Plan support agreements are often an essential component of a successful complex Chapter 11 reorganization and provide a framework for a debtor's financial restructuring. These agreements have increasingly been used to induce core groups of major lenders and bondholders to support a debtor's restructuring in return for enhanced recoveries. In re Peabody Energy, 933 F.3d 918 (8th Cir. 2019). Recently, the U.S. Court of Appeals for the Eighth Circuit in the Peabody Chapter 11 cases affirmed confirmation of a plan of reorganization built around a plan support agreement that afforded certain noteholders party to the agreement the exclusive right to purchase a disproportionate amount of the equity in reorganized Peabody sold pursuant to the plan. A group of non-signatory bondholders (the ad hoc group) had objected and argued that the right to participate in the in the new equity raise was not offered on the same terms to all bondholders, thereby rendering the plan unconfirmable under the U.S. Bankruptcy Code.

The Eighth Circuit ruled that the right to purchase equity at a substantial discount was not value distributed on account of prepetition claims but rather was "consideration for new valuable commitments" provided by PSA bondholders at a time of uncertainty in the coal markets. The Peabody decision represents a growing judicial trend toward enhancing bondholder recoveries under plan support agreements, which serve as the necessary "grease" to garner critical support and momentum for the debtor's Chapter 11 plan.

Background

Upon filing for Chapter 11 in April 2016 in the U.S. Bankruptcy Court for the Eastern District of Missouri (the Bankruptcy Court), Peabody's capital structure consisted primarily of (1) approximately $2.85 billion outstanding under first lien credit facilities, (2) $1 billion of second lien secured notes, and (3) $4.5 billion of unsecured senior notes and subordinated debentures.

Prior to the Chapter 11 filing, a $1 billion-plus contractual dispute developed between Peabody's secured lenders and its subordinated and unsecured noteholders concerning the extent of the secured lenders' security interest in the Peabody's coal mines (the collateral dispute). The debtors ultimately supported the unsecured noteholders in the collateral dispute and commenced litigation in the Bankruptcy Court seeking to limit the dollar amount of secured claims that could be asserted against the company. The Bankruptcy Court subsequently ordered the debtors, its secured lenders, and certain noteholders active in the litigation to participate in non-binding mediation in an attempt to resolve their disagreements. Other noteholders retained the right to petition the Bankruptcy Court for authority to participate in the mediation, but could not do so without agreeing to refrain from trading their notes and certain other conditions. Id. at 918-24.

New Capital Raise

The mediation ultimately produced a resolution of the collateral dispute in the context of an agreement between Peabody and the mediation parties on a Chapter 11 plan of reorganization (the plan) built around $1.5 billion in new equity commitments. The $1.5 billion equity raise had two components: (1) a $750 million "rights offering" of reorganized Peabody's common equity offered at a 45% discount to the equity value assigned in the Plan, and (2) a $750 million "private placement" of reorganized Peabody's preferred equity offered at a 35% discount to plan equity value. While all second lien and unsecured noteholders were given the opportunity to participate in the rights offering on a pro rata basis, participation was in the private placement was more complicated and less uniform. Id.

The preferred equity offered under the Private Placement was divided into three tranches. The first 22.5% was made available to only seven second lien and unsecured noteholders that were active participants in the mediation and in structuring the plan (the noteholder co-proponents), and who also agreed to purchase any unsubscribed amount of the remaining 77.5% of preferred stock. The next 5% was offered on a pro rata basis to all second lien or unsecured noteholders (including the noteholder co-proponents) that returned the required documentation discussed below by Dec. 28, 2016. As the required documentation was voluminous, first made public on December 22nd and 23rd, and actually received by individual noteholders shortly thereafter, the ad group argued that the debtors and noteholder co-proponents intentionally gave other noteholders an unreasonably short response period over a holiday week in order to make it difficult or impossible to participate in the 5% tranche. Finally, the remaining 72.5% of preferred stock was offered to all unsecured and second lien noteholders on a pro rata basis (including the noteholder co-proponents and any other noteholders that participated in the 5% tranche) and noteholders were given over thirty days to return the required forms. Id.

Private Placement Documentation

In order to participate in the Private Placement, second lien and unsecured noteholders were required to sign a plan support agreement (PSA). The PSA made participating noteholders contractually obligated to vote their existing notes in favor of the plan (which provided for an approximately 52% return on second lien note claims and an approximately 22% return on unsecured notes claims regardless of whether noteholders participated in the rights offering or the private placement). The PSA also prohibited participating noteholders from objecting to plan and all plan related documents and from transferring their notes to anyone not already party to the PSA or willing to sign a PSA joinder form. Finally, the PSA provided for the payment of a substantial "breakup fee" to noteholders in the event Peabody exercised its "fiduciary out" and pursued an alternative transaction prior to confirmation of the plan.

In addition to the PSA, noteholders participating the in private placement were required to sign a commitment agreement requiring them to "backstop" any portion of the rights offering that went unsubscribed. Peabody paid two different cash premiums to participating noteholder at closing in exchange for this commitment.

Legal Background

Section 1123(a)(4) of the Bankruptcy Code mandates that a Chapter 11 plan "provide the same treatment" for each claim or interest placed in the same class of claims or interests unless members of the class agree to less favorable treatment. In the absence of this provision, a debtor could allocate disproportionate recoveries to certain holders of the same bonds or syndicated loan in order to create support for a Chapter 11 plan at the expense of creditors with identical prepetition claims.

Despite §1123's equal treatment rule, there are several decisions from U.S. Circuit Courts of Appeals recognizing that a plan may treat members of the same class differently "so long as the treatment is not for the claim but for distinct, legitimate rights or contributions from the favored group separate from the claim." Id. at 925. For example, the Ninth Circuit affirmed confirmation of a Chapter 11 plan that did not provide for identical treatment of a company's shareholders because the debtor was able to establish that the different treatment afforded to one shareholder was provided on account of the shareholder's service as an officer and director of the debtor. In re Acequia, 787 F.2d 1352, 1358 & n.4 (9th Cir. 1986)

Additionally, while there is no Supreme Court precedent interpreting the equal treatment requirement, a landmark Supreme Court decision interpreting a different Bankruptcy Code section played an important role in Peabody. In Bank of America National Trust. & Savings Association v. 203 North LaSalle Street, the Supreme Court held that a plan that offered an existing equity holder the exclusive right to participate in a discounted equity raise violated the "absolute priority rule" embodied in Bankruptcy Code §1129. The absolute priority rule prevents distributions "on account of" junior debt claims or equity interests where a senior creditor class is not paid in full and votes against the plan. The Supreme Court held that the term "on account of" should be interpreted broadly and that only a "causal relationship between holding the prior claim or interest and receiving or retaining property … activates the absolute priority rule." Bank of America National Trust & Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999). As the equity holder at issue in 203 North LaSalle clearly received the exclusive right to contribute new capital (without any market test of the proposed terms) as a result of its connection to the debtor, the Supreme Court found that the absolute priority rule was violated. And while the absolute priority rule was not at issue in Peabody, the Supreme Court's findings regarding when value is distributed on account of prepetition claims was clearly relevant to whether the additional consideration offered to certain noteholders under the plan was on account of their prepetition claims or new contributions to the company.

Eighth Circuit Opinion

As noted above, an ad hoc group of second lien and unsecured noteholders elected not to sign the plan support agreement and other documentation necessary to participate in the private placement and instead actively opposed the plan. The ad hoc group argued that the right to purchase equity in reorganized Peabody "at a significant discount" and receive significant commitment premiums were "valuable property." And citing 203 North LaSalle, the ad hoc group stressed that such property was clearly being distributed on account of prepetition claims because of the integral role the noteholder co-proponents played in structuring the plan and the fact that other noteholders could only participate in the private placement if they agreed to support the plan.

The Eighth Circuit, like the bankruptcy and district courts, rejected the ad hoc group's equal treatment arguments. Its conclusion relied heavily on the case law referenced above establishing that different treatment within a class of claims is permitted where certain members of the class are providing additional consideration to the company. Here, it stressed that the new financing commitments provided by the noteholder co-proponents warranted additional consideration given the "volatility of coal markets at the time and uncertainty as to the debtors' future." In re Peabody Energy, 933 F.3d at n.4. The Eighth Circuit also noted that all noteholders had the right to petition the Bankruptcy Court for authorization to participate in the mediation that resulted in formulation of the plan in finding that allocating additional private placement rights to those noteholders that played a central role in structuring the plan did not violate the equal treatment rule.

Finally, the Eighth Circuit distinguished 203 North LaSalle simply by noting that, unlike the dissenting creditor in 203 North LaSalle, the ad hoc group was given the right to submit a competing proposal to Peabody. In connection with its initial objection to the plan, the ad hoc group had offered to backstop a sale of approximately $1.75 billion in new equity capital at no discount to plan equity value and without a break-up fee. This offer was rejected by both Peabody and its Official Committee of Unsecured Creditors (who independently reviewed the proposal at Peabody's request). The Eighth Circuit did acknowledge that Peabody's decision to proceed with the plan and reject the ad hoc group's proposal was motivated in part by the break-up fees associated with terminating the PSA and the additional litigation expenses that would be required to resolve the collateral dispute in the absence of the plan. Id. at 925-27.

Conclusion

In its Peabody decision, the Eighth Circuit blessed an extremely aggressive use of a new capital raise and plan support agreement to build and lock in support for a Chapter 11 plan. Its conclusions suggest that a debtor can disproportionality allocate the right to participate in exit financing among similarly situated prepetition creditors. And more importantly, a debtor can do so as long any clear value associated with participating in the financing (such as the right to purchase new equity at a discount or receive financing premiums) can be attributed to risks associated with the financing and therefore not tied to the participating creditors' prepetition claims. While this decision was highly dependent on the unique facts outlined above, it will be interesting to see if debtors will increasingly rely on exit financing and plan support agreements to build consensus among litigious creditors and, if so, whether courts in other jurisdictions will adopt a similarly narrow interpretation of what is required under the Bankruptcy Code's equal treatment rule where exit financing is provided by prepetition lenders.

John J. Rapisardi is a partner and chair of the corporate restructuring practice of O'Melveny & Myers. Joseph Zujkowski is a partner in the firm's restructuring practice. O'Melveny provided counsel to the ad hoc group discussed herein in connection with their appeal to the U.S. Court of Appeals for the Eighth Circuit.