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Preferred Equity In Peril?
Preferred equity instruments have become increasingly popular as a source of financing for private equity sponsors executing large leveraged acquisitions. Investors seeking the risk profile of debt but also the return potential of equity are attracted to the hybrid nature of preferred equity, which generally ranks senior to common equity interests (like debt) and may entitle the holder to common equity-like upside. By law, preferred equity is a varied and flexible instrument, but, in practice, it typically has a limited number of common features. One feature is that the preferred equity is entitled to a "liquidation preference" ahead of common stock. The liquidation preference is typically triggered upon a "liquidation, dissolution or winding up" whether "voluntary or involuntary" and most often equal to a fixed dollar amount per share plus accrued and unpaid dividends to the date of the liquidation, dissolution or winding up.
Whether the liquidation preference of preferred equity entitles preferred shareholders to priority over common shareholders in a Chapter 11 reorganization is a question that figured prominently in two recent high profile cases, Washington Prime Group, Inc. and CBL & Associates Properties, Inc., two public REITs (real estate investment trusts) that filed for Chapter 11 due to fallout from the COVID-19 pandemic. In each case, the debtors sought approval of a disclosure statement for a plan that contemplated holders of common stock and preferred stock sharing in a distribution on a 50-50 basis, disregarding the liquidation preference in favor of the preferred stock. In each case, dissenting parties previewed (and in CBL, ultimately, prosecuted) objections to the plan on the grounds that the distributions to common stock would violate the absolute priority rule, and in each case, the plan was ultimately confirmed with the application of the absolute priority rule to preferred stock left unaddressed. These cases highlight a risk that the lack of explicit language in applicable governing documents regarding the treatment of preferred equity in a Chapter 11 reorganization could result in parties arguing that preferred equity holders, for purposes of plan distribution, should be treated no better than common shareholders, which may be contrary to the expectations of investors in preferred equity instruments.
CBL and Washington Prime: Deathtraps to Avoid Priority Issues
In both CBL and Washington Prime, enterprise valuation was a prominent litigable issue as a result of the difficulties inherent in ascertaining the effect of the COVID-19 on real property values. Nevertheless, in both cases, the debtors took the position that, under the plan, unsecured claims were not being paid in full, and thus there was no value available for equity under an absolute priority waterfall. This position enabled the CBL debtors to argue that providing a distribution to common equity when preferred shares were receiving less than their liquidation preference was not a departure from "absolute priority," because the distribution to equity was a "tip," and "the liquidation preference is only applicable where value is otherwise available for distribution to equity holders."
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