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Insider’s Scoop: Judge Sontchi’s Decision to Confirm Horsehead’s Plan Was One of His Honor’s Most Difficult and Closest Calls in Ten Years on the Bench
In re Horsehead Holding Corp., No. 16-10287 (CSS) (Bankr. D. Del. Sept. 2, 2016) [Transcript Ruling]
Following a three day confirmation trial, which attracted scores of shareholders and running commentary via live tweets from the courtroom, Judge Sontchi confirmed the second amended plan of reorganization (the “Plan”) proposed by Horsehead Holding Corp. and its affiliated debtors (“Horsehead”) over the objection of the official committee of equity holders (the “Equity Committee”), holding that the Plan was proposed in good faith and satisfied the absolute priority rule. His Honor described the decision as one of the most difficult and closest calls that he has had to make during his time on the bench. While shareholders ultimately did not prevail, the Court praised the Equity Committee’s efforts, noting that its appointment was vindicated as it added tremendous value to the process and enabled a full and fair presentation of the facts and the law to the Court.
Horsehead, a producer of zinc and related material, entered bankruptcy on February 2, 2016. The bankruptcy followed historically low commodity prices, the shutdown of Horsehead’s zinc processing facility located in Mooresboro, North Carolina (“Mooresboro Facility”), which had been plagued by operational challenges and cost overruns, and a severe liquidity crisis arising after Horsehead’s lender under its asset-based lending facility (“ABL Facility”) declared an event of default and froze Horsehead’s bank accounts. While in bankruptcy, Horsehead negotiated with key constituencies and ultimately sought approval of the Plan, which embodied the terms of a global settlement with the creditors’ committee and a unit purchase agreement (the “UPA”) with an overwhelming majority of senior secured and unsecured noteholders (the “Plan Sponsors”).
Importantly to the confirmation dispute, the UPA contained a “no-shop” provision, which was subsequently modified by the Court at a hearing to consider Horsehead’s request for an extension of its exclusive periods, which occurred approximately two months prior to the confirmation hearing. The modifications permitted Horsehead to respond to and engage with potentially interested buyers (including those brought to Horsehead’s attention by the Equity Committee), but not to undertake a marketing process. While a marketing process typically performed pursuant to a bid procedures order was not conducted, Horsehead ran an informal process leading up to the confirmation hearing, which involved creating a process letter, reaching out and responding to potentially interested parties, and coordinating due diligence, management presentations, and site visits. As of the confirmation hearing, no binding offers had been received for all or substantially all of Horsehead’s assets.
With respect to the Plan, it proposed to eliminate over $400 million in debt from Horsehead’s balance sheet and provide Horsehead with $260 million from the Plan Sponsors to fund distributions to creditors, ongoing operations, and $100 million of necessary repairs to the Mooresboro Facility. Creditors holding allowed administrative claims, certain secured claims, priority claims, claims arising from the ABL Facility and the DIP facility, and general unsecured claims asserted against debtor Zochem would be paid in full. Horsehead’s senior secured and unsecured noteholders would receive substantially all of the equity in reorganized Horsehead; convertible noteholders would receive warrants; non-Zochem general unsecured creditors would share in a cash pool of approximately $12 million (up significantly from a $2.5 million pool originally proposed by Horsehead); and shareholders would receive nothing. The Plan was overwhelmingly accepted by the voting creditors.
In support of the Plan, Horsehead proffered a valuation performed by its financial advisor, Lazard Frères & Co. LLC and Lazard Middle Market LLC (“Lazard”). The valuation was based upon financial projections provided by Horsehead’s management under two scenarios—one which contemplated the restart of the Mooresboro Facility following the completion of necessary repairs (a “Ramp Up Scenario”) and one which did not (an “Idle Scenario”). Relying on both the discounted cash flow and comparable company analyses, Lazard’s midpoint estimates for the enterprise value of the reorganized debtor were $435 million (Ramp Up Scenario) and $318 million (Idle Scenario). Horsehead asserted that existing shareholders were out of the money under both scenarios given an approximate debt hurdle of $750 million, which totaled the claims asserted in the bankruptcy plus the $100 million post-petition infusion of capital by the Plan Sponsors to repair the Mooresboro Facility. Accordingly, Horsehead contended that the proposed treatment of claims and interests under the Plan—particularly, the distribution of reorganized Horsehead equity to the senior note claimants and the cancellation of existing equity for no consideration—satisfied the requirements of the Bankruptcy Code.
The Equity Committee, the appointment of which we analyzed earlier in the year, challenged the Plan, arguing that it was not proposed in good faith and violated the absolute priority rule. More specifically, the Equity Committee asserted that Horsehead breached its fiduciary duties by failing to conduct an adequate market test of Horsehead’s businesses and, accordingly, could not satisfy the good faith requirement of section 1129(a)(3). Moreover, the Equity Committee presented the valuation of its own financial advisor, SSG Capital Advisors, LLC (“SSG”), which determined the enterprise value of reorganized Horsehead to be $780.6 million to $862.8 million and the debt hurdle to be approximately $640 million. As such, the Equity Committee argued that its constituency was “in the money” and should receive their rightful allocation of estate value in exchange for the cancellation of their shares. To the Equity Committee, the senior note claimants who were Plan Sponsors were receiving equity in reorganized Horsehead that exceeded in value the amount of their claims, thus violating the absolute priority rule and in turn section 1129(b)’s fair and equitable requirement.
To reach its valuation conclusions, SSG’s underlying analysis differed from that of Lazard in numerous ways, including (a) reliance only on a discounted cash flow analysis, (b) the assumption that zinc prices would rise much higher than management’s projections and that the Mooresboro Facility would not only be repaired but ultimately reach its maximum capacity, and (c) excluding from the debt hurdle the $100 million the Plan Sponsors were providing under the Plan to fund Mooresboro Facility repair costs. The experts’ betas, perpetuity growth rates, and capitalization ratios also differed.
Following three days of testimony and argument, the Court confirmed the Plan. At the outset of His Honor’s ruling, the Court quickly concluded that the Plan was offered in good faith, noting that section 1129(a)(3) does not require a market check of a proposed plan and that, to the extent applicable state laws require such a check for directors and officers to fulfill their fiduciary duties, the Bankruptcy Code alters those laws. Accordingly, the resolution of the confirmation dispute came down to a determination of whether equity was in the money and a battle of the valuation experts.
While Judge Sontchi noted that his instinct said that equity was out of the money, the evidence presented made it difficult for him to reach that conclusion. He noted that the Plan Sponsors “shot themselves in their own foot” by insisting on a no-shop provision, which deprived the Court of evidence of market value. Horsehead’s informal process during the run up to the confirmation hearing was too abbreviated and not sufficiently active. Accordingly, the Court was left to determine enterprise value based on expert opinion.
Judge Sontchi began by framing the issue—is it more likely than not that equity is out of the money? The Court then parsed the different assumptions made by Lazard and SSG to determine if each were reasonable. As noted in his ruling, Judge Sontchi found certain of SSG’s assumptions to be completely within reason (for example, SSG’s use of only a discounted cash flow methodology), but certain others unreasonable. Correcting the assumptions found to be unreasonable lowered SSG’s value calculation to $653 million. This would have been sufficient to put equity narrowly in the money if the debt hurdle was only $640 million, as equity urged. However, because SSG’s valuation thesis was premised on the Mooresboro Facility being repaired and ramped up, the Court concluded that the debt hurdle must include the $100 million that the Plan Sponsors were providing to fund the cost of repairs. With that amount added to the calculation, the Court found the hurdle to surpass $653 million, deemed equity out of the money, and the Plan confirmable.
While the Court’s conclusions regarding certain of SSG’s valuation assumptions were based on the specific facts and circumstances of Horsehead, some takeaways can be made based upon Judge Sontchi’s comments while ruling. First, it is not always necessary for a valuation expert to use more than one valuation methodology (i.e. discounted cash flow, comparable company, or precedent transaction analysis). Although the use of more than one methodology can help triangulate value, it may be reasonable, based upon the particular facts and circumstances at hand, to rely only upon one, as SSG did in Horsehead. Second, it may be perfectly reasonable not to rely upon management projections if management did not have a hand in developing them. For instance, in Horsehead, management’s zinc price assumptions were based upon certain analysts’ consensus pricing while SSG relied on others to develop its assumptions. According to the Court, SSG was permitted to rely upon its own choice of analysts to forecast commodity pricing so long as the choice was reasonable. And finally, an expert’s reliance on Predicted Barra Beta may be risky as it is a “black box” in that the factors underlying the calculation are not fully disclosed. As other courts have done, Judge Sontchi held its use by Lazard in Horsehead to be troubling.