This past year was marked by extraordinary deal activity. Record breaking M&A activity drove record breaking private credit activity. Private equity M&A activity was at a substantial high, with over 8,500 deals worth $2.1 trillion, a 60% increase over 2020. Not surprisingly, in this environment, defaults were at all-time lows. The Proskauer Private Credit Default tracker showed an active default rate of approximately 1% at the end of 2021, compared to 3.6% in 2020. This is largely consistent with the syndicated loan market and, thus, no surprise that chapter 11 bankruptcy filings were at a 40-year low.
Nonetheless, private credit lenders still had to address those deals that did require restructuring. The majority of our restructurings were "amend and extends," while some required more extensive attention, including debt-for-equity exchanges, sales, and change of control transactions in both in- and out-of-court deals.
Heading into 2022, private credit activity remains robust. However, the continued unpredictability of COVID, potential interest rate increases, elimination of federal stimulus, stubborn inflation, rising wages, persistent stresses on the supply chain, among other uncertainties, continue to present challenges for many businesses.
We look back at last year's bankruptcy decisions instructive for private credit lenders. These cases involved golden shares, make-whole premiums, third-party releases, and ultra-fast prepacks. There were also a couple of cases that are noteworthy because they serve as reminders that deal structure and strength of documentation can be determinative of key lender rights.
3P Hightstown: Golden Share In the Spotlight Again
A "golden share" refers to an equity interest in a company that affords the holder a number of consent rights, including consent for the company to file a voluntary bankruptcy. Thus, the holder of a golden share has the powerful right to block a company from filing for bankruptcy. The golden share has a checkered history of enforcement because courts struggle with the tension between freedom of contract and the public policy that protects the right to file bankruptcy. In sum, some courts have been more inclined to enforce a golden share that was granted in connection with a true equity investment, and, generally, courts have not enforced a golden share if it was used as a tool for debt collection.
In 2021, the bankruptcy court for the district of New Jersey enforced a golden share. See In re 3P Hightstown, LLC, 631 B.R. 205 (Bankr. D.N.J. 2021). In 3P Hightstown, an investor held debt and preferred equity in the debtor. In connection with the equity issuance, at the time the investor made its equity investment, the debtor modified its LLC agreement (governed by Delaware law) to prohibit a voluntary bankruptcy filing without the preferred shareholder's consent. The debtor subsequently filed chapter 11 without the required consent, and the investor sought to dismiss the bankruptcy case as an unauthorized filing.
Judge Kaplan first found the LLC agreement's plain language prohibited the filing because the investor did not consent. The court then considered the public policy arguments relied upon by other courts that refused to enforce such consent rights under similar facts.
In distinguishing those other cases, Judge Kaplan emphasized the bankruptcy consent right granted to the preferred shareholder in connection with a substantial equity investment was not "merely a ruse to ensure" the debtor would repay the debt portion of its investment. Id. at 212. This fact distinguished the 3P Hightstown case from In re Lexington Hosp. Grp., LLC, 577 B.R. 676 (Bankr. E.D. Ky. 2017) and In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), where the Kentucky and Delaware bankruptcy courts struck down golden shares held by lenders who conditioned financing or forbearance on receipt of a golden share type equity stake to give the lenders veto power over a bankruptcy filing.
Judge Kaplan also considered the Delaware bankruptcy court's bench decision in In re Pace Industries, LLC, 2020 WL 5983650 (Bankr. D. Del. May 5, 2020), which we reviewed previously. See https://www.proskauer.com/alert/the-golden-share-all-that-glitters-is-not-gold. In Pace, the Delaware bankruptcy court refused to enforce a golden share held by a minority shareholder on the ground, in large part, that the refusal of the minority shareholder to consent to a bankruptcy filing conflicted with the minority shareholders' fiduciary duty to other shareholders and creditors. In our prior alert, we viewed the invalidation of the consent right on the ground of breach of fiduciary duty as a "bridge too far."
Judge Kaplan raised similar concerns expressing "serious reservations" about the notion that non-controlling minority shareholders have fiduciary duties. The court also noted that, in that case, even if such duties exist, the LLC agreement disclaimed any such duties. As a result, Judge Kaplan concluded that the golden share does not violate public policy in 3P Hightstown.
Takeaway: Private credit lenders can learn three important lessons from this decision. First, the validity of a golden share is almost always litigated. Second, the golden share is more...
