The Rise of the Sponsor-In-Possession and Implications for Sponsor (Mis)Behavior

Abstract

Changes in the capital markets and developments in the law and judicial practice have shifted the balance of power in many distress situations from creditors to financial sponsors. Only recently has there been a recognition by a subset of academics that this reflects a new prism through which to view the bankruptcy process. These studies have been largely theoretical—focusing on how these developments have come about and their implications for stakeholders and bankruptcy outcomes. This Essay offers an insider’s perspective, in the form of case studies of the role that private equity played in the bankruptcies of Caesars Entertainment and Neiman Marcus. These case studies show how the unchecked incentives of private equity sponsors have resulted in increasingly aggressive tactics that tilt the playing field in their favor, by siphoning value away from creditors for their own benefit prior to and during bankruptcy proceedings. In particular, this Essay shows how sponsors in those cases undermined basic corporate governance protections and used questionable interpretations of covenants meant to protect creditor interests to further their own self-interest. These examples further show how sponsors’ use of favored bankruptcy venues and “independent” directors have become part of the private equity sponsor toolkit. These behaviors can be viewed within a broader set of developments affecting creditor bargaining in bankruptcy and upending bankruptcy priorities that have taken hold within the bankruptcy and restructuring process for large corporate debtors. Part I introduces the case studies of Caesars Entertainment and Neiman Marcus. Part II showcases the strategies employed by the financial sponsors in those case studies, how they came about, and their implications for corporate governance, control rights, and bankruptcy outcomes. These case studies challenge many of the assumptions of court decisions, in particular North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, that have rolled back creditor protections over the past twenty years. Part III recommends a series of changes in law and bankruptcy practice to address the problems raised by this behavior and restore creditor bargaining power. This Essay argues that absent intervention by the courts, these problems will persist.

Keywords: bankruptcy, corporate reorganization, restructuring, Chapter 11, creditor governance, private equity, bankruptcy ethics