The "3Rs" Of Preferred Equity

SMART SUMMARY

• Depending on how preferred equity instruments are drafted, in a US chapter 11 case, preferred equity may be treated as "pari passu" with common equity.
• Incorporating the "3Rs" at the time of the initial investment can avoid any surprises in a downside scenario.

Background

Much ink has been spilled (including in recent Sponsor Sync issues) about the continued ascent of the "liability management exercise." Each headlining-grabbing LME results in incrementally more sophisticated and tighter credit documents, which usually restrict distressed companies from incurring additional debt when a balance sheet crosses a set leverage threshold. Those companies (and their sponsors) still need capital, which, together with an onerous interest rate environment, has resulted in a recent uptick in preferred equity issuances.

However, in a U.S. chapter 11 case much of the preferred equity currently in the market may not actually be "preferred" at all. Imagine a scenario where value clears a company's debt, value is available for equity, and a bankruptcy court could find that preferred equity holders are not entitled to a bargained-for liquidation preference, redemption price, or even the face value of their investment. Taking it a step further, what if that court could treat preferred and common holders pari passu, with each group receiving different forms of currency under a chapter 11 plan.

We think this scenario is not only possible but likely for much of the preferred equity currently in the market. Regardless, like many issues we write about in Sponsor Sync, proper advice and drafting cures all ails.

Chapter 11 Primer

The Bankruptcy Code has different standards for "cramming down" a chapter plan over the dissent of holders of claims and equity interests. With respect to equity interests, section 1129(b)(2)(C) of the Bankruptcy Code requires a chapter 11 plan to provide that either (a) impaired, dissenting equity holders will receive the greatest of (i) any fixed liquidation preference to which such holder is entitled, (ii) any fixed redemption price to which such holder is entitled or (iii) the value of their interests or (b) that no holder of a junior interest will recover any property under the plan. If that requirement is met (along with other technical ones), a plan can be confirmed over the dissent of preferred equity holders.

Potemkin Preference

Many people assume this section necessarily protects a preferred equity holder's senior status in chapter 11. Potentially not so! Under this statute, a preferred equity holder will only receive the benefit of a liquidation preference, fixed redemption price, and/or priority "waterfall" included in its preferred equity instrument if the transactions contemplated by a chapter 11 plan actually "entitle" such holder to the benefit of those provisions.

For example, many liquidation preference and waterfall provisions are triggered upon liquidation, winding-up, or dissolution of an issuer. If, however, an issuer's enterprise value clears its debt, "liquidation" and "dissolution" are probably not the result of the issuer's chapter 11 case. The plan likely effectuates a restructuring, reorganization, or recapitalization – the "3Rs." The "preferred" holder in this situation with the "typical" language in its instrument may not actually be entitled to senior treatment ahead of common equity because the plan does not contemplate a liquidation, winding-up, or dissolution.

Even if the parties originally intended such a transaction to result in a preference for the holder, a court may not consider arguments about the parties' original intent but rather simply read the words on the page. In other words, the "preference" is Potemkin – a façade with nothing behind it.

Words Matter

Carefully drafted provisions should ensure that preferred holders recover ahead of common in chapter 11 cases – assuming that is the intent. Alternatively, potential gaps in preferred equity instruments may offer strategic opportunities to issuers and common equity holders. Indeed, an enterprising sponsor may see the above as a boon; an opportunity to receive a recovery in chapter 11 when common equity may not be entitled to a recovery outside of chapter 11. Either way, the issues are nuanced and should be addressed with thoughtful legal advice from experienced counsel.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.