It happens all too often in the wake of chapter 11 bankruptcy restructurings: Creditors of a once-healthy company that fell upon hard times find it nearly impossible to sell the securities issued to them in a bankruptcy settlement.

Suddenly, these creditors have been whisked from one extreme to another. Before the bankruptcy, they held securities—usually bonds—that were actively traded and matured at a specified time. Now, though, those debt instruments have been wiped out and replaced by another type of security, usually common stock. In addition, there are legal restrictions on when and how much of that equity they can sell, and no market for it.

Those creditors found themselves in this tight spot because they were so emotional about the loss of their original investment that they failed to realize that they, not the bankrupt company, ruled the roost in negotiations for a settlement. They either weren't aware of the tactics they could use to arrange an exit strategy for their newly acquired investment, or they weren't aggressive enough in their negotiations. As a result, those equity securities may languish on their books indefinitely.

Avoiding "Chapter 22"

The first factor to consider in planning an exit strategy is that the healthier the company is when it emerges from bankruptcy, the sooner creditors will be able to sell the securities they were issued in the settlement.

Creditors may be tempted to include some debt securities as part of the settlement of their pre-bankruptcy claims. But they should be wary of burdening the company with too much new debt, because if that burden is too heavy, the company is likely to sink into "chapter 22"—another chapter 11 bankruptcy. A second bankruptcy would further erode the position of the company's former creditors and lengthen the time before they can sell their securities.

Creditors might also consider a tactic that would have an immediate positive effect on the company's balance sheet: a rights offering. This would give creditors the right to purchase debt or equity securities of the company, providing it with new money that can be used for recovery and growth after the bankruptcy.

Registration Rights for a Smoother Exit

When equity securities are to be issued to a creditor by a company emerging from bankruptcy—whether in settlement of the creditor's claims or as part of a rights offering—the creditors should be aware that the securities laws may affect their ability to sell those securities.

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The first factor to consider in planning an exit strategy is that the healthier the company is when it emerges from bankruptcy, the sooner creditors will be able to sell the securities they were issued in the settlement.

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Prior to bankruptcy, creditors usually enjoyed some liquidity for their debt securities. Those securities probably were registered with the SEC, so the securities laws were not an issue. But when those debt securities have been replaced by newly issued equity, securities laws may become an impediment to sale, especially for creditors who held a substantial amount of the company's debt.

Under §1145 of the Bankruptcy Code, securities issued in a bankruptcy are deemed to have been issued in a public offering and therefore are usually freely tradeable. But this may not be possible if the holder is a control person or affiliate of the company. The holder would come under one of these classifications by having received a significant amount of equity securities in the company or otherwise participating in the overall management of the company after the bankruptcy (for example, through seats on the company's board).

A holder that is a control person or affiliate may be subject to restrictions imposed by Rule 144 of the Securities Act of 1933, which limits the amount of securities that may be sold in a given period of time.

It should also be noted that smaller holders not subject to Rule 144 may nonetheless have difficulty selling after the bankruptcy if no liquid market develops for the company's securities.

In both of these situations, the former creditor would benefit from having negotiated—as part of the bankruptcy settlement—for the right to force the company to register its shares with the SEC. A registration would allow the former creditor to circumvent the Rule 144 volume limitations and, as necessary, employ an underwriter to assist in the sale of its shares.

The two types of SEC registration forms that can be used are Form S-1, known as the long form, and Form S-3, known as the short form. Registration with the short form is less expensive, easier and generally faster than with the long form. But the short form can only be used by a public company after its fiscal year is over and its annual report has been filed with the SEC. Thus, if creditors want to sell their shares without waiting until the end of the fiscal year or if the company is not yet public, the long form must be used.

Regardless of the form used, registration of securities can be a lengthy and time-consuming process if the SEC decides to review the offering. In this new era of heightened scrutiny, it would not be uncommon for the review process to take 90 days or longer.

Such a lengthy wait could deprive creditors of the ability to sell quickly at times when the company is healthy and the market is receptive. Thus, creditors should consider negotiating for the right to force the company to register their shares immediately upon the company's emergence from bankruptcy, using a shelf registration that would remain open for an extended period of time.

With a shelf registration statement in place, creditors would be assured that they will be able to sell their shares whenever they choose without fear of being delayed by securities law restrictions.

However, creditors should be aware that the expense involved in a shelf registration can be very burdensome for a company just coming out of bankruptcy. The long form would have to be used to register the shares and would have to be regularly updated. So it might be in the best interests of the creditors to agree to delay the shelf registration until such time as the short form could be used; the short form would automatically incorporate future public filings of the company, eliminating the need for extensive disclosure and frequent updates. If no real market is likely to develop before the company files its next annual report with the SEC, delaying the shelf registration might be the right choice.

Preferred Stock

Debt holders generally have the benefit of contractual restrictions on the company's actions as well as a higher place in the company's capital structure than common stock. In a bankruptcy restructuring, creditors often do not realize that they have the ability to preserve some of these benefits by structuring their post-bankruptcy security as preferred stock instead of common stock. Preferred stock is most frequently used in rights offerings and in situations where subordinated creditors or equity-holders will also be entitled to equity in the post-bankruptcy company.

Preferred stock affords the holder with the advantage of having a liquidation preference generally equal to the value of the preferred stock upon issuance. Upon any liquidation of the company, the holders of the preferred stock would be entitled to receive their liquidation preference before any amounts go to common stockholders.

Another attractive feature that can be negotiated along with preferred stock is the right to a set dividend prior to any dividends being paid to the common stockholders. This could be structured to look much like an interest rate to the creditors whose bonds were wiped out in the bankruptcy restructuring. The dividend doesn't have to be an immediate, hard cost to the company because it can be accrued, and thus just adds value to the preferred stock over time.

Preferred stock can also provide the holders with additional rights, including protection from dilution by new securities the company may seek to issue, preemptive rights (the right to maintain the holder's percentage of ownership in the company), rights to board seats and consent rights to certain major actions of the company.

The More Rights and Protection, the Better

Another means of obtaining some degree of control of the company is to gain board representation. This could be achieved through the reorganization of the company or, on a more permanent basis, through preferred stock or a stockholders' agreement entered into by a majority of the post-bankruptcy shareholders. The greater the voice that former creditors have in the company's decision-making process, the better position they'll be in to arrange terms for an exit strategy. But creditors who obtain board seats should realize that this will make them a control person subject to the volume restrictions of Rule 144, and as such they'll have a more difficult time selling their stock without SEC registration.

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Another means of obtaining some degree of control of the company is to gain board representation.

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Another right that creditors may want to seek is the right to force the company to redeem their shares after a specified period of time if no other avenue of exit becomes apparent. This is particularly appropriate for creditors of private companies, which have no market for their stock. While it obviously makes no sense for all of the shareholders of a company to have redemption rights, it may be prudent for certain senior creditors to extract these rights from the company to the detriment of other post-bankruptcy share-holders.

If the company was listed on any stock exchange or on NASDAQ before going into bankruptcy, creditors may want to press for relisting after the bankruptcy settlement. It may be that the company has lost so much value that it doesn't qualify for relisting, or that it would be too expensive or burdensome to be public again. Nonetheless, creditors should strongly consider imposing some obligation on the company to become relisted as soon as practicable.

Finally, although a creditors' committee is formed to represent the rights of all creditors in a bankruptcy and that committee typically hires financial and legal advisors, the interests of large creditors frequently are different from those of the holders of lesser amounts of debt. Thus a large holder, or group of large holders, may want to hire their own financial and legal advisors rather than be represented by the ones retained by the creditors' committee.

Conclusion

It is important to keep in mind that the rights described in this article can be gained only by negotiating them before a settlement with the bankrupt company is reached. They are rarely obtainable afterward.

Footnotes

¹ Brett Goldblatt is an attorney in the Los Angeles office of Milbank, Tweed, Hadley & McCloy LLP and an adjunct professor at UCLA Law School. Return to article