Delaware Bankruptcy Court Announces Bright-line Rule for Use of Lock-up Agreements in Chapter 11 Cases

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Feb 2003

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The U.S. Bankruptcy Court for
the District of Delaware has issued bench rulings in two recent cases, In re
NII Holdings Inc. and

In re Stations Holdings, which together establish a bright-line rule for the use of lock-up
agreements in connection with voting on a chapter 11 plan. Simply put, the
court ruled that votes to accept a reorganization plan cast by a party that
signed a lock-up agreement prior to the petition date may be counted for plan
confirmation, while votes cast by parties who entered lock-up agreements
post-petition and prior to the court having approved a written disclosure
statement may not be counted. In the latter cases, the court found that the
post-petition lock-up agreements violated §1125(b) of the Bankruptcy Code
because they amounted to post-petition solicitation of acceptances of a chapter
11 plan without a court-approved written disclosure statement having been
provided in advance to the locked-up parties.

As
a result, the votes cast by these locked-up parties to accept the chapter 11
plan were not counted (i.e., "designated") for purposes of plan confirmation.<a href="#2" name="2a">2</a>
Significantly, the court refused to designate an identical lock-up agreement
fully executed prior to the commencement of the chapter 11 case because it had
no jurisdiction over the pre-petition lock-up agreement, and therefore allowed
the votes of the locked-up party in support of the plan to be counted for plan
confirmation. Though not controlling precedent, these bench rulings provide
bright-line guidance for practitioners attempting to prenegotiate chapter 11
cases.<a href="#3" name="3a">3</a> The clear message to take from these recent bench rulings is that if
you intend to use lock-up agreements in a pre-negotiated case,<a href="#4" name="4a">4</a> make sure to
have fully executed lock-up agreements in hand prior to filing the case.

<h3>Lock-up Agreements Defined</h3>

Generally
in the context of pre-negotiated chapter 11 cases, lock-up agreements are
negotiated by sophisticated parties that provide for a commitment to support a
particular restructuring, subject to various terms and conditions. In a typical
prenegotiated case, the debtor and the most significant stakeholders, often the
holders of large blocks of institutional debt, will negotiate the key terms of
a proposed restructuring, prior to filing the chapter 11 case.

Usually, lock-up agreements
are agreed to and fully executed prior to filing the chapter 11 case, together
will the terms of the proposed restructuring. Such agreements are a valuable
component of a prenegotiated case as the debtor and other stakeholders know the
basic parameters of the restructuring going into the case. Indeed,
prenegotiating a chapter 11 case will remove much of the inherent uncertainty
associated with the chapter 11 process. Such cases are commenced with the
significant restructuring terms already agreed to, along with the necessary
support and financing to complete the restructuring. Parties enter into lock-up
agreements to "bind each other to a deal, even when the underlying
restructuring documents remain to be drafted and executed. Typical operative
language in a lock-up agreement provides that a significant stakeholder agrees
to support a restructuring plan subject to various terms and conditions.<a href="#5" name="5a">5</a> These
lock-up agreements are typically contingent on many events, such as the
drafting and court approval of a disclosure statement, the drafting of an
actual plan that is satisfactory to the locked-up parties, and that the debtor
suffer no material adverse changes during the pendency of the chapter 11 case.
The actual agreement of the locked-up party to vote on the plan is contingent
on satisfaction of all the terms and conditions negotiated into the lock-up
agreement.

<h3>The Timing Issue Under the Code</h3>

The
Code provides that the date the case is commenced is critical. Thus, the Code
states that "an acceptance or rejection of a plan may not be solicited
after the commencement of the case under this title from a holder of a claim or
interest with respect to such claim or interest, unless, at the time of or
before such solicitation, there is transmitted to such holder the plan or a
summary of the plan, and a written disclosure statement, approved after notice
and a hearing, by the court as containing adequate information..."<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1125(b)</a>. See, also, Fed. R. Bankr. P. 3017 and 3018.
Pre-petition, however, §1126(b) of the Bankruptcy Code provides that
"a holder of a claim or interest that has accepted or rejected the plan
before the commencement of the case under this title is deemed to have accepted
or rejected such plan, as the case may be, if (1) the solicitation of such
acceptance or rejection was in compliance with any applicable non-bankruptcy law,
rule or regulation governing the adequacy of disclosure in connection with such
solicitation, or (2) if there is not any such law, rule or regulation, such
acceptance or rejection was solicited after disclosure to such holder of
adequate information as defined in §1125(a) of this title..."<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1126(b)</a>. Both sections attempt to ensure
that the actual votes for or against the plan are based on the requisite
information having been made available to the stakeholder.

If
the court determines that votes have been solicited in violation of these
sections, the court may designate the entity casting such vote and not count
such vote for purposes of plan confirmation. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1126(c), (d) and (e)</a>. See, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Kellogg Square Partnership, 160 B.R. 336, 339 n.2 (Bankr. D.
Minn. 1993)</a>.

<h3>The Delaware Court's Bench Rulings</h3>

In
each of the recent bench rulings, the party seeking designation of the
locked-up parties, and disallowance of their votes on the plan, was
particularly concerned with the specific performance remedy and injunctive relief
provisions of the lock-up agreements. Those provisions essentially stipulated
that a breach of the lock-up agreement could not be compensated by money
damages, and permitted specific performance of the agreement upon a breach. For
example, if the locked-up party failed to vote to accept the plan, as otherwise
agreed to in the lock-up agreement, the debtor could seek a court order
requiring the locked-up party to vote to accept the plan. In each of these
cases, the party opposing the lock-up agreements argued that this specific
performance remedy effectively rendered the lock-up agreement a vote on the
plan on the theory that due to the specific performance remedy, the locked-up
party would be unable to get out of its obligation to vote in favor of the plan.
In each case, the court announced a simple, bright-line rule regarding the use
of lock-up agreements.

In
the first of these bench rulings, In re Stations Holding Co. Inc., Case No. 02-10882 (MFW), the court
designated entities that executed lock-up agreements several months after the
chapter 11 case was filed. In that case, the lock-up agreements evidenced
support of a plan that provided for the sale of the debtors' assets to a
third party. The proposed purchaser in Stations Holdings required the execution of the lock-up
agreements to foster its efforts to raise capital for the transaction. The
court ruled that the lock-up agreement in that case constituted the
solicitation of a vote on a plan. According to the court,
"solicitation," as used in §1125(b) of the Code, means asking
for a vote. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… re Snyder, 51 B.R. 432, 437 (Bankr. D. Utah 1985)</a>. The court determined that pursuant
to the lock-up agreement, a vote on the plan was sought by the debtor. Because
the solicitation occurred post-petition, and in the absence of an approved
written disclosure statement, §1125(b) of the Code was violated.
Accordingly, the court designated these entities, and their votes in favor of
the plan would not be counted for plan confirmation.

In
the other recent Delaware lock-up case, NII Holdings Inc., Case No. 02-11505 (MFW), the court
ruled that certain lock-up agreements that were executed as of several days
after the commencement of the chapter 11 case violated §1125(b). As in Stations
Holding, the court
ruled that such post-petition lock-up agreements violated §1125(b) because
the agreements were tantamount to votes to accept a chapter 11 plan that were
solicited after the commencement of the case and without a court-approved
written disclosure statement. Following a "bright-line" rule, the
court held that post-petition lock-up agreements of this kind were
impermissible under the Bankruptcy Code. As such, the court designated the
parties to the post-petition lock-up agreements, and the votes of such parties
to accept the plan were not counted for plan confirmation.

<h3>Pre-petition Lock-up Agreements Are Permissible</h3>

The
NII Holdings court
also considered an identical lock-up agreement that was fully executed and
received by the debtor and the locked-up creditor prior to the commencement of the chapter 11
case. Such pre-petition execution is the more typical scenario for lock-up
agreements. The pre-petition locked-up creditor ultimately cast a post-petition
vote to accept the plan, after the solicitation of a written disclosure
statement and pursuant to court-approved solicitation procedures. It was argued
that this lock-up agreement violated §1126(b) of the Code. However,
again following a bright-line approach, the court determined that it did not
have jurisdiction over those agreements because the debtors were not seeking to
use the pre-petition lock-up agreement as a vote in favor of the reorganization
plan. Accordingly,
the court refused to designate the party to the pre-petition lock-up agreement,
and such party's votes were counted for plan confirmation. As the execution
of lock-up agreements pre-petition is the most usual approach in pre-negotiated
cases, this ruling provides solid support for the continued viability of
pre-negotiated chapter 11 cases in Delaware.

The
court also made clear in the NII Holdings case that its ruling should not chill
negotiations over consensual chapter 11 plans. Indeed, the court acknowledged
the policy in the Third Circuit of encouraging negotiations among the parties. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… re Century Glove Inc., 860 F.2d 94 (3d Cir. 1988)</a>. See, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Square, 160 B. R. at 339-340</a>. By reading §§1125(b) and 1126(b) in
the manner it did, essentially recognizing the line in the sand at the
commencement of the chapter 11 case drawn by Congress in the Code, the
court's ruling should be read by practitioners as clear guidance to fully
execute lock-up agreements prior to filing the pre-negotiated chapter 11 case.
In doing so, practitioners should avoid further bankruptcy court scrutiny of
such agreements and should be in a position to file the chapter 11 case with
all of the benefits typically sought with a pre-negotiated filing.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Mr. DeFranceschi is a director of the Wilmington, Del., law firm of Richards, Layton & Finger P.A., where he practices law with the firm's Restructuring and
Bankruptcy Group. Mr. DeFranceschi is counsel to the debtors in the NII Holdings case discussed in this article. <a href="#1a">Return to article</a>

<a name="2">2</a> In each of these cases, the court confirmed the chapter 11 plans presented by these debtors. <a href="#2a">Return to article</a>

<a name="3">3</a> Bench rulings are decisions of the court issued verbally from the bench without a written opinion of the court. Bench rulings are not controlling precedent, but do
provide practitioners with useful guidance in navigating through cases. <a href="#3a">Return to article</a>

<a name="4">4</a> The term "pre-negotiated" case used herein refers to cases where, prior to filing the chapter 11 petitions, the debtor and some creditor constituency have reached
an agreement on the terms of a restructuring to be effectuated in a chapter 11 case, but the debtor has not actually solicited and obtained sufficient votes to
confirm the plan prior to filing. In the later circumstances, more typically referred to as a "pre-packaged" case, the parties actually solicit and obtain votes to
accept a plan prior to filing the chapter 11 case. In such cases, the debtor will need to comply with the appropriate disclosure requirements of §1126(b) of the
Code. <a href="#4a">Return to article</a>

<a name="5">5</a> While debtors typically try to lock up the necessary support for the proposed restructuring, the various other stakeholders involved, who are often agreeing to
significant concessions on their claims and are agreeing to provide new financing for the restructuring, will also demand that each party execute a lock-up
agreement to secure the commitment of each party involved. <a href="#5a">Return to article</a>

Journal Authors

Daniel J. DeFranceschi

Journal Date

Saturday, February 1, 2003 - 12:00

Bankruptcy Rule

2003