This is the next post in Plan Proponent’s series on the confirmation-related recommendations in the ABI Commission Report (and, in particular, its Exiting the Case piece). Continuing with Part C.1 (“Creditor’s Rights to Reorganization Value and Redemption Option Value”) from our last post, this post will introduce “Redemption Option Value.”
The issue driving the Commission’s ultimate recommendations regarding “redemption option value” is the issue of how best to balance the rights of secured creditors, the rights of other stakeholders, and the debtor’s reorganization needs. Part C.1 is footnote-heavy, with citations to multiple written statements from those who weighed-in on this topic at various ABI Commission Field Hearings. In other words, it’s not an issue that the Commission took lightly.
At a high level, the Commission distinguishes between its recommendations regarding valuation for adequate protection purposes (foreclosure value) (see Section IV.B.1) and valuation for distribution purposes (reorganization value). Of course, that distinction is consistent with Section 506(a), discussed in our prior post.
By “reorganization value,” the Commission means the “total enterprise value of the firm, including value generated through the chapter 11 case.” Subject to (i) Sections 506(c) and 552(b) (which we will address when we cover Sections VI.C.3 and VI.C.4) and (ii) the Commission’s redemption option value recommendations, the Commission believes that senior creditors should receive the “reorganization value of its collateral” via a plan or a 363 sale.
Of course, that entitlement collides with various issues, as the Commission points out:
- The perception that Chapter 11 cases are being run for the benefit of senior secured creditors;
- The challenge of restructuring a debtor with little equity in its property;
- How timing issues impact value allocation among constituencies;
- How debtors who are overwhelmed by secured debt can be driven to quick 363 sales; and
- The administrative insolvency that often goes hand-in-hand with the above issues.
The Commission also observes that a debtor’s “fulcrum security” now tends to be “higher in the debtor’s capital structure than in the past.” The term “fulcrum security” refers to the priority level of the class of debt at which enterprise value is exhausted. Whereas, enterprise value tended in the past to become exhausted at the unsecured debt level, it now tends to be exhausted earlier in the process at the senior creditor or subordinated senior creditor level. Although the Commission explored the possible reasons for that trend, it chose to focus, instead, on how to improve value allocation in Chapter 11 cases.
Starting with the premise that the valuation cutoff date (i.e., plan effective date or 363 order date) should not, in a hard and fast fashion, leave junior creditors out of the money, the Commission recommends the following “overarching principle”:
“[T]he general priority scheme of chapter 11 should incorporate a mechanism to determine whether distributions to stakeholders should be adjusted due to the possibility of material changes in the value of the firm within a reasonable period of time after the plan effective date or section 363x sale order date, as the case may be, which would enable junior creditors to ‘redeem’ in full the allowed claim of the impaired senior creditors receiving the reorganization value of the company under such plan or sale.”
In other words, under the Commission’s redemption option value (“ROV”) recommendation, a plan could be confirmed as follows:
First, it could be confirmed over the non-acceptance of the immediately junior class if and only if that class receives, at a minimum, the ROV, if any, for that class.
Second, it could be confirmed over the non-acceptance of the senior creditor class, even if that class is not to be paid in full under the absolute priority rule, so long as the absolute priority rule deviation is for the purpose of making the ROV distribution.
If the junior class rejects the plan and challenges the reorganization value that determines the ROV, then the Court should still confirm the plan if (i) the Court makes an evidentiary finding that the debtor did not propose the reorganization value in bad faith and (ii), except for the ROV requirement, the plan satisfies Section 1129(b)’s requirements.
The Commission makes a similar recommendation for the approval of 363 sales (i.e., immediately junior classes get their applicable ROV from the reorganization value if and only if they do not object to the sale).
Essentially, the Commission’s ROV recommendation is a recommendation that distributions should be adjusted due to the possibility of changes in firm value during some reasonable period following confirmation or sale approval. And the “option value attributable to the immediately junior class should be the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price and a duration equal to the redemption period.” Whether it’s an actual option (most likely not) or something else, the ROV should be distributed in some form.
Frankly, the ROV concept cries out for some concrete examples–we’ll cover those in our next post. Before we get to the examples, though, some qualifications bear emphasis.
First, the Commission determined that, without further study of the cost-benefit, the ROV recommendation should not apply to “small and medium-sized enterprises” (as proposed by the Commission). For the moment, the Commission has proposed separate principles for those enterprises. [We’ll address “SMEs” near the end of this series.]
Second, the ROV recommendation might make sense in simple capital structures, but it likely needs some refining to address more complex capital structures or messy fact patterns (e.g., the senior creditor is not entitled to 100% of the enterprise value; there are multiple senior creditor classes; only a portion of the junior class objects; the junior class is already getting a distribution, but is not being paid in full, etc.).
Third, the ROV recommendation is not intended to alter priorities or change allocations within classes. Rather, the purpose is to give Courts a tool for determining whether there is enough debtor value to justify a distribution to the immediately junior class.
In our next post, we’ll focus on the suggested nuts and bolts for calculating the ROV, as well as some simple examples that should help illuminate this rather abstract concept.