Don't Pay Old Equity That Is Truly 'Under Water'!

Since fair value is calculated in an appraisal proceeding at the time just before the merger's effectiveness, any value creation from prior events (such as the premature canceling of any debt being exchanged) will be factored into the calculation. Accordingly, counsel for a distressed debtor or the holders of its debt should take all necessary steps to ensure that the outstanding debt is not in any way exchanged with the debtor (or otherwise technically cancelled) prior to the merger's effectiveness.

As a practical matter, avoiding a premature cancellation can usually be accomplished by using a special-purpose entity as a vehicle for exchanging the debt and then acting as a constituent corporation in a squeeze-out merger. The special purpose vehicle would be newly formed and, prior to the squeeze-out merger, the creditors will contribute their debt to the vehicle in return for its newly issued equity. Once all the debt has been received, and not before, the special purpose vehicle would be merged into the debtor. Although these transactions discussed herein are more quickly accomplished in a private transaction among sophisticated private parties with no registration or proxy requirements, the same general principles would apply in a public registered (or exempt) broad-based deal with a proxy vote. In a public transaction, there may be additional complexity and other requirements and considerations.

In that merger, the creditors (ie, the shareholders of the special purpose vehicle) will become shareholders of the reorganized company while the old shareholders are extinguished or permitted to retain specified shares or receive new shares, cash or other consideration. Among other things, by using such a special-purpose vehicle, the parties ensure that the debt is not contributed to the debtor and cancelled until the merger becomes effective. Therefore, the debt should be deemed outstanding with its value subtracted from the enterprise value in any fair value determination. Note that any premature cancellation could undo this 'debt shield' and significantly inflate any fair value claimed by otherwise 'under-water' dissenting stockholders.

Showing 'Brink of Bankruptcy' to Avoid Paying Twice

To use the exception to the general market-value rule for valuing outstanding debt in an appraisal action, a showing must be made that the debtor was 'at the brink of bankruptcy' at the effective time of the merger. The benefit of this exception is that the fair value of shares held by any dissenting stockholder will be significantly reduced (and likely made negative) if the debt value subtracted from the enterprise value is the higher face amount rather than the lower discounted market price.

Assuming the courts continue to follow Vision Hardware (In re Vision Hardware Group, 669 A.2d 671 (Del. Ch. 1995) [the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value']), and further assuming that a record is maintained and the timing of cancellation is strictly adhered to, a company and its previous creditors (and new owners) should be able to avail itself of the 'brink of bankruptcy' exception and establish that equity is 'under-water' by satisfying all of the following factors:

Impracticability

The record should show that the debtor simply is not able to refinance its debt to seize any intrinsic value in the market discount. In Vision Hardware, evidence sufficient support this finding included the following: first, the debtor, after an evaluation, fairly determined that it had no access to capital or capital raising alternatives; and second, there was a tight debt holder control group with no desire to advance new money or alter the terms other than through a cash-out merger. See In re Vision Hardware Group Inc., 669 A.2d at 677-678.

In addition, although the court stated that a Board of Directors must always evaluate potential alternatives, the court noted that an impracticability finding is made easier when sophisticated, controlling stockholders agree to receive only nominal consideration for their equity.

Insolvency

As a threshold matter, the record should show that the debtor is legally insolvent. Historically, Delaware courts have applied an 'equitable insolvency' test to find a corporation insolvent when it is unable to meet its obligations as they become due. See Francotyp-Postala AG & Co. v. On Target Technology, Inc., 1998 WL 928382 (Del. Ch. Dec. 24, 1998) (stating that 'Defining insolvency to be when a company's liabilities exceed its assets ignores the realities of the business world in which corporations incur significant debt in order to seize business opportunities ' Defining insolvency as a corporation's inability to meet debt obligations as they fall due in the ordinary course of business is consistent with this court's precedents.'). Accordingly, a combination of opinions and/or analyses of the company's financial advisors and reports by the company's financial officers on the ability to pay debts as they become due will prove valuable.

Default

Finally, the record should show that the debtor is in default and that either the debt has been accelerated or that such default would warrant acceleration of the debt. Correspondence with senior and/or junior lenders or legal advice and correspondence should provide sufficient evidence on this point.

Maintaining a Record: Compliance, Deterrence and Guidance

A good record is relatively easy and inexpensive to maintain and will serve the company well in an appraisal proceeding. Of course, there are many ways to keep a good record. For example, meeting minutes and resolution preambles should be used to document the consideration of alternatives or the board's review of materials from financial advisors, legal advisors or the company's officers. In addition, the company should maintain files of board presentations, debt transfer accounts and cancellation receipts and material correspondence with holders of debt.

The record is useful in making critical showings discussed above, such as non-availability of capital, insolvency and/or default status, and in establishing the timing of debt cancellation. In addition, and perhaps most importantly, care should be used when preparing the Information Memorandum sent to shareholders as notice of dissenter's rights and to comply with the duty of fair disclosure. A detailed Information Memorandum can serve at least three valuable purposes: 1) legal compliance, 2) a vehicle to dissuade potential dissenters with facts clearly supporting that the stock is 'under-water,' and 3) a potential roadmap to guide the court through any appraisal proceeding. Note that the Information Memorandum is another matter often 'glossed-over' in the transaction. Be advised that Delaware law is abundantly clear that a full disclosure statement is required and that a failure to provide one gives rise to a fiduciary duty claim. Again, since former directors are usually indemnified, the new owners of the indemnifying company should demand compliance.

In all transactions, there is a temptation for parties intimately familiar with the facts to assume that certain conclusions are perfectly 'obvious' or certain matters are mere 'details' to be dealt with curtly. That impulse, when coupled with the disincentives for company's counsel to focus on certain issues in cash-out mergers involving distressed debtors, is risky and could prove costly. The risk of an unfavorable outcome in a statutory appraisal action is ultimately borne by the unsuspecting new owners ' that is, the pre-transaction holders of the debt of the distressed debtor. Accordingly, it typically falls on counsel to those holders to plan ahead and ensure these risks are identified and mitigated.

The result of adhering to the simple precautions we have identified should be increased value for the transaction, not only by reducing the risk of any additional cash payments to holders of 'under-water' equity but also by reducing the costs associated with a more streamlined and certain appraisal rights process.

Michael J. Sage and Mark E. Palmer are partners in the New York office of Stroock & Stroock & Lavan LLP, in the Financial Restructuring Group. The authors gratefully acknowledge Douglas Mintz, an associate in Stroock's Financial Restructuring Group, for his assistance in editing and researching matters addressed in this article.

As discussed last month, the law clearly shows that parties structuring cash-out mergers with distressed debtors must focus on two things: 1) timing the debt-for-equity exchange (and the resultant debt cancellation) so not to occur prior to the merger's effective time, and 2) demonstrating that the debtor was at 'the brink of bankruptcy' at the merger's effective time. A clear record should be built and maintained on these points, and the structure should accommodate the technical legal requirements.

Our own practical experiences show that, by following the steps we have outlined below, counsel can prevent inadvertent and significant payments to holders of equity assumed to be 'under-water' ' ie, more to the point, lawyers can reduce the risks that their clients will pay twice for the company's equity.

Exchanging the Debt Once Again: Timing Is Everything

Since fair value is calculated in an appraisal proceeding at the time just before the merger's effectiveness, any value creation from prior events (such as the premature canceling of any debt being exchanged) will be factored into the calculation. Accordingly, counsel for a distressed debtor or the holders of its debt should take all necessary steps to ensure that the outstanding debt is not in any way exchanged with the debtor (or otherwise technically cancelled) prior to the merger's effectiveness.

As a practical matter, avoiding a premature cancellation can usually be accomplished by using a special-purpose entity as a vehicle for exchanging the debt and then acting as a constituent corporation in a squeeze-out merger. The special purpose vehicle would be newly formed and, prior to the squeeze-out merger, the creditors will contribute their debt to the vehicle in return for its newly issued equity. Once all the debt has been received, and not before, the special purpose vehicle would be merged into the debtor. Although these transactions discussed herein are more quickly accomplished in a private transaction among sophisticated private parties with no registration or proxy requirements, the same general principles would apply in a public registered (or exempt) broad-based deal with a proxy vote. In a public transaction, there may be additional complexity and other requirements and considerations.

In that merger, the creditors (ie, the shareholders of the special purpose vehicle) will become shareholders of the reorganized company while the old shareholders are extinguished or permitted to retain specified shares or receive new shares, cash or other consideration. Among other things, by using such a special-purpose vehicle, the parties ensure that the debt is not contributed to the debtor and cancelled until the merger becomes effective. Therefore, the debt should be deemed outstanding with its value subtracted from the enterprise value in any fair value determination. Note that any premature cancellation could undo this 'debt shield' and significantly inflate any fair value claimed by otherwise 'under-water' dissenting stockholders.

Showing 'Brink of Bankruptcy' to Avoid Paying Twice

To use the exception to the general market-value rule for valuing outstanding debt in an appraisal action, a showing must be made that the debtor was 'at the brink of bankruptcy' at the effective time of the merger. The benefit of this exception is that the fair value of shares held by any dissenting stockholder will be significantly reduced (and likely made negative) if the debt value subtracted from the enterprise value is the higher face amount rather than the lower discounted market price.

Assuming the courts continue to follow Vision Hardware (In re Vision Hardware Group, 669 A.2d 671 (Del. Ch. 1995) [the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value']), and further assuming that a record is maintained and the timing of cancellation is strictly adhered to, a company and its previous creditors (and new owners) should be able to avail itself of the 'brink of bankruptcy' exception and establish that equity is 'under-water' by satisfying all of the following factors:

Impracticability

The record should show that the debtor simply is not able to refinance its debt to seize any intrinsic value in the market discount. In Vision Hardware, evidence sufficient support this finding included the following: first, the debtor, after an evaluation, fairly determined that it had no access to capital or capital raising alternatives; and second, there was a tight debt holder control group with no desire to advance new money or alter the terms other than through a cash-out merger. See In re Vision Hardware Group Inc., 669 A.2d at 677-678.

In addition, although the court stated that a Board of Directors must always evaluate potential alternatives, the court noted that an impracticability finding is made easier when sophisticated, controlling stockholders agree to receive only nominal consideration for their equity.

Insolvency

As a threshold matter, the record should show that the debtor is legally insolvent. Historically, Delaware courts have applied an 'equitable insolvency' test to find a corporation insolvent when it is unable to meet its obligations as they become due. See Francotyp-Postala AG & Co. v. On Target Technology, Inc., 1998 WL 928382 (Del. Ch. Dec. 24, 1998) (stating that 'Defining insolvency to be when a company's liabilities exceed its assets ignores the realities of the business world in which corporations incur significant debt in order to seize business opportunities ' Defining insolvency as a corporation's inability to meet debt obligations as they fall due in the ordinary course of business is consistent with this court's precedents.'). Accordingly, a combination of opinions and/or analyses of the company's financial advisors and reports by the company's financial officers on the ability to pay debts as they become due will prove valuable.

Default

Finally, the record should show that the debtor is in default and that either the debt has been accelerated or that such default would warrant acceleration of the debt. Correspondence with senior and/or junior lenders or legal advice and correspondence should provide sufficient evidence on this point.

Maintaining a Record: Compliance, Deterrence and Guidance

A good record is relatively easy and inexpensive to maintain and will serve the company well in an appraisal proceeding. Of course, there are many ways to keep a good record. For example, meeting minutes and resolution preambles should be used to document the consideration of alternatives or the board's review of materials from financial advisors, legal advisors or the company's officers. In addition, the company should maintain files of board presentations, debt transfer accounts and cancellation receipts and material correspondence with holders of debt.

The record is useful in making critical showings discussed above, such as non-availability of capital, insolvency and/or default status, and in establishing the timing of debt cancellation. In addition, and perhaps most importantly, care should be used when preparing the Information Memorandum sent to shareholders as notice of dissenter's rights and to comply with the duty of fair disclosure. A detailed Information Memorandum can serve at least three valuable purposes: 1) legal compliance, 2) a vehicle to dissuade potential dissenters with facts clearly supporting that the stock is 'under-water,' and 3) a potential roadmap to guide the court through any appraisal proceeding. Note that the Information Memorandum is another matter often 'glossed-over' in the transaction. Be advised that Delaware law is abundantly clear that a full disclosure statement is required and that a failure to provide one gives rise to a fiduciary duty claim. Again, since former directors are usually indemnified, the new owners of the indemnifying company should demand compliance.

In all transactions, there is a temptation for parties intimately familiar with the facts to assume that certain conclusions are perfectly 'obvious' or certain matters are mere 'details' to be dealt with curtly. That impulse, when coupled with the disincentives for company's counsel to focus on certain issues in cash-out mergers involving distressed debtors, is risky and could prove costly. The risk of an unfavorable outcome in a statutory appraisal action is ultimately borne by the unsuspecting new owners ' that is, the pre-transaction holders of the debt of the distressed debtor. Accordingly, it typically falls on counsel to those holders to plan ahead and ensure these risks are identified and mitigated.

The result of adhering to the simple precautions we have identified should be increased value for the transaction, not only by reducing the risk of any additional cash payments to holders of 'under-water' equity but also by reducing the costs associated with a more streamlined and certain appraisal rights process.

Michael J. Sage and Mark E. Palmer are partners in the New York office of Stroock & Stroock & Lavan LLP, in the Financial Restructuring Group. The authors gratefully acknowledge Douglas Mintz, an associate in Stroock's Financial Restructuring Group, for his assistance in editing and researching matters addressed in this article.