On March 15, 2016, Richard Davis, the court-appointed examiner in the Caesars Entertainment Operating Company, Inc. ("CEOC") bankruptcy case, issued his long awaited report concerning whether certain pre-petition transactions involving CEOC, its parent company and affiliates and the sponsors of its leveraged buyout gave rise to claims that could be brought against those entities on behalf of CEOC's creditors. Mr. Davis answered that question in the affirmative and stated his belief that the value of those claims considered by him to be "reasonable or strong" ranged from $3.6 billion to $5.1 billion.
Among the claims Davis analyzed were certain claims against the law firm that represented CEOC, its parent, Caesar's Entertainment Corporation ("CEC") and the sponsors in connection with transactions between CEOC and CEC. While Davis determined that such claims are likely not cognizable, the absence of separate legal counsel for CEOC weighed significantly on Davis' determinations of CEC's and the sponsors' liability. According to the report, had CEOC been permitted to retain its own counsel, it is possible that some or all of the transactions discussed in the Examiner's report would have been structured differently and in a manner that provided fair consideration or reasonably equivalent value to CEOC's creditors while still achieving CEOC's and the sponsors' goals. Plainly, such a revised transaction would have gone a long way to reducing or eliminating CEOC's and the sponsors' liability to CEOC's creditors.
I. Background
A. The LBO and Great Recession Impact Caesars' Business
In 2008, Harrah's Entertainment, Inc. was acquired in a $30.7 billion leveraged buyout (the "LBO") by the private equity firms Apollo and TPG (together, the "Sponsors"). The enterprise was later rebranded under the Caesars name and the company's name changed to CEOC. The LBO was funded with $24 billion in debt, more than $17 billion of which was secured by liens on substantially all of the debtors' assets, and a large percentage of which was guaranteed by CEOC's parent company, CEC.
Given the large debt incurred in connection with the LBO as well as the capital expenditures necessary for Caesars' business to continue to grow and thrive as it had pre-LBO, it was essential that Caesars continue its pre-LBO revenue growth. Unfortunately, the Great Recession took hold shortly after the LBO closed and its effects on the gaming industry were particularly devastating. Indeed, the Examiner's report states that the recession's impact on Caesars was so severe that even today the company's financial performance remains below its pre-LBO level.
B. Caesars' Debt Is Restructured to Create Runway for the Business to Recover
In response to the Great Recession, CEC and the Sponsors took a number of steps to restructure Caesars' debt to buy the business time to recover. As with any business, Caesars during this period required additional capital to fund its desired growth. To attract this capital, CEC and the Sponsors caused CEOC to enter into a number of transactions that reduced CEOC's asset base so that such assets could be financed without the overhang of the LBO debt CEOC had incurred.
1. The CERP Transaction
For example, in 2013, CEOC and CEC entered into a series of transactions pursuant to which two projects CEOC was developing were sold to a newly formed CEC subsidiary, Caesars Entertainment Resort Properties ("CERP"). According to the Examiner's report, there were no negotiations between CEOC and CEC over the consideration CEOC would receive from the sale, and CEOC and CEC were represented in the transaction by the same counsel. Notably, 70% of the consideration CEOC received comprised non-cash indirect benefits, such as the avoidance of future expenses and the release of a guarantee of lease payments given by CEC. The Examiner determined that CEOC was insolvent at the time of the CERP transaction.
2. The CES Transaction
A second transaction reviewed by the Examiner involved the creation of another new CEC subsidiary, Caesars Enterprise Service, LLC ("CES") to which CEOC granted a broad license to Caesars' customer loyalty program, and to which CEOC also transferred its enterprise-wide management responsibilities. According to the Examiner's report, the CES transaction was engineered by Apollo to protect Caesars' intellectual property and management services in the event of a CEOC bankruptcy, which was then a known risk. CEOC was not involved with the negotiation of the transaction and did not have access to its own counsel. The Examiner determined that CEOC was insolvent at the time of the CES transaction.
C. Fraudulent Transfers and Breaches of Fiduciary Duty
Given the descriptions of the CERP and CES transactions – and CEOC's insolvency at the time it entered into those transactions – it is perhaps not surprising that the Examiner finds that creditors have strong claims relating to such transactions. Indeed, with respect to each transaction, the Examiner found that creditors have strong fraudulent conveyance claims as well as strong breach of fiduciary duty claims against CEOC's directors and CEC as CEOC's controlling shareholder.
D. The Need for Independent Counsel
As the Examiner noted, law firms often represent multiple clients in transactional matters and it is common for law firms to represent the portfolio companies of their private equity clients, as well as for the same firm to represent both a parent company and its 100% owned subsidiary. When a parent and its subsidiary are both solvent, one law firm can represent both parties in a transaction between them as their interest in the outcome of the transaction is the same.
A solvent company can transfer assets for little or no consideration and is generally free to make such transfers to related parties. Indeed, if CEOC were solvent at the time of the CERP and CES transactions, its creditors would likely have no claim with respect to such transactions as a solvent company is to be managed for the benefit of its shareholders and no fiduciary duties are owed to the creditors of a solvent company.
When the portfolio company or subsidiary is insolvent, however, a different calculus is involved. In those situations, the company is to be managed for the benefit of its creditors, and it will often be the case – as with the CERP and CES transactions – that transactions that benefit the parent may not be in the interest of the subsidiary. Indeed, in such situations, there is a conflict of interest between the parties such that the same law firm cannot represent both clients unless each client gives informed consent in writing. According to the Examiner, neither CEOC nor CEC issued conflict waivers or otherwise expressed their written consent to their dual representation by the same law firm.
While we will never know what would have happened had CEOC retained its own counsel, the presence of independent counsel for CEOC may have resulted in a different outcome. As the Examiner's report illustrates, when a parent company and its subsidiary enter into transactions at a time when the subsidiary is insolvent, their respective boards of directors should take all steps to ensure the negotiations are done at arm's length, including the retention of separate counsel. While it may often be difficult for the parties and their law firm to know when a subsidiary crosses the line from solvent to insolvent, independent counsel may be better positioned to insulate a transaction between related parties from later attack.
Instead, the Examiner's Report found that the approach to the CERP and CES transactions taken by CEC and the Sponsors evidenced a desire to protect their own interests at the expense of CEOC's external creditors and led to what the Examiner deems to be strong claims against them ranging from $461 million to $1 billion. A cautionary tale, indeed.
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