United States: Distressed Unitranche Debt After RadioShack: While Instructive, No Cause For Comfort

Nutter McClennen & Fish Attorneys Philip Rosenblatt and John Loughnane examine developments in the RadioShack bankruptcy case concerning agreements among lenders that form the basis of unitranche transactions. While the RadioShack case is interesting and instructive, they argue that it should not provide any false sense of comfort to lenders.

Experienced unitranche lenders and distressed debt investors understand that the unitranche structure, for all its benefits, suffers from a significant uncertainty in the event of a borrower bankruptcy. Specifically, there is no guarantee that a bankruptcy court will be empowered to adjudicate issues arising under the agreement among lenders (AAL) that forms the basis for a unitranche transaction. Recent developments in the RadioShack bankruptcy case concerning litigation over two AALs provide an interesting opportunity to further consider this issue.

As discussed later in this article, although the RadioShack proceedings did involve interpretations of the AALs at issue, the case does not stand for the proposition that all bankruptcy courts are empowered to address all AAL issues in other cases. Indeed, because the parties in the RadioShack case consensually appeared before the court, the case did not present the fundamental constitutional issue that forms the basis of the significant uncertainty confronting lenders and distressed debt investors on this issue. Thus, although helpful to understand the RadioShack proceedings, the jury is still very much out on the basic question of whether bankruptcy courts are empowered to adjudicate AAL issues without the consent of the parties.

In its January/February 2015 issue, the ABF Journal published our article, "Structuring Unitranche Transactions: A Prudent Approach to Drafting Agreements." In that piece, we discussed certain advantages and challenges perceived by borrowers and lenders in unitranche structures, which combine elements of senior and junior financings into a single loan agreement.

An essential component of any unitranche financing is the AAL, which is intended to operate similarly to an intercreditor agreement. We emphasized the critical importance of drafting such agreements precisely in order to facilitate proper judicial review and interpretation, provided recent examples of courts struggling with imprecise contractual language outside the unitranche area, and noted the economic frustration that parties can experience when courts are tasked with ruling on imprecise language.

Because the borrower is not typically a party to the AAL, we noted the uncertainty of whether a bankruptcy court would have the power or desire to determine any controversies arising under an AAL. A bankruptcy court's refusal or inability to rule on intercreditor issues under an AAL could force judicial interpretation of the AAL to another court.

Bankruptcy cases are time-sensitive matters that necessarily proceed quickly through critical issues such as post-petition financing and sales efforts. Practically, the bankruptcy court is the most efficient and well-informed forum to determine AAL issues. However, as discussed later in this article, practicality and efficiency are not the relevant standards due to nagging constitutional issues that have nipped at the ankles (and higher) of the U.S. bankruptcy court system for years. The nagging presence of this judicial review issue is further reason to ensure a lender's rights are protected in a unitranche deal by very clearly drafting — there may be a non-bankruptcy judge reviewing and interpreting the AAL who has limited experience with the inner workings of unitranche financing. Distressed debt investors who are considering acquiring a unitranche position also need to be mindful of these issues.

Unitranche Issues in RadioShack

On February 5, 2015, RadioShack commenced Chapter 11 after a long and public period of attempted turnaround efforts, refinancing and restructurings. Set forth below is a short description of the company's debt structure and a summary of the AAL-based objections to the company's bankruptcy sales process.

When the company finally filed, its primary liabilities consisted of debt owed pursuant to two different unitranche financing transactions. First, RadioShack was party to a $585 million 2013 asset-based credit facility secured by a first priority lien on current assets, and a second priority lien on certain non-current assets (2013 credit agreement). At the time of filing, the obligations under this facility were owed to a variety of funds referred to as the "first out ABL lenders" as well as to Standard General acting as last out lender under the 2013 credit agreement.

Secondly, in addition to obligations owed under the 2013 credit agreement, RadioShack was party to a $250 million term loan with a different set of lenders secured on a second priority basis by current assets and by a first priority lien on certain non-current assets. The lenders under this facility consisted of certain funds managed by Cerberus Capital Management as first out lender and Salus Capital Partners as last out lender (2013 term loan).

As of the petition date, approximately $215 million was outstanding under the 2013 credit agreement and approximately $250 million in aggregate principal amount was outstanding under the 2013 term loan. Other indebtedness included certain senior unsecured notes and unsecured trade and other debt arising from operations.

The agents under the 2013 credit agreement and 2013 term loan were parties to an intercreditor agreement, dated December 10, 2013. In addition, because the 2013 credit agreement and the 2013 term loan were structured as unitranche facilities, each facility was documented by its own AAL.

AAL-Related Issues Resolved

In some respects the RadioShack Chapter 11 presented very typical issues of a distressed retailer needing court protection. In other respects, the size of the company's operations — 21,000 employees, 4,400 company-owned stores in the U.S., Mexico and Asia and another 1,100 dealer/franchise stores throughout the world — presented unique challenges to salvaging value in a rapidly changing environment. Upon filing the case, the company sought approval of an asset sale process pursuant to which Standard General would act as stalking horse and be permitted to credit bid its portion of the secured debt owed by the company under the 2013 credit agreement.

The sale motion led to various objections and a four-day hearing. Two AAL-based objections were considered. First, the first out ABL lenders under the 2013 credit agreement objected by claiming that under their applicable AAL, Standard General as last out lender under that facility was precluded from submitting a credit bid if any obligations to the first out ABL lenders remained outstanding. The first out ABL lenders sought full payment for contingent indemnification claims and certain expenses as a condition to a credit bid by Standard General, its counterparty under the 2013 credit agreement AAL.

Secondly, although Cerberus, the first out lender under the 2013 term loan, submitted a statement supporting the sale, Salus, its AAL counterpart under the 2013 term loan, did not. Indeed, Salus voiced its objection to the court. In its short statement in support, Cerberus pointed to section 14(c) of the applicable AAL, which provided that if Cerberus supported a sale, Salus "shall not object to or oppose any such sale."

Although the court did not issue a written decision on its ruling, publicly available transcripts reveal that during the hearings the court clearly considered the AAL issues in evaluating whether to approve the sale.

With respect to the first out ABL lenders' objection under the 2013 credit agreement, the court commented that under the facts and circumstances of the case it would be unreasonable to withhold all sale proceeds to secure such contingent claims even though the claims formed a valid part of the claims of the first out ABL lenders under the applicable AAL. Further, the court commented that the interest of the first out ABL lenders in securing protection for indemnification claims could be arranged through the implementation of a reserve account.

Eventually, as is often the case in bankruptcy, the parties reached a compromise and agreed to withhold a fraction of the total sale proceeds as a reserve to satisfy potential indemnification claims, thus resolving the objection of the first out ABL lenders.

With respect to Salus' objections, the court allowed Salus to raise objections to the sale that could be raised by unsecured creditors, but ruled that the AAL supporting the 2013 term loan restricted Salus from pressing objections that could only be raised by a secured party. Having ruled that the court would allow Salus to object as an unsecured creditor, the court considered objections questioning the fairness of the sale process, the amount of the Standard General bid and other issues. After considering those objections, the court overruled each of them.

The Uncertainty Continues

Although it is interesting and useful to understand the treatment of unitranche issues in the RadioShack case, prudent lenders and distressed debt participants should not view the case too broadly. If there is any general takeaway from the case for unitranche participants it is this: parties that consent to bankruptcy court determinations and participate in the Chapter 11 process can expect that a bankruptcy judge will render decisions and offer observations that can be critical to resolution of issues — either judicially imposed or consensually created. Nothing newsworthy there — that is what bankruptcy judges do in every case.

The RadioShack proceedings do not serve as any indication at all on the important question of whether bankruptcy courts have the power in all cases to enforce AAL agreements whenever presented before a bankruptcy court. Indeed, if a party to an AAL decides to contest the bankruptcy court's ability to judicially determine AAL issues, then the bankruptcy court may find itself powerless to hear the dispute due to limitations imposed on the bankruptcy courts under federal law.

Carefully Scrutinized Constitutional Constraints

The history of bankruptcy in the U.S. — dating back to an express grant in the U.S. Constitution for Congress to pass uniform laws on the subject — is fascinating but there is neither room nor need to attempt to recount it in this article. Much of that history has struggled with the constitutional role of bankruptcy courts within the federal judicial system. A short summary of the issue at a high level is necessary to understand the challenges that AALs may continue to face in bankruptcy court even after the RadioShack proceedings.

In a nutshell, for much of the 20th century, bankruptcy matters were administered by referees appointed by U.S. district court judges. Congress did not create the position of bankruptcy judge until 1978, which followed rules issued by the U.S. Supreme Court recognizing the increasing judicial responsibilities of the referees. Pursuant to the Bankruptcy Reform Act of 1978, Congress established bankruptcy courts in each judicial district. The legislation called for bankruptcy judges to be appointed under Article I of the U.S. Constitution by the president and confirmed by the Senate for terms of fourteen years.

Unfortunately, Congress' effort to modernize the bankruptcy system ran headlong into a constitutional challenge. In 1982, in Northern Pipeline Construction Co. v. Marathon Pipe Line Co.,1 the Supreme Court held that Congress could not constitutionally assign bankruptcy jurisdiction to independent courts lacking the protection of a lifetime appointment enjoyed by federal judges under Article III of the U.S. Constitution.

Thereafter, Congress addressed this issue by making a bankruptcy judge's appointment subject to the supervision of the federal courts of appeals and preserving jurisdiction for the district courts of certain matters. Congress delineated certain matters as "core" for bankruptcy courts to determine and characterized other matters as "noncore" for which bankruptcy courts could not issue final determinations but rather could only propose findings of fact and conclusions of law to be presented to the district court for final adjudication.

In 2011, in Stern v. Marshall,2 the Supreme Court determined that Congress' designation of certain, but not all, matters to bankruptcy judges as "core" exceeded the limitations of Article III. In particular, the Supreme Court held that even though Congress had legislated that bankruptcy courts could finally determine counterclaims to a proof of claim, the U.S. Constitution prevented such an issue to be finally determined by an Article I bankruptcy judge. Thus, the Supreme Court held that the bankruptcy court lacked constitutional authority to make a final ruling. Stern has been followed by a series of other Supreme Court decisions involving bankruptcy court jurisdiction in recent years including Wellness International Network, Limited v. Sharif,3 decided in May of 2015. In Wellness, the court held that bankruptcy judges do have the authority to adjudicate so-called Stern type claims (claims designated as core by Congress but for which bankruptcy courts cannot make final decisions) when the parties to such disputes consent knowingly and voluntarily to final adjudication by the bankruptcy court.

This brief history of U.S. bankruptcy court jurisdiction is offered merely to provide a glimpse of the large-scale battle that has played out over many years concerning the role and scope of U.S. bankruptcy judges. The story may not be over. Indeed, it is entirely possible that a bankruptcy court might conclude that it lacks the power to determine and finally adjudicate issues existing between two lenders party to an AAL. More likely, at the behest of a party to an AAL, a bankruptcy court may be instructed by a higher court that it lacks such power.

As noted, no party to the RadioShack proceeding raised any concerns about the bankruptcy court's ability to determine the AAL issues. That is not surprising as the case involved a proverbial melting ice cube, and the parties may well have determined under the circumstances to use the bankruptcy process to salvage the highest return possible rather than venture into a constitutional thicket.

The problem with AALs in the context of a borrower bankruptcy is not whether the court will review and adjudicate issues under an AAL if the parties consent. Wellness removes any lingering concern on that. Rather, the issue is whether a party will find itself in a non-bankruptcy forum if another party does not consent to the Article I bankruptcy court making a final decision on an AAL dispute.

As we noted in our article last winter before RadioShack filed, there are a number of issues that a well-drafted AAL needs to cover. These include provisions relating to: respective standstill and voting rights; payment waterfalls from collateral proceeds; debtor-in-possession financing/post-petition financing matters, including post-petition interest and adequate protection; planned section 363 sale proposals and transactions; relief from the automatic stay and voting on proposed plans of reorganization and claim classification issues. Many aspects of the AALs governing the RadioShack unitranche debt were not evaluated in the RadioShack sale proceedings. Going forward, if a party refuses to consent to the jurisdiction of a bankruptcy court to consider the contractual terms between two creditors, the fight over such issues could move beyond the bankruptcy court to another forum. Although a bankruptcy court routinely interprets such issues in the context of intercreditor agreements — where the debtor is a party to the intercreditor agreement — that level of certainty does not exist with respect to AALs.

Conclusion

The RadioShack proceedings offer an interesting case study in the treatment of unitranche lenders under two agreements among lenders that existed in that case. While interesting and instructive, the case should not provide any false sense of comfort to lenders and distressed debt participants in the burgeoning world of middle-market financing using unitranche structures. Lenders participating in such transactions need to continue to ensure that, in the effort to simplify the process for the borrower, important rights are sorted out among lenders with clear language in the event of a default. The language of the agreements will be critical, and taking the time to build trust and agree on language that spells out rights, remedies and obligations during challenging times remains of the utmost importance. Distressed debt buyers considering acquiring unitranche debt will benefit from careful due diligence on the documents and parties for every transaction.

Originally published in the November/December 2015 issue of ABF Journal.

Footnotes

1. 458 U.S. 50

2. 564 U.S. 2 (2011)

3. 575 U.S ___ (2015)

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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