United States: Avoiding Illusory Recoveries: The Importance Of Black-Scholes Protections For Warrants Issued Under A Bankruptcy Plan

As many investors anticipated, the deep trough in the commodities market over recent years resulted in a number of companies in commodity industries restructuring their balance sheets through a Chapter 11 bankruptcy process. Because companies often reorganize in the midst of a market downturn, a commodity company's low EBITDA during this time usually results in low values being placed on the company's reorganized equity. Low equity values make it difficult to provide junior creditors with significant recoveries on account of their claims, and senior creditors, who frequently accept the reorganized equity on account of their claims, end up being awarded a substantial amount of the reorganized equity of the debtor. Absent a negotiated resolution, junior creditors run the risk of receiving little to no recovery on account of their claims, only to have the commodity markets and the value of the reorganized equity recover post-bankruptcy. Under those circumstances, senior creditors receive a windfall at the junior creditors' expense.

Using Warrants to Bridge the Gap in Negotiations

When expected recoveries for junior creditors are low, a company and/or its senior lenders may — in an effort to garner consensus from creditor constituencies — offer junior creditors consideration in the form of a relatively small percentage of equity in the reorganized company and/or warrants to purchase up to a certain percentage of equity in the reorganized company at a specified strike price for a period of time post-emergence. Warrants are often used as a tool to bridge the gap in negotiations between a debtor (or senior creditors) and junior creditors, as they offer value to junior creditors in the form of option value if/when the market recovers during the term of the warrant (thereby allowing the junior creditors to participate in the upside), in exchange for consensus and the resolution of valuation or other litigation.

When warrants are issued as consideration in a reorganization plan, they are usually given a strike price that puts them "out of the money" when the company emerges from bankruptcy (based on an implied enterprise value of the company upon emergence). But because warrants are exercisable over a period of years (which can vary anywhere from three to 10 years or more), they have option value to creditors for the life of the warrant. The Black-Scholes model is the standard method used for valuing warrants. To determine value, the Black-Scholes model uses inputs that include (i) the stock price at the time of valuation, (ii) the strike price of the warrant, (iii) the remaining term of the warrant, (iv) the risk-free rate of return, and (v) the historical volatility of the common stock. A lower strike price and/or a longer term of the warrant will result in a higher value for those warrants. And assuming all other inputs remain constant, a higher volatility will yield a higher warrant value.

Black-Scholes Protections

Before agreeing to accept warrants as consideration for claims in a bankruptcy case, it is important to understand the risks associated with those warrants. One obvious risk is that markets may not recover, and warrants may never come "into the money" prior to their expiration. Another important — but less obvious — risk junior creditors must keep in mind is the potential for the reorganized company to enter into a transaction (e.g., a sale, squeeze-out merger or other change of control) that could negatively impact or even eliminate the value of warrants altogether. If, for example, a company has issued five-year warrants with a strike price of $1 billion, and in the second year post-bankruptcy it agrees to sell itself for consideration of less than $1 billion, the warrants could be determined to have only the value they would have if they were exercised immediately prior to the transaction. Because the transaction value is less than the strike price, the warrants could not be exercised, and therefore may be canceled for no consideration. There are ways to protect against this second risk.

One way to protect the value of the warrants is to negotiate for "Black-Scholes protections" in the event of a change-of-control transaction, whereby the reorganized company would be required to measure the value of the warrants as of the transaction date using the Black-Scholes model, and pay the warrant holders consideration at least equal to the value of those warrants as part of the transaction. 1 Failing to protect the value of the warrants in this manner may ultimately make the value of the warrants illusory, especially in an industry where there is anticipated consolidation.

These Black-Scholes protections are not unprecedented, but are not as common as one would expect. In a handful of recent bankruptcy cases, creditors have negotiated for Black-Scholes protections for warrants under certain circumstances. One example is, In re Sabine Oil & Gas Corporation, No. 15-11835 (SCC) (Bankr. S.D.N.Y. 2015), in which certain creditors who were being provided with two tranches of warrants under the Chapter 11 plan specifically negotiated for a "Black-Scholes cash out trigger" which provided for a valuation and cash out of the warrant holders upon certain triggering events, including the sale of all or substantially all of the company's assets or the sale of certain specified assets with an accompanying dividend. 2 Other companies have provided warrants with Black-Scholes protections under particular circumstances, including (i) a sale by the majority equity holder of over 85% of its equity interests, or a sale of 85% of the company's assets (see In re General Maritime Corporation, et al.); 3 or (ii) a change-of-control transaction with an affiliate (see n re LyondellBasell Industries N.V., et al.). 4

Arch Coal: Modified Black-Scholes Protections

The preservation of value provided by Black-Scholes protections and their potential impact on future transactions may create circumstances where the company and/or the senior creditors may be reluctant or unwilling to provide a warrant package with full Black-Scholes protections for the life of the warrant. The question then becomes: how do junior creditors protect the value of their warrants in a cash-out transaction?

One example of a negotiated resolution is embodied in the recent case of In re Arch Coal, Inc., et al., No. 16-40120 (Bankr. E.D. Mo. 2016). In January 2016, Arch Coal – a company engaged in the mining and preparation of metallurgical coal and thermal coal and the second largest holder of coal reserves in the United States – filed for bankruptcy protection in the Eastern District of Missouri. At the outset of Arch Coal's bankruptcy cases, the company and its secured lenders offered a package of consideration – consisting of 4% of the reorganized equity, and warrants to purchase up to 8% of the equity in the reorganized company – to over $3 billion of second lien and unsecured creditors. In addition, the warrants were afforded no protections in the event of a transaction below the strike price. On behalf of all unsecured creditors, the official committee rejected this proposal and proceeded to engage in negotiations with the company and an ad hoc group of its secured lenders for a package of consideration that provided sufficient value to unsecured creditors. 5

Ultimately, these negotiations culminated in a package of $30 million in cash (some of which would be allocated to non-funded-debt unsecured creditors), 6% of the equity in the reorganized company and 7-year warrants for up to 12% of the reorganized equity, with a strike price based on a $1.425 billion equity value. In July 2016 – at the time the deal was announced – the debtors estimated a going concern enterprise value of between $650 million and $950 million, and an estimated equity value of $324 million to $666 million. Unsecured funded-debt creditors viewed the warrants as valuable, and given the speculated consolidation of the coal industry in the coming years, wanted to preserve that value in the event of a near-term transaction when the warrants were still out of the money.

Through negotiations, unsecured creditors were able to negotiate a modified version of the Black-Scholes protection for 5 years of the warrants' 7-year term, capped the cash-out value of the warrants with a step-down over time. Specifically, the warrant package provided for Black-Scholes protection if any merger, recapitalization, business combination or other transaction that resulted in a change to the new common stock is consummated within the first 5 years post-emergence for consideration that is less than 90% reporting stock (i.e., more than 10% cash) for less than the strike price. In such a transaction, the warrant holders would receive a payment capped at the lesser of: (i) the Black-Scholes value (with a volatility input equal to the lesser of 50% and the 180-day historical volatility on Bloomberg), and (ii) $45 million for the first year, $40 million for the second year, $35 million for the third year, and $30 million for the fourth and fifth years post-emergence. 6

With this revised warrant package, over 97% of unsecured funded-debt creditors voted to accept the plan, which was confirmed by the Bankruptcy Court on September 13, 2016. Arch Coal emerged from bankruptcy as a public company on October 5, 2016. 7

The Takeaway

Allowing junior creditors to participate in any market recovery through the use of long-term, out-of-the-money warrants has the potential to provide significant value for those creditors, but is not without risk. To mitigate risk and preserve value for junior creditors, those creditors need to ensure that the warrant value is protected in the event of a squeeze-out merger or other similar transaction in which the minority shareholders are cashed out. In the event the company or its senior lenders resist traditional Black-Scholes protections, an alternative structure, like that used in Arch, presents a creative solution that can both foster consensus and maximize value for junior stakeholders.

Footnotes

1 The Black-Scholes protection is, in addition to other minority protections, negotiated as part of a warrant package.
2 See Memorandum Decision Confirming Debtors' Second Amended Joint Chapter 11 Plan of Reorganization (Aug. 18, 2016); see also In re Autoseis, Inc., No. 14-20130 (Bankr. S.D. Tex. Dec. 2, 2014) [Dkt. 870] (Black-Scholes value paid upon change of control); In re Solutia, Inc., No. 03-17949-SCC (Bankr. S.D.N.Y. Oct. 16, 2007) (Black-Scholes value paid upon sale, lease, transfer or other disposition of all or substantially all of company's property, assets or business). 
3 In re General Maritime Corporation, No. 11-15285(MG) (Bankr. S.D.N.Y. Apr. 16, 2012) [Dkt. No. 744].
4 In re LyondellBasell Industries, N.V., No. 09-10023 (CGM) (Bankr. S.D.N.Y. Apr. 5. 2010) [Dkt. No. 4142].
5 Kramer Levin served as counsel to the official committee of unsecured creditors in the Arch Coal bankruptcy cases.
6 The plan also provided an option for holders of funded-debt claims to elect to receive cash in lieu of warrants, which election would reduce the payments on a pro rata basis. 
7 Upon emergence, Arch's reorganized equity was trading at approximately $71 per share. With a per-share exercise price of $57, this put the new warrants issued under the plan in the money upon emergence. 

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