In an opinion that mostly flew under the radar in 2021, Judge Christopher Sontchi from the Bankruptcy Court for the District of Delaware (the “Court”) found a private equity sponsor (the “Sponsor”)1 liable (and, in some cases, not liable) under various contractual and tort theories in connection with actions the Sponsor took or did not take in its failed efforts to stave off a potential bankruptcy filing of its portfolio company, Allied Systems Holdings, Inc., now known as ASHINC Corporation (“Allied” or the “Company”).2 Pending appeal,3 the Sponsor could be liable for well over $100 million in damages to a litigation trust set up in the Company’s subsequent bankruptcy (the “Trust”) and to certain lenders that also sued the Sponsor.
This decision provides key lessons for private equity sponsors of distressed companies to avoid or minimize liability in potential future litigation. When a company files for bankruptcy and has insufficient value to pay creditors in full, estate representatives and creditors often look to “deep pockets” to try to fill the hole. This can result in investigations and claims against the debtor’s owners, including private equity sponsors. In some cases, the sponsor can negotiate prior to the bankruptcy filing for a release of claims against it, effective upon the consummation of a chapter 11 plan, in exchange for a cash payment and/or for agreeing to give up its equity interest for no consideration, depending on the strength of the potential claims.4 That agreement usually, but not always, survives the subsequent bankruptcy filing, particularly in a “prepackaged chapter 11 case.”5 Unfortunately for the private equity sponsor, sometimes it faces actual litigation by the bankrupt estate, often through a litigation trust formed under a confirmed chapter 11 plan.
This opinion provides a guidepost of legal doctrines that could be asserted against private equity sponsors when their portfolio companies end up in distress. Given its importance, the Weil Restructuring Review will explore the implications and lessons of this opinion in a series of articles over the coming months.
This first article analyzes the breach of contract claims stemming from the Sponsor’s acquisition of Allied’s first lien debt. Although a sponsor does not always own debt in its portfolio companies, the potential acquisition of debt is a common tool sponsors consider to improve the financial condition of distressed portfolio companies or the sponsor’s position as an equity owner. There are often special provisions of credit agreements addressing debt acquired or held by affiliates of a borrower, and this case highlights the importance of sponsors carefully reviewing, interpreting, and following these provisions. In addition, even outside the context of credit agreements, the breach of contract section of the opinion has lessons that could be applicable to other contracts between a sponsor and its portfolio company.
Future articles will discuss other claims against the Sponsor, including fraudulent transfer, breach of fiduciary duty, equitable subordination, and recharacterization.
In short, in disposing of cross-motions for summary judgment, Judge Sontchi held that:
- (i) The Sponsor breached its obligations under the Company’s credit agreement by failing to make a required capital contribution upon its acquisition of the Company’s debt; (ii) the breach of obligations to the Company and various lenders under the credit agreement was continuous, meaning that the statute of limitations did not begin to accrue until the Company sold its assets in bankruptcy, years after the initial breaches; and (iii) the Sponsor was liable to the Trust for the full cash amount of the capital contribution equal to 50% of the face value of the term loans purchased by the Sponsor even though the loan agreement contemplated that the Sponsor would contribute debt that it purchased substantially below par (as detailed below, an amendment to the loan agreement that deleted the capital contribution obligation was determined to be invalid due to inadequate consents);
- The Sponsor was liable for a fraudulent transfer, as the Company made a series of payments to the Sponsor for legal fees and other related expenses while the Company was insolvent and it did not receive direct value or a roughly equivalent indirect benefit for the value conferred;6
- The Sponsor may have breached its fiduciary duties to the Company by (i) failing to alert the Company’s board about an earlier offer from a competitor to buy first lien debt, which it intended to use to acquire the Company through a credit bid in a section 363 sale and (ii) causing the Company to reimburse it for certain fees and expenses;
- The litigation trustee had met her burden as to certain elements to “equitably subordinate” the Sponsor’s claims against the Company, while the extent to which the Sponsor’s claims should be subordinated would be reserved for trial; and
- The facts did not warrant the “recharacterization” of the Sponsor’s claims from debt to equity.
The relevant facts here are long and somewhat complicated, but they are important to understanding the actions that gave rise to the Sponsor’s liability. Nonetheless, readers can skip the Background section and go straight to the “Legal Analysis” or “Takeaways” section if they wish.
First Chapter 11, Loan Agreements
Allied was a car hauling company engaged in the transport of new vehicles in North America. In May 2007, Allied exited its first chapter 11 case with the Sponsor controlling the reorganized company’s equity and board.7 At the same time, Allied entered into a two-tiered financing structure with various lenders under the First Lien Credit Agreement (the “FLCA”) and the Second Lien Credit Agreement (the “SLCA”).
As initially executed, the FLCA and the SLCA excluded the Sponsor from being an “Eligible Assignee,” meaning that a holder of debt could not sell, assign, or transfer any portion of its debt, rights, or obligations to the Sponsor. As is typical, the FLCA also provided for the “Requisite Lender(s)” being entitled to take certain actions and exercise particular remedies, or refrain from doing so, on behalf of all lenders; the term was defined as the party or parties holding the majority of the first lien debt, which was calculated through the defined term “Term Loan Exposure.”8 Only “Requisite Lender” consent was needed for most amendments under the FLCA, but certain amendments required the consent of all lenders, including any amendment that had “the effect of” changing the definition of Requisite Lender.9
Financial Distress, Third Amendment to the FLCA
In 2008, like many companies in its industry, Allied began to experience financial distress. With the first lien debt trading well below par, many lenders were trying to sell their holdings but lacked buyers. To help deleverage the Company and avoid triggering defaults under the credit agreements, the Sponsor sought to acquire some of the Company’s debt and to contribute a portion of such acquired debt to Allied’s equity. The FLCA and SLCA, however, precluded lenders from selling to the Sponsor, as it was not an Eligible Assignee. To permit the transactions, the Company and the majority of the FLCA lenders signed the Third Amendment to the FLCA (the “Third Amendment”) on April 28, 2008. The SLCA was similarly amended.
The Third Amendment lifted the restrictions on lenders selling term loans to the Sponsor by changing the definition of “Eligible Assignee,”10 but it limited the amount of first lien debt (up to the lesser of 25% of the total term loan exposure or $50 million) the Sponsor could acquire11 and required the Sponsor to contribute at least 50% of the aggregate principal amount of any term loans it acquired to Allied’s capital within ten days of purchase (the “Capital Contribution”), with those loans subsequently to be deemed cancelled.12 The Third Amendment also restricted the Sponsor’s voting rights as a lender by amending the definition of “Term Loan Exposure” to exclude the Sponsor’s debt,13 added covenants not to sue by the Sponsor or against the Sponsor (although with language that ultimately failed to capture the actions that ended up exposing the Sponsor to liability), and otherwise restricted remedies against the Sponsor.14
The Sponsor did not acquire any first lien debt immediately following the Third Amendment,15 but it did acquire $40 million of second lien debt, $20 million of which it converted into equity. The Sponsor asserted that this transaction enabled the Company to avoid a covenant default and a going-concern opinion from its auditors.16
Fourth Amendment to the FLCA
As the Company’s financial condition continued to deteriorate due to the global recession, Allied and the lenders entered into a series of forbearance agreements, but those agreements lapsed in late 2008 and were not renewed.17 With Allied in default, including missing interest payments beginning in 2009, the lenders were free to exercise remedies against Allied under the FLCA for over three years, but chose not to do so at that time.
By 2009, ComVest Investment Partners (“ComVest”) had acquired a sufficient amount of Allied’s first lien debt to become the “Requisite Lender” under the FLCA. The Sponsor, Allied, and several of the other lenders became concerned that ComVest intended to cause Allied to file a second bankruptcy. In March 2009, the Sponsor entered into negotiations with ComVest to purchase its holdings of Allied’s first lien debt.
To enable the Sponsor to acquire ComVest’s debt, in August 2009, Allied executed the Fourth Amendment to the FLCA (the “Fourth Amendment”) with a single lender, ComVest. The Fourth Amendment eliminated the Capital Contribution obligations and voting restrictions of the Third Amendment, the latter by changing the definition of “Term Loan Exposure” back to its original form, thereby eliminating the exclusion of the Sponsor’s debt in the calculation of Requisite Lender.18
The Sponsor and ComVest also entered into a Loan Purchase Agreement (the “LPA”), transferring ComVest’s debt to the Sponsor, which then declared itself to be the Requisite Lender under the FLCA.19 Although Allied was not a party to the LPA, the LPA also required Allied to agree to the Fourth Amendment and to pay for certain of ComVest’s and the Sponsor’s legal fees and related expenses.20 Crucially, as the Fourth Amendment purported to eliminate the Capital Contribution requirement, the Sponsor did not make a capital contribution following its acquisition of the ComVest debt.
Certain other first lien lenders – BDCM Opportunity Fund II, LP, Black Diamond CLO 2005-1 Ltd. (together, “Black Diamond”), and Spectrum Investment Partners, L.P. (“Spectrum,” and together with Black Diamond, “BD/S”) – took the position that the Fourth Amendment was invalid because it was enacted with majority lender support instead of unanimous lender support, as required by the FLCA for any amendment that had “the effect of” amending the definition of Requisite Lenders, and therefore the actions of the Sponsor taken in reliance upon the ineffective Fourth Amendment breached the Third Amendment. The agent also contested the validity of the Fourth Amendment, resulting in significant litigation that was ultimately settled in 2011 (that settlement included the agent, but not the lenders, which, as discussed below, subsequently sued).
Potential Acquiror Emerges
In 2011, another car hauling company, Jack Cooper Transportation (“JCT”), made offers to purchase Allied’s first lien debt from the Sponsor and BD/S, explaining that it planned to use that debt to acquire Allied’s assets in a section 363 sale in a second chapter 11 case. During the negotiations, the Sponsor demanded that because it was the Requisite Lender, JCT should pay it a 15% premium on its first lien debt as compared to other lenders. No transaction with JCT was consummated at that time, and the Sponsor did not bring JCT’s offer to the board’s attention.21
Litigation and Second Chapter 11 Filing
In 2012, BD/S filed a lawsuit against the Sponsor in state court seeking a declaration that the Fourth Amendment was invalid because it was not enacted with the unanimous support of the lenders and, therefore, the Sponsor was not the Requisite Lender. The state court found in favor of BD/S in March 2013 (the “NY State Court Decision”). The court held that because the Fourth Amendment “affected” every lender and had “the effect of” amending the definition of Requisite Lenders, the FLCA required unanimous lender consent for it to be effective, while the Fourth Amendment was executed with only majority lender consent. Specifically, the Fourth Amendment changed the definition of “Term Loan Exposure” to delete the language that excluded the Sponsor’s debt from its calculation; Term Loan Exposure, in turn, was used in the definition of Requisite Lenders.22 The appellate court later affirmed the holding that the Fourth Amendment was ineffective because it required the consent of all lenders.23
In the meantime, in May 2012, BD/S filed an involuntary chapter 11 petition against Allied, which subsequently consented to the bankruptcy.24 Allied filed an adversary proceeding seeking clarification as to the validity of the Third Amendment and the identity of the Requisite Lender(s) under the FLCA. In August 2013, the Court granted summary judgment to BD/S, holding that (i) the Third Amendment was valid; (ii) the Sponsor was collaterally estopped from asserting the Fourth Amendment’s validity due to the NY State Court Decision; and (iii) BD/S were the Requisite Lenders under the FLCA; the Third Circuit later upheld the decision on appeal.25
Interestingly, in a blow to the Sponsor, these courts rejected the Sponsor’s argument that the same logic that resulted in the NY State Court Decision invalidating the Fourth Amendment should also result in the invalidation of the Third Amendment (which required the Capital Contribution), because it too changed the definition of Term Loan Exposure (by explicitly excluding any debt held by the Sponsor), which had “the effect of” changing the definition of Requisite Lender, yet failed to receive unanimous lender consent.26 The courts rejected these arguments for several reasons, including that the Third Amendment “affected no Lender,” only the Sponsor, because the exclusion of the Sponsor was consistent with the original FLCA. In contrast, the effect of the Fourth Amendment was that, for the first time, the Sponsor could be included as a Requisite Lender.27
Later that year, JCT, the same company that had made the 2011 offer to purchase the first lien debt, purchased substantially all of the Company’s assets in a section 363 sale, albeit at a lower price than the offer it made two years earlier.
The Court confirmed Allied’s chapter 11 plan in 2015, the plan became effective in 2016, and a litigation trustee (the “Trustee”) was appointed to pursue claims against the Sponsor.28 BD/S intervened in the lawsuit.
Legal Analysis (Breach of Contract Claim)
Among the issues on which the Trustee and BD/S sought summary judgment was the Sponsor’s purported breach of the FLCA for its alleged failure to make a Capital Contribution following its 2009 purchase of the ComVest debt. Specifically, under the Third Amendment, the Sponsor was required to make a Capital Contribution to Allied, within 10 days of its purchase of any first lien term loans, of 50% of the face amount of the first lien term loans it acquired. The plaintiffs asserted that the Sponsor’s failure to make the Capital Contribution (approximately $57.4 million) by August 31, 2009 resulted in a breach of the FLCA and the Third Amendment (as the Fourth Amendment, which had purported to delete the Capital Contribution provision, was declared invalid).29
Under New York law, the elements of a breach of contract consist of (i) the existence of a contract, (ii) plaintiff’s performance under that contract, (iii) defendant’s breach thereof, and (iv) resulting damages.
In this case, the first three elements of the breach of contract claim were uncontested (as the Sponsor did not make the Capital Contribution that was required under the governing Third Amendment), leaving open only the question of whether the Trustee could successfully establish damages.30 The Court also considered the Sponsor’s defenses based on the statute of limitations and the covenant not to sue.
Under New York law, mathematical precision is unnecessary to determine damages. To prove damages, a plaintiff is required to show only “a stable foundation for a reasonable estimate of the damage incurred as a result of the breach,” with the burden of proving any uncertainty as to the amount of damages falling upon the wrongdoer.31 The Sponsor argued that damages could not be determined.
Relying on expert testimony, the Sponsor stated that it was “totally speculative to presume that a capital contribution of debt in 2009 would have created any value for Allied” as “Allied was about to not pay interest” and “forgiveness of the debt would have transferred value from debt holders to equity, or…from one lender to another, not to Allied.”32 Further, without the Sponsor’s purchase of the debt, Allied would likely have filed for bankruptcy sooner and been liquidated at a “fire sale price.”33 Therefore, because Allied failed to prove that it had suffered any damages or, at a minimum, because the Sponsor had demonstrated that the issue of damages was disputed, there existed material issues of fact which should block the Trustee’s motion for summary judgment on the issue.
The Court rejected these arguments as speculative. Although the Court recognized that a second bankruptcy might have been inevitable, “[the Sponsor’s] failure to make the Capital Contribution ensured such a result.”34 The Court held that “the reasonable foundation for the amount of damages is the full value of the Capital Contribution that the Sponsor failed to pay.”35
Another key issue in the damages dispute was the Sponsor’s argument that it never agreed to make a cash contribution of $57.4 million; rather, the contemplated contribution was of debt that was trading well below par. The Sponsor pointed out that the Third Amendment’s recitals and other applicable sections referenced a contribution of term loans, not cash.36 The Sponsor asserted that it would be “absurd” to assess damages based on a cash payment in the face amount of the debt, as the debt was trading at a “material discount” to par at the time and such an assessment would result in the Sponsor having paid ComVest $43 million for the debt and then having to pay 133% more than that to Allied in respect of the Capital Contribution.37 Given the trading prices of the term loan debt at that time, it would, therefore, be “illogical” for the Third Amendment to have required a cash contribution.38 As a result, the Sponsor stated that it should not be held liable for the full amount of a cash contribution that the Third Amendment did not mandate.
Judge Sontchi was not persuaded by the Sponsor’s arguments. “Reading the entire FLCA and the Third Amendment together, the specific provisions as to the form of the Capital Contribution outweigh the general provisions of the recital.”39 The Court found that “[the Sponsor] was obligated (shall – mandatory) to make a Capital Contribution and could (may – permissively) make that Capital Contribution in…an exchange for equity interests.”40 While the Capital Contribution could have theoretically taken the form of either debt or cash, in reality, “Allied received neither.”41
Because it was impossible for the Sponsor to satisfy its Capital Contribution obligation through a contribution of debt at that point in the bankruptcy case, the Sponsor’s “original option of cash or contribution of [loans] is now precluded” and the Sponsor was required to satisfy its Capital Contribution obligation by paying cash at the face amount of the debt.
Moreover, the Sponsor was obligated to pay prejudgment interest on the cash amount, accruing at the statutory rate of 9% from the date of the breach, as required by New York law for a contractual breach of performance.42 This prejudgment interest obligation was not insignificant, amounting to over $60 million, given that the breach occurred in 2009.
Covenant Not to Sue
The Sponsor also argued that the Trustee’s breach of contract claim was barred by the covenant not to sue in the Third Amendment. According to the Sponsor, the Third Amendment set forth specific instructions that enabled the other lenders and the agent to exercise certain remedies relating to a breach of the Capital Contribution provision, but notably omitted Allied from the list of parties able to exercise remedies for such breach. Thus, the Trust, as successor to Allied, was precluded from recovering on account of the breach.43
Looking at the issue through the lens of covenants not to sue being permitted under New York law, but “disfavor[ed]” and “subject to the closest of judicial scrutiny,” the Court rejected the Sponsor’s defense based on the covenant not to sue.44 The Court found that the Third Amendment did not limit Allied’s “remedies at law,” as it would be “incongruous” for the Third Amendment to both “grant Allied’s right to the Capital Contribution and, simultaneously, bar Allied from enforcing that right.”45
The Court also held that the covenant not to sue was inapplicable, as it related to “any capital contribution of Term Loans made by [the Sponsor] to [Allied]” and the Sponsor did not actually “make” any “contribution of Term Loans.”46 The Sponsor argued that the covenant not to sue waived claims related to any omission in connection with the Capital Contribution and the only possible omission would be the failure to pay the Capital Contribution in its entirety. However, the Court found numerous other possibilities of omissions that could occur, such as the proper paperwork being omitted, and rejected this defense as unpersuasive.47
This result may have felt especially unfair to the Sponsor because, as the Sponsor pointed out in its summary judgment brief, earlier in the proceedings, the Court dismissed the Sponsor’s cross-claims and counterclaims against BD/S on the basis that they were barred by the FLCA’s covenant not to sue.48
Statute of Limitations
The Sponsor also argued that the breach of contract claim was barred by Delaware’s three-year statute of limitations as the payment should allegedly have been made in August 2009, but the complaint was not filed until November 2014, over five years later.49 In response, the Trustee asserted that the statute of limitations did not accrue until full damages resulting from the breach were ascertainable because of the “continuous contract” and “continuous breach” doctrines.50 Determining whether these doctrines applied required analyzing “whether the obligations under a contract are continuous or severable,” which “turns on the parties’ intent” and can be “ascertained through the contract’s terms and subject matter, ‘taken together with the pertinent facts and circumstances’ surrounding its formation.”51
The Trustee pointed to a number of different obligations as evidence that the FLCA was a continuing contract, including the lenders’ entitlement to recurring principal and interest payments, access to financial information, and the Capital Contribution. The Trustee argued that the initial purchase of ComVest’s debt and the declaration that the Sponsor was the Requisite Lender was simply the initial triggering breach, which then caused the Sponsor to breach the FLCA continuously, including by (i) causing the Company to cease making principal or interest payments from that point forward; (ii) blocking lenders from receiving any of Allied’s financial information and access to its management; (iii) preventing restructuring discussions among lenders; (iv) preventing the lenders from exercising remedies for the numerous ongoing events of default; (v) asserting certain claims against the agent and other lenders in violation of the covenant not to sue; and (vi) demanding that JCT pay the Sponsor, and no other first lien lender, a $1.15 premium for each dollar of first lien debt.52 As further reinforcement for this point, the Trustee cited an internal 2011 Sponsor email from one of its partners (who was also the chairman of the Allied board) that withholding the financials would “simply [be] another breach (one of many) under the credit agreement.”53
The Sponsor countered that the above points were merely the “effect” of the initial breach and did not change the fact that the statute of limitations began to accrue at the time of the initial breach in August 2009.
Judge Sontchi sided with the Trustee. In reviewing the case law, the Court observed that the statute of limitations in other cases had been “appropriately suspended for the period during which [plaintiff’s] liabilities grew” and that it would be inefficient to require a plaintiff “to sue continually” at each and every breach to enforce its rights.54 As a result, the Court agreed with the Trustee that “the parties had a continuous contract that [the Sponsor] continuously breached.”55 According to the Court, this meant that “it would have been impossible to determine the extent of the breach until such time as the JCT sale, which determined the bulk of the damages.” Therefore, the Court denied the Sponsor’s motion for summary judgment based on the statute of limitations.56
Implied Covenant of Good Faith and Fair Dealing
The Trustee’s complaint also alleged that the Sponsor had breached the implied covenant of good faith and fair dealing under New York law. This doctrine provides that a party to an agreement may be liable for breach of that agreement by taking an action that, while not prohibited by the express terms of the agreement, is contrary to the parties’ mutual expectations.
With respect to the breach of contract claim, there are several key lessons for private equity sponsors of distressed companies.
First, to avoid facing major liabilities down the road, sponsors should work closely with counsel to ensure a thorough analysis is performed at the outset when considering the level of consent required to amend documents. Words in legal documents matter, and even the best intentions to help a troubled portfolio company can backfire if the proper procedures are not followed and appropriate lender or other approval is not obtained. In this case, the Sponsor’s liability for breach of contract resulted primarily from its erroneous reliance on the validity of the Fourth Amendment, which itself stemmed from its initial misreading of the amendment provisions in the Credit Agreement. If any contractual issue is subject to multiple interpretations, the sponsor should keep in mind the risks of a court later adopting an interpretation contrary to the one the sponsor adopted in taking or not taking action.
Second, sponsors should tread carefully when constructing rescue packages for their portfolio companies. While there is an inherent appeal in saving endangered investments in a distressed portfolio company through protective investment conditions, those overly protective provisions can sometimes be used as evidence of a sponsor utilizing its position to the detriment of the lenders or the company. Sometimes the sponsor is the only source (or cheapest form) of financing for a distressed company and an infusion of cash or reduction in debt at the right time could result in saving the company and increasing the sponsor’s overall investment value. But others will be looking at the actions of the sponsor in structuring that rescue package and, if things don’t go well, the sponsor may have created additional liability for itself rather than just lost the additional capital it invested in an effort to save its initial investment.
Third, even though a sponsor generally owns substantially all or all of the equity in its portfolio companies, the sponsor remains at risk of being held liable for breach of contract if it fails to honor its obligations under an agreement with a company, especially if the company ends up in chapter 11. In chapter 11, the debtor has a duty to maximize value for the benefit of all stakeholders, and if the “debtor in possession” (the board of which is controlled by the sponsor) does not investigate and pursue potentially viable claims against the sponsor, others can, and usually will, do so on behalf of the company, including the unsecured creditors committee and/or a litigation trustee appointed under a plan.
Fourth, litigation is inherently unpredictable, so it is important to minimize the risk of liability in considering whether litigation or settling is the proper course of action. Although a sponsor may have certain facts on its side, a court may find that a sponsor acted too aggressively, spurring the court to come down hard against the sponsor even if such behavior may not appear unlawful on its face or on its own.
Fifth, to the extent the sponsor believes it is mitigating the risk of liability to a portfolio company (or really any contractual counterparty) through a covenant not to sue, it must ensure the language is as clear and broad as possible. In addition, where liability may have arisen prior to a transaction, sponsors can attempt to obtain releases as part of consensual transactions. Short of that, it also may be possible to contractually limit damages for any breach through a liquidated damages provision and waiver of consequential, special, and punitive damages.
Sixth, and similarly, clear language should be used to describe all of the sponsor’s obligations (for example, its ability to satisfy capital contributions through debt contributions).
Seventh, under the theory of “continuous breach,” sponsors could face liability for breaches that initially occurred many years earlier. The statute of limitations for a potential breach may not begin to accrue when the breach first occurs, but the breach could be held to be continuous until damages are ascertainable.
Eighth, a great lesson for everyone in all contexts is to be mindful of what you write in emails, particularly non-privileged emails, as these could come back to haunt you in future litigation.
While a sponsor cannot anticipate all potential future events in the lifespan of its portfolio companies, this decision highlights some of the risks a sponsor faces if one of its portfolio companies files for bankruptcy and also provides guidance on how to minimize the risk of liability arising from its dealings with a distressed portfolio company.
The authors would like to thank Glenn West (retired Weil private equity partner), Andrew Yoon (Weil banking partner), and Robert Berezin (Weil litigation partner) for their valuable assistance in reviewing this article.