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Since the 1980s, financially distressed companies have utilized so-called prepackaged plans to restructure their balance sheets. Debtors facing bankruptcy have gone to their major creditors and persuaded them to sign “lock-up” agreements supporting a particular plan of reorganization before the debtors filed under Chapter 11. In theory and in practice, lock-up agreements have reduced the uncertainty of bankruptcy for debtors and creditors alike. Now, two recent cases in the U.S. Bankruptcy Court in Delaware have added procedural complexities to that process. In Mpower Holding Corp., No. 02-11046-PJW, and NII Holdings Inc., No. 02-11505-MFW, bondholders who had executed lock-up agreements with financially distressed companies found themselves in rather unexpected positions — not on the creditors’ committee and, with respect to certain bondholders, with disqualified votes on the final reorganization plan. In short, the benefits of the lock-up agreements were undermined. OFF THE COMMITTEE In the last quarter of 2001, Mpower began discussions with an ad hoc committee of holders of its senior notes, as well as with holders of its preferred stock, with respect to the financial restructuring of the company. An agreement was reached with respect to the terms of the restructuring, and Mpower filed for bankruptcy under Chapter 11. Shortly thereafter, the U.S. trustee chose not to appoint an official committee of unsecured creditors. Apparently, a key consideration for the U.S. trustee was its judgment that the bondholders that were parties to the lock-up agreement would not be able to appropriately discharge their fiduciary duties as members of a creditors’ committee. Nonetheless, the ad hoc committee of bondholders actively participated in the case. The Chapter 11 plan proposed by Mpower provided for the payment of the ad hoc committee’s attorney fees. The U.S. trustee objected to this provision, contending that the plan usurped the provisions of Section 503(b) of the U.S. Bankruptcy Code, which requires an administrative expense claimant to demonstrate that it has made a “substantial contribution” in the Chapter 11 case in order to be reimbursed for its attorney fees from the bankruptcy estate. Chief Judge Peter Walsh confirmed the reorganization plan on July 17, 2002. However, the court reserved the issue as to whether the ad hoc committee’s fees and expenses could be paid pursuant to the plan or whether Section 503(b) applied. Counsel for the ad hoc committee filed an application for attorney fees, and a hearing was held on Sept. 25. The ad hoc committee argued that the terms of the proposed restructuring plan were assumed under the terms of the final restructuring plan and, as a result, the contractual obligation to pay the fees was binding upon the restructured company. While the court did not agree, it did find on Nov. 18 that counsel had made a substantial contribution as required by Section 503(b) and approved the fee application over the objections of the U.S. trustee. Thus counsel for the Mpower ad hoc committee ultimately received compensation from the bankruptcy estate. Yet the U.S. trustee’s position remains a matter of concern. Will the U.S. trustee in future cases choose not to form an official creditors’ committee because of concerns over the role of an ad hoc committee? Will counsel to future ad hoc committees not receive compensation unless counsel can demonstrate “substantial contribution”? If the answer to these two questions is yes, the dynamics of representing ad hoc committees in a prebankruptcy situation have certainly changed. VOICES AT THE TABLE NII Holdings involved similar issues in the context of ad hoc committees. In NII Holdings, the U.S. trustee declined to appoint to the official creditors’ committee any of the bondholders who were parties to lock-up agreements reached before the bankruptcy petition was filed. (Some of those agreements were actually executed post-petition, the consequences of which are discussed below.) Rather, the U.S. trustee appointed the financial institution acting as indenture trustee for certain issues of the bond debt, a trade creditor, and the holder of a disputed claim. The ad hoc committee of bondholders filed an emergency motion to reconstitute the committee or to require the U.S. trustee to appoint a new committee, arguing that the interests of the overwhelming majority of bondholders were not being adequately represented. The indenture trustee and NII Holdings both actively supported the ad hoc committee. The U.S. trustee actively opposed it. The U.S. trustee contended that the existence of the lock-up agreements placed the bondholders who were parties to them in a conflicted situation that would preclude them from exercising their fiduciary duties as members of the official committee. The U.S. trustee also argued that the so-called “fiduciary out” that is typical in most lock-up agreements — allowing the debtor’s bondholders to consider other restructuring proposals — did not cure the conflict as the bondholders were committed to the plan and could not independently judge alternative proposals. The argument before the Bankruptcy Court focused on the standard of review for the U.S. trustee’s decision to appoint creditors to an official committee, and whether the appointed committee adequately represented the creditors in the case. Counsel for the ad hoc committee did not argue that the composition of the official committee must reflect, on a pro rata basis, the outstanding indebtedness. However, counsel argued that the committee must adequately represent creditor constituencies. The court denied the ad hoc committee’s request. While the court expressed some concern related to the ability of the bondholders to fully test the debtor’s reorganization proposal, the court’s decision rested largely on the determination that the U.S. trustee’s decision was neither arbitrary nor capricious. NII Holdings took another interesting twist with respect to the locked-up bondholders. Certain bondholders actually signed lock-up agreements after NII Holdings’ petition date. The U.S. trustee filed a motion to disqualify the votes of those bondholders on the reorganization plan, arguing that the votes must be disqualified under Section 1126(e) of the Bankruptcy Code because they were the result of an improper post-petition solicitation process. The U.S. trustee contended that the votes had been solicited after the commencement of the case but prior to the approval of the disclosure statement. The ad hoc committee of bondholders responded that the numerous contingencies contained within the lock-up agreements precluded a finding that the company had undertaken to improperly solicit acceptances of the reorganization plan (which at the time of the execution of the later lock-up agreements had not yet been filed with the court). At an Oct. 22, 2002, hearing, Judge Mary Walrath approved the motion of the U.S. trustee and disqualified the votes of the bondholders who had executed lock-up agreements following the petition date. Nonetheless, the reorganization plan was overwhelmingly accepted by the creditors and was confirmed on Oct. 28. AFTERSHOCKS The U.S. trustee’s positions in Mpower Holding and NII Holdings (as adopted by the Bankruptcy Court in Delaware) will likely cause some changes in the way prepackaged plans proceed. On a very practical level, counsel may require larger retainers so as to provide some assurance of payment through the Chapter 11 case. In addition, the usual gamesmanship at the organizational meeting of the official creditors’ committee may be altered. Counsel for the ad hoc committee may hold certain bondholders back from executing lock-up agreements until the organizational meeting has been held so as to ensure that enough bondholders get on the official committee to assure that counsel for the ad hoc committee is selected as counsel for the official committee. As far as voting is concerned, the court’s rather bright-line ruling in NII Holdings may militate in favor of delaying the filing of the bankruptcy case until the lock-up agreements have actually been executed. (Of course, delaying the filing of a case until the lock-up agreements have been executed may contradict the gamesmanship with respect to appointment to the creditors’ committee.) The court’s ruling does create certain impediments for ongoing negotiations with additional creditors after the bankruptcy petition is filed. This problem may be mitigated by using the language approved by the U.S. Bankruptcy Court for the Southern District of New York in the Texaco case in the early 1980s. In that case, the postpetition lock-up agreement merely required Pennzoil, a significant creditor, not to support or vote for any other plan or proposal (a negative covenant) as opposed to requiring a vote in favor of the Texaco plan (an affirmative covenant). In any event, bankruptcy practitioners should pay some serious attention to these recent Delaware cases. They highlight the importance of executing lock-up agreements in ways that do not impede ad hoc committee members from serving on an official creditors’ committee. Dennis J. Connolly is a partner in the Atlanta office of Alston & Bird. His practice concentrates on commercial litigation and bankruptcy. Connolly can be reached at [email protected].

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