Independent administrators and private lenders

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The appointment of an independent administrator is a powerful tool for private lenders. The tool, however, must be skillfully deployed as it can engage lender liability if misused. In this article, we discuss: (1) the value of the tool, (2) when to use it, (3) the risks of using it, and (4) practical advice.

Why should a lender consider appointing an independent director? Independent directors serve as a means of neutralizing a board’s allegiance to the controlling shareholder. In the private credit market, the board of directors is generally controlled by directors appointed by the sponsors, and organizational documents often eliminate (or significantly limit) their fiduciary duties. This can be a dangerous combination for lenders in a restructuring scenario. Consider the following hypothesis: Secured creditors with a delinquent loan to an underperforming company are pressuring the borrower to begin a sales process that could lead to a face value recovery. The board, however, knows that an immediate sale would wipe out equity, perhaps prematurely. The board therefore chooses to pursue an alternative with a low chance of success to move towards optimistic projections, but with a chance of equity recovery. This assumption is real, especially for distressed borrowers with sufficient cash to execute the options, with the lender holding all the downside risk and often still funding the process. The appointment of an independent director is designed to introduce a voice of neutrality and fairness into the decision-making process of the board of directors with the hope and expectation that independence from the majority shareholder allows the board to steer towards viable strategies for maximizing value.

When should a lender consider appointing an independent director? Independent administrators are most often used in two phases of a private credit restructuring. First, director appointments occur in the context of abstention or amendment negotiations. In other words, when a borrower needs the lender’s waiver or new funds, the lender has the power to require the appointment of one or more independent administrators. In this context, an independent director is usually added to the board by consent and provides a voice to defend strategies that might not be attractive to the majority shareholder. Independent directors are also used in the later stages of a restructuring where the parties find themselves at an impasse at the negotiating table. At this point, a lender may consider exercising remedies by unilaterally changing the composition of the board as part of a post-default recourse exercise. [1] The fiduciary duties of directors, which are incumbent on the company and its shareholders, regardless of who appoints or appoints them, may prevent directors from disclosing the substance of board meetings to lenders. One solution to this problem is for lenders to require in their forbearance agreements the free flow of communications with independent administrators, subject to the confidentiality provisions of the credit agreement.

What are the risks for the nominated lender? A lender’s decision to appoint one or more administrators is not a risk-free exercise. Risk should be assessed along a continuum and the appointment itself (whether made by consent or unilaterally pursuant to the operational credit agreement) does not create risk. However, risk enters the equation when the independent director acts. If the independent administrator harms the business and demonstrates that he is an accomplice to the lender, then in a resulting bankruptcy creditors can claim that the lender (through the actions of its agent-administrator) exercised a undue control over the borrower and its operations in an unfair manner. way that hurt them. These are the ingredients of equitable subordination in a bankruptcy case, which is a doctrine that allows a bankruptcy court to alter relative priorities as a remedy for creditors harmed by a lender’s inequitable conduct. This is an extraordinary remedy used to remedy egregious conduct. Lenders will want to make sure the record is clean so they can blunt any allegations of bad faith or undue influence.

What are the best practices for using this tool effectively? Lenders can minimize liability risks by taking precautionary measures, particularly critical when the appointment is orchestrated unilaterally by the lender as part of a recourse exercise. After performing this exercise countless times, the Proskauer Private Lending Group has identified the following practical tips and advice. Every situation is different and the suggestions below are intended as guidelines and not as exclusive, finite requirements.

  1. For directors appointed with the consent of the sponsor, let the sponsor choose from a list of two or three candidates acceptable to the lenders.

  2. Appoint competent directors based on relevant experience and expertise.

  3. Honestly and candidly assess all “connections” between lenders and their lawyers and any director nominees. We apply the standard of “cross-examination” – what will the director say about the extent of the relationship with named lenders in the bright light of cross-examination in court? Assume that all connections will be leaked. Some connectivity may be appropriate, and the mere fact that the director has been appointed by someone with the authority to do so does not generally in itself prove a lack of independence. [2] A comfortable relationship, however, with multiple terms will be fodder for attack. To assess the closeness of the relationship, consider:

    1. Total of the candidate’s historical engagements, total number of active engagements and frequency of engagements.

    2. Diversity of candidate nominations. Someone nominated by a wider variety of parties and interests (sponsors, lenders, trade creditors, etc.) may indicate a bias less favorable to a particular viewpoint.

    3. Number and concentration of commitments associated with specific parties (for example, the lender, its affiliates or its attorney). A high number or percentage of engagements with particular parties may give rise to allegations of trust and favouritism.

    4. Current and historical ownership of any investment in Obligor, its Affiliates, Lenders and their Affiliates. Economic interest is a classic indication of bias that could materially impede the exercise of independent judgment and undermine the protections of the business judgment rule.

    5. Current and past roles, including management, board or council, of other businesses and nonprofits. This can expose the relationship to parties who may have an adverse interest to the debtor.

    6. Family ties with respect to any of the above.

  4. Finally, assess the candidate’s courtroom experience and ability to demonstrate diligence, clarity, and sound reasoning. Lenders may wish to consider candidates who have taken, on occasion, well-reasoned positions adverse to their appointees, who are committed and who ask difficult questions.

Structuring the verification process with these practices in mind can help prevent headaches along the way. But good hygiene doesn’t stop at the dating process. Here are five practical post-date tips:

  1. Communications (including email) with the Independent Administrator are not private. Assume they will be leaked, especially if things go wrong.

  2. Treat the Director independently, as you would any other independent third party.

  3. Recognize that the best tool of persuasion is a viable value-maximizing proposition superior to other alternatives.

  4. Ensure that the independent director has access to independent professionals of their choice (and not lender advisers), particularly in scenarios where the independent director controls the board.

  5. In the event the restructuring is consummated by a Chapter 11 matter, it is critical that the lender “owns the narrative” and fully embraces transparency about the actions it has taken to replace the board.

In sum, the use of independent administrators is a powerful tool for private lenders. When strategically deployed in accordance with credit documents and with a skilled navigator able to identify and avoid pitfalls, this strategy could be the difference between an au par repossession and a severe deficiency. But attention to the science of governance is essential. It is a specialty that must be navigated with precision.

NOTES

[1] The mechanisms for changing the composition of the board of directors as part of a recourse exercise are beyond the scope of this client article. However, we would be happy to discuss this subject with you on an individual basis.

[2] To see Kanter vs. Barella489 F.3d 170, 179 (3d Cir. 2007) (“The Aronson noted that the appointment or election of a director at the request of a majority shareholder is not sufficient to demonstrate a lack of independence because it is “the usual way in which a person becomes a director of a company “.”) (quoting Aronson v. Lewis473 A.2d 805, 816 (Del. 1984)).

© 2022 Proskauer Rose LLP. National Law Review, Volume XII, Number 73

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