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Breach of the Covenant of Good Faith Leads to Equitably Subordinated Debt and the Possibility of Losing Millions

 

By: Lauren Casparie

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re LightSquared, Inc.,[i] a bankruptcy court recently equitably subordinated the claim of an entity that the founder, chairman of the board, and controlling shareholder of a competitor of the debtor created in order to circumvent a credit agreement’s restrictions on transferring the debt to certain parties.  In particular, the LightSquared court determined that the entity breached the implied covenant of good faith by effectively acquiring the debt on behalf of the competitor’s controlling shareholder.[ii]  In LightSquared, the debtor entered into a credit agreement that restricted transferring the debt to certain disqualified companies and all natural persons.[iii] When a competitor company inquired about purchasing the debt, it discovered that the agreement’s schedules listed competitor as a disqualified company.[iv]  Since the competitor could not purchase the debt directly, its controlling shareholder formed an investment vehicle for the exclusive purpose of buying the debt, thereby circumventing the credit agreement’s restrictions on transferring the debt, in order to give the competitor effective control over the debtor’s reorganization.[v] The investment vehicle was under capitalized, resulting in the creditor funding multiple purchases by transferring money from his personal account.[vi] Eventually, the investment entity purchased enough debt to give it a blocking position and the power to enforce certain rights during the debtor’s subsequent bankruptcy.[vii] After this purchase, rumors started to circulate that the controlling shareholder of the competitor was behind the purchasing.[viii] After hearing of these rumors, the debtor’s management strongly suspected that the controlling shareholder was behind the investment vehicle’s acquisition of the debt but never inquired into this suspicion.[ix] A month after obtaining a blocking position, the controlling shareholder made presentations to the competitor’s board of directors, informed them that he was behind the purchases of the debt, and proposed that the competitor submit a bid seeking to acquire the debtor’s assets.[x] Later, without informing the board of directors, the controlling shareholder submitted a bid on the competitor’s behalf for the debtor’s assets.[xi] This bid would have resulted in the investment entity being paid in full on the debt with an additional $140 million profit.[xii] Subsequently, the debtor filed for bankruptcy under chapter 11 of the Bankruptcy Code.[xiii]

Approximately a year after the debtor filed, one of the debtor’s major shareholders commenced an adversary proceeding against, among others, the competitor, the investment vehicle, and the competitor’s controlling shareholder alleging multiple causes of action arising out of the debt.[xiv] Subsequently, the debtor intervened in the adversary proceeding and filed a complaint asserting numerous causes of action against the defendants.[xv]  The defendants each moved to dismiss the debtor’s complaint.[xvi]  In addition, the investment vehicle also moved to dismiss the major shareholder’s complaint.[xvii]  The bankruptcy court then dismissed all of the claims asserted by a major shareholder, except its claim seeking disallowance of the investment vehicle’s claim under section 502(b) of the Bankruptcy Code.[xviii] With respect to the debtor’s claims, the bankruptcy court only dismissed the debtor’s equitable disallowance claim and its tortuous interference claim against the investment vehicle.[xix]  The bankruptcy court then held a trial with respect to the remaining causes of action.[xx]  Initially, the bankruptcy court held that the investment entity did not breach the credit agreement when it purchased the debt because the express terms of the credit agreement did not preclude from purchasing the debt.[xxi] As such, the bankruptcy court rejected the equitable disallowance claim because it found that the agreement specifically provided that debt held by ineligible persons was still enforceable.[xxii]  The bankruptcy court, however, went onto hold that the investment vehicle breached the implied covenant of good faith when it purchased the debt for the competitor’s benefit, delayed the closing of trades and ultimately harmed the debtor and its creditors.[xxiii] The bankruptcy court found numerous actions taken by the investment entity breached the covenant of good faith. First, the bankruptcy court determined that the controlling shareholder essentially used the investment vehicle as a front to implement his strategy of purchasing the debt for the benefit of the competitor, a forbidden lender under the agreement.[xxiv] Second, the controlling shareholder and the investment vehicle also acted in bad faith when he purposely delayed the closing of hundreds of million of dollars of the debt trades.[xxv] This delayed prevented other creditors from knowing when they were going to be paid and taking any desired action with their money.[xxvi] While the bankruptcy court determined that the investment vehicle breached the implied the covenant of good faith, the court concluded that the debtor was not entitled to an affirmative recovery for such breach because the debtor failed to affirmatively investigate whether the shareholder was behind the debt purchasing. [xxvii]

After determining that the investment vehicle breached the implied covenant of good faith, the bankruptcy court then turned to the issue of whether to equitably subordinate the investment entity’s claims.  When determining whether to equitably subordinate the investment entity’s claims, the bankruptcy court applied the three-prong test from the Matter of Mobile Steel Co.[xxviii] In order for a claim to be equitably subordinated under the Mobile Steel test, (1) the claimant must have engaged in some type of inequitable conduct[xxix]; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant[xxx]; and (3) the equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code, this prong is automatically meet when the first two are satisfied.[xxxi] In LightSquared, the bankruptcy court found that the investment vehicle engaged in inequitable conduct by purchasing the debt and delaying the closing of the transactions. In particular, the delayed closing resulted in harm to the creditors because it was done for no specific purpose and prevented other creditors from using the money as they desired.[xxxii] In applying each of the prongs from the Mobile Steel test, the court decided to equitably subordinate the investment entity’s claim in an amount to be determined later.[xxxiii]

LightSquared is significant because it demonstrates the need to carefully draft a credit agreement in such a way that minimizes the ability of third party to circumvent the agreement’s restrictions on transferring the debt. For example, in LightSquared, the credit agreement included the undefined term subsidiary in the definition of “Disqualified Company,” which was not broad enough to include the investment entity under the definition a “Disqualified Company” because the competitor did not own the investment entity.  By failing to include the defined term “Affiliate” in the definition of “Disqualified Company,” the credit agreement failed to prohibit the transfer of debt to an entity under common control with a Disqualified Company. Accordingly, had the credit agreement included Affiliate in the definition of Disqualified Company, the investment entity would have qualified as a Disqualified Company because the investment entity and the competitor were under the common control of the shareholder. Additionally, a borrower should attempt to protect itself by including a provision in the credit agreement that makes debt held by Disqualified Companies unenforceable, which would prevent strategic purchase of the debt. Lenders, however, may not be willing to agree to such a term that could expose them to liability if they transfer the debt to a company that turns out to be ineligible.

Along with the drafting issues, other practical issues arise from Lightsquared. The biggest issue is the danger that face entities that develop schemes to circumvent credit agreement restrictions.  By employing these schemes, a creditor faces the possibility of a breach of good faith and equitable subordination as a result of that breach. By having the debt equitably subordinated, the distribution to the investment vehicle on account of its claim will likely be reduced.  As a result, the investment vehicle, and ultimately the controlling shareholder of the competitor, may go from being repaid in full with a $140 million profit to only partially recovering on the claim.  Ultimately, this could cost the controlling shareholder hundreds of millions of dollars. On the other side of the coin, the debtor must take affirmative steps to protect itself if it wants to be able to recover damages resulting from such a breach. Instead of sitting back and doing nothing, the debtor must take affirmative steps, such as conducting discovery through a Rule 2004 examination, to determine the identity of the entity behind the scheme at question if the debtor hopes to recover damages from such entity for the breach of the covenant of good faith.



[i]In re LightSquared Inc., 511 B.R. 253 (Bankr. S.D.N.Y. 2014)

[ii] Id.

[iii] Id. at 267- 68 (“The Credit Agreement restricts transfers of the LP Debt. Section 10.04(a) of the Credit Agreement provides, in pertinent part:

[N]o Lender may assign or otherwise transfer any of its rights or obligations hereunder except (i) to an Eligible Assignee in accordance with the provisions of paragraph (b) of this Section 10.04, (ii) by way of participation in accordance with the provisions of paragraph (d) of this Section 10.04 or (iii) by way of pledge or assignment of a security interest subject to the restrictions of paragraph (f) of this Section (and any other attempted assignment or transfer by Borrower shall be null and void).”

[iv] Id. at 269 (“Disqualified Company” is defined in Section 1.01 as follows:

[A]ny operating company which is a direct competitor of the Borrower identified to the Administrative Agent in writing prior to the Closing Date and set forth on Schedule 1.01(a), and thereafter, upon the consent of the Administrative Agent ... such additional bona fide operating companies which are direct competitors of the Borrower as may be identified to the Administrative Agent from time to time and notified to the Lenders. A Disqualified Company will include any known subsidiary thereof.”).

[v] Id.

[vi] Id. at 277.

[vii] In re LightSquared Inc., 511 B.R. at 280.

[viii] Id.

[ix] Id.

[x] Id. at 287.

[xi] Id. at 331.

[xii] In re LightSquared Inc., 511 B.R. at 331.

[xiii] Id. at 262-63.

[xiv] Id. at 263.

[xv] Id.

[xvi] Id

[xvii] In re LightSquared Inc., 511 B.R. at 263.

[xviii] Id.

[xix] Id.

[xx] Id.

[xxi] Id. at 315.

[xxii] Id.

[xxiii] In re LightSquared Inc., 511 B.R. at 317.

[xxiv] Id.  at 333 (“That which a corporation is contractually unable to accomplish itself in its own name cannot be accomplished by interposing a shell company. As the court stated in Standard Chartered, “[i]t is not a matter of piercing corporate veils.... It is a matter of requiring a party to ... honor the contract and its covenants and not attempt to defeat assigned rights by interjecting an affiliated company”).

[xxv] Id.

[xxvi] Id.

[xxvii] Id. at 341.

[xxviii] Id. at 347 (citing Matter of Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977))

[xxix] In re LightSquared Inc., 511 B.R. at 347-49 (“Prong I of the Mobile Steel tests requires a showing that the claimant engaged in some type of inequitable conduct. Inequitable conduct is not limited to fraud or breach of contract, rather, it includes even lawful conduct that shocks one’s good conscience.”).

[xxx] Id. at 349- 52 (“Once inequitable conduct has been found, the Court must next determine whether the claimant’s conduct caused injury to the debtor or its creditors, or resulted in an unfair advantage to the claimant.”)

[xxxi] Id. at 352. (“The third prong of the Mobile Steel test acknowledges that equitable subordination cannot be used to alter the statutory scheme imposed by bankruptcy law. Accordingly, while a bankruptcy court can apply the equitable doctrine at its discretion, its power to subordinate an allowed claim is not boundless and courts cannot use equitable principles to disregard unambiguous statutory language of the Bankruptcy Code.”)”

[xxxii] Id.

[xxxiii] Id. at 342.