District Court Reverses Judge Lopez’s Approval of ConvergeOne Plan Rights Offering Backstop Premiums; Says Exclusion of Minority Lenders in RSA, Prepackaged Plan Violated Equal Treatment of Creditors Requirement Under Serta

Relevant Document:
Order

Last night, Sept. 25, U.S. District Judge Andrew Hanen reversed Judge Christopher Lopez’s approval of the ConvergeOne debtors’ plan equity rights offering backstop arrangement, concluding that excluding minority lenders from participation in the backstop from the beginning of the case violated the requirement of equal treatment of similarly situated creditors under the Bankruptcy Code.

The decision could have massive ramifications for bankruptcy cases generally because backstop premiums have become a crucial element of DIP facility and rights offering structures in chapter 11 cases. Citing the Fifth Circuit’s December 2024 Serta decision, Judge Hanen rejects the debtors’ principal argument in favor of providing backstop premiums to a select group of creditors within a particular class: that the premiums were consideration for a new, postpetition financial commitment (the backstop) and not consideration on account of the favored lenders’ prepetition claims.

Under Serta, Judge Hanen says, a court must look behind the actual language of a plan to determine whether special treatment for a subclass of creditors is given on account of prepetition claims or postpetition value. Judge Hanen focuses on the fact that the backstop structure was set out in a restructuring support agreement and prepackaged plan before the case was even filed, meaning the excluded lenders never had a realistic opportunity to participate or propose an alternative.

According to Judge Hanen, the debtors’ plan “offered a valuable and exclusive opportunity to backstop an equity-rights offering for a portion of the class of creditors but not the remaining creditors.” This opportunity, he continues, “was offered to the subclass of creditors without any exchange of value for the opportunity,” and the opportunity “resulted in significantly higher recoveries to some class members for the same claims.”

“Since this pre-planned arrangement constituted unequal treatment, the backstopping and equity-rights aspect of the Plan violated the equal-treatment requirement” of section 1123(a)(4) of the Bankruptcy Code, the district judge concludes.

Octus analyzed the possible implications of the Serta decision for backstop premiums, and the ConvergeOne appeal in particular, in February and April.

Under ConvergeOne’s RSA and prepackaged plan, a group of first lien lenders, which included sponsor CVC Capital, agreed to backstop a $245 million reorganized equity rights offering in exchange for an $85.75 million discounted direct investment and a 10% backstop fee/put option premium worth $37.7 million. According to Judge Hanen, the backstop allowed majority lenders to recover 31% more than excluded lenders.

A group of excluded lenders argued that the backstop violated section 1123(a)(4) of the Bankruptcy Code, which requires that a plan “provide the same treatment for each claim or interest of a particular class.” Judge Lopez confirmed the plan in May 2024, finding the “exclusive investment opportunities” offered to the majority group were compensation for a new, postpetition backstop commitment and not distributions on account of prepetition claims that had to be shared with the excluded lenders.

The bankruptcy judge also rejected the excluded lenders’ argument that the backstop was not market-tested, as required by the absolute priority rule and the U.S. Supreme Court’s 1998 203 North LaSalle decision. Judge Lopez held that the decision and the absolute priority rule were inapplicable because the debtors were not attempting to cram down any dissenting class under section 1129(b) of the Bankruptcy Code. Judge Lopez remarked at the time that the decision was “not a close call.”

The excluded lenders appealed and, after the Fifth Circuit issued the Serta decision, argued that the circuit court’s ruling required reversal. In Serta, the Fifth Circuit held that section 1123(a)(4) requires an “objective approach to equal treatment” and directed bankruptcy courts to “look below the surface to determine whether distributions” under a plan – in the Serta case, indemnification protections – “were in fact equal in value.”

In reversing Judge Lopez, Judge Hanen relies on “both LaSalle and Serta” for his conclusion that “the exclusive backstopping opportunity present in this case constituted treatment for a claim and allowed for some class members to receive higher recoveries than others in the same class.” “Therefore, the backstopping opportunity that was offered to some free from competition, but not all, class members violated 11 U.S.C. § 1123(a)(4),” Judge Hanen says.

Judge Hanen emphasizes that even if the postpetition backstop itself provided new value to the debtors in exchange for the premiums, the opportunity to participate in the backstop was based on the majority lenders’ prepetition claims, and the minority lenders were excluded before the case was filed.

“In the context of this pre-packaged plan, the fact that the Minority Lenders were expressly excluded – and were, in fact, intentionally restricted from participating in the deal – makes it undisputable that the backstopping agreement was an exclusive opportunity given to a subset of class members,” Judge Hanen explains. “This exclusivity created a distinction among class-members without any real opportunity for the excluded members to access the opportunity.”

Under Serta, Judge Hanen explains, a court must look “below the surface to determine whether distributions were in fact equal in value” and “examine the inequality both in opportunity and result.” In this case, the judge reasons, “participation in the backstopping opportunity – which provided discounted stock purchases and significantly higher recoveries – was offered exclusively to some creditors without any consideration for the opportunity to participate.”

The judge concedes that the majority lenders “provided the backstopping funds,” which “qualified them to receive discounted equity (benefit) on the backend.” However, Judge Hanen reasons, the “opportunity to participate in the backstop and provide this additional consideration” was “made exclusive to certain creditors – in exchange for nothing – long before the pre-packaged bankruptcy was ever filed.”

In Serta, the judge says, the Fifth Circuit “looked past the language of the plan to discern whether the effect of the plan was unequal.” “While Debtors in this case can argue that the Plan itself treats all creditors the same, Serta rejects a surface-level or overly formalistic (or simplistic) inquiry into equality,” Judge Hanen holds.

Judge Hanen also questions whether the backstop “was itself supported by adequate consideration,” citing the absence of a market test in accordance with LaSalle. The district judge cites testimony from Evercore, the debtors’ investment banker, that a “[m]arket test is exposing an investment opportunity to some competitive tension.” “[T]his was not done in this case,” Judge Hanen says.

“To put it bluntly,” the judge continues, “at the time the bankruptcy petition was filed” and the restructuring support agreement with the favored group was executed, “the train had already left the station, and the Minority Lenders were never permitted to board.” The debtors asserted that the excluded lenders had the opportunity to propose an alternative to the backstop during the case and did so, Judge Hanen notes, but that opportunity “was illusory at best” in a quick, prepackaged chapter 11 with an RSA backed by the majority.

Judge Hanen also compares the required market test to the “open market exchange” exception to pro rata treatment for similarly situated lenders in the liability management context, another key issue in Serta. “There was certainly no attempt to allow new potential investors to bid,” the judge notes, “or submit the deal to an ‘open market’ as described in Serta.”