Concurrent Rights Offerings by Chapter 11 Debtors

Section 1145 of the Bankruptcy Code, among other things, permits an issuer-debtor to distribute securities of the reorganized debtor to its stakeholders on account of, and in exchange for, their claims against or interests in the debtor, pursuant to a confirmed Chapter 11 plan, in reliance on the bankruptcy court's oversight of the debtor's disclosure process, rather than the more expensive and time-consuming registration process under the Securities Act.

The Section 1145 exemption also permits a debtor to raise incremental capital from its stakeholders in a public offering pursuant to a Chapter 11 plan ' again, subject to bankruptcy court approval ' without registering the offering with the SEC provided that, among other things, the offering satisfies Section 1145's principally/partly test. This test requires that the securities be offered and sold principally in exchange for a claim against or interest in the debtor, and only partly for cash or other consideration. Given the amount of equity capital required to fund Kodak's Chapter 11 plan (as compared with the estimated recovery levels for unsecured creditors), it was unclear whether the 1145 exemption was available to conduct a single-rights offering of sufficient size.

Previously, most debtors confronted with this dilemma concluded that their offerings were 1145-exempt based on direct no-action relief from the SEC, or because the offering was in compliance with previous SEC guidance ' or instead, they relied on the exemption from registration provided by Section 4(a)(2) of the Securities Act and the safe harbor provided by Rule 506 of Regulation D promulgated thereunder. Until the implementation of the recent amendments to Rule 506 (discussed herein), the prohibition under Regulation D on sales of securities by means of general solicitation or general advertising restricted stakeholders' access to such an offering by limiting a debtor's ability to communicate broadly with creditors who were potentially eligible investors. This prohibition caused debtors to impose rigorous and cumbersome procedures in order to ensure that solicitation efforts and other communications with investors would not run afoul of the requirements of the Regulation D safe harbor or other exemptions for private offerings.

Concurrent Offerings

An important requirement for the Official Committee of Unsecured Creditors' (the Creditors' Committee) support for Kodak's plan of reorganization was that the rights offering be made available to the broadest possible pool of qualified unsecured creditors. In an effort to maximize the pool of eligible investors, Kodak implemented two concurrent but separate rights offerings, one for $72 million pursuant to Section 1145 (the 1145 Offering) and a second for $406 million pursuant to Section 4(a)(2) of the Securities Act and Rule 506 thereunder (the 4(2) Offering). The latter was reduced on a dollar-for-dollar basis by the amount subscribed for in the 1145 Offering, which was capped at approximately $72 million.

For purposes of simplicity, Kodak's offering in reliance on the safe harbor under Rule 506 of Regulation D was referred to as the “4(2) Offering” in filings with the bankruptcy court and in materials circulated to the participants in the rights offerings, notwithstanding that the offering was made in reliance upon Rule 506. This article uses the same definitions.

This concurrent offering structure provided for the offering and sale of some of Kodak's post-emergence equity to all of its unsecured creditors in the 1145 Offering, subject to certain limitations discussed below. The majority of the equity was raised in the 4(2) Offering.

As also discussed herein, the 4(2) Offering was limited to “accredited investors” and “qualified institutional buyers” that had a “pre-existing, substantive relationship” with Kodak to ensure compliance with Rule 506 and, in particular, the prohibition on general solicitation or general advertising that then applied to all offerings under Rule 506.
Accordingly, stakeholders that did not hold eligible Kodak claims prior to Kodak's public announcement of the rights offerings were precluded from participating in the 4(2) Offering. The pre-announcement holding requirement limited the liquidity of Kodak claims following the public announcement because the universe of buyers who could acquire claims and exercise the related subscription rights in the 4(2) Offering was limited to accredited investors and qualified institutional buyers that were pre-announcement holders of significant Kodak claims.

The recent SEC amendments to Rule 506, however, should mitigate this adverse impact on liquidity. As discussed herein, new Rule 506(c) permits an issuer to offer and sell securities by means of a general solicitation or general advertising in reliance on the Regulation D safe harbor provided that it takes “reasonable steps” to verify that all purchases in the offering are made by accredited investors.

Background

Kodak's plan of reorganization was conditioned on, among other things, the consummation of a number of transactions, including raising sufficient equity capital to fund the repayment of Kodak's prepetition second lien debt.

Participants in the rights offerings, including the Backstop Parties, acquired approximately 34 million shares of Reorganized Kodak's outstanding common stock representing approximately 85% of Reorganized Kodak. Six million shares representing approximately 15% of Reorganized Kodak were to be distributed directly to Kodak's unsecured creditors (including the Backstop Parties) on account of their claims. The common stock issued in the rights offerings and distributed directly to unsecured creditors was subject to dilution for shares issued to the Backstop Parties as a “backstop fee” as well as dilution by warrants distributed to unsecured creditors, and equity granted pursuant to Reorganized Kodak's new management equity plan.

Based on the valuation implied by the rights offerings and the dilutive effect of the other equity issuances, Kodak's financial adviser concluded that the implied value of Reorganized Kodak's common equity was approximately $498 million.

In connection with obtaining court approval of its disclosure statement and related solicitation procedures, Kodak also obtained court approval to conduct the rights offerings contemporaneously with the vote-solicitation process.

Legal Considerations

Section 1145(a) of the Bankruptcy Code permits a debtor satisfying certain requirements to, among other things, offer or sell a security of the debtor under a plan of reorganization without registering the offering under Section 5 of the Securities Act or any state or local law requiring registration for offer or sale of a security. Among other things, reliance on the Section 1145 exemption requires that the offer or sale be principally (or wholly) in exchange for a claim against or interest in the debtor, and only partly for cash or other consideration.

Absent the availability of the Section 1145 exemption, a debtor would need to register its offering with the SEC in accordance with the Securities Act and any applicable state laws governing such offerings, or rely on another exemption from registration. Historically, the most commonly utilized exemption has been the “private placement” exemption provided by Section 4(a)(2) of the Securities Act or by Rule 506 of Regulation D thereunder, which, prior to the recent amendments to Rule 506, exempted certain private offerings subject to the requirement that no such offering could be conducted by means of general solicitation or general advertising.

The three principal benefits associated with the Section 1145 exemption are: first, that there is no need to limit participation to accredited investors or others who have the sophistication and wherewithal to invest in a private offering; second, that there is no need to avoid general solicitation or general advertising in conducting the exempt offering; and third, that securities issued pursuant to Section 1145 are freely tradable by the recipients (with the exception of any party that is deemed an “underwriter” within the meaning of Section 1145(b), including any party that is an “affiliate” of the issuer for purposes of the Securities Act). Conversely, securities issued in reliance on the 4(a)(2) exemption are “restricted securities” for purposes of Rule 144 under the Securities Act and, under that Rule, may not be re-sold into the public market without registration for at least six months. It should be noted that restricted securities also may be sold in the private market pursuant to an exemption from Securities Act registration other than Rule 144.

Structuring the 1145 Offering

Given the amount of capital required to fund Kodak's plan, compared with the estimated unsecured creditor recovery, it was decided that a single $406 million rights offering to unsecured creditors might not satisfy the principally/partly test. The SEC has granted no-action relief under the Section 1145 principally/partly test only in cases where a debtor's creditors were eligible to purchase new securities for a cash amount that was less than the value of the recovery on their claims, based on the issuer's demonstration of the implied value of the creditors' recovery.

These no-action letters addressed purchases of securities up to varying amounts, depending on the facts and circumstances of each case. See, e.g., Jet Florida System Inc., SEC No-Action Letter, 1987 SEC No-Act. LEXIS 1490 (Jan. 12, 1987) (SEC granted no-action relief where plan of reorganization provided creditors with a right to purchase securities at a price equal to 63& to 75% of the implied value of the recovery on the claim); Barry's Jewelers, Inc., SEC No-Action Letter, 1998 WL 425887 (July 20, 1998) (plan of reorganization provided bondholders with a right to purchase securities at a total price equal to 24% to 55% of the implied value of the recovery on the bonds); Bennett Petroleum Corp., SEC No-Action Letter, 1983 SEC No-Act. LEXIS 3102 (Dec. 27, 1983) (plan of reorganization provided for the issuance of one share of preferred stock in exchange for one share of outstanding common stock, plus an amount in cash equal to 75% of the unweighted average of certain bids on the common stock reported by market makers during the 10 business days prior to the confirmation date of the plan).

Despite this limitation, it was critical to develop a structure that would permit unsecured creditors to participate as broadly as possible in the equity raise. Specifically, due to differences in opinion among Kodak, the Backstop Parties and the Creditors' Committee as to the equity value of Reorganized Kodak, coupled with the projected recovery levels for general unsecured creditors, Creditors' Committee support for the plan hinged on developing an appropriate structure ' balancing the committee's participation demands with the legal confines of the principally/partly test and the limitations imposed under Section 4(a)(2) and Regulation D.

Given these parameters, the parties developed the concurrent rights offering structure. The 1145 Offering was a smaller rights offering (up to $71,640,000) open to all general unsecured creditors. To ensure compliance with Section 1145 and satisfaction of the principally/partly test, a creditor could subscribe for no more than the number of shares that the creditor was projected to receive as a direct distribution on account of its general unsecured claim.

This construct was implemented to satisfy the principally/partly test because, with respect to each eligible unsecured claim, the amount of cash paid by a creditor in the 1145 Offering was necessarily less than the value of the aggregate distribution to the creditor on account of its claim ' taking into account not only the direct stock distribution but also its right to receive cashless warrants and a litigation trust interest.

A complicating factor in designing the 1145 Offering was developing an appropriate estimate of a participant's ultimate direct equity distribution for purposes of satisfying the principally/partly test because Kodak's claims resolution process was not complete at the time of the rights offerings. To address this uncertainty, participation in the 1145 Offering was limited to creditors (1145 Eligible Participants) that held “1145 Eligible Claims.” To ensure that an 1145 Eligible Participant could not subscribe for more shares in the 1145 Rights Offering than it would be entitled to receive under the plan, 1145 Eligible Claims were limited to general unsecured claims that were “stipulated to” by Kodak on or prior to the Claim Determination Date and each 1145 Eligible Participant's maximum participation was determined by dividing the amount of its 1145 Eligible Claims by the projected maximum amount of the general unsecured claims pool. The purpose of these safeguards was to ensure that the number of shares of common stock available for purchase by a creditor in the 1145 Offering would not be greater than the number of shares to be distributed to that creditor on account of its claims.

Next month we will discuss how the 4(2) offering was structured and the implications of new Rule 506(c) under the Securities Act.

Michael Torkin is a partner in the General Practice Group at Sullivan & Cromwell LLP, specializing in Bankruptcy & Restructuring matters. He represents clients in complex Chapter 11 reorganizations and out-of-court restructurings. Mr. Torkin also advises private equity and hedge funds in connection with distressed M&A and opportunistic investments. He may be reached at [email protected]. Chiansan Ma is an associate in the General Practice Group at the firm.

Eastman Kodak Company conducted the first-ever parallel rights offerings in connection with its recently consummated Chapter 11 plan of reorganization ' one conducted in compliance with Section 1145 of the Bankruptcy Code and the other with Rule 506 of Regulation D under Section 4(a)(2) of the Securities Act of 1933 (the Securities Act). Kodak raised approximately $406 million for approximately 85% of its new common equity. Six institutions (the Backstop Parties) agreed to backstop the rights offerings.

The structure was designed to raise capital for Kodak's emergence from Chapter 11 through a public offering and a separate private placement of reorganized Kodak equity to a pool of Kodak's eligible unsecured creditors, without requiring that the offerings be registered with the Securities and Exchange Commission (SEC) pursuant to the Securities Act.

The Section 1145 Exemption

Section 1145 of the Bankruptcy Code, among other things, permits an issuer-debtor to distribute securities of the reorganized debtor to its stakeholders on account of, and in exchange for, their claims against or interests in the debtor, pursuant to a confirmed Chapter 11 plan, in reliance on the bankruptcy court's oversight of the debtor's disclosure process, rather than the more expensive and time-consuming registration process under the Securities Act.

The Section 1145 exemption also permits a debtor to raise incremental capital from its stakeholders in a public offering pursuant to a Chapter 11 plan ' again, subject to bankruptcy court approval ' without registering the offering with the SEC provided that, among other things, the offering satisfies Section 1145's principally/partly test. This test requires that the securities be offered and sold principally in exchange for a claim against or interest in the debtor, and only partly for cash or other consideration. Given the amount of equity capital required to fund Kodak's Chapter 11 plan (as compared with the estimated recovery levels for unsecured creditors), it was unclear whether the 1145 exemption was available to conduct a single-rights offering of sufficient size.

Previously, most debtors confronted with this dilemma concluded that their offerings were 1145-exempt based on direct no-action relief from the SEC, or because the offering was in compliance with previous SEC guidance ' or instead, they relied on the exemption from registration provided by Section 4(a)(2) of the Securities Act and the safe harbor provided by Rule 506 of Regulation D promulgated thereunder. Until the implementation of the recent amendments to Rule 506 (discussed herein), the prohibition under Regulation D on sales of securities by means of general solicitation or general advertising restricted stakeholders' access to such an offering by limiting a debtor's ability to communicate broadly with creditors who were potentially eligible investors. This prohibition caused debtors to impose rigorous and cumbersome procedures in order to ensure that solicitation efforts and other communications with investors would not run afoul of the requirements of the Regulation D safe harbor or other exemptions for private offerings.

Concurrent Offerings

An important requirement for the Official Committee of Unsecured Creditors' (the Creditors' Committee) support for Kodak's plan of reorganization was that the rights offering be made available to the broadest possible pool of qualified unsecured creditors. In an effort to maximize the pool of eligible investors, Kodak implemented two concurrent but separate rights offerings, one for $72 million pursuant to Section 1145 (the 1145 Offering) and a second for $406 million pursuant to Section 4(a)(2) of the Securities Act and Rule 506 thereunder (the 4(2) Offering). The latter was reduced on a dollar-for-dollar basis by the amount subscribed for in the 1145 Offering, which was capped at approximately $72 million.

For purposes of simplicity, Kodak's offering in reliance on the safe harbor under Rule 506 of Regulation D was referred to as the “4(2) Offering” in filings with the bankruptcy court and in materials circulated to the participants in the rights offerings, notwithstanding that the offering was made in reliance upon Rule 506. This article uses the same definitions.

This concurrent offering structure provided for the offering and sale of some of Kodak's post-emergence equity to all of its unsecured creditors in the 1145 Offering, subject to certain limitations discussed below. The majority of the equity was raised in the 4(2) Offering.

As also discussed herein, the 4(2) Offering was limited to “accredited investors” and “qualified institutional buyers” that had a “pre-existing, substantive relationship” with Kodak to ensure compliance with Rule 506 and, in particular, the prohibition on general solicitation or general advertising that then applied to all offerings under Rule 506.
Accordingly, stakeholders that did not hold eligible Kodak claims prior to Kodak's public announcement of the rights offerings were precluded from participating in the 4(2) Offering. The pre-announcement holding requirement limited the liquidity of Kodak claims following the public announcement because the universe of buyers who could acquire claims and exercise the related subscription rights in the 4(2) Offering was limited to accredited investors and qualified institutional buyers that were pre-announcement holders of significant Kodak claims.

The recent SEC amendments to Rule 506, however, should mitigate this adverse impact on liquidity. As discussed herein, new Rule 506(c) permits an issuer to offer and sell securities by means of a general solicitation or general advertising in reliance on the Regulation D safe harbor provided that it takes “reasonable steps” to verify that all purchases in the offering are made by accredited investors.

Background

Kodak's plan of reorganization was conditioned on, among other things, the consummation of a number of transactions, including raising sufficient equity capital to fund the repayment of Kodak's prepetition second lien debt.

Participants in the rights offerings, including the Backstop Parties, acquired approximately 34 million shares of Reorganized Kodak's outstanding common stock representing approximately 85% of Reorganized Kodak. Six million shares representing approximately 15% of Reorganized Kodak were to be distributed directly to Kodak's unsecured creditors (including the Backstop Parties) on account of their claims. The common stock issued in the rights offerings and distributed directly to unsecured creditors was subject to dilution for shares issued to the Backstop Parties as a “backstop fee” as well as dilution by warrants distributed to unsecured creditors, and equity granted pursuant to Reorganized Kodak's new management equity plan.

Based on the valuation implied by the rights offerings and the dilutive effect of the other equity issuances, Kodak's financial adviser concluded that the implied value of Reorganized Kodak's common equity was approximately $498 million.

In connection with obtaining court approval of its disclosure statement and related solicitation procedures, Kodak also obtained court approval to conduct the rights offerings contemporaneously with the vote-solicitation process.

Legal Considerations

Section 1145(a) of the Bankruptcy Code permits a debtor satisfying certain requirements to, among other things, offer or sell a security of the debtor under a plan of reorganization without registering the offering under Section 5 of the Securities Act or any state or local law requiring registration for offer or sale of a security. Among other things, reliance on the Section 1145 exemption requires that the offer or sale be principally (or wholly) in exchange for a claim against or interest in the debtor, and only partly for cash or other consideration.

Absent the availability of the Section 1145 exemption, a debtor would need to register its offering with the SEC in accordance with the Securities Act and any applicable state laws governing such offerings, or rely on another exemption from registration. Historically, the most commonly utilized exemption has been the “private placement” exemption provided by Section 4(a)(2) of the Securities Act or by Rule 506 of Regulation D thereunder, which, prior to the recent amendments to Rule 506, exempted certain private offerings subject to the requirement that no such offering could be conducted by means of general solicitation or general advertising.

The three principal benefits associated with the Section 1145 exemption are: first, that there is no need to limit participation to accredited investors or others who have the sophistication and wherewithal to invest in a private offering; second, that there is no need to avoid general solicitation or general advertising in conducting the exempt offering; and third, that securities issued pursuant to Section 1145 are freely tradable by the recipients (with the exception of any party that is deemed an “underwriter” within the meaning of Section 1145(b), including any party that is an “affiliate” of the issuer for purposes of the Securities Act). Conversely, securities issued in reliance on the 4(a)(2) exemption are “restricted securities” for purposes of Rule 144 under the Securities Act and, under that Rule, may not be re-sold into the public market without registration for at least six months. It should be noted that restricted securities also may be sold in the private market pursuant to an exemption from Securities Act registration other than Rule 144.

Structuring the 1145 Offering

Given the amount of capital required to fund Kodak's plan, compared with the estimated unsecured creditor recovery, it was decided that a single $406 million rights offering to unsecured creditors might not satisfy the principally/partly test. The SEC has granted no-action relief under the Section 1145 principally/partly test only in cases where a debtor's creditors were eligible to purchase new securities for a cash amount that was less than the value of the recovery on their claims, based on the issuer's demonstration of the implied value of the creditors' recovery.

These no-action letters addressed purchases of securities up to varying amounts, depending on the facts and circumstances of each case. See, e.g., Jet Florida System Inc., SEC No-Action Letter, 1987 SEC No-Act. LEXIS 1490 (Jan. 12, 1987) (SEC granted no-action relief where plan of reorganization provided creditors with a right to purchase securities at a price equal to 63& to 75% of the implied value of the recovery on the claim); Barry's Jewelers, Inc., SEC No-Action Letter, 1998 WL 425887 (July 20, 1998) (plan of reorganization provided bondholders with a right to purchase securities at a total price equal to 24% to 55% of the implied value of the recovery on the bonds); Bennett Petroleum Corp., SEC No-Action Letter, 1983 SEC No-Act. LEXIS 3102 (Dec. 27, 1983) (plan of reorganization provided for the issuance of one share of preferred stock in exchange for one share of outstanding common stock, plus an amount in cash equal to 75% of the unweighted average of certain bids on the common stock reported by market makers during the 10 business days prior to the confirmation date of the plan).

Despite this limitation, it was critical to develop a structure that would permit unsecured creditors to participate as broadly as possible in the equity raise. Specifically, due to differences in opinion among Kodak, the Backstop Parties and the Creditors' Committee as to the equity value of Reorganized Kodak, coupled with the projected recovery levels for general unsecured creditors, Creditors' Committee support for the plan hinged on developing an appropriate structure ' balancing the committee's participation demands with the legal confines of the principally/partly test and the limitations imposed under Section 4(a)(2) and Regulation D.

Given these parameters, the parties developed the concurrent rights offering structure. The 1145 Offering was a smaller rights offering (up to $71,640,000) open to all general unsecured creditors. To ensure compliance with Section 1145 and satisfaction of the principally/partly test, a creditor could subscribe for no more than the number of shares that the creditor was projected to receive as a direct distribution on account of its general unsecured claim.

This construct was implemented to satisfy the principally/partly test because, with respect to each eligible unsecured claim, the amount of cash paid by a creditor in the 1145 Offering was necessarily less than the value of the aggregate distribution to the creditor on account of its claim ' taking into account not only the direct stock distribution but also its right to receive cashless warrants and a litigation trust interest.

A complicating factor in designing the 1145 Offering was developing an appropriate estimate of a participant's ultimate direct equity distribution for purposes of satisfying the principally/partly test because Kodak's claims resolution process was not complete at the time of the rights offerings. To address this uncertainty, participation in the 1145 Offering was limited to creditors (1145 Eligible Participants) that held “1145 Eligible Claims.” To ensure that an 1145 Eligible Participant could not subscribe for more shares in the 1145 Rights Offering than it would be entitled to receive under the plan, 1145 Eligible Claims were limited to general unsecured claims that were “stipulated to” by Kodak on or prior to the Claim Determination Date and each 1145 Eligible Participant's maximum participation was determined by dividing the amount of its 1145 Eligible Claims by the projected maximum amount of the general unsecured claims pool. The purpose of these safeguards was to ensure that the number of shares of common stock available for purchase by a creditor in the 1145 Offering would not be greater than the number of shares to be distributed to that creditor on account of its claims.

Next month we will discuss how the 4(2) offering was structured and the implications of new Rule 506(c) under the Securities Act.

Michael Torkin is a partner in the General Practice Group at Sullivan & Cromwell LLP, specializing in Bankruptcy & Restructuring matters. He represents clients in complex Chapter 11 reorganizations and out-of-court restructurings. Mr. Torkin also advises private equity and hedge funds in connection with distressed M&A and opportunistic investments. He may be reached at [email protected]. Chiansan Ma is an associate in the General Practice Group at the firm.