Prepackaged bankruptcy can sound mighty attractive in our financing-constrained age with few willingly venturing into the casino that is the bankruptcy process.  Faced in bankruptcy’s bluff-filled world with much to lose and little cash to survive, a pre-packaged bankruptcy sounds startlingly attractive.  Legal issues shape the entire process starting with the impact of the 2005 bankruptcy reforms and continuing through predictable claims of duties breached and rights trampled.  While this may sound upsetting, it’s better than the alternative. For reasons relating to capital structure, operations and legalities, it is not open to all. The unlucky ones proceed into the contentious bankruptcy processes.

Prepacks, as they’re affectionately termed, have certain advantages: they eliminate the need for post-petition negotiation, they let the company get right back to business; and they prove far less expensive.  Most importantly in our current environment, they side-step unavailable financing markets. They are no panacea. As seen in quite recent attempts at prepacks, they can present their own fair share of legal risks.  While some are clean, their zero-sum impact on capital structures lead to issues being raised by equity holders, debt-holders, or both.

Debtors’ preference for getting in and out of bankruptcy quickly can be seen in a mini-deluge of prepackaged bankruptcy filings some of which are called out below. These pre-negotiated reorganization plans result from pre-bankruptcy negotiations that are effective and (in the broad sense of the word) consensual.  While they have always proven attractive, they are now more so for two reasons. First, the less debtor friendly Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 limits a debtor’s “exclusivity” period (a period during which other interested parties are expressly prohibited from submitting reorganization plans) to a maximum of 18 months. As a result, debtors now the run the risk of having their bankruptcies proceedings high-jacked by other interested parties (debtors had a virtually unlimited exclusivity period under the old bankruptcy rules). Along with that, financing and investment markets are the elephant in the (court) room. While pre-bankruptcy recapitalization monies were once widely available from a raft of banks, private equity firms, hedge funds and other lenders, this is no longer the case. Coupled with unfriendly markets for bankruptcy financing (termed debtor-in-possession, or DIP financing), Scylla and Charybdis are starting to sound attractive. 

While all would love to enter a prepackaged bankruptcy, not all can. To over-simplify, companies enter this weakened state for one of two reasons.  They either have flawed balance sheets (in many cases due to over-leverage) or flawed P&Ls (often due to more fundamental operating issues).  The former group may not feel it, but they are the lucky few; the latter group is not.  The former have overleveraged balance sheets that may have resulted from their own debt-fueled acquisitions binges or from their acquisition (and debt-loading) by leverage-loving PE firms.  They may find the prepack process quite suitable.  This assumes that their stakeholder base (bondholders, lenders and equity-holders) is concentrated enough, or otherwise motivated, to allow effective cat-herding and decision-making.

Representing a clean and easy prepackage is Charter Communications. The country’s fourth largest cable television provider was built through a string of debt financed acquisitions. The interest payments on the company’s $21 billion worth of debt (a third of which was scheduled to mature during the next five years) was simply too much, and the company recently skipped a multi-million dollar interest payment. So, Charter started negotiating terms of a prepackaged bankruptcy with heavy weight creditors such as Fidelity, Franklin Financial, and Capital Research and Management. The parties finally settled on a deal that would be enacted within the protection of Chapter 11 and called for a debt-for-equity swap, fresh capital injection, and payment of the interest arrears. The company has disclosed that it will file for bankruptcy by April 3, 2009, and that it intends to use cash on hand to fund the bankruptcy proceedings. Nevertheless, prepackaged bankruptcies don’t always go so smoothly.

Spectrum Brands’, the maker of Rayovac batteries and Remington shavers, recent prepackaged bankruptcy is emblematic of the kinds of challenges equity holders can raise. As in most reorganizations, Spectrum’s stockholders will see their see their holdings completely wiped-out. However, at least one of Spectrum’s current shareholders believes that this plan is, to say the very least, unfair to shareholders. The “zone of insolvency” is the point at which a company’s board should switch the focus of their fiduciary duties from the economic interests of the shareholders to those of the creditors. Mittleman Brothers, a hedge fund, made a fiery filing on Form 13D this week which disclosed that it controls slightly more than 5% of Spectrum’s stock.  The filing calls the prepackaged bankruptcy plan an “obscene dereliction of fiduciary duty” and attributes the unfairness to Spectrum’s bias towards its former PE owners, who are now its creditors.  This filing presumes that the company was not within the “zone of insolvency.” The filing further demands that Spectrum withdraw the reorganization plan and support the formation of an Equity Committee. Barring that, Mittleman Brothers is prepared to file a motion with the court to force the appointment of the aforementioned committee.

Station Casinos’ recent prepackage solicitation shows how creditors can challenge an impending prepackage. The highly leveraged PE backed gaming empire recently attempted an unsuccessful out-of-court debt exchange. Station went back to the drawing board and negotiated a prepackaged bankruptcy plan with some of its creditors and solicited support from other public note holders. The reorganization plan calls for a debt-for-equity swap and capital injection to happen within the confines of Chapter 11 protection. However, in Murchison v. Station Casinos Inc, the plaintiff alleges that an impending eleventh-hour, clandestine debt exchange will substantially disadvantage his notes prior to the bankruptcy filing. The suit contains similar allegations (in fact it is filed by the same plaintiff) as Murchison v. Harrah's Entertainment Inc, which is the lawsuit against Harrah’s debt exchange offer that was recently covered in Legal Currents. The allegations included: A class action lawsuit alleging breach of indenture, violation of the all shares/best price rule, inequitable, and breach of an implied covenant of good faith and fair dealing. However, at the heart of the case seems to be a dispute around the facts of what Station is actually soliciting approval for: a debt exchange or a prepackage bankruptcy. Nonetheless, the bankruptcy process is designed to advantage certain creditors and disadvantage others, so even the most carefully negotiated prepackaged bankruptcy can lead to a creditor challenge or lawsuit.

Even faced with legal claims of breach of fiduciary duty, inequitable subordination and breach of indenture, pre-packs are still preferable to the alternatives.  Bankruptcy is a zero-sum game, at least in the short term.  As an alternative, consider the unlucky ones. They either have uncooperative stakeholders, flawed business models or both. For one reason or the other, newspapers like Tribune Co., retailers like Circuit City and the U.S. auto giants are all faced with very different prospects.  For these players, a “simple” rework of their balance sheet does not begin to solve their fundamental problems.  Prepack or otherwise, they have their work cut out for them.