Cooperation Agreements, Overview and Effectiveness in Restructuring Situations

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In a near-zero interest rate era, borrowers had the upper hand to secure loose credit documents as lenders competed for a limited number of investments. Lower cost of capital allowed private equity sponsors to aggressively lever up their investments, which accounted for 50% of large corporate defaults in the COVID-default cycle [1]. However, even if their investments turned worthless, borrowers and sponsors found ways to raise new capital under creative interpretations of credit docs and ambiguous covenants at the expense of certain lenders. These innovative out-of-court transactions are referred to as liability management exercises (LMEs), some of which we have explored in our double-dip, triple-dip, and pari-plus articles. 

Today, we will shift focus to how creditors have responded to LMEs with ‘cooperation agreements.’ Until now, creditors had no choice but to watch sophisticated sponsors handpick a select few who would receive preferential treatment. Distrust ran through messy, unorganized capital structures. But what if creditors could defend themselves as a unified group and even play offense against borrowers and sponsors? In this article, we will analyze what motivates creditors to join cooperation agreements, the tradeoffs, a case study of Caesars Entertainment, and the future outlook on the technology. 

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Cooperation Agreement Overview 

Let’s get to the post. Cooperation agreements are binding agreements between creditors to work together on potential restructuring plans, vote in favor of any future group-approved restructuring proposal, and reject proposals not supported by the group. This is not to be confused with restructuring support agreements (RSAs), signed between debtors and creditors to agree on the treatment of debt and plans during a bankruptcy process [2]. Instead, cooperation agreements do not include borrowers, and parties do not lay out specific details of a restructuring plan. However, it can improve their bargaining power against a borrower when an LME has been executed or pre-emptively prevent one from happening upon identifying loose covenants or news of confidential negotiations. 

Imagine you are a lender of a distressed company with limited options to maximize value. All the other creditors across the capital structure want a piece of the shrinking pie. Under loose credit docs, your position in the capital structure could be wiped out at any second. Even worse, you may be unaware of when and what terms are being confidentially negotiated between the borrower and other creditors. 

As creditors do not have a fiduciary duty – a binding legal responsibility  – to serve the interests of other creditors, they are free to negotiate the best terms with borrowers. These are called ‘sweeteners,’ such as increased coupon rates, higher seniority, or stakes in the reorganized company’s equity. The more creditors compete with each other, the more the borrower can negotiate less attractive terms for creditors, exploiting the fear in creditors that borrowers always have alternative deal opportunities. 

There’s a bit of game theory running in the creditor’s head: either to accept the borrower's enhanced offer (we will refer to this as ‘defection’) or to cooperate with fellow holdout creditors while taking on the risk of other creditors aligning with the borrower. Ultimately, individual creditors will join a cooperation agreement if they believe there are sufficient creditors to reach a majority group together.  

Key Motivations to Join a Cooperation Agreement 

Given the option to either accept or reject a cooperation agreement, what motivates creditors to select cooperation is to protect their positions in the capital structure while aligning interests with other creditors for greater bargaining power against aggressive borrowers and sponsors. 

• Long-term Returns: While creditors may be offered attractive short-term returns from borrowers, cooperation may preserve long-term benefits such as joining future alliances with other repeat lenders in the leveraged loan market. Leveraged loans offer investors attractive returns while reducing risks as a secured lender. However, more investors have been competing for a limited number of deals in a slower M&A and LBO environment, making scale and relationships with other lenders and borrowers crucial. Furthermore, siding with borrowers would decrease the payoff offered to lenders over time. 

• Lack of Incentives to Join LMEs: Theoretically, LMEs can inject capital and provide more runaway for a distressed company, but in many cases, they have failed to address the key structural and operational issues that caused the distressed situation. As seen through Envision, Incora, iHeart, and JCrew, companies ultimately filed for Chapter 11 while sponsors secured more fees from upsides in the post re-organized company’s equity, and improved their positions in court. It turns out that even the recovery rate of first lien claims, the most secure part of the capital structure, who executed LMEs prior to bankruptcy was a mere 47% [4]. 

• Control Over Credit Docs: Cooperation agreements can tighten loose credit documents and rebuild covenants. They could also implement new provisions limiting loopholes for LMEs. For example, simple majority voting schemes can allow a creditor group holding 55% of the debt to modify key provisions in credit docs to their advantage. Amendments to the waterfall provision would allow borrowers to issue more senior or pari-passu debt, which refers to the same tranche of debt. Existing senior lenders are no longer guaranteed to repay their debt first and have access to the borrower’s collateral. In some cases, simple majority lenders with more than 51% of votes would amend ‘pro-rata’ sharing provisions to ‘non pro-rata.’ When new debt has been issued, this would disregard the original percentage of debt held by each lender and distribute a proportionally higher percentage of new debt to the simple majority lenders [5]. These maneuvers demonstrate the deterioration of ‘sacred rights’ in credit docs over the past years as amendments no longer require unanimous consent of all affected lenders. However, a cooperation agreement group signed by more than two-thirds in debt can create a new provision requiring 100% of votes to change such provisions in credit docs [3]. 

• Significance of Other Creditors: Simply modifying debt instruments cannot prevent the creative interpretation of existing loopholes in credit documents. To defend themselves, lenders must rely on other lenders to achieve a majority 'blocking' position to reduce the risk of being excluded from handpicked lenders. This blocking position is achieved by holding at least one-third of the debt of the impaired class, preventing other lenders from voting on a less desirable plan of reorganization, and dictating the direction and recoveries in a restructuring. 

• Collective Bargaining Power: By creating a united majority group, borrowers have limited options to foster competition among lenders to extract the most attractive terms. While conflicting interests allowed for borrower flexibility, it would be difficult to tailor the ‘sweeteners’ to each creditor. It also prevents sponsors from offering a few lenders better terms based on which lenders they want to continue financing their LBOs. 

Binding Terms that Restrict Individual Creditors 

Considering the benefits of joining a cooperation agreement, it seems like most creditors would be willing to sign the agreement. However, law firms have noticed that only one-fourth of creditors interested in a cooperation agreement would end up signing [6]. Here are a few rights that individual creditors would need to sacrifice to benefit the collective group. 

• Cannot opt out on specific deals or pursue litigation: this puts lenders with minority positions at a disadvantage as they have less voting power within the group 

• Limited to selling holdings and exiting positions: this could be necessary depending on fund structure to return capital to investors and lower risk appetite frequently 

• Any additional debt incurred is subject to the terms of the agreement: this limits the creditor’s control over their strategy and interpretation of the future value of the borrower 

• Prohibited from communicating with the borrower and agents [3]: this can create an opportunity cost of a better deal or ability to adapt to a borrower's shifting stance 

Factors Behind the Success of a Cooperation Agreement 

After evaluating the tradeoffs, a creditor is open to the idea of joining a cooperation agreement. What about the perspective of other creditors? The success of forming and leveraging a cooperation agreement depends on many idiosyncratic factors of the company’s capital structure and financial profile, as outlined below. 

• Alignment of Interests: A tight-knit group with similar investment styles, valuation of the business, and pre-existing relationships leads to more effective cooperation. However, some capital structures include crossholders who hold debt tranches across the capital structure, including the equity in the private equity sponsor in some cases. While they may have aligned incentives with a particular creditor group, they are comfortable sacrificing recovery for one debt tranche to maximize total returns. This flexibility gives them the means to opt out of cooperation agreements even while taking a loss in a certain tranche. 

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