Restructuring

Contributed by Sara Coelho

What rights do holders of securitized debt have to participate in a bankruptcy case?

AmericanWest Bancorporation’s recent bankruptcy sale of equity it held in a subsidiary bank has been trumpeted as a novel solution to overcome barriers to recapitalization and reorganization of failing banks.  The tools that made the AmericanWest reorganization successful, however, are the traditional tools of chapter 11 – namely, using chapter 11, particularly a sale under section 363 of the Bankruptcy Code, to avoid consents that would be required outside of bankruptcy. Although commentators on the case have suggested otherwise, the result is not extraordinary – a debtor may use section 363 to sell property of the estate even over the objection of creditors.  The attention the case has received simply by using section 363 is, therefore, somewhat surprising.
AmericanWest, however, highlights one of the problems of securitized debt – who were the real parties in interest with the right to object to AmericanWest’s sale?  In AmericanWest, the bankruptcy court determined that indirect investors in trust preferred securities (commonly referred to as “TruPS”) did not have standing to participate in the chapter 11 case and, therefore, could not object to the sale.  At what point in the securitized debt chain, though, should the holder of an economic interest have the right to be treated as a party in interest and under what circumstances?  Could denial of standing to holders of securitized debt obstruct progress in other chapter 11 cases involving securitized debt?
In AmericanWest, a bank holding company filed for chapter 11 with the goal of selling the equity in its wholly owned subsidiary bank in a sale under section 363 of the Bankruptcy Code.  The bank subsidiary did not file for bankuptcy protection; as a bank, it is not eligible to file a chapter 11 case.  The sale was necessary to find a new investor that was willing to inject additional capital into the bank and avoid a regulatory takeover.
At the outset of the case, the holding company debtor sought approval of bidding procedures for an expedited sale of its equity in the bank (subject to competing bids at auction) to a stalking-horse bidder that was expected to receive all necessary regulatory approvals.  No competing bids were submitted, and the stalking horse purchased the bank for $6.5 million, up to $2 million of which was credit bid from DIP financing provided by the stalking horse.  The stalking horse bidder also committed to provide up to $200 million to recapitalize the bank, value that did not directly benefit the holding company’s creditors but was key to regulatory approval of the transaction.  From the FDIC’s perspective, the sale would breathe new life into an undercapitalized bank without an FDIC takeover and without tapping the FDIC insurance fund — an outcome that papers filed in the case estimated could save the FDIC fund as much as $330 million.  Although the sale clearly benefited the FDIC and creditors of the non-debtor bank, indirect creditors (indirect investors in the TruPS) attempted to argue that the debtor’s sale process was not maximizing value for the estate.
The objecting parties, however, were not direct creditors of AmericanWest and, in fact, were not even direct holders of the TruPs.  As is the typical structure of TruPS, AmericanWest had created trusts to which AmericanWest had issued debentures.  These trusts generated funds by selling preferred interests (the TruPs) to investors, typically collateralized debt obligation funds (“CDOs”).  Neither the trustees of the trusts nor the CDOs objected to the sale – certain investors in the CDOs objected.
These CDO investors asserted that they were the real parties with an economic stake in the outcome of the case and that the features of the TruPS and the structure of the CDOs prevented effective representation of their interests.  Prepetition, the structure of the TruPS prevented restructuring negotiations (a point made by the debtor when it commenced its chapter 11 case).  Postpetition, the trustees for the CDOs holding the TruPS could act only after receiving a direction from two-thirds of the CDO investors, and gathering such consents and taking action required more time than the expedited schedule allowed.
The debtor argued, and the court agreed, that the CDO investors were creditors of a creditor (the CDO) of a creditor (the debenture trust) of the debtor.  Such interest, the bankruptcy court concluded, was too attenuated to justify the CDO investors’ participation in the bankruptcy case.  The court also stated, though, that “party in interest” status, and the standing to participate that it confers, must be decided case-by-case based upon the facts and circumstances of each case.
AmericanWest arguably rejects drawing a bright line in determining standing and ostensibly supports flexibility in deciding who may participate in a bankruptcy case.  Investors, however, are left with uncertainty about who will protect their interests – would, for example, the CDO that was the direct holder of the TruPS have standing to participate even though it was not a creditor of the debtor?  The structure, however, also creates uncertainty for debtors attempting to restructure.  While lack of standing did not pose a problem for the debtor in AmericanWest, it may be problematic, for example, for a debtor soliciting votes on a plan where the direct legal interests are held by a trustee (or multiple layers of trustees) who may refuse to participate because the trust documents do not provide clear guidance on the powers of the trustee or because the trustee has conflicting directions or simply a lack of direction from its constituency.
Ironically, many of the “bankruptcy remote” investment structures that have been created were not designed to function in a bankruptcy of one of their investments.  If the structures themselves are not fixed to enable real participation in restructurings, bankruptcy law may have to evolve, and the law of standing may have to develop in ways that leave room to consider allowing for direct solicitation of holders of securitized debt where governing documents make it impossible or extremely difficult to propose a reorganization plan.