Borrower beware:  in times of distress, your credit documents may give your secured lenders an opportunity to “flip” control of your board

Distress happens, even at companies that once appeared financially solid. When it does, the company, its board (which may be controlled by a sponsor in a public or private equity scenario), and its lenders often enter into restructuring discussions in search of a consensual path forward, typically under the terms of a forbearance agreement.

Recently, however, some lenders (particularly in the middle-market private credit space) have sought to short-circuit the traditional restructuring process. Rather than negotiate with their borrower on the terms of a forbearance or more holistic capital structure solution, certain middle-market private credit lenders have turned to previously underutilized provisions in security documents — the exercise of voting rights given to a collateral agent through a voting proxy as part of the pledge of a borrower’s equity, otherwise known as pledged equity proxy rights. The trend is not isolated to private companies. Public companies have also seen a recent rise in lenders attempting to seize control of boards, which can further complicate a company’s position as it attempts to restructure its debt obligations.

In a traditional secured financing, a parent holding company — which owns the equity of a borrower entity lower in the corporate structure — will pledge the borrower’s equity to secure the loan. As part of that pledge, the holding company often grants a contractual proxy to the collateral agent. Other than to the extent agreed in the credit documents, that pledge should not affect the holding company’s ability to vote the pledged equity prior to the occurrence of an event of default — the holding company acts as a traditional corporate parent as long as it complies with credit documents.

But, when a proxy is granted as part of the collateral package, the occurrence of an event of default often will empower the collateral agent to exercise the rights of a borrower’s shareholders to appoint board members (i.e., the pledged equity proxy rights) if so directed by the required lenders. If that happens, the collateral agent can exercise such pledged equity proxy rights to remove existing directors and “flip” the board, installing directors friendly to lenders instead. Further, if the company has also pledged equity of any of the borrower’s subsidiaries (which often happens), the collateral agent can remove and replace directors at those subsidiary boards as well. Credit documents vary on how much notice is required prior to the exercise of such pledged equity proxy rights, with a trend, at least in private credit deals, toward no notice requirement at all or notice contemporaneous with the exercise of the pledged equity proxy rights, following the occurrence of an event of default.

Once lenders have control of a borrower’s board, they can replace officers, hire advisors and otherwise direct the governance of the company, notwithstanding equity ownership of the sponsor or public shareholders.  

Practical Consequences

Beyond the obvious consequences, a “flip” can exacerbate issues faced by an already distressed company. With the loss of control of the borrower’s board (and perhaps the boards of subsidiaries as well), a sponsor loses significant leverage in restructuring discussions with lenders. Filing for voluntary bankruptcy relief requires proper corporate authorization, and, without control of the borrower’s board, the sponsor loses the ability to file its portfolio company for chapter 11 and, with it, the threat of filing, which itself can be a powerful tool in restructuring negotiations. A change in the board composition of a borrower (which often is an operating entity) also may trigger “change of control” default and/or notice provisions in material contracts and leases. A “flip,” therefore, could result in counterparties tightening trade terms or terminating contracts altogether. Further, if a company has other funded debt obligations, it may also trigger direct defaults or cross-defaults under those credit documents, which may strain intercreditor relations. Either of the foregoing could result in a liquidity crunch, especially if the other funded debt is in the form of a revolver or similar instrument, or exercise by such parties of self-help remedies.

Though relatively little case law exists on these issues, at least one court — the United States Bankruptcy Court for the District of Delaware in In re CII Parent, Inc. — held that a proper pre-bankruptcy exercise of pledged equity proxy rights by lenders to effectuate a board “flip” was enforceable and could not be unwound in a bankruptcy case of the borrower’s corporate parent. In CII Parent, a direct lending firm provided a credit facility consisting of a term loan and revolving loan. As part of a collateral package to secure the loan, the corporate parent (and borrower under the credit agreement) pledged its 100% equity interest in its subsidiary, which itself wholly owned multiple indirect subsidiaries. Following certain defaults by the borrower under the credit agreement, the borrower and lender entered into a forbearance agreement. Following expiration of the forbearance period, but prior to the borrower commencing bankruptcy, the lender exercised the pledged equity proxy rights granted under the credit agreement. The parent filed for chapter 11 protection shortly thereafter.

Once in chapter 11, the debtor-parent filed a motion seeking to, among other things, enforce the automatic stay to regain control of equity of the pledged subsidiary, which the debtor-parent argued was estate property. According to the debtor-parent, the agent violated the automatic stay provisions of the Bankruptcy Code by exercising control over such bankruptcy estate property. 

The court disagreed, holding that the proxy decoupled the voting rights from the ownership of the equity, the agent complied with the credit documents in exercising the rights granted under the proxy and nothing in the Bankruptcy Code prohibited the lenders’ pre-bankruptcy actions. Therefore, the debtor could not recover control of its pledged subsidiaries in its bankruptcy cases. In effect, the company lost the ability to file itself and its subsidiaries for bankruptcy protection and use the bankruptcy cases to restructure its debt.

Similar pre-petition facts arose in the public company context in the chapter 11 cases of CBL & Associates Properties (CBL), albeit with a different ending. As security for its obligations under a credit facility (including a term loan and revolving loan), CBL, a publicly traded real estate investment trust, pledged interests in certain of its subsidiaries. Facing financial stress in light of the ongoing COVID-19 pandemic, CBL entered into restructuring conversations with the lenders under its credit facility and holders of its senior unsecured notes. Following a series of alleged defaults under the credit agreement for the credit facility, the agent sent CBL a notice of acceleration. The parties, nonetheless, continued negotiations around a consensual global restructuring. After several months, over a two-day period, the agent purported to exercise its pledged equity proxy rights and take control of the boards of the pledged subsidiaries. Concurrently with taking purported control of the boards, the board at each pledged subsidiary passed a unanimous written consent, which (among other things) expressly restricted the rights of each pledged subsidiary from filing for bankruptcy protection without consent of the agent.

Over the weekend that followed, CBL filed chapter 11 cases for over 170 entities, including the pledged subsidiaries. At the same time, CBL commenced an adversary proceeding (i.e., a lawsuit within a chapter 11 case, which is adjudicated by the bankruptcy court) against the agent, seeking (among other things) a declaratory judgment that no events of default occurred under the credit agreement and for enforcement of the automatic stay for the agent’s alleged control of estate property (i.e., the equity interests in the pledged subsidiaries). The agent responded, seeking to dismiss the bankruptcy cases of the pledged subsidiaries on the grounds that those entities did not have proper corporate authority to file chapter 11 petitions. 

The bankruptcy court issued a temporary restraining order in favor of CBL, which then resulted in a consensual standstill order between CBL and the agent. Ultimately, the parties settled the adversary proceeding as part of a broader global resolution on the terms of the restructuring. Although the case ended with a successful plan of reorganization, the purported exercise of the pledged equity proxy rights accelerated the filing and complicated the initial days of CBL’s chapter 11 cases.


As soon as a company shows signs of financial distress, professionals should be engaged to review the credit documents and determine potential exposure and mitigation strategies. If problems continue and a company is teetering on the edge of a default, the public company (and sponsor, if applicable) should prioritize negotiating for a forbearance (or similar agreement) with lenders. 

All parties should also be careful not to rely on handshake deals and relationships with lenders when a borrower faces a potential default. In the world of private credit and direct lending, there has been an uptick in aggressive tactics, like board flips, that historically may have been less palatable to a traditional credit syndicate. And, if restructuring discussions stall with a default looming, the company’s board should consider its strategic alternatives — including a potential voluntary bankruptcy filing — to protect control of the company.