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Using a Debt-for-Equity Swap to Acquire a Distressed Business: The Constar International Bankruptcy as a Case in Point


Corporate & Finance Alert

April 7, 2009

Debt-for-equity swaps were a fairly common means of acquiring a distressed business in the 1980’s and the 1990’s. As the name suggests, by such a swap, a creditor or a group of creditors would acquire a distressed business by converting their debt into equity. Such swaps could occur either inside or outside of bankruptcy. As a result of the swap, the distressed business’ balance sheet could be significantly delevered. The price for the swap, however, was that existing equity would be substantially diluted or (especially in a bankruptcy context) eliminated altogether. The obvious risk inherent in a debt-for-equity swap is the ultimate failure of the acquired business. In that event, the erstwhile creditor(s), now equity holder(s), would lose their investment, especially if the business were liquidated in a bankruptcy.

Six bankruptcy cases filed by affiliated debtors at the very end of 2008 in the United States Bankruptcy Court for the District of Delaware (“Bankruptcy Court”) demonstrate that debt-for equity swaps may remain a viable method of acquiring a distressed business. On December 30, 2009 (“Petition Date”), Constar International, Inc. (“Constar”) and five subsidiaries (collectively, with Constar, “Debtors”) filed voluntary Chapter 11 bankruptcy petitions with the Bankruptcy Court. With their bankruptcy petitions, the Debtors filed a pre-arranged Joint Plan of Reorganization that memorialized the results of pre-petition negotiation with certain creditor constituencies. The stated goal of the bankruptcy filing was to convert senior subordinated debt into equity, thereby delevering the Constar balance sheets by approximately $175 million. This article will address the Constar bankruptcy and the issues raised by the debt-for-equity swap that is the linchpin of the proposed reorganization.

Constar is the is the parent of four wholly owned subsidiaries, all of which are debtors in bankruptcy with Constar. One of those subsidiaries is the parent of three wholly foreign subsidiaries, one of which is also a debtor in bankruptcy with Constar. Constar was purchased by Crown Cork & Seal Company, Inc. (“Cork”) in 1992. As a result of a 2002 IPO in which Crown sold 10.5 million of its shares in Constar, which constituted most of its equity in Constar, Constar became a public company. As of December 31, 2007, Crown owned approximately 10% of Constar’s public stock. As of the Petition Date, there were no issued or outstanding shares of preferred stock in Constar. As a result of the bankruptcy filing, on January 8, 2009, Constar’s stock was de-listed from the NASDAQ Stock Market.

Contemporaneously with the 2002 IPO, on November 20, 2002, Constar completed a public offering of $175 million in 11% Senior Subordinated Notes with a maturity of December 1, 2012 (“SSN’s”). At that time, Constar also entered into a $250 million senior secured credit facility consisting of a $150 million seven-year term loan and a $100 million five-year revolving loan facility. The proceeds from the SSN offering and the term loan were used to repay indebtedness to Crown.

On February 11, 2005, Constar completed a refinancing of its secured debt by means of a sale of $220 million in Senior Secured Floating Rate Notes due 2012 (“Senior Secured FRN’s”) and contemporaneously entered into a four-year $70 million Senior Secured Asset Based Revolving Credit Facility (“ABR Facility”). As a result of an interest rate swap in February, 2005, $100 million in face value of the Senior Secured FRN’s had an effective fixed interest rate of 7.9%.

Constar and its subsidiaries are global producers of polyethylene terephthalate (“PET”) plastic containers, primarily designed and manufactured for soft drinks and water. Constar has also been expanding into the growing custom PET market. Notwithstanding its expansion into that market, however, Constar’s revenues have declined and its losses increased over the last several years. Constar pointed in various pleadings in its bankruptcy case to declining consumer demand for carbonated beverages and bottled water and the shift by water bottlers and other customers to self-manufacturing of bottles and other containers as the major causes of its financial problems. Constar’s distressed financial situation is particularly evidenced by a decline in net cash from operations between 2006 and 2007 from $44.3 million to $10.3 million. Under those circumstances, by Autumn, 2008, Constar had concluded that they were unable to support their debt load. In light of the current credit crisis, they also concluded that refinancing its debt on commercially reasonable terms was at best unlikely.

Faced with the financial challenges outlined above, Constar began negotiations with certain holders of the SSN’s during 2008 to restructure the Debtors’ debt. The negotiation let to the formation of an Ad Hoc Committee of holders of SSN’s (“Ad Hoc Committee”), the members of which, Constar believed, held more than 50% of the face amount of the SSN’s. The negotiations with the Ad Hoc Committee led to a proposal to convert the SSN’s into new equity in Constar. Such a conversion would significantly reduce the Constar Debtors’ debt load, as well as its debt service obligations. By December 15, 2008, Constar and the Ad Hoc Committee had reached an agreement in principle whereby the Debtors would file Chapter 11 bankruptcy petitions and a joint pre-arranged plan of reorganization providing for, inter alia, (i) the conversion of the SSN’s into equity of a reorganized Constar (except for shares reserved for Constar’s management pursuant to a management incentive plan), (ii) the payment in full of the Debtors’ trade vendors, and (iii) the reinstatement of the Senior Secured FRN’s and their payment in full according to their terms, thereby leaving them unimpaired for purposes of the Bankruptcy Code. None of the members of the Ad Hoc Committee are bound to vote in favor of the pre-arranged plan, but Constar believes that the plan has the support of a majority of the holders of the SSN’s.

On December 30, 2008 (“Petition Date”), along with their bankruptcy petitions, the Debtors filed Disclosure Statement for the Debtors’ Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code (“Initial Disclosure Statement”), to which a copy of the pre-arranged Joint Plan of Reorganization Under Chapter 11 of the United States Bankruptcy Code (“Initial Plan”) was attached as an exhibit. On the same day, the Constar debtors filed a motion for the approval of the Initial Disclosure Statement. The hearing for the approval of the Initial Disclosure Statement was set for February 3, 2009, a date only thirty-five (35) days after the bankruptcy filings.

As of the Petition Date, the Constar debtors’ outstanding indebtedness for borrowed money included $220 million in Senior Secured FRN’s and $175 million in SSN’s. As of December 17, 2008, the Constar Debtors’ indebtedness for borrowed money also included approximately $23 million in borrowings under the ABR facility and approximately $6.1 million under issued but undrawn lines of credit. Following the Petition Date, the Constar Debtors obtained debtor in possession financing (“DIP Facility”) of up to $75 million from a syndicate of lenders including Citigroup Global Markets, Inc. and Wells Fargo Foothill, LLC, with Citicorp USA, Inc. as Administrative Agent. This facility was expected to provide sufficient funds for the Debtors’ operations for the limited time they anticipated functioning in bankruptcy. It also contemplated the satisfaction of the amounts due on the ABR Facility.

The docket of the Constar bankruptcy cases does not reflect that any opposition was filed to the approval of the Initial Disclosure Statement. However, the Debtors clearly continued negotiations with various creditor constituencies, which are reflected in the revisions to the Initial Disclosure Statement and the Initial Plan. Those negotiations led to the filing of a First Amended Joint Disclosure Statement for the Debtors’ First Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code and a First Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code on January 29, 2009. Further negotiations resulted in the filing, on February 3, 2009 of a Second Amended Joint Disclosure Statement for the Debtors’ First Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code (“Amended Disclosure Statement”) and a Second Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code (“Amended Plan”). Subject to certain immaterial modifications to the Amended Disclosure Statement and the Amended Plan that were addressed at the February 3, 2009 hearing on the adequacy of the Amended Disclosure Statement, the Bankruptcy Court approved the Amended Disclosure Statement. A hearing for the confirmation of the Amended Plan has been set for April 27, 2009, a date less than one hundred twenty (120) days after the Petition Date.

Consistent with the results of the pre-petition negotiations with the Ad Hoc Committee, the Amended Plan provides for the de-acceleration and allowance in full of the Senior Secured FRN claims. Similarly, in full and final satisfaction of their claims against the Debtors, the holders of SSN’s will receive a pro rata share of the stock in the reorganized Constar upon the effective date of the Amended Plan, which is anticipated to occur approximately 11 days after its confirmation. The Debtors will pay the expenses of the Indenture Trustee for the SSN’s in full. Essentially, the plan provides for the holders of SSN’s to become the new owners of Constar, which will continue to own its subsidiaries. As noted above, that ownership is subject to the possible dilution of that ownership by shares in the reorganized Constar Debtors to be reserved pursuant to a management incentive plan. Consistent with the change in ownership of Constar to the holders of SSN’s, the existing tock in Constar, including Crown’s stock, will be cancelled.

The Amended Plan also provides for the payment in full of administrative priority claims, priority tax claims and general unsecured claims against the Debtors in a manner, the Debtors contend, will leave those claims unimpaired for purposes of the Bankruptcy Code. In point of fact, the Amended Plan contemplates the payment of the bulk of the administrative, priority tax and general unsecured claims against the Debtors very shortly after its confirmation, on the effective date of the Amended Plan.

Subject to the terms of the DIP Facility and at the Constar Debtors’ option, claims arising under the DIP facility will either be paid in full or converted in to an exit financing facility. Payment of the DIP Facility in full upon confirmation, however, will only occur if the Debtors’ obtain alternative exit financing.

Claims arising out of the rescission of a purchase or sale of a security of Constar or one of its affiliates, for damages arising from the purchase or sale of such a security or from an contribution or reimbursement claim arising out of such a purchase or sale will receive no distribution under the plan. By virtue of § 510(b) of the Bankruptcy Code, those claims are subordinated to the payment of unsecured claims. Consequently, pursuant to § 1129(b) of the Bankruptcy Code, as long as existing equity receive nothing from a distribution under the Amended Plan, holders of subordinated claims need not receive any payments under the Amended Plan.

The Amended Plan is structured so that the Constar Debtors’ need only obtain the acceptance of the holders of the SSN’s, and, in fact must obtain the acceptance of the holders of the SSN’s. See § 1129(a)(10) of the Bankruptcy Code (if a plan of reorganization impairs any class of claims, as a condition to confirmation, at least one of those classes of claims must accept the plan), The holders of priority tax claims, Senior Secured FRN’s and general unsecured claims will be paid in full so their claims are otherwise unimpaired for purposes of the Bankruptcy Code. Hence, they are deemed to have accepted the Amended Plan. The holders of § 510(b) claims and existing equity interests in Constar will be deemed to have rejected the Plan, because they will receive no distributions under the Amended Plan. Under § 1126(c) of the Bankruptcy Code, to obtain the necessary acceptance of the holders of the SSN’s, the Debtors will need the votes of at least half of those holders of SSN’s who vote on the Amended Plan and those holders must hold at least two-thirds of the face amount of the SSN’s of those holders of SSN’s voting on the Amended Plan. In sum, confirmation of the Amended Plan is largely dependent on the Debtors’ gamble that the Amended Plan enjoys sufficient support from among the holders of SSN’s.

The Constar bankruptcy case showcases the benefits, potential limitations and risks involved in the acquisition a distressed business through a debt-for equity swap in a bankruptcy case. For the distressed business, such a swap can substantially de-lever its balance sheet and bring its debt service obligations to a more manageable level. For the creditors seeking to acquire the business, assuming the bankruptcy case does not get mired in delay, a debt-for-equity swap in bankruptcy can provide a streamlined process for acquiring the business, especially if the major creditor constituencies are on board, as appears to be the case in the Constar bankruptcy. In that regard, if the Amended Plan is actually confirmed on April 27, 2009, the Debtors could be out of bankruptcy, with new owners in place and a much lower debt burden, by late April, less than five months after the Petition date. Utilizing a debt-for-equity swap in a bankruptcy scenario also eliminates the risk to a creditor seeking to acquire a distressed business inherent in an asset sale (whether under § 363 of the Bankruptcy Code or, outside of bankruptcy, in an Article 9 UCC sale) that another party may be the successful bidder. The entry of a confirmation order in a bankruptcy case can provide the new owners of a distressed business with clear evidence of their ownership interest that is not subject to the uncertainties and second guessing that can accompany the acquisition of a business via a Chapter 9 sale, particularly a private sale. The acquisition of a large or complex business can be better accommodated by a debt-for-equity swap under a bankruptcy plan of reorganization. Finally, in contrast to a debt-for-equity swap outside of bankruptcy, a debt-for-equity swap grounded in a bankruptcy plan of reorganization can provide for the discharge of some the distressed company’s debt without full payment, although administrative, pre-petition priority and secured claims (up to the value of the collateral) must be paid in full. It bears noting, however, that the Bankruptcy Code provides flexibility in the payment or restructuring of priority tax claims and secured claims, something that is not as readily available outside of bankruptcy and can be a very valuable restructuring tool.

As the Debtors expressly recognized in the Amended Disclosure Statement, however, a debt-for-equity swap is not without risk and is probably viable only in certain contexts. In the Constar bankruptcies, for example, the various creditor constituencies have, thus far, been very cooperative, something that does not always happen, even in a bankruptcy proceeding. A lack of cooperation between creditor constituencies can drown a bankruptcy case in delay and, in some cases, prevent confirmation if a plan proponent cannot obtain sufficient creditor support for a plan. In that regard, the formulation of the Amended Plan demonstrates the Debtors’ acknowledgement of the need to obtain sufficient creditor support for the Amended Plan and have left most creditor classes unimpaired and are relying on obtaining the votes of the class of creditors (the holders of SSN’s) who seem very likely to support the Plan. In sum, the Debtors have proposed an Amended Plan that is likely to encourage cooperation between creditors and the Debtors and between and among creditor constituencies.

The Debtors also recognize that, even if it is grounded in a debt-for-equity swap, a plan of reorganization must comply with all applicable provisions of the Bankruptcy Code. The Debtors recognize in the Amended Disclosure Statement that, even if a debtor or other plan proponent obtains sufficient votes to confirm a plan, the objection by one creditor can de-rail confirmation if the creditor can convince the bankruptcy court that the plan violates an applicable provision of the Bankruptcy Code. In this regard, although the Debtors believe that the Amended Plan complies with all of the applicable provisions of the Bankruptcy Code, the Bankruptcy Court might disagree.

Another risk to the success of a successful debt-for-equity swap is that there may be insufficient financing available to fund either or both of (a) the distressed business’ operations pending consummation of the swap and (b) the reorganized business’ emergence from bankruptcy. In that regard, it bears noting that the Debtors were able to obtain the DIP Facility to fund their operations pending the debt-for-equity swap, which, at the Debtors’ option, can be converted to exit financing. The Debtors also anticipate having sufficient funds to pay administrative expenses, priority tax claims and general unsecured claims on or shortly after the effective date of the Amended Plan, a significant portion of which may be funded through the DIP Facility. Obtaining the DIP Facility was probably facilitated by the likelihood Constar bankruptcy would be resolved on an expedited basis. However, it is more difficult to get DIP financing in the current credit markets. In sum, as with any other bankruptcy reorganization, a bankruptcy reorganization grounded in a debt-for equity swap requires sufficient funding, whether through operations, DIP financing or funding by the creditors whose debt will be converted into equity.

A debt-for equity swap can also trigger defaults under existing loan or contract documents, registration requirements under state or Federal Securities laws or the loss or reduction of tax attributes. For example, as the Constar debtors recognize, a debt-for-equity swap can trigger change-of-control provisions in loan and other transactional documents that can effectively undo the benefits of the swap. Indeed, one of the conditions for consummation of the Amended Plan will be a determination by the Bankruptcy Court, that, at least for some purposes, the conversion of the SSN claims into equity and the extinguishment of existing equity will not be deemed to have resulted in a change-of-control of the Debtors.

A debt-for-equity swap may also trigger registration requirements under Federal or state Securities Acts, particularly if a creditor accepting securities in exchange for debt seeks to resell the security. Utilizing a bankruptcy to effectuate a debt-for-equity swap can reduce that risk. In that regard, § 1145 of the Bankruptcy Code generally exempts from the requirements of state and Federal Securities laws concerning the purchase and sale of securities the offer or sale of stock, options, warrants or other securities by the debtor if (a) the offer or sale occurs under a plan of reorganization, (b) the recipients of the securities hold a claim against, an interest in, or claim for administrative expense against, the debtor, and (c) the securities are issued in exchange for a claim against or interest in the debtor or are issued principally in such exchange and partly for cash and property. However, a determination whether the offer of securities under a plan is exempt from state or Federal securities registration law can be complicated and any creditor being offered securities under such a plan should consult experienced securities counsel before accepting the plan or the securities. The same is especially true if the creditor seeks to re-sell the securities distributed to it under a plan of reorganization. Indeed, in the Amended Disclosure Statement, potential recipients of securities in the proposed debt-for equity swap are advised to consult counsel to determine the extent to which the distribution to them of equity in the reorganized Constar and their re-sale of those securities are exempt from state and Federal securities registration laws.

A debt-for-equity swap may have tax ramifications for both the distressed business so acquired and the creditors who receive stock in the distressed business in exchange for their claims. Although a debt-for-equity swap in bankruptcy should not technically result in cancellation of indebtedness income to the distressed business, it will likely result in the reduction of the distressed business’ tax attributes, such as net operating loss carryforwards. The swap also will likely be deemed an ownership change for federal income tax purposes potentially further limiting the ability to utilize net operating loss carryforwards and other tax attributes. The Internal Revenue Code includes provisions that specifically address debt-for-equity swaps effected in bankruptcy court that may favorably alter these results.

For the creditor receiving stock in exchange for its claim, the income tax treatment of the swap will depend in large part on whether the debt instrument held by the creditor constitutes a security for purposes of the Internal Revenue Code. The “market discount” provisions of §§ 1276 through 1278 may also trigger adverse tax consequences because of the debt-for-equity swap. In sum, as the Debtors recognized in their Amended Disclosure Statement, a creditor seeking to swap debt for equity should have experienced tax counsel carefully review the proposed transaction and the relevant facts to determine the tax consequences to both the distressed business being acquired and the creditor receiving equity in exchange for debt before entering into the transaction.

Of most importance, however, is the fact that a successful debt-for equity swap will not guaranty the survival of the distressed business. The Debtors, for example, spend several pages outlining the business challenges they will face after reorganization which could affect their profitability as reorganized entities. They make it clear that the stock that the holders of SSN’s will receive upon confirmation may ultimately be worthless if the reorganized Debtors fail.

In conclusion, a debt-for-equity swap grounded in a plan of reorganization can provide an expeditious means for creditors to acquire a distressed business. The swap can eliminate the uncertainties inherent in a UCC Article 9 sale and the risk of another party acquiring the business. Grounding the swap in a bankruptcy plan can also provide a means of reducing and/or restructuring the distressed business’ debt. However, a swap grounded in a bankruptcy plan is not without risks – bankruptcy cases can get bogged down in delay. The cooperation of significant creditor constituencies is imperative to avoid these delays but is not always obtainable. Any necessary financing must be available and the creditor seeking to acquire a distressed business through a debt-for equity swap may need to provide DIP and exit financing. Tax and securities law considerations must be addressed. Finally, even a successful swap will not guaranty future business success.

Should you have any questions regarding your own situation, please contact David N. Crapo of our Financial Restructuring & Creditor’s Rights Department or your Gibbons attorney in our Corporate Department.