Another Tool in the Chapter 15 Toolbox: Reverse Vesting Transactions

Canadian debtors have addressed this problem by employing an innovative solution called a “reverse vesting transaction.” In a reverse vesting transaction, the debtor issues new shares in its company to a purchaser while simultaneously cancelling all existing shares without payment to existing shareholders. The purchaser designates which assets and liabilities it wishes to remain with the company (rather than acquire the debtor’s entire business). Excluded assets and liabilities are transferred to a newly formed residual company. The debtor then exits the insolvency proceeding with only the assets and liabilities it wants, and the residual company replaces the debtor, where the excluded assets (including the proceeds paid by the equity purchaser) and liabilities are administered for the benefit of creditors. Reverse vesting transactions are increasingly popular in Canada due to their flexibility.

Canadian courts have approved reverse vesting transactions relying on the wide authority granted under the Companies’ Creditors Arrangement Act (CCAA). Canadian courts analyze these transactions using the same factors applied to sale transactions under the CCAA, plus additional factors, such as (i) whether stakeholders are better off under the reverse vesting transaction than other available options, (ii) the economic result of the transaction, (iii) whether the consideration paid reflects the importance of the licenses, permits and assets being preserved, and (iv) the necessity of the transaction.

Reverse vesting transactions permit transfers that would not be available under chapter 11. Pursuant to Section 365, a debtor may assume, assign or reject executory contracts and unexpired leases; however, this broad grant of authority is constrained by Section 365(c)(1), which, in the absence of consent, prevents a debtor from assuming or assigning an executory contract if applicable non-bankruptcy law excuses the non-debtor party from accepting performance from or rendering performance to someone other than the debtor. While Section 365(c)(1) was initially limited to personal services contracts, cases have expanded its application to include intellectual property licenses, government contracts, franchise agreements and partnership agreements. Separately, certain government licenses, such as FCC licenses, require prior regulatory approval for transfers. As a result, a debtor’s ability to maximize the value of its assets in a sale process in chapter 11 may be constrained or delayed due to need to obtain required consents.

Additionally, a chapter 11 debtor is only able to separate assets and liabilities through either an asset sale or a plan of reorganization. A reverse vesting transaction enables a purchaser to maintain the corporate entity by receiving new shares in that entity and select assets, including otherwise unassignable license and permits, through an accelerated sales process, without having to obtain consent from counterparties to inalienable contracts or licenses or participate in a more time consuming and expensive plan confirmation process, where consents, voting and satisfaction of other confirmation conditions would still be required and non-debtor releases are not available. Conversely, a reverse vesting transaction is only subject to approval by a Canadian court, and, if there is a chapter 15 proceeding, recognition by the U.S. court.

U.S. bankruptcy courts have frequently recognized these transactions under chapter 15 of the Bankruptcy Code; however, nearly all were recognized through orders that did not explain the court’s reasoning for recognition. The Bankruptcy Court decision in Iovate Health Sciences International Inc. is the first decision to analyze the recognition of reverse vesting orders in chapter 15 cases.

Iovate’s Reverse Vesting Transaction
Iovate Health Sciences International Inc. and its affiliated debtors commenced a proceeding under Canada’s Bankruptcy and Insolvency Act, which was converted to a CCAA proceeding in which a monitor was appointed. The Bankruptcy Court for the Southern District of New York recognized Iovate’s CCAA proceeding as a foreign main proceeding.

Iovate possessed inalienable licenses to import goods and sell products in Canada. As a result, the monitor initiated a sale and investment solicitation process (SISP), through which a purchaser acquired the company through a reverse vesting transaction. Releases were provided to the monitor and purchaser for claims and causes of action relating to the SISP and transaction, other than those based on fraud or willful misconduct.

The Canadian court entered an order approving the reverse vesting transaction (RVO) and an ancillary order approving the subscription agreement, transaction and releases. The Canadian court noted that the structure preserved otherwise untransferable assets, allowed $114 million in non-capital losses to be carried forward that could not be carried forward through an asset sale, and ensured contracts remained with the company. Iovate sought recognition of the RVO in its chapter 15 case, as well as approval of the transfer of excluded property located in the United States to the residual company and recognition of the releases.

The Bankruptcy Court’s Decision
The Bankruptcy Court recognized the RVO issuing a lengthy opinion addressing both the Canadian process and the relief that a U.S. bankruptcy court can fashion in a chapter 15 case. The Bankruptcy Court approved the transaction, despite a parallel outcome not being available to debtors in chapter 11. Relying on Section 1521 of the Bankruptcy Code, which outlines the “broad” discretionary relief a court may grant upon recognition of a foreign proceeding, the Bankruptcy Court concluded that it is “not limited in granting potential relief by the bounds of relief that would otherwise be available if this was proceeding under chapter 11, provided that such assistance is consistent with the principles of comity and satisfies fairness considerations set forth in Section 1507(b), or the sufficient protection considerations of Section 1522.” The Bankruptcy Court found that the RVO sufficiently protected creditors’ interests because an independent monitor oversaw the SISP, the SISP implemented procedures to enhance competitive bidding, and the transaction maximized Iovate’s value. As such, the transaction was not manifestly contrary to U.S. public policy.

Iovate compared the SISP to a section 363 sale in a chapter 11 case in its recognition motion. Despite similarities to a chapter 11 sale process, the Court did not review the reverse vesting transaction under Section 363. First, the Bankruptcy Court found that the issuance of new stock in the debtor and cancellation of the remainder of the debtor’s stock was not a stock sale transaction subject to review under Section 363. Second, the Bankruptcy Court found that none of the excluded property being transferred to the residual company was located in the United States, such that the transfer of those assets did not trigger a Section 363 analysis.

The Bankruptcy Court was careful to distinguish the reverse vesting transaction from the Texas Two-Step. The Texas Two-Step is grounded in statute, whereas a reverse vesting transaction is a creature of practice and the broad grant of jurisdiction under the CCAA. Additionally, the Texas Two-Step is a prepetition liability shuffle between a “GoodCo” and a newly formed “BadCo.” By contrast, a reverse vesting transaction occurs after a CCAA proceeding commences, is subject to court and monitor supervision, which considers the interests of creditors and other stakeholders.

Finally, the Bankruptcy Court approved the third-party releases contained in the RVO. The Bankruptcy Court noted that, while such releases might not be permissible in a chapter 11 case after Purdue, the court has the ability under section 1522(a) to approve the releases that have already been approved by the Canadian court. The Court found that the releases were properly tailored, limited in scope, and did not include fraud or willful misconduct. As such, creditors, the debtor, and other interested parties were sufficiently protected under Section 1522(a). Approval of these releases is consistent with holdings in many other, post-Purdue, chapter 15 cases.

Conclusion
Reverse vesting transactions are increasingly used by Canadian debtors to maximize the value of their assets, including otherwise untransferable permits and licenses. This structure is an attractive option for Canadian debtors with U.S. operations and untransferable assets, as it allows purchasers to select assets and liabilities it wishes to obtain while preserving the corporate entity, providing a unique workaround to restrictions in the Bankruptcy Code. Moreover, this structure removes the uncertainty of obtaining third-party consents to transfer, enables debtors to provide third-party releases, and bypasses the plan confirmation requirements a traditional chapter 11 debtor faces.

(This is another in our series of client alerts related to international and cross-border insolvency issues.)