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How to raise capital for a financially troubled company Cravath Swaine & Moore LLP

In recent years companies experiencing solvency or liquidity problems wereable to raise new capital in the debt and equity capital markets with

relative ease. The markets were flush with liquidity,- due in part to theproliferation of non-traditional lenders such as hedge funds and otherswilling, and in some cases eager, to invest in distressed situations. In fact, thecompetition among lenders to provide capital in distressed situationsenabled companies to increase their leverage at a relatively low cost.As has been widely reported, capital market conditions in 2008 and beyondmight not be as favourable. According to Standard & Poor’s, the ratio ofdistressed corporate debt to all speculative grade debt rose from 6.1 per centin December 2007 to 11.1 per cent in January 2008, making it the highestpercentage since September 2003. Standard & Poor’s also reported that nineleveraged loans defaulted in January 2008 compared to only two during2007. Moody’s Investors Service has projected that the global speculativedefault rate will rise substantially in the next 12 months from the 1.1 per centprevailing in December 2007 (the lowest level since March 1982).

In addition, it appears that liquidity in the capital markets might not beas available as it was in the past few years. Traditional and non-traditionallenders alike seem to have become more conservative in their lendingpractices for several reasons, including concerns about a possible recession inthe US economy, market volatility, weakness in consumer spending and thesubprime mortgage and housing crisis and its effect on financial institutionsworldwide. The tightening in the credit markets has already affected manytransactions ranging from private equity-sponsored leveraged buyouts toexit financing arrangements for companies seeking to emerge from theirreorganisations under Chapter 11 of the US Bankruptcy Code.

In this challenging environment, a financially troubled company that isable to identify the source of its distress, formulate a strategy to raise newcapital and execute quickly might be able to prevent further deterioration to itsfinancial health. This chapter begins with a discussion of financing alternativesand potential sources of capital, and then discusses the issues that a companymight confront as it formulates its business objectives and legal strategies.

Financing alternatives

In general, a financially troubled company might raise much-needed capitalthrough various types of debt or equity financing. The cost of each of thesetypes of capital depends primarily on the perceived risk of repayment, whichis contingent not only on company and industry-specific risk, but also onpriority of repayment if the company fails. The Bankruptcy Code, as well asapplicable non-bankruptcy law, sets forth a priority scheme whereby:• secured lenders are entitled to a distribution up to the value of their

respective collateral;• unsecured creditors are entitled to the value of any unencumbered assets,

including any surplus value in the secured lenders’ collateral; and

Richard Levin, partner

Robert Trust, senior associate

Cravath Swaine & Moore

LLP

How to raise capital for a financiallytroubled company

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• equity interest holders are entitled to whateveris left after all secured and unsecured creditorshave been paid in full (including accrued andunpaid interest).

Accordingly, higher-priority claims such assecured debt financings are generally lessexpensive to the company than lower-priorityclaims such as unsecured debt. An equity holder –whether it holds preferred or common stock – is theleast assured of receiving a return of or on itsinvestment, so it usually demands the highest riskpremium. In addition, a company might considerselling hard assets or a business segment ormonetising other property, such as accountsreceivable. Later insolvency can create legal risksfor the buyer, which might affect purchase price orstructure.

Debt financing

A company might be able to raise debt capital if itcan assure the lender that it will repay the newloan. A lender might seek assurances through thecompany’s pledging of some or all of its property ascollateral. A lender might also insist that anyfinancial covenants in the debt documents be tightso that it has sufficient warning of declines in thecompany’s operating performance. For example, aleverage ratio covenant measuring debt to free cashflow (ie, earnings before interest, taxes,depreciation and amortisation) for a financiallytroubled company might be set at close to 90 percent of the company’s projected cash flow, insteadof 75 per cent to 80 per cent for a more financiallystable company.

A company without any unencumbered assetsmust explore other options, each of which becomesmore expensive as the uncertainty of repaymentincreases. For example, if all the company’s assetsare already encumbered, it might consider afinancing secured by a lien junior to the existingsecured lender’s lien. Depending on the severity ofthe financial distress, the company could alsoexplore raising unsecured or subordinated debt,which is more difficult and expensive the moreleverage the company already has. If these optionsare not viable, the company might refinance itsexisting debt from new investors.

In addition to the lower risk premiumsassociated with debt, debt is less expensive to thecompany than the equivalent amount of equity dueto the better tax treatment of debt under US law. Ingeneral, the company can deduct the interest to be

paid on debt, lowering the actual loan cost, whereasdividends are taxed as profit before they can bereturned to the equity interest holder.

Equity financing

As a financially troubled company might beinsolvent, it is usually very difficult to raise equitycapital. An equity interest holder is entitled todistributions only after all creditors have been paidin full. Accordingly, the risk of an equity investorlosing its investment is relatively high.

Despite this risk, a non-traditional lender suchas a hedge fund often pursues opportunities whereit might be able to acquire an equity position in thecompany. Thus, a hedge fund might provide rescuefinancing to a troubled company in the form of debtand equity financing. Such rescue financing oftencontains a requirement that the hedge fund bepermitted to participate directly or indirectly in thecompany’s governance – for example, by havingthe right to designate one or more directors. Thedebt/equity financing arrangement provides thelender with the greater certainty of repayment thatdebt offers and the potential upside and control ofan equity investment. As a result, the total cost ofthese types of arrangement to the company is oftenvery high.

Asset sales

A company can also sell assets or monetise otherproperty such as accounts receivable to raisecapital. Selling assets such as property, plant andequipment might also reduce operating andoverhead expenses. Selling accounts receivable at adiscount to a factor that assumes receivablescollection risk also might provide quick cash to thecompany, although the discount for non-recoursefactoring is often quite high. Selling assets might bepreferable to debt or equity financing because thecompany might obtain the necessary capitalwithout incurring the ongoing financing costs.There are no interest payments or risk premiumsowed to an asset purchaser.

However, if the assets are already pledged ascollateral, the company may have to persuade thesecured lender to permit the company to retain thenet cash proceeds for working capital purposesinstead of using it to reduce the secured debt. Inaddition, the purchaser may be concerned that thetransfer might be attacked as a constructivelyfraudulent transfer, which occurs if the companywas insolvent at the time of the transfer or was

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How to raise capital for a financially troubled company Cravath Swaine & Moore LLP

rendered insolvent by the transfer and the companyreceived less than reasonably equivalent value orfair consideration. Few options are available to thepurchaser to mitigate this risk. For example,opinions from well-established financial firms thatthe company was solvent or that the considerationwas fair might be second-guessed in a laterbankruptcy case, particularly to a court reviewingthe situation with the benefit of hindsight.

Sources of capital

Identifying a capital source that is ready, willingand able to infuse new capital on acceptable termsand conditions is challenging. The company mustconsider all possible sources, including existingand new lenders and investors, its customers andany combination of these sources. This sectiondescribes some of the issues that the companyshould consider in pursuing these different sourcesof capital.

Existing investors

A financially troubled company searching for newcapital usually turns first to its existing investors,for several reasons. First, existing investors shouldbe familiar with the company, its business and itsmanagement, and should therefore require lesstime to conduct due diligence. The company canoften prevent the expense, distraction and delay ofmaking management presentations and providingextensive due diligence material, which could beadvantageous where the company faces animminent liquidity crisis.

Second, under existing debt documents thecompany might need its existing creditors’ consentto a capital infusion. The company might obtainconsent more easily from existing creditors, or evena subset of that group, if they are the new investors.Existing creditors might still demand a consent feeand amendments to their existing debt documentsenhancing the credit as the price of their consent. Ifcapital market conditions remain challenging, suchamendments could result in increased pricing andthe elimination of any borrower-friendlyprovisions.

Finally, unlike new investors, existing investorsoften have an interest in protecting theirinvestment. If the investors believe the company’ssurvival is the best way to maximise recovery onthe existing investment, they may have little choicebut to provide additional capital, albeit onexpensive terms.

New investors

While existing investors might have an advantageand an interest in providing new capital, thecompany should still explore opportunities withnew investors. New investors looking at a situationfor the first time might be able to offer different orcreative types of capital that could fit within theconfines of the company’s existing capital structure.Furthermore, non-traditional investors such ashedge funds and private equity firms haveexpanded their focus to include investments indistressed situations. In 2006 and the first half of2007 private equity firms and hedge fundsspecialising in distressed situations have raisedmore than $40 billion. As a result of their expertiseand available capital, these non-traditional lendershave become an attractive source of financing.

In addition, new investors provide thecompany with negotiating leverage overrecalcitrant existing investors. Even if the companyhas no intention of moving forward with a newinvestor group, its negotiating leverage with itsexisting investors should be enhanced if it canshow that it has a credible alternative.

Existing customers

In a more modest way, existing customers may alsoserve as a source of capital. A customer might agreeto accelerate payment on an existing accountsreceivable or to provide a lump-sum subsidy toprovide much-needed liquidity to protect itssupplier. These types of arrangement are morecommon in the automotive industry, for example,where the failure of a single company in the supplychain as a result of financial troubles to provideparts just in time could cause a ripple effect,potentially shutting down manufacturingoperations until an alternative supply is obtained.As a result, some companies have implementedvendor rescue programmes to provide financial oroperational assistance to a distressed supplier.

Raising capital

Raising capital poses special challenges for afinancially troubled company because it is often amultilateral, complex negotiation involving thecompany’s most important constituencies,including existing and prospective investors,customers, suppliers and employees. During thesenegotiations the company must know its businessobjective and the legal means for accomplishing it,

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which is usually an out-of-court restructuring or aChapter 11 case. This section describes some of thedynamics and considerations that might affect theoutcome of these negotiations.

Identifying the cause of financial trouble

Before a company begins discussions with existingor prospective investors, it must identify the causeof its financial distress. Causes of financial distressvary widely among companies and industries. Forexample, airlines have suffered from:• competition from low-cost carriers;• reduced air travel after the terrorist attacks of

September 11 2001; and• most recently, escalating fuel costs.

Automotive parts manufacturers have sufferedfrom:• increasing commodity prices;• greater competition; and• greater legacy liabilities, such as pension and

retiree healthcare costs.

The sub-prime mortgage crisis has already hurthome building and weak consumer spending willhurt retailers.

Regardless of the cause, a company mustunderstand why its financial performance hasdeteriorated. A clear understanding of the cause ofthe financial distress indicates to existing investors,customers, suppliers, employees and prospectiveinvestors that management is in control and canaddress the problems. Maintaining theseconstituencies’ confidence helps to prevent losingkey customers and employees to competitors andthe imposition of tougher credit terms by suppliers.Furthermore, where several financially troubledcompanies might be competing for capital, investorconfidence in senior management can be crucial toa company’s efforts to distinguish itself.

Reviewing the capital structure and existing debtdocuments

While a company diagnoses its financial troubles,the company and its legal counsel should review thecapital structure and the covenants and restrictionsin the company’s existing debt documents. Thisinformation will help the company to identifywhich capital-raising activities it can pursuewithout the consent of its existing stakeholders. Ifconsent is required, creditors can and often dorequire consent or similar fees and impose other

conditions, making the process more expensive andonerous for the company. Accordingly, a company’sability to navigate around these potential hurdles iscrucial to its rehabilitation.

The ability of existing stakeholders to opposenew financing or other capital-raising activitiesdepends primarily on the limitations in the existingdebt documents. Debt documents commonlyrestrict the ability of a company and usually itsdirect and indirect subsidiaries to incur secured orunsecured debt, refinance existing debt with moresenior debt, sell core or non-core assets, engage inaffiliate transactions, amend or waive certain juniordebt document provisions or repay junior debt.Financial maintenance covenants periodicallymeasuring a company’s leverage, interest expenseor fixed charges against its earnings before interest,taxes, depreciation and amortisation (usually eachfiscal quarter and at fiscal year-end) also limit acompany’s debt capacity. In addition, many debtdocuments require a company to use a minimumpercentage of net cash proceeds from new debt,new equity or asset sales to pre-pay existing debt.As a result, many capital-raising activities mightnot actually yield additional liquidity. Failure tocomply with these provisions could trigger animmediate event of default, thereby permitting thelenders to accelerate the debt and exercise rightsand remedies.

Similar capital-raising limitations exist even inso-called ‘covenant-lite’ deals, which often includeincurrence-based financial covenants with whichthe borrower must comply to incur debt, sell assetsor engage in specified other activities. Thus, afinancially troubled company might be unable tosatisfy the incurrence-based covenant at the verytime that it needs to enter into that type oftransaction to raise new capital.

Obtaining the requisite consents

Most debt documents require at least a simplemajority consent to amend the restrictionsdiscussed above or waive any events of default.However, obtaining those consents at a reasonableprice might pose a challenge for the financiallytroubled company. The dynamics in consentnegotiations have changed during the last fewyears, in part due to the prominence of hedge fundsand other non-traditional lenders in the creditmarkets.

Identifying the right lender or bondholdergroup with which to discuss restructuring optionshas become substantially more complicated. More

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financial institutions invest strategically in differentsecurities in a company’s capital structure to hedgetheir risks and obtain more access and input in anyrestructuring process. However, the companymight not even be aware of which securities aparticular entity holds because certain instruments(eg, credit default swaps, total return swaps andparticipations) entitle the investor to, or protect theinvestor from, the economic value of the securitywithout being identified as the beneficial holder onany official register of lenders or security holders.Institutions often say that they hold or have theeconomic interest in more securities than isreflected on any register, and the company has todo its best to try to verify that information.

Further, the interests of an institution holding aparticular class of securities might not actually bealigned with other holders of the same class. In thepast, it could generally be assumed that existingsecured lenders would oppose certain actions takenby unsecured bondholders and vice versa.However, as a result of the cross-holdings betweenclasses, some secured lenders which are alsobondholders or equity interest holders might usetheir secured lender position to protect their bondor equity investment. The negotiation process isthus somewhat less predictable.

Finally, an institution might be reluctant tobecome involved in restructuring negotiationsbecause it would likely become restricted in itstrading activities after it came into possession ofmaterial non-public information. Some institutionsmight agree to become restricted for a short-periodof time, but the company has to address theseissues on a case-by-case basis.

Out-of-court restructuring versus Chapter 11 case

A company unable to persuade a creditor group tosupport a proposed restructuring generally has twosources of leverage:• It might be able to point to a new investor

willing to provide capital within the confines ofthe existing debt documents and capitalstructure; and

• It can file a case under Chapter 11 of theBankruptcy Code.

A Chapter 11 case has several advantages overan out-of-court restructuring.

First, the bankruptcy court may provideprotections that are not available in an out-of-courtrestructuring for lenders providing new financingor purchasers buying assets. A company might be

able to obtain a debtor-in-possession (DIP)financing at the outset. The Bankruptcy Codeaccords special status to the liens and claimssupporting the loans. A DIP lender typicallyrequests collateral. The Bankruptcy Code permits anew loan to be secured by a senior (or priming) orequal lien on already encumbered property if thepre-petition secured lenders consent or the DIPshows that the pre-petition secured lenders’ interestin the collateral is “adequately protected” fromdiminution in value during the case. As a practicalmatter, companies often prime liens only with theirpre-petition lenders’ consent, but they still canprovide adequate protection by paying the lendersan agreed periodic amount, granting replacementliens on property the company acquires duringbankruptcy and agreeing to other concessions.

In addition, the bankruptcy court may grant aDIP lender super-priority administrative expensestatus, which gives the lender first priority, aboveother priority claimants and holders of generalunsecured pre-petition claims, on anyunencumbered assets if the DIP lender’s collateralis insufficient to pay its full claim amount. Further,the Bankruptcy Code requires, as a condition to acompany’s emergence from bankruptcy, that it payall priority claims in cash in full. The combinationof the priming lien and super-priority claim oftenmakes otherwise reluctant lenders willing toprovide financing.

Similarly, the bankruptcy court can assure cleantitle to protect an asset purchaser in a bankruptcycase. Section 363 of the Bankruptcy Code permits aDIP to sell assets “free and clear” of interests so thatliens and claims, including successor liabilityclaims, attach to the proceeds of the sale, not theassets being sold. In addition, bankruptcy courtapproval of a sale should eliminate any fraudulenttransfer risk in the sale. These protections mitigatethe risk that the purchaser would later be burdenedwith unexpected liabilities or litigation.

Second, the Bankruptcy Code also providestools to help a company in its restructuring. Forexample, Section 362 imposes an automatic stayenjoining most collection actions and litigationagainst the company. Thus, a company facingnumerous lawsuits, or facing substantial liabilitiesstemming from product liability, asbestos or othermass tort claims, could find the structure, controland transparency that a Chapter 11 case affords tobe beneficial. The automatic stay enjoins all suchlitigation and thus gives the company breathingspace from the costs and distraction of litigationand an opportunity to compromise the litigation

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claims under a Chapter 11 plan. Over the last 10years, companies facing billions of dollars inaggregate asbestos liability have successfullypursued bankruptcy cases for that very purpose.

Moreover, a company might resolveoperational restructuring issues more readily in abankruptcy case. In addition to being able to sellnon-core assets freely and clearly, a company mayreject executory contracts and unexpired leaseswith above-market or unfavourable terms underSection 365 of the Bankruptcy Code. Rejectionconstitutes a court-approved breach of the contract,relieving all parties of any further contractualobligations (with very few exceptions) and treatingthe non-debtor counterparty claim for contractualdamages as a general unsecured pre-petition claim.Retailers often liquidate inventory and reject leasesfor unprofitable stores; manufacturers might rejectplant leases to consolidate manufacturing orwarehousing operations in a better location.

The Bankruptcy Code’s voting provisions arealso more favourable than those in existing debtdocuments. Out of court, a company seeking tocompromise its debt or to get its lenders toexchange debt for new equity in the reorganisedcompany must obtain each affected lender’sconsent. In contrast, in Chapter 11 approval by onlya majority in number of holders and two-thirds inamount of claims of those who voted on the plan ineach voting class provides sufficient consent.Dissenting creditors are bound.

The Bankruptcy Code also permitsconfirmation under the cram-down provisions on anon-accepting class of claims or equity interests ofa Chapter 11 plan that at least one impaired class ofcreditors has accepted if the plan’s treatment of thenon-accepting classes does not discriminateunfairly against and is fair and equitable to the non-accepting classes. The cram-down provisionseffectuate the absolute priority rule by ensuringthat a junior class of claims or equity interests doesnot receive a distribution under a Chapter 11 planunless the senior class has been paid in full.

Thus, a Chapter 11 case can obviate the need forcreditor unanimity to effectuate the company’sbalance-sheet restructuring and make it binding onall creditors and equity holders. These types ofrestructuring are sometimes accomplished inshorter, less expensive Chapter 11 cases commonlyreferred to as pre-packaged or pre-negotiated cases,where the company negotiates the Chapter 11plan’s terms before filing and then uses theBankruptcy Code’s less than unanimous votingprovisions to obtain creditor approval.

However, a Chapter 11 case is not a panacea forthe financially troubled company. In fact, a Chapter11 case typically imposes substantial costs, both inthe impact on the business and in the professionalfees a company must pay. Chapter 11 can alsodistract management from operations and add alayer of risk and complexity because manytransactions integral to rehabilitation efforts requirebankruptcy court approval. As a result, a dissentingstakeholder has a forum and an opportunity toobject and be heard on matters before the court,potentially impeding the reorganisation.

Furthermore, once a company commences aChapter 11 case, it must still formulate and executea business strategy to emerge. This strategy couldinclude an operational restructuring involvingrejecting unprofitable leases or selling assets. Acompany can also use a Chapter 11 to implement abalance-sheet restructuring by exchanging old debtfor new equity in the reorganised company. Ineither case, however, Chapter 11 is a means ofimplementing the business strategy, not an end initself.

Finally, Chapter 11 cannot help a company toresolve financial distress caused primarily byexternal factors such as increasing commodityprices, greater competition in the industry orescalating fuel costs. These issues are outside thecompany’s control and the Bankruptcy Code doesnot provide means to address them.

Despite its disadvantages, Chapter 11 mightstill be inevitable in certain circumstances. Whetherthe company is able to raise capital outsidebankruptcy depends at least in part on existinginvestors’ willingness to consent to an out-of-courtrestructuring and existing customers’, employees’and suppliers’ willingness to continue to supportthe business. The absence of any one of thesefactors might compel a company to seek reliefunder Chapter 11, despite its best efforts to preventthat outcome.

Obtaining the approval of the board of directors

Throughout this process, the company needs theguidance, support and approval of its board ofdirectors for any course of action. Directorsconsidering restructuring options shouldunderstand their fiduciary obligations in thesecircumstances. Directors owe fiduciary duties ofloyalty, care and good faith exclusively to thecorporation and, in an acquisition context, to itsshareholders. A director is entitled to a legalpresumption, known as the business judgement

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rule, that so long as the director did not have anyself-interest in the proposed transaction, he or shehas acted in good faith and in the best interests ofthe corporation.

A director’s duties do not change as a companyapproaches insolvency or becomes insolvent. In aninsolvent company the value of a creditor’s claimsmay be affected by business decisions, while ashareholder’s interests might be at leasttemporarily worthless. For these reasons creditors,in addition to shareholders, have standing to bringa derivative action against the directors for breachof fiduciary duty. A director should be particularlysensitive to transactions that have the effect ofbenefiting the company’s insiders or particularlythemselves.

Even though a non-self-interested director hasthe benefit of the business judgement rule, a failedout-of-court restructuring strategy may causelosses that can prompt a creditor to sue for breachof fiduciary duty or other related claims based onlaws relating to preferences, fraudulent transfers orillegal dividends. As a result, a director should takeparticular care during this process to avoid self-interest in reviewing matters presented to the board

for review or decision.

Conclusion

A financially troubled company does not have aneasy path to raising capital. It requires thecooperation of a diverse group of parties whoseinterests might not be aligned with those of thecompany or even each other. After a company hasidentified the source of distress, what its existingdebt documents permit and whether existinginvestors will consent, it must weigh up thesubstantial costs, delay and risks associated with aChapter 11 filing against the company’s ability toaccomplish the same business objectives in an out-of-court restructuring. This task is not easy.

If market conditions continue to deteriorate, ashas been predicted, it will not get any easier. Therewill likely be greater competition among manyhighly leveraged companies for what might be adiminishing amount of available capital. As aresult, capital – whether obtained in a bankruptcyor in an out-of-court restructuring – might be moreexpensive and the terms and conditions on which itis provided might be more onerous.

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