For many years, private equity firms have partnered with one or more other sponsors to form consortiums to pursue large acquisition targets. In these situations, the group members want to be sure there is general philosophical alignment regarding governance, investment horizon and related matters so they can operate as a team when overseeing the business post-closing. But with private equity firms increasingly raising credit funds, equity ownership of a portfolio company by multiple sponsors may arise in a more indirect way: as the consequence of a restructuring (whether in- or out-of-court) and in which the company’s debt is converted to equity. This transformation may result in the sponsor owning and controlling the reorganized business jointly with a group of fellow former debtholders, who may have very different levels of equity investment experience and orientation. For these soon-to-be strange bedfellows, anticipating corporate governance and liquidity pressure points is essential in negotiating contractual arrangements that reconcile different perspectives and align the new governance and exit/liquidity rights with their business objectives.
To highlight current market trends regarding post-restructuring governance, we surveyed governance documents – including charters, LLC agreements and shareholder agreements – for a number of restructured companies emerging from Chapter 11. The restructured companies examined spanned the energy, retail consumer products, healthcare and telecom industries and, in more than two-thirds of the cases, had assets and liabilities between $1 billion and $5 billion. We focused on situations that involved significant prepetition debtholders converting their holdings into significant ownership stakes in the reorganized companies. In our analysis, we refer to holders of 30% or more of a reorganized entity’s common equity as “Controlling Shareholders,” holders of between 10% and 30% as “Major Shareholders” and holders of less than 10% as “Minor Shareholders.”
Our review of the governance terms of these restructurings underscored the view that a shareholder negotiating post-reorganization governance provisions should bargain for checks and balances tailored to how active a role that shareholder wants to take in the reorganized investment. Unsurprisingly, our review showed that Major Shareholders frequently bargained for director designation rights (some of which were transferrable, enhancing marketability of the equity position for those who held such rights), with such rights generally correlating with the relative size of the investor’s position to the other investors in the deal.
In addition to director designation rights, we reviewed approval requirements for particular corporate actions. Regardless of the composition of the shareholder group, it was not unusual to see transformative actions like substantial asset sales or bankruptcy filings be subject to supermajority voting thresholds at the board or shareholder level, or for particular directors or shareholders to have veto rights over such decisions when their institutions held Controlling Shareholder or Major Shareholder equity stakes. The same held true for material debt and equity issuances.
Exit rights are also a hot topic for consideration and negotiation by investors. The cases we reviewed underscored that parties often carefully consider their future plans when negotiating an exit from bankruptcy and bargain for tailored flexibility while limiting the potential for non-consensual hostile actions.
We review our findings below, including a detailed discussion of director designation rights and their transferability, approval regimes for certain significant corporate actions, and exit considerations, including a review of transfer restrictions, tag and drag rights, rights of first offer or refusal and initial public offerings.
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Director Designation Rights and Transferability
Board representation in the examples we reviewed followed the same general pattern: so long as a shareholder maintained a certain percentage ownership, it was entitled to appoint a roughly proportionate number of directors to the board, with the number of designees stepping down and ultimately falling away as the shareholder sold down or was diluted by new share issuances. In the seven cases we examined that included a single Controlling Shareholder with several Major Shareholders and Minor Shareholders, the minimum go-forward ownership required for Controlling Shareholders to maintain their original number of designees ranged from 20% to 50% of the equity. This suggests that Controlling Shareholders in crowded capital structures are expected, unsurprisingly, to maintain their substantial positions as a quid pro quo for substantial board representation.
Although all relevant governance documents we reviewed provided for step downs, one company with several Major Shareholders and Minor Shareholders—but no single Controlling Shareholder— also provided for step ups. In that case, designation rights fell away below 15% ownership, provided one designee between 15% and 35% ownership, and provided two designees at or above 35%, with the total number of board seats automatically increasing to accommodate the change. The lack of a single Controlling Shareholder appears to have allowed for the fluidity of this provision of the agreement.
One tactic used by Minor Shareholders seeking to protect their interests in the face of the greater influence of Controlling Shareholders or Major Shareholders is to be allowed to aggregate their holdings and thereby collectively satisfy minimum designation ownership thresholds. For example, in one reorganization that included a Controlling Shareholder, two particular Minor Shareholders could designate one director as long as their combined equity holdings exceeded 7.9%, and four particular Minor Shareholders could designate five directors as long as their collective holdings were at least 25%. In another case with multiple Major Shareholders, two Minor Shareholders had the right to appoint one director as long as their combined holdings exceeded 15%.
The cases we examined cut both ways regarding transferability of director designation rights, with some allowing, and others disallowing, designation rights to be transferred, and without any apparent correlation with the relative sizes of the parties involved. This is obviously an issue that is negotiated on a case-by-case basis.
While securing coveted director designation rights is often a goal for investors in a reorganized entity, such rights obviously impose legal duties and responsibilities for the individual designated. Unless the reorganized entity is a limited liability company or other legal entity that permits a fiduciary duty waiver—and all of the LLC examples we reviewed contained such waivers—directors must be aware of and abide by the fiduciary duties accompanying their position, such as the duty of care and the duty of loyalty. As we expected, most of the cases we examined included waivers of corporate opportunities (with narrow exceptions, and obviously subject to confidentiality obligations) to limit the potential for directors to be caught between competing obligations amongst companies in their individual business portfolios.
Approval Rights and Supermajority Board Votes
All the reorganized companies we examined provided for approval rights over some, if not all, of the corporate actions discussed below. Note, however, that the rights discussed here represent only a few frequent examples of what is possible; governance documents may be negotiated to include various oversight mechanisms, or a lack thereof, over corporate actions ranging from material contracts and new lines of business to annual budgets and CEO compensation.
Investor protections around significant asset sales varied widely across cases, in part due to the range in business sizes. Dollar thresholds above which board approval was required ranged from $5 million to $125 million; one shareholder agreement provided for simple majority approval for sales outside the ordinary course between $1 million and $25 million, but for sales greater than $25 million, supermajority approval was required. Another shareholder agreement provided that asset sales above a certain percentage of the company’s fair market value required two-thirds shareholder approval.
Approvals and dollar thresholds incurring new debt and equity also varied among companies, again likely reflecting that negotiations are driven by the situation’s particular circumstances. Nonetheless, patterns were observed. For all cases reviewed where there was either a Controlling Shareholder or several Major Shareholders, all material new debt required one or more of supermajority board consent, supermajority shareholder consent or the consent of principal shareholders, affording all significant parties a meaningful opportunity to influence the outcome.
Similarly, approval thresholds for new equity capital issuances varied but tended to require, regardless of the breakdown of shareholder positions, supermajority board or supermajority shareholder approval. Three reorganized companies we examined, all of which involved a single Controlling Shareholder, required the approval of named investors for any new equity issuance. The tightest restrictions in the agreements examined prohibited share issuances to anyone other than existing parties to the shareholder agreement (which itself could not be amended without majority shareholder consent); that agreement involved a single Controlling Shareholder, in addition to several Major Shareholders and Minor Shareholders. On the other hand, we also found examples requiring only a simple board or shareholder majority vote.
Predictably, shareholders placed high hurdles in front of future bankruptcy filings. One shareholder agreement negotiated among several Major Shareholders stipulated that neither the company nor any of its subsidiaries could file bankruptcy without the prior approval of 75% of directors then in office—not just those present for the vote. Another situation involving one Controlling Shareholder and several Major Shareholders required not only a board majority, but also the approval of each of three principal investors (one of whom had an ownership stake just under 40%, while the other two each held approximately 25%). Several other agreements required the individual consent of one or more Controlling Shareholders and Major Shareholders to file bankruptcy. It is worth noting that veto rights (sometimes called “golden shares”) held by creditors in bankruptcy situations, including those also holding equity positions, have been the subject of litigation. (A recent article by our Debevoise colleagues in the ABI Journal explores this topic in detail.)
Exit Considerations
When it comes to an entity’s ability to preserve its current holdings or make a full exit, the relevant rights are heavily negotiated and customized by the parties in question. The following overview of share transfer restrictions, tag and drag rights, rights of first offer or refusal, and the ability to an initial public offering (IPO) highlight the range of possibilities for addressing the need for flexibility and transferability in a reorganized entity’s equity.
About two-thirds of the reorganized entities we reviewed included share transfer restrictions in their governance documents. Again, there was no clear correlation between the relative holdings of the negotiating parties and the type of restrictions put in place, indicating that business needs or other context-specific facts may have been more important than investor preferences in determining the final negotiated terms. Two entities had hold periods after closing (of two-and-a-half and three years) with an exception for sales to affiliates, while other entities prohibited sales to competitors (with one entity including a DQ list, additions to which had to be approved by at least two principal shareholders). One entity provided for no restrictions for investors in certain classes of stock, while investors in other classes needed board approval for transfers (again with a carveout for affiliate transfers). Other entities prohibited transfers prior to an IPO, yet one entity carved out its largest equity holder from this restriction.
Similar to transfer restrictions, tag and drag rights for the entities assessed were varied. The minimum size of the proposed equity transfer triggering tag rights ranged from 10% to 50% of an issuer’s equity. Some provisions provided tag rights for all holders if the applicable minimum transferring threshold was met, while others limited rights to holders of more than 3% to 5% of the equity, leaving certain Minor Shareholders without the right to join a substantial equity sale. The most common drag structure required holders of more than 50% of the common stock (or specified classes of stock) to approve a sale transaction before other holders could be dragged into the sale (though one entity had an 80% shareholder approval threshold before drag rights could be exercised), indicating a permissive market position for general sale approval. Some entities provided time-based restrictions as well, ranging from 18 months to four years after reorganization, before a drag could be implemented. One entity we examined combined some of these elements, giving drag rights to any equitized debtholder that amassed a 66.67% equity position prior to the fifth anniversary of the restructuring or more than a 50% position thereafter.
In addition, almost all precedents reviewed included some form of a right of first offer (ROFO) or right of first refusal (ROFR) for share sales. Entities with a single Controlling Shareholder or multiple Major Shareholders as the largest holders often included exclusive ROFO or ROFR rights for such holders, highlighting the desirability of such rights when a shareholder has the negotiating power to secure them. Examples included providing a ROFO in favor of the company, but if not exercised by the company, in favor of principal stockholders; a ROFR held by the company and one specific Controlling Shareholder; and a ROFO expiring three years after the effective date reserved for the company and two Major Shareholders, as long as their individual ownership thresholds at the time of the offer continued to be at least 15%.
These types of transfer restrictions fell away upon an IPO (as they should if appropriately drafted). Supermajority board and shareholder votes were common for approving an IPO, ranging from 75% board majorities (in a deal among several Major Shareholders), to approval by all directors designated by principal shareholders (in a deal among a Controlling Shareholder and two Major Shareholders), to a single specified investor’s consent (in a deal involving a Controlling Shareholder with almost two-thirds of the post-reorg equity), to the consent of at least one director appointed by the largest principal shareholder and one director appointed by another principal shareholder (in a deal with one Controlling Shareholder, several Major Shareholders and several Minor Shareholders). Still, a handful of entities required a simple majority board vote regardless of whether there was a Controlling Shareholder.
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In the end, our recent market check suggests that parties can confidently advocate for protections that fit their priorities, making thoughtful post-reorganization planning a key exercise in any restructuring negotiation. While an investor’s percentage ownership stake in the entity in question is a major factor in determining the negotiating weight they can leverage to secure the governance rights most important to their goals, the above analysis highlights the diversity of outcomes that are possible when creative negotiating is paired with solutions tailored to the facts and circumstances of the business entity and parties in play.
The Private Equity Report Fall 2024, Vol 24, No 3