fundamental benefits of its credit agreement. By allowing the secured lender to bid up to the total amount of its secured obligation in the sale of collateral, credit bidding enables the lender to compete with cash bids from third parties. This mechanism upholds the secured lender’s essential right, both inside and outside of the CCAA, to obtain either the money owed or the assets securing the debt. Furthermore, credit bidding safeguards the secured lender from the sale of collateral at a value lower than its full worth.

Still, some secured lenders refuse to credit bid because they cannot or do not want to own the business or collateral assets, even for a short period of time, due to policy restrictions, the additional costs of restoring or maintaining the assets, or the lack of a viable strategy to operate and eventually monetize the business or assets. This was the case for lenders to the distressed Canadian e-grocer that we recently helped rescue. In another recent CCAA case involving a private credit fund as the primary secured lender, the IDSP resulted in only one third-party bid, which was a fraction of the fund’s debt, and the fund’s manager decided not to exercise its right to credit bid. The private credit manager lacked the internal capabilities to manage the debtor’s business as a going concern, which would have most certainly resulted in a superior recovery.

While credit bidding is recognized as a vital aspect of the secured creditor’s rights, some argue that it can hinder bidding activity or impede the debtor’s ability to maximize asset value. Substantial litigation has taken place in U.S. bankruptcy cases over the years to determine the merits of credit bidding in general. The efficacy of the credit bid mechanism, which typically serves to protect secured lenders against undervaluation during IDSPs, can be compromised in situations where a third party acquires secured debt with the intent of pursuing a loan-to-own strategy to gain control of the target company. In such cases, the secured party may intentionally suppress the market value instead of enhancing it. Credit bidding can be utilized to deter or restrict bidding activities before or during an auction, discouraging prospective bidders from participating in the sales process.

The third-party debt buyer’s inclination to assume ownership of the debtor’s business, rather than seeking repayment of the loan, can disrupt the sales process. Instead of maximizing the value of the assets, the secured party has sought to diminish the sales price of the debtor’s assets. This approach would primarily benefit the third-party debt buyer while placing the estate’s other creditors at a disadvantage. The implementation of the third-party debt buyer’s loan-to-own strategy would very likely dampen market interest for the bankruptcy sale.

Overall, credit bidding provides experienced secured lenders and astute distressed investors with a powerful shield to protect their interests, acquire assets, and navigate the complexities of the bankruptcy process. Credit bidding can result in a permanent transfer of wealth from the bankruptcy estate to the secured lender equal to the difference between the fair market value of the collateral and the credit bid plus the value of any deficiency claim against the bankruptcy estate. It enables them to strategically utilize their secured claims, ensuring the preservation of asset value and facilitating acquisitions in a manner that may not require significant cash outlays.