Death Trap Provisions in Chapter 11 Cases: Coercion by Another Name
If you were asked to quickly define what the chapter 11 process involves – in no more than a sentence – a reasonable answer would be that it involves bucketing all pre-existing creditors into distinct classes, coming up with a valuation for the debtor moving forward, and then creating a Plan of Reorganization that a sufficient number of impaired creditors can agree to which specifies the recovery value of the aforementioned classes loosely based on the rule of absolute priority.
Just looking at the above answer might make the process sound quite prosaic. In fact, it may all sound entirely mechanical -- as if the chapter 11 process is really just a conveyor belt that every debtor predictably moves along until they re-emerge from bankruptcy.
However, while the conveyor belt analogy isn’t wrong – since every debtor is going to follow more or less the exact same process, there is a defined format for how certain documents should look, etc. – think about how much subjectivity is involved at each stage of the process (e.g., how do we know what the debtor is really worth?).
The strict and sophisticated framework that envelops the chapter 11 process – all overseen by the loving grace of the court – belies the fact that the process all boils down to the debtor and a sufficient number of impaired creditors negotiating an equitable plan for moving forward.
If you’ve ever found yourself taking a step back and asking yourself why restructuring investment bankers are bringing in eight-figure fees for navigating what, at least superficially, appears to be a rather mechanical process, here’s your answer: you have adversarial and aggrieved parties clawing at a limited pool of economic value, and they need to be guided towards some kind of mutually agreed upon solution so everyone can move on (because the longer the debtor is in-court, the more they’ll be bleeding value).
So, a restructuring banker is being paid for their knowledge of the process, their ability to devise an equitable solution, and (most importantly) their ability to get that solution agreed to by a sufficient number of impaired creditors to wrap up the process as quickly as possible.
What tends to complicate matters the most in the chapter 11 process is that there’s no objective answer to what the debtor is really worth. So, if impaired creditors don’t feel they’re getting the recovery they should – based on what they think the company is worth – then this sets up the debtor for potentially getting into a protracted valuation fight.
Unless, of course, the debtor has some more coercive tactics up their sleeve for strong-arming prickly impaired creditors...
Table of Contents
As per usual, this is an absurdly long post so I've broken it down into a number of different sections you can navigate to using the links below.
So, here’s a scenario: there’s a company, let’s say they’re in the oil industry, and suddenly there’s an unprecedented global health event that demolishes the price of oil. In fact, for a brief moment oil kind of trades at a negative price (e.g., you’re being paid to take physical oil because no one wants it).
As a result, the company quickly drains its liquidity and is now facing a cash crunch. So, the company engages some restructuring bankers, and they begin reaching out to creditors to start a dialogue about maybe doing some kind of out-of-court solution, but, regrettably, it becomes obvious no fulsome solution is going to avail itself.
With no out-of-court solution possible, the company files chapter 11. Now the aim of the company is to get in-and-out of the process as quickly as possible while right-sizing its balance sheet. After all, the bankruptcy process is expensive and the longer the debtor is in the process, the more value destruction that will occur.
So, the debtor needs to create a Plan of Reorganization that lays out who the classes of debt are and how they’ll be treated. In other words, they need to determine what each class will be getting for a recovery value based on the Plan value that’s been arrived at.
But what should that Plan value be? Obviously, in this scenario, it’ll be relatively tightly correlated to the price of oil. However, having just gone through an unprecedented oil shock due to a global health event, who can say what that will be? Maybe the price will rebound immediately, maybe it’ll languish for years, maybe it’ll go down even further!
As I’ve mentioned many times before, the most contentious part of the chapter 11 process usually comes down to valuation. From the perspective of the debtor, they’d like a relatively low valuation as that will mean they can emerge with a slimmer capital structure. However, from the perspective of impaired creditors getting cents on the dollar, an increased valuation will mean an increased recovery value for them.
If the debtor isn’t careful and tries to force a Plan with too light of a valuation, a class of creditors could start a valuation fight that may then require having to go through a time-consuming and costly cramdown process to get the initial Plan approved. This process will involve the court needing to ascertain the valuation of the debtor and then ensure that those classes higher in priority than the objecting class of creditors aren’t being overcompensated and that those classes that are lower in priority than the objecting class of creditors aren’t receiving anything.
Note: Obviously I'm heavily glazing over the chapter 11 process here for the purposes of setting up the rest of this article -- keep in mind that actual cramdowns are rare and most of the time, perhaps after significant horse-trading and subtle coercion, a consensual Plan is developed.
In order to avoid either getting into a cramdown fight or otherwise getting bogged down in the process with an intransigent impaired class, a so-called “death trap” provision can be utilized to try to preemptively strong-arm an impaired class – that may otherwise want to pick a valuation fight – to vote to accept the Plan of Reorganization (remember that the only classes that will vote on the Plan are those that are impaired).
So, what a death trap provision will do is give a junior impaired class a binary choice: if they vote to accept the Plan of Reorganization, then they’ll be given some small level of recovery, but if they don’t vote to accept the Plan of Reorganization, they’ll either be given nothing or something substantially less than they would’ve if they had initially accepted.
Now obviously death trap provisions can only be utilized when certain conditions are present. In particular, debtors can utilize death trap provisions against a certain impaired class when their Plan value dictates that technically that impaired class isn’t owed anything if one were to strictly apply the rule of absolute priority. The theory that’s underpinning the death trap provision is that because the impaired class isn’t technically owed anything, what's really happening here is that a small amount of value is being gifted from a more senior class to compensate a more junior class to try to entice them to vote for the Plan and avoid delays in confirmation (as avoiding delays avoids value destruction, etc.).
Put another way, the debtor is essentially saying to the impaired class who they’re trying to convince to vote for the Plan: “Look, based on our Plan value we don’t think you should be getting any recovery value at all. However, valuations are always tricky and it’s in everyone’s best interest not to start a valuation fight here and drag this out. So, we’ll give you a little bit of value if you vote to accept the Plan we've devised. But if you don’t vote to accept the Plan, then we’re not going to give you anything. So, take what we’re giving you now and vote to accept the Plan, or be prepared to roll the dice with a potential cramdown.”
As already mentioned, death trap provisions are going to be utilized against classes that are at the margins. Or, in other words, they’re going to be utilized against classes that are technically owed nothing – per the Plan valuation – but for whom a reasonable argument could be made that they could be owed something if the debtor is valued more aggressively.
Note: There's a few wrinkles in here when it comes to past death trap precedence, but we'll glaze over them to avoid muddying the waters. What I've described above holds true for almost all death trap situations.
So, as you’d imagine, death trap provisions usually only target one class of debt (whatever class happens to be most at the margin). There are exceptions though. For example, Chisholm was an interesting case in which they used death trap provisions to coerce their second lien, pre-reorg equity, and general unsecured creditors into accepting their Plan. However, Chisolm was a bit of a unique circumstance as the value of the company was heavily underwater when the Plan was devised due to them being an oil and gas extraction company filing near the height of the pandemic. Chisolm also happened to be backed by Apollo and Ares -- so it’s not much of a surprise that they’d be more aggressive in using death traps than others would.
Most often you’ll see the death trap provision target either the equity or the 2L. However, as illustrated above, there’s nothing that precludes the inclusion of a death trap anywhere else.
An interesting question – which hopefully is reasonably intuitive if I’ve explained things well so far – is whether you think that death traps targeting pre-reorg equity will be more commonly seen with energy companies or retail companies, all else being equal.
What you should immediately be thinking of is that the valuations of retail companies will be relatively range bound and stable. However, since energy companies will have valuations that are much more dependent on volatile underlying commodity prices there’s much more room for argument around valuation with them (in particular, if commodity prices are abnormally low at the time the Plan is devised).
As a result, pre-reorg equity holders in energy companies tend to be much pricklier as they understand that a sudden rise in the underlying commodity price could all of a sudden leave them with a significant recovery value. This is an entirely fair point and many oil and gas companies that filed in Q3/Q4 of 2020 suddenly looked much better – while they were still going through the process – as commodity prices rebounded.
Anyway, the point is that you’ll often see energy companies use death trap provisions targeting equity in order to coerce them into quickly accepting the Plan and to stop them from either fighting for a higher valuation or just trying to draw out the process as much as possible in the hopes that commodity prices rebound in the interim (e.g., Chisholm Oil and Gas, Pioneer Energy, Denbury Resources, etc.).
Thus far we’ve established that death traps are essentially a carrot-and-stick phenomenon – you offer an impaired class some modest amount of recovery (the carrot) if they vote to accept the Plan, but if they vote to reject the Plan you offer them much less or, more often, nothing at all (the stick).
However, we haven’t yet established what exactly the form of recovery being offered to the impaired class involves. While the form of recovery can be structured a number of different ways, most of the time it’ll be a pool of cash, post-reorg equity, or warrants.
The rationale for offering post-reorg equity or warrants is obvious. You’re essentially saying to the impaired class, “Look, you shouldn’t technically get anything according to the Plan value we’ve developed. However, we know that you may think our Plan value is too low. So, what we’ll do is throw you some post-reorg equity or warrants. This way if you’re right and the value of the company is significantly greater than we think it is, then you’ll get uncapped upside value!”.
In terms of the amount of compensation given to classes targeted by a death trap, there’s nothing formulaic here. However, in classic death trap scenarios it’s usually pretty modest and will leave the class with a 1-5% recovery value (which isn't much, but is better than nothing!).
Alright, let’s wrap things up by going through a little example to make this all a bit more concrete. One thing you’ll notice about death trap provisions is that they are often utilized by sponsor-backed companies that have entered into robust restructuring support agreements prior to filing.
Note: When I refer to an RSA as being robust, what I mean is that it has broad-based support from creditors within the largest classes (e.g., a very high percentage of the largest classes have signed on to the RSA).
The reason why you’ll often see death trap provisions crop up in these scenarios is that sponsors are sophisticated and want to get in-and-out of the process as quickly as possible. By entering into a robust RSA pre-filing they’ve done the toughest part, but they run the risk of having a few junior impaired classes with some thorny creditors drag out the process (since they have nothing much to lose by waiting around trying to get a higher valuation).
So, by thrusting a death trap on one or more of these junior classes it puts pressure on them to accept the little bit they’ve been offered - that they may not technically deserve - in order to disincentivize them from throwing a wrench into the process. To put it a bit colorfully: the debtor is barreling down the tracks of the chapter 11 process at full steam and is essentially throwing the junior class a few cents and saying don’t get in our way or we’re going to run you over.
So, let’s talk about CWT. They represent a classic pandemic-case as they were a travel management company that was humming along reasonably well but then were, as you can imagine, devastatingly impacted by the onset of the pandemic.
Given that CWT was sponsor-backed and had a relatively concentrated pool of creditors, they were not only able to enter into a robust RSA pre-filing, they were able to do a full pre-pack. In fact, they were able to do a pre-pack in a day (meaning they were able to get in-and-out of court in a day).
Note: In the restructuring guides I’ve talked about there being a trend toward ever quicker pre-packs occurring. While getting in-and-out of court in a day was unfathomable a decade ago, we’ve had a few sponsor-backed companies do so over the past few years (e.g., Belk).
Anyway, one of the reasons why CWT is a classic pandemic case is that they were forced to file not because of gradually slowing demand for their services but rather due to demand falling off a cliff (which obviously no company is in a great position to handle).
As a result, the Plan value contemplated in their RSA is actually reasonably large because it’s predicated on the pandemic subsiding and business returning to some level of normality in the future -- they just, like so many others, weren't in a position pre-filing to withstand however long it’d take for demand to return to normalized levels. So, according to the Plan, most classes of debt are unimpaired and thus aren’t entitled to vote as they would obviously accept the Plan. Instead, just three classes are impaired as you can see below:
The marginal class in this case – that could potentially be owed some small amount, if you were to make a stronger valuation case – is Class 7. However, clearly the debtor doesn’t think they’re owed much of anything as Class 5 got 100% of the post-reorg equity as part of their recovery and Class 6 got just a few warrants as their recovery. So, Class 7 was targeted with a death trap provision to essentially make sure it wasn’t worth their time to throw a wrench into the prepack and delay getting in-and-out of court in a day.
This death trap involved giving the creditors in the class their pro-rata share of $250,000 in cash if they voted to accept the plan and nothing if they voted to reject it. This equates to a recovery value – since this was a very small class – of a bit more than 2%.
While this may seem like a relatively miniscule recovery value, keep in mind that death traps are always used to coerce acceptance of a Plan for classes at the margin. In this case Class 7 was deemed to be entirely out-of-the-money per the Plan valuation, so technically they were owed nothing unless the valuation was successfully challenged. So, it wouldn’t be sensical for these creditors to receive that much higher of a recovery -- especially if it’s in cold hard cash, not something with more nebulous value like post-reorg equity or warrants.
Part of the reason why I chose to write about death traps is they demonstrate that despite the fact that the in-court process can appear quite rigid and mechanical on the surface, there can be a lot of horse-trading and subtle coercion that happens.
While death traps have become increasingly common, they’re still relatively rare. Further, they, by definition, happen at the fringes of the process and aren’t remotely close to being the centerpiece of any Plan. However, they can be utilized to make sure that a potentially troublesome impaired class can't delay, or even derail, the process.
So, you should really think of death trap provisions as being another potential tool in the toolbox for getting a debtor's Plan across the finish line if the right circumstances present themselves.
Anyway, hopefully this has been relatively interesting to read and helps shed a bit of light on ways debtors can try to set themselves up to get through the process as quickly as possible (to avoid prolonged value destruction, ever-mounting professional fees, etc.).
Needless to say, this kind of stuff isn’t something you need know for interview purposes at all. So, don’t worry about this coming up. Instead, focus on classic restructuring interview questions, learning what restructuring investment banking broadly is, learning about more general terms like structural subordination, etc.
However, if you’re ever researching a chapter 11 case and you notice in the Plan of Reorganization that some class will either get something if they accept the Plan, or get nothing if they don’t, and are a bit confused on what’s going on, now you know!