The Wall Street Journal reports that Exxon-Mobil’s recent $31 billion purchase of natural gas exploration firm XTO Energy confirms a recovery of merger and acquisition activity over the past 2 months. It reports that November and December had the most M&A activity since the summer of 2008, with values 4 times greater than a year ago. Also leading this charge were Warren Buffet’s largest ever $26 billion investment in the railroad industry, and the $4.6 billion merger of Stanley Works and Black & Decker. November alone saw the announcement of 41 U.S. deals worth a combined total of approximately $47.5 billion, benefiting mostly large Wall Street banks and boutique financial firms. Sources within the chemical industry also expect a 2010 rally in the number of deals.

Many experts believe these increases in M&A activity signal good news for the health of the broader economy in 2010. Indeed, the recent surge seems to be the result of increased access to capital markets, the stagnation of which has been cited repeatedly as the cause of the continued lagging of a broader recovery. Accompanying these positive indicators are the apparent stabilizing of economies world-wide, financing becoming more available in the broader spectrum, and the narrowing of the gap in price expectations between buyers and sellers. Consistently, a large regional bank representative recently said at a lunch meeting that their bankers have been directed to increase lending dramatically in 2010 as underwriters loosen standards for loan approval.

Until recently, any positive indicators of recovery always have seemed to accompany at least as many negative ones. As 2009 ends, however, the negative indicators appear to be waning strongly in favor of the positive. Also, while many experts claim, perhaps too definitively, that this recession is over, others hinge their disagreement mostly on lagging unemployment data. Yet unemployment typically is the last area to improve after a recession as companies tend to wait until they clearly are understaffed before resuming hiring. Moreover, early 2010 should provide great opportunities for companies to contact their previously obstinate bankers again to seek (or refinance) lines of credit and other financing.

Much is being made of the “US Pay Czar,” Kenneth Feinberg’s, effort to limit executive compensation at firms that have not re-paid TARP funds.  Feinberg plans to force 175 corporate executives to cut their salaries by 90%.

A Wall Street Journal article suggests that Feinberg won’t stop at limiting salaries:

“Mr. Feinberg will also demand a series of corporate governance changes at the firms, including splitting the chairman and CEO positions, requiring boards of directors to create “risk” committees and eliminate staggered board elections, which critics charge inhibit change.”

Feinberg’s pay restrictions will be ineffective in achieving their desired goals.  Many executives who face a 90% pay cut will simply leave their firms.  But further federal intervention into corporate governance is troubling.  Corporate law has been a long been the domain of States.  So any federalization of permissible takeover defenses represents a huge shift in the power toward Washington and away from more local government. 

More importantly, staggered board elections operate as a takeover defense to prevent hostile bidders from acquiring control of the company.  The legality of the anti-takeover measures (such as the staggered board) evolved out of several high-profile Delaware Chancery Court cases in the 1980’s.  Like them or not, anti-takeover defenses yield substantial benefits to shareholders. Indeed, having a staggered board allows managers to negotiate harder and extract a higher price for the shareholder. 

Corporate governance is not likely to improve with the elimination of staggered boards.  Activist shareholders will be better equipped to challenge management - but there is no guaranty that these activist shareholders will yield more stable financial institutions.  Indeed, some acquirers may ratchet up leverage and use the company to take riskier bets in the marketplace than the old management.  As the same time, shareholders (and a nation of 401k holders) will suffer as their shares have a lower total value to potential acquirers.

Many commercial leases contain provisions granting landlords a lien on the tenant’s assets. These leases often provide that property abandoned by the tenant upon termination of the lease belongs to the landlord. These lease provisions reduce the security granted to commercial lenders because they can create conflicting priorities of liens.

Article 9 of the Uniform Commercial Code does not always address the priority of non-Article 9 liens. Worse, landlord liens are expressly excluded from the scope of Article 9. See 810 Ill. Comp. Stat. 5/9-109(d). If the debtor defaults, the secured creditor is likely to find itself in a priority fight with the landlord over the collateral.

It can get worse than a simple priority fight. In this economy it is not uncommon for businesses to abruptly close shop and abandon their property on the leased premises. As a result, the landlord is often the first party to discover the debtor’s insolvency. This gives the landlord a huge head start in the race to the courthouse door to obtain a judicial order confirming the landlord’s ownership. In some cases the secured creditor is not aware of the location of the collateral. In such a scenario, the landlord may have disposed the debtor’s property before the secured creditor became aware of the default. In addition, if the landlord does not cooperate the secured creditor may not be able to access the premises to remove the collateral without a court order.

However, the secured creditor may be able to reach an agreement with the landlord regarding the collateral. Many landlords do not have the interest or ability to hold auctions for abandoned property. So long as they obtain some redress for their damages, the landlord may permit the secured creditor to remove the collateral from the premises. Removal of the collateral also makes it easier to relet the premises.

Many of the secured creditor’s nightmares with respect to landlords can be avoided with two simple measures (1) regular inspections of the tenant’s business facilities to ensure that the collateral has not been moved; and (2) obtaining landlord waivers where the landlord recognizes the lien and permits the secured creditor to remove the collateral upon default. Most landlords understand that the health of their tenant’s business depends on their ability to secure adequate financing. As a result landlords generally are willing to waive their lien rights in exchange for a relatively nominal amount (often partial rent while the premises are accessed by the secured creditor).

One final item to note, which is overlooked with surprising frequency.  Secured creditors should not engage in self help when their collateral is under lock and key under premises owned by another party.  Article 9 security interests will not provide a defense to a charge of breaking and entering.

Latching onto a footnote in a 1991 decision of the Delaware Court of Chancery referring to an expansion of directors’ fiduciary duties when a corporation is in the “zone of insolvency”, creditors started asserting breaches of fiduciary duties when directors did not accede to their claims. SeeCredit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp., Civ. A No. 12150, 1991 WL 277613, at *34 n. 55 (Del. Ch. Dec. 30, 1991). Delaware courts have now rolled back these claims clarifying that Credit Lyonnais intended to shield the board and management of a Company from fiduciary claims by shareholders and that the expansion of fiduciary duties to include creditors did not create an independent cause of action by creditors. SeeProd. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004); N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del.2007).

By rolling back fiduciary claims, the Delaware courts decisions highlight the importance of properly drafted covenants in credit agreements. Many borrowers dislike the cumbersome package of affirmative, negative and financial covenants that populate the credit agreements, often with good reason. The standard covenant package in most form credit agreements shackles the operations of the borrower by blocking many business decisions without a creditor’s permission slip. However, from the creditor’s perspective it bears the downside of risky behavior by the borrower. A properly drafted covenant package measures the financial health of the borrower and promptly alerts the creditor when there is a deterioration of the borrower’s business. Even if the borrower has not yet defaulted on its payment schedule, covenant breaches get creditors a seat at the table for any reorganization prior to formal insolvency or payment defaults.

It is possible to find a somewhat happy medium between the competing interests of the borrower and creditor by carving out certain activities and expenditures from the covenants. However, the recent credit crisis has shown the downside for creditors who too often lend money with light covenant requirements to borrowers being aggressively wooed by other lenders. Many creditors (particularly banks) are in the business of lending money, not operating businesses. While it is in their interest to maintain a long term relationship with the borrower, creditors should craft a covenant package that does not leave them in the position of a firefighter who shows up after the house has burned down to cinders.

A previous entry highlighted some of the perils of stock pledges. It can get worse.

The most glaring limitation in a pledge of stock of a privately held company is the absence of a public market for the stock. This potentially saddles the creditor with stock that it cannot sell (absent a shareholder agreement with mandatory buy-sell provisions).  Additionally, if the stock pledge does not include all or a controlling amount of the company the creditor may not be able to elect directors of the company to force a sale of the company.  This could leave the creditor in the position of Don Quixote tilting at windmills.

However, even with these limitations stock pledges are still fairly common.

To begin with, they are often the most cost effective way to obtain a security interest.  Since the lien is perfected by possession of the stock certificate or blank stock powers, both parties can avoid UCC filing costs (or even worse, mortgage filing costs) and requirements.  Enforcing the lien upon default involves simply signing over the stock to the creditor’s name and enforcing rights as a shareholder to sell the stock or vote to force a sale of the company.  This may permit the creditor to act without court action, particularly when the pledge gives the creditor vote of a controlling interest in stock.

Stock pledges are often not as intrusive in the day to day operations of the business and do not preclude the ability to obtain additional financing or trigger defaults on existing financing (Note: encumbering stock can trigger a default under many standard bank documents).  In some cases, the company may have sufficient value that even the acquisition of a minority interest may have inherent values.

While stock pledges are not perfect even when properly perfected, the circumstances of the transaction may make them the appropriate form of security.  The pros and cons of doing so should be carefully considered.

Here is a scenario to ponder.  A Debtor issues two Promissory Notes, one to Creditor A and the other to Creditor B.  The Note to Creditor A is dated earlier and is secured by a properly perfected pledge in the Debtor’s stock.  The Note to Creditor B is secured by a properly perfected and filed UCC financing statement on all assets of the Debtor.  There is no Intercreditor and Subordination Agreement between Creditor A and Creditor B.  Debtor defaults.  Would you rather be Creditor A or Creditor B?

Article 9 of the UCC addresses a number of priority scenarios when different creditors lien against the same asset. See 810 ILCS 5/9-317 to 810 ILCS 5/9-339. However, it does not provide much guidance as to the practical economic effect of two creditors who properly perfected their liens against different assets.

In the scenario above, Creditor A may enforce its pledge to gain voting control of the Debtor and attempt to sell the business.  However, Creditor B still has a valid lien against the Debtor’s assets that will not be extinguished by Creditor A assuming control of the Debtor.  Creditor B can still proceed against the assets and recover its obligations, possibly leaving Creditor A with a shell company.

Creditor A would be in a better position if it had an Intercreditor and Subordination Agreement with Creditor B that ensured Creditor A was paid off before Creditor B.  However, this scenario also presents the lesson to creditors often cited by Alastor “Mad-Eye” Moody in the Harry Potter books – “Eternal Vigilance.”  Know what your debtors are up to and what encumbrances they are racking up.

This scenario also highlights certain limitations of using stock pledges to secure debt.  These will be explored further in a later blog.