Corinne Ball ()
Overleveraged distressed companies with potentially sound business prospects may present opportunities for savvy well-financed purchasers that are willing to participate in the bankruptcy process. That participation is not limited to bidding at a bankruptcy sale under §363, but may also include purchasing debt to pursue what is sometimes called a “loan to own” strategy. Insiders have long been alert to the bankruptcy court’s authority to scrutinize their actions, intervene and potentially disallow their claims.1 Now competitors also need to be alert as well.
Recently, Charles Ergen, the founder, chairman of the board of directors and controlling shareholder of DISH Network and activist distressed investor in the LightSquared Chapter 11 case, was the focus of bankruptcy court scrutiny as his hotly contested attempt to take over LightSquared encountered and succumbed to the equitable power of the bankruptcy court. Despite amassing close to $1 billion in senior secured debt, a claim that ordinarily would place Ergen in control of a creditor class enjoying significant power in a Chapter 11 case, Ergen will not enjoy the rights associated with that position. Instead, Ergen faces the subordination or disallowance of his claim due to what the bankruptcy court determined was his inequitable conduct in purchasing LightSquared’s debt through an end-run around prohibitions in the credit agreement with the intent to manipulate the bankruptcy proceedings and the bankruptcy court.2
LightSquared (or the Company) is a telecommunications company, owned by Harbinger Capital Partners. The Company’s business was premised upon launching a nationwide wireless-phone network using airwaves previously reserved for satellite use, but stalled when the Federal Communications Commission rescinded a decision granting the Company the right to build its network on the grounds that it would interfere with GPS signals used by the military and law-enforcement agencies. The Company filed for Chapter 11 relief on May 14, 2013 after it failed to reach an agreement with its secured lenders to avoid a default under its $1.5 billion LightSquared LP credit agreement.
Shortly before the bankruptcy, Ergen, using an entity named SP Special Opportunities (SPSO), purchased $287 million of the Company’s $1.5 billion senior secured LP debt, including Carl Icahn’s $247 million position, igniting speculation in the press regarding the identity and intent of the SPSO purchaser. Following SPSO’s purchase, the Company, in accordance with the terms of the credit agreement, modified its list of disqualified or ineligible lenders to include DISH. Ten days later, the Company filed for Chapter 11.
After the Company’s bankruptcy filing, Ergen (through SPSO) continued to purchase LightSquared’s secured debt, with his final purchase on April 26, 2013 bringing his total ownership to approximately $884 million in face value. Two weeks later on May 15, 2013, Ergen submitted an unsolicited cash bid for the Company’s spectrum for $2.2 billion on behalf of a newly formed buyer that would be “owned by one or more of Charles Ergen, affiliated companies, and/or other third parties.”
Subsequently, the Company filed an adversary proceeding against Ergen, SPSO, DISH and related company EchoStar, alleging unlawful conduct by Ergen and the entities he controls in purchasing the Company’s debt in violation of the disqualified companies provision of the credit agreement and further alleging that Ergen et al. engaged in additional inequitable conduct during the course of the bankruptcy. The Company sought to disallow or subordinate Ergen’s secured claim pursuant to §510(c) of the Bankruptcy Code. The Company also sought confirmation of its proposed reorganization plan, pursuant to which Ergen’s secured claim would be subordinated below the repayment of all other lenders with a note to Ergen that would repay his nearly $1 billion debt over the course of seven years. Other holders of the same debt were to be paid in cash in full.
Bankruptcy Court’s Decision
In a somewhat unusual move, after extensive and contentious testimony at the trials, the bankruptcy court, at a hearing held on May 8, 2014, read its bench decisions on both the adversary proceeding and plan confirmation aloud on the record. The court stated that, because of the tremendous time and effort required to render written decisions, and given that the Company was projected to run out of cash by June 15, 2014, the court would render its decisions on the record from the bench so that the Company’s funds were not depleted in the meantime. The bankruptcy court held that based upon the inequitable conduct by Ergen and SPSO, Ergen’s secured claim should be equitably subordinated in part, in an amount to be later determined. However, the court also determined that Ergen’s claim would not be disallowed and ultimately denied confirmation of the Company’s plan of reorganization because its treatment of SPSO’s claims was not fair and equitable.
Pursuant to §510(c) of the Bankruptcy Code, the doctrine of equitable subordination may be employed by the bankruptcy court to rearrange the priorities of creditors’ interests and to place all or part of a wrongdoer’s claim in an inferior status to achieve a just result in a debtor’s reorganization.3 This provision codified a long-standing judicial doctrine. Consistent with precedent,4 the bankruptcy court identified the three prong test for equitable subordination. First, the claimant must have engaged in some type of inequitable conduct. Second, the conduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. Third, equitable subordination of a claim must not be inconsistent with the provisions of the Bankruptcy Code. Before applying this standard to SPSO, the bankruptcy court further observed that courts in the Southern District of New York also consider the following: (a) inequitable conduct directed against the debtor or its creditors may be sufficient to warrant subordination of a claim irrespective of whether it was related to the acquisition or assertion of that claim; (b) a claim or claims should be subordinated to the extent and only to the extent necessary to offset the harm that the debtor and its creditors suffered on account of the inequitable conduct; and (c) an objection on equitable grounds must contain some substantial factual basis to support its allegations of impropriety.5
Though not technically in violation of the explicit terms of the credit agreement, the court concluded that Ergen’s and SPSO’s covert, continued attempts to obtain the Company’s debt, and ultimately a blocking position in the Company’s capital structure, violated the spirit of the credit agreement and amounted to a breach of the implied covenant of good faith and fair dealing. Despite Ergen’s testimony at trial that he felt his purchase of the debt was a “great investment” and was simply purchased by him in his personal capacity, the court found his testimony to be utterly uncredible on this point and many others. Indeed, the court found that there was overwhelming evidence in the record that SPSO’s acquisition of the Company’s debt was carried out for the benefit of DISH, and in knowing violation of the spirit of the credit agreement.
The court stressed that many aspects of SPSO’s conduct, including making purchases anonymously, acquiring a blocking position and making an unsolicited cash bid for distressed assets, were perfectly lawful. However, SPSO’s purchase of the Company’s debt to preserve a strategic option for the benefit of DISH, when DISH was a disqualified company under the credit agreement, violated the spirit of the credit agreement’s restrictions on competitors owning LightSquared’s debt. The court found that this violation of the implied covenant of good faith and fair dealing was inequitable conduct sufficient to provide a grounds for equitable subordination. In addition, the court found that SPSO engaged in inequitable conduct by effectively sidelining millions of dollars of Company debt by purposefully delaying the closing of LightSquared debt trades while Ergen and DISH fine-tuned their bid strategy.
Once inequitable conduct had been found, the court next determined whether the claimant’s conduct caused injury to the debtor or to its creditors or resulted in an unfair advantage to the claimant. In the case of Ergen and SPSO, the court held that SPSO’s conduct in acquiring the Company’s debt and in controlling the conduct of the Chapter 11 case through purposeful delays in closing hundreds of millions of dollars in debt trades during a critical time frame in the case prevented the case from moving forward and ultimately undermined the ability of the Company, the constituents and the court to conduct the case. As such, the court found that SPSO’s claim would be equitably subordinated in an amount to be determined.
Ergen’s testimony was a key factor in the court’s equitable subordination determination. On multiple occasions throughout the court’s decision, the court emphasized what it viewed as wholly uncredible testimony from Ergen. For instance, with regard to Ergen’s initial decision to vote against the potential forbearance amendment that would have allowed the Company to potentially avoid filing altogether, the court stated that Ergen’s failure to testify truthfully was “significant” and “part of a troubling pattern of noncredible testimony.” Again, when describing Ergen’s testimony regarding SPSO’s failure to close certain debt trades, the court stated that “[n]one of this testimony was credible.” Finally, in summarizing Ergen’s testimony for purposes of the court’s factual findings, the court stated:
Mr. Ergen’s testimony leaves little doubt that he has a tremendous amount of knowledge and expertise with respect to the wireless telecommunications industry, displaying great command of detail with respect to spectrum issues and spectrum deployment strategy. And yet his testimony becomes remarkably less precise and straightforward when queried about his involvement in the events leading to the termination of [his unsolicited] bid, and his answers with respect to potential competition between DISH and LightSquared were facile and disingenuous.
Indeed, Ergen’s testimony may not have left much room for the court to think otherwise. At one point in Ergen’s testimony, he stated, “We don’t have a business policy of playing in the mud, but … if people get in the mud, we’re not opposed to being in the mud with them.” Ultimately, the court was not convinced by Ergen’s statements regarding his actions or motives throughout the case, and if nothing else, such incredible testimony added further support for the court’s equitable subordination determination.
Subsequent Outcome, Mediation
After equitably subordinating a portion of Ergen’s claim and denying confirmation of the Company’s plan of reorganization, the court gave the parties strict instructions for moving the case forward, stating “the time is long overdue for the parties to adjust their expectations, tone down their animosity and work constructively to maximize the value of LightSquared’s valuable spectrum assets.” The court gave the parties two weeks to negotiate a settlement, after which the court would require the parties to mediate before Judge Robert D. Drain. After failing to come to a global settlement plan, mediation before Drain was ordered by the court on May 28, 2014.6 The mediation remains ongoing.
The court in LightSquared stressed, on more than one occasion, that many aspects of SPSO’s conduct, while aggressive, are entirely acceptable and do not provide grounds for equitable subordination. Such acceptable actions include buying distressed debt, buying distressed debt anonymously, buying distressed debt anonymously at prices close to par, acquiring a blocking position in a class of debt and making an unsolicited bid for the assets of a debtor. Indeed, the court stressed that the Bankruptcy Code itself perhaps even contemplates self-interested and aggressive creditor behavior and stated that nothing in its decision should in any way alter such conduct in the distressed marketplace. Here the evidence and the court’s experience over more than two years of a contentious case established a pattern of interference and disruption, focused upon advantaging a competitor and disadvantaging the debtor, potentially depriving the debtor of other viable opportunities as the passage of time eroded its cash resources. Surely, LightSquared should cause strategic buyers or competitors to proceed carefully in pursuing a distress acquisition through a “loan to own” strategy. Yet, there should be little doubt that the testimony by Ergen, a major player, if not competitive force, in satellite telecommunications, tipped the scales towards equitable subordination. LightSquared is not unique in having contract terms in its credit agreements that restrict or prohibit certain investors or competitors from buying the borrower’s debt and becoming debt-holders under the credit agreement. LightSquared, however, may be among the first cases to rely upon such restrictive provisions to penalize a strategic competitor. While the extent of subordination has yet to be established, it is clear that in addition to the rights acquired by a distress investor through claim purchasing, how an investor with a major position looking to take over a debtor conducts itself may be a factor in the outcome of a case.
Corinne Ball is a partner at Jones Day.
1. As previously discussed in the Distress M/A articles, “Ninth Circuit Resolves Circuit Split to Allow Recharacterization” and “Gulf Fleet a Lexicon for Sponsors, Affiliate Transfers and Failed LBOs,” bankruptcy courts continue to rely on equitable principles such as recharacterization and equitable subordination in response to increased advocacy and potential manipulation by debt holders in recent bankruptcy cases.
2. Transcript of Hearing and Bench Decisions, In re LightSquared, No 12-12080-SCC (Bankr. S.D.N.Y. May 8, 2014).
3. Specifically, §510(c) states:
The court may—(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate.
11 U.S.C. §510(c).
4. See Benjamin v. Diamond (In re Mobile Steel), 563 F.2d 692, 700 (5th Cir. 1977) (setting out the Mobil Steel test for equitable subordination); see also In re 80 Nassau Assocs., 169 B.R. 832, 837 (Bankr. S.D.N.Y. 1994) (adopting the Mobil Steel test for equitable subordination).
5. See id.
6. Order, In re LightSquared, No 12-12080-SCC (Bankr S.D.N.Y. May 28, 2014).