Reorganisation plans frequently include releases of non-debtor third parties, but this is one area where informed hedge fund creditors have significant power to resist the destruction of an important alternate source of recovery.
Debt investors are generally savvy enough to obtain third-party guarantees of their claims, often by the principal debtors’ subsidiaries, directors or other closely related parties. When the principal debtor goes into bankruptcy or reorganisation, the return on a debt investment is likely to depend in large part on the enforceability of these guarantees.
Debtors commonly attempt to protect related parties from their guarantee exposure, however, by folding these obligations into a restructuring plan that provides for a release of the non-debtor third-party guarantors in exchange for whatever distribution is made to creditors under the plan.
A group of hedge fund investors recently won a major victory in just such a case, a case that will serve as a useful point of reference for future resistance to such releases. Vitro SAB de CV is a century-old Mexican holding company for a large glass-manufacturing conglomerate. Vitro had borrowed about $1.2 billion on unsecured notes, guaranteed by substantially all of Vitro’s subsidiaries. Around the time when Vitro announced its intention to restructure its debts, vulture fund investors snapped up the notes, likely seeking a tidy arbitrage profit.
Vitro pursued an aggressive strategy in its Mexican restructuring proceedings. While it was negotiating several ill-fated informal restructuring proposals with its external creditors, Vitro upended its debt position with its subsidiaries, exchanging $1.2 billion in claims against the subsidiaries for $1.5 billion in obligations owed to the subsidiaries.
This positioned the subsidiaries as insider creditors with substantial influence over the voting regime in Vitro’s formal Mexican proceedings to come. In contrast to US reorganisation law, the Mexican restructuring law did not require Vitro to segregate its insider creditors from its external creditors. As a result, Vitro was poised to submit an insider-supported pre-packaged restructuring plan soon after initiating formal restructuring proceedings in December 2010.
Vitro’s plan proposed to extinguish the $1.2 billion in external debt and release the subsidiaries from their guarantees in exchange for a distribution to creditors of (1) a nominal cash payment, (2) $800 million in new guaranteed notes, with payments delayed by several years, and (3) $95 million in debt obligations convertible into 20 per cent of Vitro’s restructured equity.
This plan was approved by the requisite majority of creditors, but only because the majority of voting claims were inter-company debt held by Vitro’s subsidiaries. No more than one-third of the external creditors accepted this plan, but Vitro was able to orchestrate an insider-driven cram-down on its external creditors. The Mexican court approved the plan, which became effective in February 2012.
A group of dissident hedge fund investors resisted this end-run around the terms of the note indenture, particularly with respect to the forced release of the non-debtor subsidiary-guarantors. These objecting creditors pursued a variety of enforcement actions in US courts against the US assets of Vitro and its subsidiaries.
Seeking to enforce the terms of its Mexican restructuring order and terminate the US enforcement actions, Vitro initiated a case under Chapter 15 of the US Bankruptcy Code. While Chapter 15 takes a very accommodating stance toward cross-border recognition of and cooperation with foreign insolvency orders, the Vitro case illustrates the limits of this cooperation. Vitro’s requested relief was denied by the Bankruptcy Court and then again by the regional Court of Appeals, the highest court for all but a small handful of US cases.
The appellate decision provides useful guidance for both debtors and creditors with respect to the narrow boundaries of US enforcement of third-party releases in foreign insolvency decrees. The court explicitly reconfirmed the US policy of cooperating with foreign insolvency orders, announcing that “comity is the rule under Chapter 15, not the exception”. This is true, the court acknowledged, even in cases where US law would not allow for the kind of relief provided in the foreign order.
Though most US courts had concluded that third-party releases of the kind present in the Vitro plan were prohibited, a few courts had held otherwise, so a third-party release might meet the governing standard of being “substantially in accordance with” US bankruptcy law.
The few cases that had approved third-party releases, however, strictly limited their use to “extraordinary circumstances”. Such releases might be acceptable if they were essential to a successful reorganisation, the released guarantors had provided substantial consideration to the estate for the benefit of creditors, and the creditors whose guarantee claims were to be released had either consented to the plan by a large majority or had received full payment on their claims.
Nothing approaching any of these factors was present in Vitro’s case. Shareholders were to retain $500 million in interests under the plan, rather than infusing this value into a distribution to creditors, who were taking a substantial haircut – hardly a context that suggested an essential need for non-consensual third-party releases.
The subsidiaries here did not seem to have contributed any value to the estate; indeed, $1.5 billion in claims against them had disappeared in a suspicious eve-of-restructuring planning strategy.
Most troubling, these releases were approved by only a small fraction of affected noteholders in a plan that proposed payment of less than half of creditors’ original claims. Vitro is a virtually perfect illustration of how not to structure a third-party release for successful importation into the US.
Illustrations of successful releases have appeared recently on the northern side of the US border. In the 2010 case of Metcalfe & Mansfield Alternative Investments and again in 2012 in the case of Kitchener Frame Limited, Canadian courts approved third-party releases accepted by nearly 100 per cent of affected (non-insider) creditors, the releases were essential to a successful reorganisation plan, and the released parties were contributing tangibly and meaningfully to the plan.
The Metcalfe release was later successfully enforced in the US under Chapter 15, and the Kitchener Frame release likely will be if the debtors attempt to enforce their plan in the US.
Vitro’s case thus represents an important landmark for both debtors and creditors. In explicit and expansive terms, it reaffirms the US dedication to cooperation and comity with foreign insolvency orders.
Nonetheless, it points out that creditors retain important bases for resistance when debtors take advantage of foreign restructuring laws that diverge too dramatically from US practice.
Third-party releases are one common incursion into creditors’ rights where creditors have greater than usual traction for resistance, at least insofar as enforcement against US assets is concerned.