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. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.