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The Anatomy of Double Dip Bankruptcy Claim

convertarb — Tue, 20 Mar 2012 00:22:59 +0000

This post was taken from Distressed Debt Investing.

The Anatomy of a Double-Dip

Mark P. Kronfeld (1)

American Bankruptcy Institute

Bankruptcy lawyers and distressed investors often loosely use the term “double-dip” to describe scenarios where a creditor can increase its recovery by multiplying its allowed claim against a particular entity or asserting claims against multiple entities (or any combination thereof). For example, a “double-dip” exists in bankruptcy, where a creditor has the benefit of a guarantee from a debtor entity (the first dip) and the primary obligor asserts an independent “incremental” claim (the second dip) against a debtor entity, which also ensures to that same creditor’s benefit. This incremental claim can arise by virtue of an intercompany loan, a fraudulent-transfer claim or even by statute. Where the incremental claim is asserted against the guarantor entity, this would give rise to a “true double-dip,” which would provide for a 2x recovery vis à vis the guarantor entity (capped at payment in full).

The double-dip issue has appeared in a number of recent restructurings, including Enron Corp., CIT Group Inc., Lehman Brothers Holdings Inc., General Motors Corp., Smurfit-Stone Container Corp. and AbitibiBowater Inc. Regardless of the variety of the double-dip, the creditor’s ability to benefit from full simultaneous multiple claims and receive enhanced recoveries from the double-dip is based on a number of key legal and factual predicates.

In Diagram 1, the parent company (guarantor) creates a finance subsidiary (issuer/principal obligor) whose purpose is to issue debt and transfer the proceeds to the parent. The subsidiary is created solely for the business concerns of the parent and has no tangible assets. (2)

Assume for purposes of Diagram 1 that – as is common – the parent guarantee is a “guarantee of payment” for the full principal amount. It is therefore immediately triggered and enforceable upon the subsidiary’s default. This is in contrast to a “guarantee of collection,” which contains certain conditions precedent to enforceability. Moreover, even though guarantees often contain guarantor waivers of all rights of subrogation, indemnity and reimbursement against the principal obligor (3), assume that the guarantee in question does not have such a waiver and, in the event that the parent actually pays on the guarantee, it will have a claim for reimbursement against the subsidiary for any amounts paid under applicable state common law. (4)

Outside of bankruptcy, so long as the parent continues to pay its debts there is no issue, but on the company’s insolvency, the finance subsidiary bonds will receive the benefit of a $2 billion allowed claim against the parent—tw otimes the amount of the principal originally loaned. The result is simple math: The parent in essence is required to make two distributions to the indenture trustee for the bonds on account of the $1 billion claim: first, as a direct distribution on account of the $1 billion guarantee claim, and second, indirectly via the $1 billion intercompany claim, which flows to the subsidiary and out to the subsidiary’s creditors (again, the bonds). Put another way, because the guarantee claim and the intercompany claim of an equal amount are both allowed in full against the parent and compete with the parent’s other creditors on a pro-rata basis, bond holders receive the benefit of a $2 billion claim against the parent for a $1 billion advance.

A recent example of this occurred in Lehman Brothers. Prior to the petition date, Lehman Brothers Treasury Co. BV (LBT), a finance subsidiary, issued more than $30 billion in notes and immediately upstreamed the proceeds to its parent, Lehman Brothers Holdings Inc. (LBHI). As in Diagram 1, the LBT notes were guaranteed by LBHI. In the subsequent insolvency proceedings, the LBT noteholders asserted a direct claim on the guaran tee against LBHI and sought to recover indirectly from LBHI on account of the intercompany claim flowing to LBT. Both claims were allowed pursuant to the plan. (5)

Why Does the Double-Dip Work

Why do the bondholders get the benefit of two claims for a single advance? First, when a primary obligor and a guarantor are liable on account of a single claim, the claimant can assert a claim for the full amount owed against each debtor until the creditor is paid in full. This is a function of applicable state law and the Bankruptcy Code, which provides that a claim must be allowed “in the amount of such claim in lawful currency of the United States as of the date of the filing of the petition.” (6) Post-petition payments by a guarantor or obligor do not reduce the claim against the other. (7) The bonds get a full $1 billion claim against the parent and the subsidiary, regardless of any partial recoveries received.

Second, absent substantive consolidation (8), subordination or recharacterization, claims resulting from unsecured intercompany loans are generally entitled to the same pro-rata distribution in bank ruptcy as every other unsecured claim. Therefore, the $1 billion intercompany claim is entitled to a distribution from the parent’s bankruptcy estate (9), which distribution flows down to the subsidiary and out its bondholders.

Third, until the underlying creditor is paid in full, the Bankruptcy Code (via §§ 502 and 509) effectively disallows and/or subordinates the guarantor’s claim for reimbursement against the principal obligor, making it impossible for the guarantor to assert a claim that competes with the recovery of the principal creditor. In the parent company/finance subsidiary structure previously discussed, the parent has a claim against the subsidiary for reimbursment to the extent it makes a payment on the guarantee, and in the example, that claim has not been waived in the underlying documentation. Were that claim allowed against the subsidiary, it would set off against and reduce the intercompany claim. (10)

Section 502(e)(1)(b) provides that the guarantor is not entitled to an allowed claim for reimbursement against the principal obligor if such claim is “contingent” (i.e., if the guarantor has not paid on the guarantee). Moreover, even if the guarantor pays a portion of the amount due (rendering the claim no longer “contingent”), § 509(c) subordinates the claim of the guarantor until the primary creditor is paid in full (either from the debtor or from any other source). Similarly, while § 509(a) provides that a guarantor who pays a portion of the principal claim can subrogate to the claim of the original creditor (the indenture trustee for the bonds), that subrogation right is also subordinated to payment in full of the underlying creditor. Because the claim is disallowed (if contingent) and subordinated (if not contingent), it can never be set off against the intercompany claim until the bonds are paid in full.

Possible Threats

Complications relating to guaran tees may impact the double-dip, and the terms of the governing guarantee must be examined. Is it a guarantee of payment or collection? Is the guarantee joint and several? Was the guarantee (and/or intercompany transactions performed) given prior to the expiration of any applicable statutes of limitations for fraudulent conveyance? (11)
The governing law under the guarantee should also be examined, as well as the law applicable to the entire structure. The discussion above assumes application of U.S. and state law generally, but many finance subsidiaries are incorporated in foreign jurisdictions. If foreign law applies to either the guarantee or intercompany claim, the double-dip could be jeopardized. For instance, certain jurisdictions may, as a matter of law, subordinate intercompany claims.

Risks of substantive consolidation must also be analyzed because substantive consolidation, if utilized by the bankruptcy court, will eviscerate guarantees and intercompany claims. Under the doctrine of substantive consolidation, intercompany claims of the debtor companies are eliminated, the assets of all debtors are treated as common assets and claims against any of the debtors are treated as against the common fund. (12) Courts analyzing substantive consolidation disputes have considered numerous factors, including commonal- ity of ownership, directors and officers; whether subsidiaries were inadequately capitalized; the existence of separate employees and businesses; the existence of corporate formalities; commingling of assets and functions; the degree of difficulty in segregating assets and liabilities; and creditor expectations. Substantive consolidation of a U.S. entity and a foreign entity may, however, pose particular challenges.

Other factual issues need to be under stood as well. When a finance subsidiary is the issuer, the debt proceeds are typically transferred to another entity such as the parent. The means by which the transfer is made must be examined as part of the double-dip analysis. Upstream dividends and/or downstream capital infusions will generally not give rise to intercompany claims. If there is no intercompany claim, there is no double-dip.

However, to the extent any “dividends” or “capital infusions” take place within the applicable statute of limitations, they may be avoidable as a fraudulent conveyance giving rise to an intercompany claim, thereby creating a double-dip. In fact, a claim against the debtor recipient of the debt proceeds by virtue of a fraudulent conveyance may be superior to a claim arising under an intercompany loan where the fraudulent conveyance is treated as a general unsecured claim but the intercompany claim might have been deemed subordinated or recharacterized.
Moreover, even if the intercompany transfers appear as a “loan” on the intercompany ledger, its terms should be ascertained to understand any risk that the bankruptcy court might recharacter ize the intercompany transaction. (13) In particular, the rights and obligations of the counterparties to the intercompany transaction should be analyzed. In the Smurfit-Stone cross-border proceeding, the Canadian court held that although the intercompany claim upon which bondholders relied for a portion of their “double” recovery was clearly a “loan” in the general sense, it was nonetheless not a basis for a double-dip recovery because the terms of the intercompany loan stated that upon an insolvency proceeding, the “loan” would be repaid in valueless equity. (14)

Equally important is the tracing of the amount and flow of funds. Diagram 2 presents a variation on the double-dip theme. The facts are similar to those in the first scheme, but instead of transferring the $1 billion to the parent (a guarantor), the finance subsidiary has transferred the cash to a nonguarantor debtor affiliate. Although the recovery on the intercompany claim still results in distribution to the subsidiary for the benefit of bondholders, the claim is diluted by the nonguarantors’ other creditors, resulting in less than a true double-dip. Obviously, if the nonguarantor subsidiary was solvent or made a larger distribution, bondholders could recover more than 2x, but regardless, the true double dip is jeopardized when the cash flows out to a nonguarantor.

Leakage could also result if the finance subsidiary/principal obligor has additional third-party creditors (such creditors will dilute recovery on account of the principal claim against the financing subsidiary). Note that even if there are no creditors on the subsidiary balance sheet, and even if the subsidiary’s documents preclude the incurrence of additional debt, the entire capital structure needs to be understood. For example, is there a large underfunded pension, and is the pension likely to be the subject of a distress termination in bankruptcy? If so, the Pension Benefit Guaranty Corp. may attempt to assert a claim against the subsidiary.

Conclusion

In any insolvency situation, nonborrower credit support carries with it the promise of additional recoveries against different obligors. Creditors with the benefit of guarantees (and investors determining what securities to buy) should carefully examine the applicable facts and law to determine whether any variety of double-dip exists it will enhance recoveries.

The Postpetition Interest Debate

convertarb — Sun, 18 Mar 2012 00:30:37 +0000

Distressed Debt Investing Website:

The Postpetition Interest Debate: What Distressed Debt Investors Need to Know

Bankruptcy Courts have long taken divergent approaches to the appropriate calculation of postpetition interest on general unsecured claims in solvent debtor cases. While some courts have applied the federal judgment rate of interest pursuant to 28 U.S.C. § 1961(a), other courts have favored the interest rate agreed upon prepetition between the debtor and its creditors to the extent enforceable under state contract law. The prepetiton contract rate of interest often substantially exceeds the federal judgment rate. Therefore, the decision to apply one rate of postpetition interest over the other can dramatically alter recoveries to holders of general unsecured claims.

The controversy surrounding the postpetition interest debate lies in fundamental disagreement over the statutory interpretation of section 726(a)(5) of the Bankruptcy Code, which provides that an unsecured claimholder of a solvent debtor is entitled to “payment of interest at the legal rate from the date of the filing of the petition.” 11 U.S.C. § 726(a)(5) (emphasis supplied).

Although the requirements of chapter 7 typically do not apply to chapter 11 proceedings, section 726 of the Bankruptcy Code applies indirectly through the “best interest of creditors” test in section 1129(a)(7), which requires that distributions proposed under a chapter 11 plan must at least equal the amount such holder would have received under a chapter 7 liquidation. Applying section 726(a)(5), a solvent debtor liquidating under chapter 7 would have to pay holders of general unsecured claims postpetition “interest at the legal rate” before it can make any distributions to equity interest holders.

While courts have historically split over whether the term “interest at the legal rate” means a rate fixed by federal statute (i.e., the federal judgment rate) or a rate determined by a prepetition contract (i.e., the contract rate), several recent decisions have favored the federal judgment rate as an appropriate metric for postpetition interest. See, e.g., Opinion, In re Washington Mutual, Inc. et al., Case No. 08-12229 (MFW) (Bankr. D. Del. Sep. 13, 2011); Onink v. Cardelucci (In re Cardelucci), 285 F.3d 1231 (9th Cir. 2002); In re Garriock, 373 B.R. 814 (E.D. Va. 2007); In re Adelphia Communications Corp., 368 B.R. 140 (Bankr. S.D.N.Y. 2007); In re Dow Corning Corp., 237 B.R. 380 (Bankr. E.D. Mich. 1999).

These courts have argued the application of a single, uniform interest rate, as opposed to varying rates based upon the individual contracts of each unsecured claimholder, ensures that no single creditor will receive a disproportionate share of any remaining assets to the detriment of other creditors. In addition to promoting the equitable treatment of creditors, these courts have ruled that the federal judgment rate also achieves judicial efficiency by eliminating the burdensome scenario under which a chapter 11 debtor would have to calculate postpetition interest at a different rate, based upon a different contract, for each individual creditor. Of course, the notion of equality among creditors who bargained for different deals may not be fair. And, the calculation of interest at different rates is hardly a daunting task.

Notwithstanding the courts that support the federal judgment rate in their calculation of postpetition interest, however, the jurisprudence still leaves the door open for the application of interest at the contract rate. This should come as good news to distressed debt investors holding unsecured claims against a solvent debtor’s estate that carry prepetition interest at a contract rate considerably higher than the governing federal judgment rate.

Even in the most recent bankruptcy court decision applying the federal judgment rate, Judge Walrath conceded that while “the federal judgment rate [is] the minimum that must be paid to unsecured creditors in a solvent debtor case . . . the [c]ourt [has] discretion to alter it.” See Opinion, Washington Mutual at 77 (citing Judge Walrath’s previous decision In re Coram Healthcare Corp., 315 B.R. 321, 346 (Bankr. D. Del. 2004) (ruling “the specific facts of each case will determine what rate of interest is ‘fair and equitable.’”)). But, Judge Walrath then clarified that “[t]o the extent that [she] suggested in Coram that the federal judgment rate was not required by section 726(a)(5), [she] was wrong.” See Opinion, Washington Mutual at 78 n. 35.

While the Washington Mutual decision may ultimately mean that holders of general unsecured claims have no entitlement to postpetition interest at the contract rate in the Third Circuit, Judge Walrath did recognize the appropriateness of contract rate interest in two limited circumstances: (i) when creditors are over-secured pursuant to section 506(b) of the Bankruptcy Code and (ii) when contractual subordination provisions require junior creditors to pay senior creditors all interest at the contract rate. See Opinion, Washington Mutual at 80-81. Of course, the latter observations were dicta.
Absent these two limited circumstances, distressed debt investors in the Third Circuit and elsewhere can utilize the equities of the case to argue for the application of contract rate interest. Even then, holders of unsecured claims have no certainty that they will prevail. Distressed debt investors must discount this risk as they try to analyze recoveries on general unsecured claims in chapter 11 cases of solvent debtors.

Contesting Priming Liens in DIP Financing

convertarb — Tue, 28 Feb 2012 00:46:21 +0000

Distressed Investing Website:

Contesting Priming Liens in DIP Financing

Within any chapter 11 business bankruptcy, a secured creditor runs the risk of having its interest primed in favor of a lender who provides the debtor additional operating capital during the pendency of the bankruptcy proceedings through debtor-in-possession (“DIP”) financing under § 364 of the Bankruptcy Code. Such risk is not easy to quantify, is highly fact-specific, and may depend on, among other things, whether the creditor sought to be primed is oversecured or undersecured. A recent case in the Bankruptcy Court for the Northern District of Illinois is illustrative of the circumstances under which a priming lien will be granted, and provides insight into the Court’s analysis for those secured lenders who would like a deeper understanding of this issue. The case is notable for the detail the Court provides in its analysis of when a priming lien under § 364(d) is appropriate. Fullsome court decisions have been few and far between in recent years as most DIP financing arrangements are consensual.
In In re Olde Prairie Block Owner, LLC, 448 B.R. 482 (Bankr. N.D. Ill. 2011), the Debtor owned “two parcels of choice real estate” located adjacent to McCormick Place in Chicago (one of North America’s leading convention centers), where the Debtor intended to develop a hotel complex to serve those visiting McCormick Place. At an evidentiary hearing on the prepetition secured creditor’s lift stay motion, the Court found the value of the Debtor’s property to be approximately $81 million, based on evidence offered by the Debtor’s expert witness. Because the prepetition lender was unwilling to advance any additional funds, the Debtor sought DIP financing that included a priming lien over the prepetition lender’s $48 million mortgage on the parcel. Thus, the prepetition secured lender was oversecured by over $30 million.
Judge Schmetterer issued a thoughtful decision that set forth the analytical framework for considering priming DIP loans. A debtor can obtain credit secured by a senior or equal lien on encumbered estate property with court approval and after notice and a hearing only if: (1) the debtor is unable to obtain credit otherwise and (2) the interest of the creditor to be primed is adequately protected. 11 U.S.C. § 364(d). Generally, “adequate protection” requires that a secured lender receive compensation or something of value during the pendency of the bankruptcy case to protect it against the diminution or erosion in value through depreciation, dissipation, or any other cause, including the dollar value of the priming DIP loan. Adequate protection can take many forms, including, but not limited to, periodic cash payments, postpetition security interests (replacement liens), liens in unencumbered property, or an “equity cushion” (the amount by which the secured lender is oversecured).
Under § 364 of the Bankruptcy Code, there is no requirement that the debtor explain or justify its proposed use of funds. However, as the Court explained, if the Debtor’s borrowing request was granted, the funds would become property of the bankruptcy estate and therefore subject to the usage limitations set forth in § 363 of the Bankruptcy Code. Under § 363, a debtor may use or sell estate property outside the ordinary course of business only after notice and a hearing, and after the debtor demonstrates an “articulated business justification” for the use of the funds.
In Olde Prairie, the Debtor demonstrated that it was not able to obtain credit under less onerous terms than those offered by the DIP lender. Next, the Debtor was able to demonstrate that the existing senior lender’s interest was adequately protected by virtue of the large equity cushion (approximately 38% of value) to protect the senior lender from any potential diminution in value during the pendency of the case. However, the Court noted that a large equity cushion is not a “debtor’s piggy bank and the uses contemplated for the new loan must have serious likelihood of benefitting the property and advancing the purposes of reorganization. A priming lien without such a showing would impose an unwarranted burden on the secured creditor if reorganization fails.” The Court further noted that because the valuation was based on expert opinion, which is not a substitute for testing the market to obtain actual sales or funding, “allowing a priming lien should be considered with caution to avoid transferring the entrepreneurial risk of failure by Debtor’s investors and principals onto the secured creditor…Given the inherent uncertainty of determining valuation through methods commonly used by experts in appraising real estate, some restraint in allowing priming liens to fund particular expenses is warranted.”
The Court found that most of the expenses the Debtor sought to fund with the DIP loan would likely advance the value of the bankruptcy estate and further the Debtor’s reorganization. The Debtor anticipated using the funds to lobby for certain tax benefits, which would increase the overall value of the parcel and encourage outside investment. The Debtor was also using the funds to further its hotel development plans. The Court thus found that the Debtor had shown under § 363 that it had articulated a “serious . . . business justification for most of the proposed uses of the requested loan, regardless of whether they are inside or outside the ordinary course of business, and that those uses are in the best interest of the estate.”
The outcome might have been different in the Olde Prairie case had the prepetition secured lender been undersecured (that is, if the value of the collateral was less than the secured lender’s claim). Indeed, there is ample authority that holds that an undersecured creditor cannot be primed when the value of the prepetition secured lender’s collateral will decrease during the bankruptcy case and the debtor cannot provide any adequate protection for such decrease. See, e.g., In re Swedeland Dev. Group, Inc., 16 F.3d 552 (3d Cir. 1994) (denying DIP financing on priming basis where debtor sought postpetition financing to fund construction of residential units on a partially finished real estate development, the prospects of which were inherently risky); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (Bankr. S.D. Fla. 2010)(denying postpetition priming loan where debtors sought postpetition financing to complete development of a hotel and casino that was only 70% complete and was not operating or generating any cash); In re YL West 87th Holdings LLC, 423 B.R. 421 (Bankr. S.D.N.Y. 2010 )(denying postpetition financing where debtor owned an unfinished real estate development project and its prospects for success were highly speculative).
In addition, an undersecured prepetition lender who holds a blanket lien on a debtor’s assets typically argues that it cannot be adequately protected for the diminution in value of its collateral caused by the priming loan because the debtor has no unencumbered assets to pledge as security for such decrease in value during the pendency of the bankruptcy case. See e.g., In re Swedeland, 16 F.3d 552, 567 (3d Cir 1994)(“[t]he law does not support the proposition that a creditor … undersecured by many millions of dollars, may be adequately protected when a superpriority lien is created without provision of additional collateral by the debtor.”).
After considering these cases, can a secured lender draw a bright line and conclude that a debtor can prime an oversecured lender but not prime an undersecured lender? Not exactly; for there are circumstances where a debtor may provide an undersecured prepetition lender with adequate protection by preserving and maximizing the value of its collateral during the bankruptcy case. See e.g., In re Hubbard Power & Light, 202 B.R. 680 (Bankr. E.D.N.Y. 1996)(holding that the secured creditor was adequately protected where a first priority priming lien “would enable the [d]ebtor to commence operating and as an operating business, all of the [d]ebtor’s assets would increase in value [and] [a]lthough it [was] not clear what that value would be, it certainly would be of a greater value than the value of the [d]ebtor’s property in its [non-operational] state”); see also In re 495 Cent. Park Ave. Corp., 136 B.R. 626 (Bankr S.D.N.Y. 1992) (holding that a prepetition secured creditor was adequately protected because “the value of the debtor’s property [would] increase as a result of the renovations funded by the proposed financing”)(“Although appraisers for both sides disagree as to what the value of the building would be following the infusion of approximately $600,000.00, there is no question that the property would be improved by the proposed renovations and that an increase will result. In effect, a substitution occurs in that the money spent for improvements will be transferred into value. This value will serve as adequate protection for Hancock’s secured claim.”); In re Yellowstone Mountain Club, LLC., No. 08-61570, 2008 WL 5875547 (Bankr. D. Mont. Dec. 17, 2008)(holding that secured creditors were adequately protected because, among other things, without the proposed financing, the debtor’s business would “go dark” to the detriment of all creditors and the DIP financing would, therefore, “preserve the value of their collateral and in fact enhance it in an amount that exceeds the amount of the DIP Loan by multiples.”). Thus, in situations where a secured lender is undersecured, it may still be primed if the debtor can demonstrate that the value of the secured lender’s collateral will be preserved or enhanced through the DIP financing.
Because DIP financing is often the lifeblood of a debtor during a chapter 11 bankruptcy case, participants are well-advised to be familiar with the circumstances when a priming lien may be granted and when it may not.
George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP. George can be reached at grmesires [at] uhlaw.com.

Capital Structure Arbitrage

convertarb — Tue, 07 Feb 2012 01:06:20 +0000

Distressed Debt Investing

Capital structure arbitrage is a strategy used by many directional, quantitative, and market neutral credit hedge funds. In essence, it is going long one security in a company’s capital structure while at the same time going short another security in that same company’s capital structure. For instance, “long sub bonds, short senior bonds”, or “long equity, short CDS”, or maybe “long 1st lien bank debt, short 1st lien bonds.” A portfolio manager can express many different view points inside a single company’s capital structure that exploits things like variations from mean differences, covenant irregularities, market supply/demand technical, etc. This is the first part in a number of posts I plan to do on this topic over the next few months (with others focused on secured vs unsecured, covenant differences, basis trading, etc)
The capital structure arbitrage trade is, in theory, less risky than going outright long one security or the next. With that said, because a number of cap structure arbitrage strategies require leverage (via repo, TRS, etc) to hit firm’s target IRRs, a trade going against you can be devastating.
One of the more common capital structure trades seen in the market is long senior paper versus short subordinated paper. All else being equal, in very bullish times the difference between the spreads of the two bonds will be tighter than in very bearish times. This is because in bull markets, investors search and reach for yield thereby increasing demand for the more yieldy paper.
One of the most common functions I use in Bloomberg is HS < go >. This function is dubbed the “Historical Spread Graph/Table” You can pull in two bonds and look at the difference in spread between the two (these can be any bonds…in fact you can pull in all sorts of statistics, but for this exercise we will focus on a select few).
Below is a chart of the FDC’s 9 7/8% of 2015 (Seniors) vs FDC 11.25% of 2016 (sub) over the past year. The top part of the chart lays out the spread to treasury of each of the bonds with the bottom chart showing the difference between the two.

What is not shown are the relative statistics. Over this period (since 2/8/2011) the mean spread difference between these bonds was ~350 bps. Today it stands at 268 bps. The low occurred on 5/10/2011 with a spread differential of 92. The high occurred at 843 pm 9/29/2011. Here is another chart of those two dates highlighted:

The above chart is a chart of the VIX over the same time period. As you can see when markets are bulled up (i.e. VIX is low), the spread differential between the senior and sub bonds are tight. When markets are bearish (i.e. VIX is high), the spread differential between the senior and sub bonds are wide.
The question then becomes: What is the right spread differential? Or better, what should be the intrinsic compensation and investor receives for taking on additional leverage and further subordination? There is a term in credit analysis: Spread per turn of leverage (or in some cases, yield per turn of leverage). If XYZ issuer has $100M of EBITDA, $200M of Senior Debt and $300M of Sub Debt (so $500M of total debt, with both notes maturing on the same day and trading at par), senior leverage would be 2.0x and sub or total leverage would be 5.0x. If the Senior Bonds were yielding 6% and the Sub Bonds yielding 10%, you would be receiving 300bps of yield per turn (6%/2.0x) and for the sub bonds you’d be receiving 200bps of yield per turn (10%/5.0x). All else being equal, the seniors would be a better value.
But let’s add a little bit of complexity to the issue. Let’s say the business of XYZ is worth 10x EBITDA. In that case, in a simple world, the recovery on both bonds would be par+. Then wouldn’t the subs be better value? You are picking 400 bps for the same recovery. With that said, determining the recovery rate of each security becomes fundamental to determining if yield / spread differentials are appropriate. The situation dramatically changes when one layer of the capital structure is levered 2-3x and another is levered 8-9x. More leverage = more swings in recovery. If one bond is pricing in a recovery rate significantly different than you are calculating, this could create opportunities on either the long or the short side.
And just to add a little more complexity (because this is getting fun): Depending on if the bond is trading above or below par changes the equation as well. This is more relevant for higher quality issuers, but if you have two pari bonds of the same issuer trading at 120 and 100 respectively, the bond trading at 120 will have a higher spread than the bond trading at par. Assume this issuer’s recovery rate in a restructuring is 30 cents. If you buy the 120 bonds today, you stand to lose 90 points whereas if you buy the par bond, you stand to lose 70 points. You thus have $20 extra dollars at risk (Price bond 1-Price bond 2). If the average spread on the bond is 300 bps, and our recovery rate is 30, the implied default rate = 9%. 9% * those 20 extra points at risk = 180bp of extra compensation needed. Lets say the 120 bond is trading 250 bps wide of the 100 bond. Well that would be an interesting opportunity that could be arbitraged by going long the 120 bond, and short the par bond.
As a quick side / corollary point to the above analysis: In his most recent letter, Howard Marks notes that:
“…we don’t undertake the tactical actions described above in response to what we or some economists think the future holds, but rather on the basis of what we see going on in the marketplace at the time. What things do we react to?
The simplest signs surround valuation. What’s the yield spread between high yield bonds and Treasurys? And between single-B and triple-C? What are the yields and premiums on convertibles? Are distressed senior loans trading at 60 cents on the dollar or 90? …” Here is a chart from JP Morgan’s Peter Acciavatti depicting the difference in yields between bonds rated B and CCC:

As you can see, in very bearish times (late 2008-mid 2009, as well as 2001-2003), this spread blows out. In bullish times the spread is smaller. Currently at 465 bps versus a median of 508 bps, it stands the market is probably slightly overvalued (we have silently moved into the low 4s on my “risk pendulum scale“), which is not to say the market will not continue grinding higher – I just don’t think you are getting compensated for taking that risk. Some strategists are starting to throw in the flag (Goldman Sachs just got marginally constructive on credit). Full capitulation which equates to bubble territory has not happened yet with still many parties on the sell side calling for a pull back which would have been blasphemy in 1Q 2011

Fraudulent Conveyance in Dynegy

convertarb — Tue, 20 Sep 2011 23:27:40 +0000

From xtract research 9/20/11

There are two types of fraudulent transfers under the Delaware Fraudulent Transfer Act. The first, actual fraud, requires actual intent to hinder, delay or defraud any creditor. Actual intent is very difficult to prove, and we don’t believe, it can be successfully argued here. The second, constructive fraud, requires the holders prove (1) that Dynegy Holdings made the transfer without receiving a reasonably equivalent value in exchange for the transfer AND (2)(A) Dynegy Holdings was insolvent at that time of the transfer, or (B) became insolvent as a result of the transfer, or (C) or was engaged in a transaction for which its remaining assets would be unreasonably small in relation to the Transaction.”

After the initial step of the reorganization, bondholders argued that the ring-fencing of CoalCo and GasCo amounted to a fraudulent conveyance – stripping assets owned by Dynegy Holdings which provided credit support. The Delaware Chancery Court was able to dismiss the fraudulent transfer claim based on the simple fact that the ring-fencing did “not contemplate a predicate transfer of property belonging to Dynegy Holdings” and that “*Dynegy Holdings+ will have the same indirect ownership interest in the physical assets after the Transaction as it did before.” However, now that CoalCo has been transferred to Dynegy, the assets clearly have been transferred out from under Dynegy Holdings. In exchange, Dynegy promised to make payments under the Undertaking Agreement as described above. If the Board’s $1.25B valuation of CoalCo is correct then Dynegy can argue that equivalent value was provided. On the other hand, bondholders may claim that the undertaking of Dynegy, a holding company with no operations, is less valuable than the CoalCo equity previously owned by Dynegy Holdings. Even if this argument is successful, bondholders still face the difficult challenge proving that the transfer triggered one of the insolvency prongs of the second part of the statute.

Should Dynegy Holdings file for bankruptcy, the Bankruptcy Code contains a similar analysis with respect to fraudulent transfers and “reasonably equivalent value” under Section 548. If less than reasonably equivalent value can be established, then the transfer can be avoided if the debtor was insolvent and certain other elements exist.

In our estimation, the success of the Exchange Offer hinges on whether the transfer of CoalCo was proper and whether the transfer can withstand legal challenge. Although we have not conducted a lengthy analysis to determine all the arguments available to bondholders in connection with a fraudulent conveyance claim, it does appear that bondholders would face a difficult challenge in court and therefore are likely to accept the exchange.

Credit bid rulings : Philadelphia Newspapers, DBSD

convertarb — Thu, 10 Feb 2011 01:04:37 +0000

Distressed Debt Investing Website 2/10/11

Philadelphia Newspapers

In 2006, Philadelphia Newspapers, LLC (debtor), acquired the Philadelphia Inquirer, Philadelphia Daily News, and philly.com for $515 million with a $295 million loan secured by a first priority lien on substantially all of the debtors’ assets. In February 2009, the debtors filed for Chapter 11 after defaulting on their loan agreements. The debtors’ proposed plan called for a sale of substantially all the debtors’ assets in an auction as well as a transfer of their Philadelphia headquarters to the secured lenders. The bid procedures required cash funding and specifically precluded the lenders from credit bidding. (1)

The Stalking Horse bidder in this case was an entity controlled by the local Carpenters Union pension fund and Bruce Toll, a personal friend of the debtor’s CEO. Additionally, until the day before the asset purchase agreement was signed, the Stalking Horse held 50% of the ownership interests in the parent of the debtor corporation. (2) Since the Newspaper properties represent iconic brands in Philadelphia, the debtor also engaged in a public relations campaign branding itself as David “local newspaper” vs. Goliath “Wall Street hedge funds”. This was ironic given that the CEO had mismanaged the leveraged buyout of the company, filed it for bankruptcy and instituted significant head count reductions effecting middle class working people while he earned an $800K annual salary. Nevertheless, the debtor successfully painted the banks as the villain.

The debtor’s POR included a 363 sale at public auction of substantially all the debtor’s assets free and clear of all liens. The sale would not include the debtor’s headquarters which would be transferred to the secured lenders in full satisfaction of their claim. Under the Plan, the purchase would generate approximately $37 million in cash for the Lenders. Additionally, the Philadelphia headquarters which was valued at $29.5 million and would be subject to a two-year rent free lease for the new owners (representing a recovery of about 20%). The Lenders would receive any cash generated by a higher bid at the auction. The plan also established a $750,000 to $1.2 million liquidating trust fund in favor of general unsecured trade creditors and provided for a distribution of 3% ownership to the GUCs if the senior lenders agreed to waive their deficiency claims. (3) Secured lenders objected to the plan because it required all bids on the sale to be in cash, thus if the secured lenders wanted to bid on the assets they would have to pay in cash only to receive the cash back under the plan. Although secured creditors would essentially be paying themselves with a cash bid, the group held firm to the principle of a secured creditors’ right to credit bid.

In October 2009, the bankruptcy court issued an order refusing to bar the lenders from credit bidding. The bankruptcy court reasoned that Section 1129(b)(2)(A) of the Bankruptcy Code (known as the cramdown provision), when read in conjunction with Sections 363(k) and 1111(b), required that a secured lender be able to credit bid in any sale of the debtors’ assets. This provision states that a plan is “fair and equitable” and thus confirmable over the objections of a secured class, provided that the secured class is given the “indubitable equivalent” of its secured interest. Moreover, before a court may “cram down” a plan over the objection of a dissenting creditor class, both the absolute priority rule and the fair and equitable standard must be satisfied. However, the debtor appealed and the district court reversed the bankruptcy court’s decision. The 3rd US Circuit Court of Appeals affirmed the district court’s ruling and addressed the issue of whether secured creditors have a statutory right to credit bid their claims in a 363 sale done in the context of a plan of reorganization. (4)

The 3rd Circuit upheld the POR relying on what is characterized as the “plain meaning” of the Bankruptcy Code Section 1129 (b)(2)(A). The court held the plan could be confirmed as it met the “fair and equitable” requirement of Section 1129 (b)(1) arguing that secured creditors received the “indubitable equivalent” of their claims under the plan. Section 1129(b)(2)(A) lists three alternative paths by which a plan may be “fair and equitable” to secured lenders:

the secured lenders retain their liens to the extent of the allowed claims and receive deferred cash payments equal to the allowed amount of their claim;
the property is sold free and clear of liens and the secured lenders attach their liens to the proceeds of a Section 363(k) sale (which specifically incorporates credit bidding);
OR the secured lenders realize the Indubitable Equivalent of their claims (does not mention credit bidding)(5)

http://www.ca3.uscourts.gov/opinarch/094266p.pdf

The court reasoned that according to the plain meaning of the statute, the use of the word “or” between the three subsections is a disjunctive clause which allows the debtor to choose one of the three alternatives when selling its assets free and clear of liens. Therefore, if the debtor offers the indubitable equivalent under subsection (iii), the secured lender’s right to credit bid is precluded. The court applied reasoning used by the 5th Circuit In Re Pacific Lumber Co. In the PALCO case the court terminated the debtor’s exclusivity after 1 year and confirmed a plan put forth by a joint bid by a secured creditor and competitor. Additionally, the plan paid the noteholders full cash value of their claims while precluding them from credit bidding on the assets.

The court rejected the secured creditors’ claim that they had the right to credit bid and commented that the credit bid was unnecessary given that noteholders were receiving the full cash value of their claim. The court in Philadelphia Newspapers cited the approach the 5th Circuit took in the PALCO case as one concerned with “fairness to creditors” rather than the mecanics of a cramdown. Moreover, the court emphasized that lenders retained the right to object to the plan at confirmation on the grounds that “the absence of a credit bid did not provide it with the ‘indubitable equivalent’ of its collateral.” (6)

http://business-finance-restructuring.weil.com/wp-content/uploads/2010/10/SCOPAC-09-40307-CV0-10-19-2010-USCA5.pdf

Judge Thomas Ambro of the 3rd Circuit wrote a strong dissenting opinion based on the principle of statutory construction; that specific principles prevail over general ones. (7) The legal reasoning employed in the dissent is beyond the scope of this article, however it provides some great insight and is worth reading.

The PALCO and Philadelphia Newspapers rulings have established that in the context of a plan of reorganization credit bidding is not a right (at least in the 3rd and 5th Circuits). This is significant in that the 3rd Circuit governs Delaware where many large corporate bankruptcies are overseen. However, the issue of the right to credit bid in a 363 sale outside of a plan was not addressed. The court remanded back to the bankruptcy court the issue of whether secured creditors were receiving the Indubitable Equivalent and that the plan met the Fair and Equitable test. That issue was never decided as creditors took matters into their own hands and won the auction with a cash bid of $138.9mm.

What these rulings demonstrate is that secured creditors have lost some strategic ground in being able exercise influence and take possession of the collateral through the right to credit bid. Funds employing a loan-to-own strategy should weigh carefully how these decisions may impact the timing and manner of deployment of capital in a distressed investment. Had the secured creditors been the DIP lenders in these situations, they would have been able to exert far more influence in determining the outcome. It is likely that during the next cycle banks will again be reeling from mark-to-market losses in their trading and CMBS books and will again not be able to deploy DIP capital as was the case in the 2008-2009 cycle. The early part of the cycle will be ripe with opportunities for those funds with dry powder to effectuate control through a third party or roll-up DIP loan.

DBSD

DBSD, a subsidiary of ICO Global, is a satellite communications company focused on S-Band spectrum that received authorization from the FCC to integrate an ancillary terrestrial component (ATC) into its MSS (Mobile Satellite Service) system allowing them to provide integrated mobile satellite and terrestrial communications services. While the spectrum has enormous value, the large capital expenditures required to launch satellites and fund the cash burn until they are operational, has forced two major players DBSD and Terrestar, majority-owned by Harbinger Management, to seek bankruptcy protection.

The strategic value of these assets has brought into conflict hedge funds such as Harbinger a major player in the space through its company LightSquared, and DISH Network, controlled by satellite mogul Charlie Ergen, who also owns Echo Star Communications. Mr. Ergen has tried to gain control of both DBSD and Terrestar through a loan-own-strategy by investing in the debt of these two companies. The prospect of a strategic buyer using a loan-own-strategy has generated a lot of controversy. In the case of DBSD, it led to a rare decision by Judge Robert E. Gerber of the United States Bankruptcy Court for the Southern District of New York to “designate” or disallow the vote of DISH, a ruling the Second Circuit Court of Appeals upheld.

The facts in the DBSD case are unique in that a strategic buyer (rival corporation) had purchased all of the debtors’ $40mm first-lien secured debt at par in addition to $111mm of $650mm 2nd lien debt not subject to a PSA (Plan Support Agreement). The purchases were made after the debtors had filed an amended plan of reorganization that would have satisfied the first lien debt in full with a new secured PIK note and modified liens.

The creditor’s admitted purpose in buying the debt was to vote against the plan and take control of the debtor. The court found that: “When an entity becomes a creditor late in the game paying 100 cents on the dollar, as here, the inference is compelling that it has done so not to maximize the return on its claim, acquired only a few weeks earlier, but to advance an ‘ulterior motive’ condemned in the case law.” (8)

Under section 1126(e) of the Bankruptcy Code, a court may, on request of a party in interest, “designate” (disqualify) the votes of an entity whose acceptance or rejection of a plan of reorganization is not in good faith. (9) The Bankruptcy Code does not define good faith, thus courts have developed a basis for determining actions that demonstrate a “badge of bad faith”. Such actions include, among other things, attempting to assume control of the debtor, to put the debtor out of business or otherwise gain a competitive advantage, or to destroy the debtor out of pure malice (10)

The court found that “DISH’s acquisition of First Lien Debt was not a purchase to make a profit or increase recoveries under a reorganization plan. Instead DISH made its investment in DBSD as a strategic investor looking ‘to establish control over this strategic asset.’ The Court cited evidence that DISH purchased the debt at par after an amended plan had been filed; and that internal DISH documents and sworn testimony revealed plans to use the purchase of debt to “control the bankruptcy process” and “acquire control” of the debtor, a “potentially strategic asset.” Therefore, Judge Gerber concluded that “DISH’s conduct is indistinguishable in any legally cognizable respect from the conduct that resulted in designation in Allegheny, and DISH’s vote must be designated for the same reasons.” (11)

http://www.scribd.com/doc/48438738/Second-Circuit-Ruling-in-DBSD-Case

Under the proposed plan, the first lien debt was to be restructured under an amended facility that extended the maturity of the Senior Debt from one year to four years, provided payment in kind (“PIK”) interest at 12.5 percent, with no cash payments until final maturity. In addition, the first lien creditors would receive liens on all of reorganized DBSD’s operating assets, but not on the securities, which were to be used to secure a working capital line and fund continuing operations. In determining whether the plan should be confirmed, the court analyzed whether the creditor was provided the indubitable equivalent of its claim. The court examined the issue of whether the secured creditors’ claim would have the same level of protection as it did prior to confirmation, in other words, did the new note have sufficient collateral cushion. The court ruled that given the assets securing the debt had an enterprise value six times the amount of debt due at maturity, their level of protection was equal. (12)

DISH appealed Judge Gerber’s ruling and upon appeal, the United States District Court for the Southern District of New York affirmed his decision. The District Court held that the Bankruptcy Court’s finding that DISH had acted as a strategic investor seeking control over the debtor was not clearly in error, and rejected the argument by DISH that there was insufficient evidence to establish that they had displayed a lack of good to satisfy section 1126(e) of the Bankruptcy Code. (13) DISH appealed to the 2nd US Circuit Court the designation of its vote and in addition argued that they cannot be forced to accept a reduced collateral package that strips them of their lien on the securities with no substitution. (14) The Second Circuit upheld the District court’s ruling. However, it appears that Mr. Ergen is not going away quietly. It was announced recently that DISH struck a deal with DBSD’s management that would keep all of the debt unimpaired and allow DISH to acquire a controlling interest in the debtor.

While this ruling had unique circumstances given that the creditor was a strategic buyer who purchased its claim at par after a plan had been disclosed, it may provide ammunition to junior creditors seeking to assert leverage in a case where a control distressed hedge fund or private equity fund is seeking to obtain control through the debt. Would the decision be applicable if all the facts were the same except that the creditor in question was a large distressed fund?

At the very least distressed investors looking to acquire controlling interests need to be aware of the risks of being deemed a “strategic investor” It is likely that aggressive junior creditors seeking to avoid a cramdown will now cite this case as a basis for leaving senior creditors unimpaired or unable to vote. Moreover, Philly News and PALCO have left open the question of credit bidding outside of a plan. While not all distressed investors seek control when investing, very often it becomes the only effective means for exercising remedies and maximizing recoveries. In light of these rulings, control distressed investors should be prepared to face some challenges on several fronts in the next cycle. Praemonitus Praemunitus. (Forewarned is Forearmed)

Adequate Protection : GAP

convertarb — Tue, 04 Jan 2011 20:19:18 +0000

Distressed Debt Investing Website 01/04/11

Adequate Protection is always as an interesting issue when it comes to investing in distressed bonds and bank debt secured by various assets. Because a creditor’s interest is secured by those same assets, it is assumed that the debtor will set up a mechanism to preserve the value of that collateral. Generally speaking, adequate protection comes from periodic post-petition cash payments (i.e. post-petition interest) or granting of additional liens.

A few weeks ago, we introduced The Great Atlantic & Pacific Tea Company’s Bankruptcy. Bonds are currently up from our recommended price and are trading in the low 90s context. With that said, we have been following the docket closely and saw an objection coming from a group calling themselves “the Ad Hoc Consortium of Certain Holders of A&P 11 3/8% Senior Secured Notes.”

For reference, here is the case’s website: GAP’s Bankruptcy Docket. You can click on “Court Documents” to access the docket.

Before we get to the objection, it would be useful to explain a number of introductory proceedings on a typical bankruptcy docket. Legal counsel to debtors and creditors must file a “Motion for Admission” to the court to represent their clients. Sometimes, and especially when Ad-Hoc groups are being represented, legal counsel will list the clients they are representing. For example, “Counsel to the Ad Hoc Consortium of Certain Holders of A&P 11 3/8% Senior Secured Notes” listed Secured Note Holders in an Exhibit in Docket #309:

It is noted in the opening paragraph of the objection that the ad hoc note holders (holders listed above) own 44% of the outstanding bond issue. Needless to say, this gives them a blocking position. What I found most interesting about this disclosure was the size of this block with the entire street knowing that Yucaipa was also a holder of these bonds. A similar case would be Terrestar, where rumors that a number of bond holders took a blocking position to better the deal they expect to get from Echostar, the interested party in that case:

In essence, the ad hoc note holders are objecting to certain aspects of the DIP financing as well as use of cash collateral. They argue that before the Chapter 11 filing, they were behind approximately $330M of debt and because of the size of the DIP will now be junior to as much as `$950M (“The figure $950.5 million is equal to the sum of $331.7 million plus the $800 million DIP Financing, plus the $15 million Carve Out, less $196.2 million in letters of credit [to avoid “double-counting” them as they would otherwise arguably be included in both the $331.7 million figure as well as the $800 million figure]). And because of the potential for a material drop in the value of their security interests, the Secured Note Holders argue they are entitled to adequate protection.

Now, the Debtors have proposed adequate protection in this case including junior liens on unencumbered property as well as other replacement liens that arguable they would have gotten even if it was not party of the DIP order. But the ad-hoc group is arguing that the debtors have not shown in one way or another, that this adequate protection “cuts it” so to speak.

Outside of the adequate protection requests, the ad hoc group brings up a fascinating argument that because the intercreditor agreement was between the Secured Note Holders and the pre-petition credit facility (which has been repaid by the DIP), and not the debtors or the DIP lenders, the intercreditor agreement is also not enforceable by either the debtor or the DIP lenders.

So what is the ad hoc group of note holders asking for? Adequate Protection (reimburesement of expenses and post petition interest) among other things:

“…provide the Secured Noteholders with the same types of adequate protection that are provided to the DIP Lenders and the Pre-Petition Secured Lenders, including: (1) payment of reasonable expenses, including professional fees and expenses, of the Secured Noteholder Consortium; (2) the current payment of the semi-annual coupon amount as provided for in the Secured Notes Indenture as an adequate protection payment provided for in Bankruptcy Code Section 361(1) and (3) access to information on the same terms as provided to the DIP Lenders, including, without limitation, notice of any offer to purchase any material assets of the Debtors, including any offer to purchase the Debtors as a going concern, or any retail banner owned by the Debtors as of the Petition Date, and notice of any intention to reject any material unexpired leases or executory contracts.”

…as well as consent and notice rights comparable to DIP lenders along with disclosures of fees paid to the DIP agent and DIP lenders.

Not only that – but a very interesting request: “Disclosure of Yucaipa’s debt holdings, as discussed in footnote 7 above.”

Yucaipa and Footnote 7? In a footnote in the objection:

“Moreover, it has been reported that Yucaipa Cos. (“Yucaipa”), which the Debtors indicate hold a majority of their preferred stock (and control 2 board seats as a result), have recently acquired certain debt of the Debtors, including Secured Notes. Yucaipa has a history with the Debtors’ operations, having sold the Pathmark chain to the Debtors in December 2007 for $1.4 billion. Counsel to the Secured Noteholder Consortium has made a request of Yucaipa’s counsel (Latham & Watkins LLP) to disclose the amount of Yucaipa’s holdings of other Debtor debt issuances, including any Secured Notes, but as of the date hereof Yucaipa has not provided such information. The Secured Noteholder Consortium submits that Yucaipa should disclose the amount of its debt holdings (including holdings of Secured Notes) forthwith.”

Very interesting.

To me it seems like they have a pretty compelling argument – It is hard to imagine junior lines here providing true adequate protection. With that said, I am sure the company will comes up with a response and it will be up to the judge (or back door negotiating) to come up with a compromise here – especially given the size of the block here. Maybe they get adequate protection in the form of accrued interest payments at the default rate at the end of the Chapter 11 proceedings? Hard to tell at this point. We will continue to follow Great Atlantic’s bankruptcy and any rulings / motions regarding adequate protection.

Prepackaged bankruptcy gift to equity holders: Insight Health

convertarb — Mon, 20 Dec 2010 01:36:55 +0000

Distressed Debt Investing Website 12/20/10

As noted many times on this site, Chapter 11 cases are expensive. From paying $700-$1200/hour for senior lawyers, success based fees for financial advisors, and (in my opinion the most important) business issues such as loss of customers, suppliers, employees, etc costs start to add up. That being said, and because of certain 2005 changes to the bankruptcy code regarding exclusivity timing, more and more bankruptcies are going the prepack bankruptcy route. And to make sure things go smoothly, the creditors driving the show are offering a gift to possible dissenting classes to make sure the Chapter 11 proceedings go off without a hitch.

Last week, after all the hub bub of the Great Atlantic’s bankruptcy filing, people seem to have forgotten that Insight Health filed for bankruptcy just a few days earlier. Here is the press release:

InSight Health Services Holdings Corp. (“Insight Imaging” or “the Company”) (OTCBB:ISGT.ob – News) today announced it had reached an agreement in principle with holders of a significant majority in aggregate principal amount of its outstanding senior secured floating rate notes due 2011 (the “Notes”) regarding a restructuring of the Notes. Insight Imaging has entered into a restructuring support agreement (the “Support Agreement”) with such holders (the “Supporting Holders”), which contemplates restructuring the Notes through a jointly agreed plan of reorganization to be filed with the bankruptcy court (the “Court”). The terms of such pre-packaged plan are set forth in a term sheet made part of the Support Agreement, but may be amended or modified in accordance with the terms of the Support Agreement (a “Qualified Plan”). The terms of the Qualified Plan contemplate an exchange of all of the Notes for all of the common stock of the reorganized Company upon exit from bankruptcy, resulting in the elimination of 100% of the Notes from the Company’s balance sheet.

The Support Agreement provides that the Supporting Holders will, among other things, vote to accept a Qualified Plan and support a debtor-in-possession financing facility (the “DIP Facility”). The Company is currently in discussions with Bank of America, N.A. (“Bank of America”), the administrative agent under its current revolving credit facility, regarding the DIP Facility. The Support Agreement will require Insight Imaging and certain of its subsidiaries to file a Qualified Plan with the Court, obtain a confirmation order from the Court and effectuate the Qualified Plan within the time-frames set forth in the Support Agreement.

Insight Imaging also announced that holders of greater than 75% of the principal amount outstanding of the Notes, the trustee under the indenture governing the Notes and the collateral agent under the security documents relating to the Notes have entered into an agreement to forbear from exercising their remedies under the Notes, the indenture and related security documents as a result of events of default arising from the November 1, 2010 interest nonpayment and the expiration of the applicable 30-day grace period. The forbearance period ends not earlier than December 10, 2010, by which time the Company expects to have filed a prepackaged plan of reorganization. Bank of America has also extended the forbearance period under the Company’s revolving credit facility, as amended, from December 1, 2010 to December 15, 2010.

Kip Hallman, Insight Imaging’s President and CEO, stated, “This restructuring is being undertaken to eliminate more than $290 million of debt, substantially improving our cash and liquidity position. We intend to complete the reorganization as quickly as possible. In the meantime, we will continue to operate our business as usual to provide quality services to our customers and our patients. We look forward to emerging as a much stronger business, with a capital structure that will enable us to maximize the long-term value of the company.”

For those interested, you can find the Insight Health bankruptcy docket here: Insight’s Chapter 11 docket

As those in the distressed community will know, this will not be the first trip to the rodeo for Insight. From the disclosure statement:

On May 29, 2007, InSight Health Services Holdings Corp. and InSight Health Services Corp. Filed voluntary petitions to reorganize their business under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the District of Delaware (Case No. 07-10700) (the “2007 Reorganization”). The filing was in connection with a prepackaged plan of reorganization and related exchange offer. On July 10, 2007, the Delaware bankruptcy court confirmed InSight Health Services Holdings Corp. and InSight Health Services Corp.’s Second Amended Joint Plan of Reorganization pursuant to Chapter 11 of the Bankruptcy Code. The plan of reorganization became effective and InSight Health Services Holdings Corp. and InSight Health Services Corp. emerged from bankruptcy protection on August 1, 2007. Pursuant to the confirmed plan of reorganization and the related exchange offer, (1) all of InSight Health Services Holdings Corp.’s then existing common stock, all options for the common stock and all of InSight Health Services Corp.’s 9.875% senior subordinated notes due 2011, or senior subordinated notes, were cancelled and (2) Holders of InSight Health Services Corp.’s senior subordinated notes and Holders of InSight Health Services Holdings Corp.’s common stock prior to the effective date received 7,780,000 and 864,444 shares of newly issued common stock, respectively, in each case after giving effect to a one for 6.326392 reverse stock split of such InSight Health Services Holdings Corp.’s common stock.

While the reorganization attempted to deleverage InSight Health Services Holdings Corp.’s and InSight Health Services Corp.’s balance sheets and improve their projected cash flow after debt service, both still have a substantial amount of debt, which requires significant interest payments. As of September 30, 2010, the Debtors had total indebtedness of approximately $298.3 million in aggregate principal amount, including InSight Health Services Corp.’s $293.5 million in principal amount of Senior Secured Notes.

Looks like we have ourselves a good ole’ Chapter 22 on our hands.

Who are the parties of interest here? Well we know a Plan Support agreement will have been filed in a pre-pack like this, so let’s take a look at the disclosure statement and see what we can find. On page 494 – 496 of the PDF, one can see that J.P. Morgan’s Credit Trading Group and affiliates of Black Diamond have signed the agreement. To give you a sense of how this bond has traded over the past few years, take a peak:

According to Trace (the graph above is based on Trace versus my message runs) there was a million + dollar worth of bonds traded on the 22nd of November. Alex Bea, a fantastic distressed debt trader from JPM who was the axe in this name, stoppped making markets sometime in October – thinking they got restricted and all that was left was sporadic runs from a number of brokers / dealers.

For the rest of this post, I will assume the bonds trade at 25 cents on the dollar. The allowed claim, according to the plan, of the Insight secured floaters is $293.5M with very little debt ahead of you in the capital structure. There has been a $15M DIP authorized which, according to the disclosure statement, will be rolled into a $20M revolving exit facility.

The disclosure statement also came with projections:

As you can see, the company plans to emerge with very little debt and a marginal cash balance. What does that mean for our bonds?

Insight Health has two direct publicly traded comps: Alliance Healthcare Services (AIQ) and Radnet (RDNT). Both stocks have had lackluster performance in the face of declining reimbursement rates in a predominantly fixed cost structure combined with hefty debt loads. According to Bloomberg, RDNT trades at 5.1x 2011 EBITDA and AIQ trades at 4.9x EBITDA. What does that mean for Insights bonds?

According to the projections, Insight looks to generate approximately $25M of EBITDA in 2012 (full year 2011 not really helpful given reorg costs). At 5.0x, this translates into $125M of value versus $293.5M of claims or 40 cents on the dollar – which at a purchase price of 25 gives us approximately a 25% IRR over 2 years. Not too shabby. Of course, if we haircut the multiple 1.0x turns reflecting the weaker mobile business of Insight, we get an IRR closer to 16%.

As we’ve talked about in previous posts, one really has to scrutinize projections. Why? Because management’s incentive is to create a low valuation for the stock so their upside is greater. In Insight’s case:

The Management Equity Plan will provide for a certain percentage of New Common Stock, not to exceed eight percent (8%) of the fully diluted New Common Stock, to be reserved for issuance as options, equity or equity-based grants in connection with the Reorganized Debtors’ management equity incentive program and/or director equity incentive program. The amount of New Common Stock, if any, to be issued pursuant to the Management Equity Plan, and the terms thereof shall be determined by the New Board on or as soon as reasonably practicable after the Effective Date.

The scrutiny of projections will be for another post. The question I am trying to address: If the floaters are going to make 16-25% in possibly artificially low projections and management is making off with possibly 8% of the company, what is happening to the equity? The equity is receiving a “gift”.

You think I am using that term as slang. No, gentle reader, it really is called a a “gift”:

Now what are the specifics of this gift:

They are warrants to buy up to 2% of stock on a fully diluted basis
Three year expiration
Exercisable when enterprise value is greater than $215M

Exercisable when EV is greater than $215M? In 3 years?? $215M on the contemplated $25M of EBITDA is an 8.6x multiple. Or backing into the cash flow required on a more realistic 5.0x multiple, EBITDA would have to grow 20% a year for the next three years to reach $43M for these warrants to be in the money. In my opinion, highly doubtful.

If you had simply read that you were getting warrants for 2% of the company you may have been happy (albeit nearly a 99% drop in the stock) and have even considered getting long the equity in a spec play out of Gordon Gekko’s playbook. But that gift is in all likelihood a donut to placate equity holders that just want SOMETHING. As I try to stress often on this site, I spend just as much time on the document side of things as I do looking at business and industry trends. Always read the fine print in distressed debt. It can save you many a land mines in the future.

Trade Claims Primer

convertarb — Tue, 26 Oct 2010 01:10:51 +0000

Distressed Debt Investing

Trade Claims Primer

Introduction

While bank lenders and bondholders generally represent the largest portion of debtor’s pre- petition claims, upon filing there is a large constituency of other creditors who also possess claims against the debtor at various levels of priority within the capital structure. Because the sale, assignment and transfer of ownership of these claims are not considered securities, securities trading laws do not apply. The lack of uniformity and active market for these claims makes the instruments less liquid and transparent, thereby providing an opportunity for outsize returns for those willing to perform the necessary due diligence and shoulder the liquidity risk.

Vendor claims generally trade at a 10-20% discount to other wise pari passu securities and therefore present a potential arbitrage opportunity for investors. The typical vendor does not wish, or may not be financially able, to wait months or possibly years to receive his money and is usually sufficiently motivated to sell his claim at a discount. A distressed investors may also purchase trade claims as a way to obtain strategic advantage in a restructuring. By gaining control of a larger share of a company’s General Unsecured Claims (“GUCs”), a sophisticated distressed investor can gain leverage to influence negotiations with the Debtor and other Creditors. By purchasing trade claims at a discount to the unsecured debt he already owns, the investor also lowers the effective cost basis of his investment (assuming trade and bonds will receive the same consideration in the reorganization). In addition, if the claims pool is large enough an investor can set up a capital structure arbitrage trade by going long a trade claim and short pari passu unsecured bonds of the same company.

In structuring such a trade, one must ensure that the bond and the claim are at the same entity and that the bond does not have any guarantees or claims on subsidiaries that might make it more valuable. For instance in the case of Nortel Networks, their North American bonds issued at Nortel Networks Inc (“NNI”) had guarantees from their Canadian parent which the trade claims of NNI did not. Thus, one had to segregate the value of the North American and Canadian operations to determine the value of an NNI claim. Fortunately in this case there were bonds issued at the Canadian parent Nortel Networks Corp (“NNC”) that did not have recourse to NNI, so one could subtract the value of an NNC bond from an NNI bond to find the implied value of an NNI claim. Many times this is not the case and one needs to try and apportion the value using information available in the company’s financial statements. If the company has subsidiaries that are not guarantors of its debt then it will segregate the financials of the guarantor and non-guarantor subs. Also, one may look to segment reporting of revenue and EBITDA and attempt estimate how much value may be attributable to the various entities. In a scenario where the investor faces a great deal of uncertainty over valuation and how it will be attributed amongst various entities, he must bid an appropriate discount to compensate for the risk.

Types of Claims

A “Claim” is a right to payment, whether that right is fixed, liquidated, potential or contingent (i.e., based on the outcome of litigation). Claims can fall into different categories: priority, secured, unsecured, contingent, liquidated, disputed or matured. The most common claim to arise out of a bankruptcy filing is a vendor claim or trade claim as they are more commonly known. These claims arise due to the fact that a company’s suppliers ship goods on credit ranging anywhere from 30-90 days. When a company files for bankruptcy it likely to be in arrears on its accounts payable, this increases the amount of debt on its balance sheet (AP), thereby increasing the tradeable instruments in the debtor’s obligations. While trade claims are the most common, there several other types of claims that arise from a bankruptcy filing which provide potential investment opportunities. These include:

Contract Rejection Damage Claims: Damages resulting from the termination of contracts under Section 365 of the Bankruptcy Code.
Deficiency Claims: Secured claims that are under collateralized result in a deficiency claim under Section 506 of the Bankruptcy Code for the portion of the claim where there is insufficient collateral securing the claim.
Pension/OPEB Claims: Collective Bargaining Agreements (“CBAs”), Defined Benefit Pension Plans and other employee benefits that are terminated pursuant to Sections 1113 and 1114 of the Bankruptcy Code give rise to unsecured claims.
Contingent Claims: Claims that may result from pending lawsuits, environmental damages or other contingent events. Some examples of cases where large contingent claims were involved include the asbestos cases such as Owens Corning, Grace and Armstrong and environmental claims include cases such as Asarco and Tronox.
Priority Claims: Generally include back taxes and unpaid employee wages and benefits, however, can also include lease deposits up to $2,452 and “Gap Claims” which arise when the Debtor is targeted in an Involuntary Bankruptcy Petition filed by one of its Creditors. All trade debts incurred in the period between the filing of the Involuntary Bankruptcy Petition and potential Entry of the Order for Relief by the Bankruptcy Court will be deemed to have a priority status.
503(b)9 Claims: These are claims for goods shipped within 20 days of a company filing for bankruptcy. Unlike other trade claims, these claims are accorded administrative status and are paid in full as long as the estate is administratively solvent.
Reclamation Claims: Reclamation claims allow for the Creditor to reclaim the goods shipped to the Debtor. These claims arise under state law, §2-702(2) of the Uniform Commercial Code (“UCC”). Once the Debtor files for bankruptcy protection, §546(c) of the Bankruptcy Code preserves a creditor’s state law reclamation rights, those rights are enhanced by the code and create additional requirements and defenses. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) expanded the reclamation period from 10 days to 45 days prior to a bankruptcy and to 20 days post-petition from 10 days previously. There are a number of requirements that must be met for these claims as well as potential defenses against such claims.

Proof of Claim

In order for the Creditor’s claim to be paid he must file a Proof of Claim (“POC”) with the court. This is done by filling out Official Form 10 within 90 days from the Section 341 meeting of creditors and filing it with the Bankruptcy Court. The date past which a claim can no longer be filed is known as the Claims Bar Date, and claims past this date generally will not be paid, although it is possible to appeal. The POC will have a Docket Stamp on it denoting the date of its filing. The POC must be signed by the creditor, include the amount of the claim, whether there is a perfected security interest and have attached to the POC documentation evidencing the claim such as invoices, purchase orders or contracts.

Sourcing Trade Claims

Upon filing of its petition for bankruptcy, or within 14 days of filing, the Debtor is required to file its Schedule of Assets and Liabilties and its Statement of Financial Affairs (“SOFA”). The Schedules are the primary source used to locate claim holders. In practice the Debtor routinely is granted extensions to the filing of schedules and it can take some time before a potential investor has the requisite information in order to bid on a claim. Nevertheless, upon petition the Debtor must file a list containing the name, address and claim of the creditors that hold the 20 largest unsecured claims, excluding insiders. For a sophisticated trade claims investor it is possible to begin negotiations to purchase a claim utilizing this information, albeit without knowing whether the debtor is disputing the claim or if the amount of the claim at petition will be the same as what is listed on the Schedules.

The Schedules also contain the name, address, amount of claim and whether that claim is, Contingent, Liquidated/Unliquidated or Disputed. Contingent claims are claims that may arise contingent upon an event taking place in the future, such as an adverse judgment in an ongoing lawsuit or claims related to remediation for environmental damages that are not fully know. A Liquidated Claim is a claim where the dollar amount is known. An Unliquidated Claim is one where the debtor has liability, but the exact monetary measure of that liability is unknown. A tort case where the Debtor has been found guilty, but where the amount of the liability has yet to be established would fall into this category. Disputed claims are claims where the Debtor is disputing the validity of the claim and intends to file an objection to the claim. This generally occurs later in the case in the form of an Omnibus Objection made by the debtor. Below is an example of a Debtor’s Schedule of Assets and Liabilities filed by Tronox Inc.

Purchasing a Trade Claim

In examining the schedules it best to bid on an Allowed Claim. Under Section 502(a), a claim for which a proof of claim has been filed is deemed “Allowed” unless a party of interest (e.g. Bankruptcy Trustee, or the Debtor) objects to the claim, in which case the Bankruptcy Court will conduct a hearing to determine whether, or to what extent, the claim should be allowed. There are instances where the Debtor marks every claim on the schedule as disputed or contingent. This increases the risk and will required extra due diligence as well as the willingness to litigate if need be.

Once a claim holder willing to sell has been located, the negotiation process for purchasing the claim begins. This process can take anywhere from a few days to several weeks depending on the complexity of the issues involved. Since the seller is not a capital markets participant, he may change his mind several times throughout the negotiation process and also increase his offer based on competing bids. Moreover, factors may come into play in the due diligence phase that require a re-pricing or cancellation of the trade altogether. If an investor is bidding on a disputed claim he will need to factor the risk that the claim might ultimately be disallowed into his bid price. In addition, he may want to reduce price of his bid to allow him to negotiate with the debtor for a reduction in claim size in exchange for a stipulation that the debtor will treat the claim as an Allowed Claim.

Due Diligence

Once an initial bid is agreed upon, the parties enter into a trade confirmation, subject to final due diligence. This phase again can take a few days to a few weeks depending on the issues involved. At this stage in the process the buyer will begin examining the documentation supporting the claim. This includes reviewing invoices, purchase orders, or other contracts in order to determine the validity of the claim. It is also necessary to reconcile the amounts on the invoices with what is filed on the POC and the Schedules. If the invoice is for less than what is listed on the POC or what is listed on the POC is less than on the schedules, the purchaser must reconcile these discrepancies before funding, or have the buyer agree to indemnification provisions should the claim be allowed at a lower amount. The purchaser must also confirm that the entity at which the claim he is purchasing is filed corresponds to the entity listed on the supporting invoices as well as have been filed prior to the Claims Bar Date.

The claims purchase will be executed via a custom tailored contract known as a Purchase Sale Agreement (“PSA”). The PSA will contain provisions governing the transfer of the claim, Representations and Warranties and Indemnification provisions. The PSA will required the seller to provide Reps and Warranties on the ownership, validity and lack of any encumbrances on the claim. In addition, the PSA will contain Indemnification provisions, should the claim be impaired or disallowed . This means that if for some reason the purchaser of the claim needs to seek recourse because the seller misrepresented his claim or it was disallowed as a result of actions taken by the seller, , the purchaser must be able to rely on the counter party to indemnify him for his losses. If the counter party is financially unstable, not a well established enterprise, or is itself at risk of bankruptcy, then there is risk that he will not be able to perform his duties under the PSA. When the counter party is a publicly traded company, has, publicly issued debt or has a credit rating, it is fairly easy to do counter party due diligence. However, if the counter party is a small, private business, then counter party risk assessment becomes more difficult. One source of information is Dun & Bradstreet which compiles credit and other financial information on private businesses. In addition, the purchaser can and should ask for financial statements, bank statements, summary of tax returns and other information as needed to gain comfort with the counter party’s credit worthiness. Should legal disputes arise the between the buyer and seller, the PSA should contain provisions for settling the disputes. It is common for the PSA to require disputes to be litigated under New York or Delaware law, courts which routinely handle complex commercial litigation. This also avoids being in the home town court of the seller of the claim. If the claim being purchased is from a foreign supplier whose country is a signatory to the NY Convention of the International Chamber of Commerce (“ICC”) arbitration, then the PSA should include provisions for disputes to be settled via arbitration as courts of signatory countries are required to enforce arbitration judgments conducted in accordance with ICC rules.

Legal Issues Affecting Trade Claims

There are several legal issues that can impact the value of a claim or cause the claim to be disallowed. The following is a brief summary of some of the major issues that need to be diligenced from a legal perspective before purchasing a claim.

Equitable Subordination. If the seller of the claim aided and abetted fraud, insider trading or breach of fiduciary duty his claim may be equitably subordinated causing the priority of the claim to be moved to the end of the priority chain. This has the effect of the claim being treated as equity, not debt. This risk is heightened when a claim is purchased from an insider and one must have strong reps and warranties from an insider that he has not aided and or abetted any malfeasance. The purchaser must also have indemnification provisions covering such breaches. It can be several months post closing of a trade that these issues are discovered and even longer until they are adjudicated. In order to minimize this risk seek to avoid purchasing claims of company, insiders or those where the relationship could be potentially deemed as “insider”.

Avoidance Actions. When a company files for bankruptcy all payments made in the 90 days prior to bankruptcy (1 year for payments to insiders) are investigated as potential Preference Payments. A Preference Payment is the payment of a debt to one creditor rather than dividing the assets equally among all those to whom he/she/it owes money, often by making a payment to a favored creditor just before filing a petition to be declared bankrupt. The Bankruptcy Trustee has the power to Avoid (unwind) any payments that are deemed to be a Preference This is known as an Avoidance Action and the money is reclaimed by the bankruptcy estate . There are several criteria that are used to evaluate whether a payment was a Preference:

The transfer was “to or for the benefit of a creditor.”
The transfer was made for or on account of an “antecedent debt”—that is, a debt owed prior to the time of the transfer.
The debtor was insolvent at the time of the transfer. (Fraudulent Conveyance which has 2-year look-back pursuant to 11 U.S.C. § 548)
The transfer was made within 90 days before the date of the filing of the bankruptcy petition or was made between 90 days and one year before the date of the filing of the petition to an insider who had reasonable cause to believe that the debtor was insolvent at the time of the transfer.
The transfer has the effect of increasing the amount that the transferee would receive in a liquidation proceeding under chapter 7 of the bankruptcy law (11 U.S.C.A. § 701 et seq.). 11 U.S.C.A. § 547

However, Section 547(c) of the Bankruptcy Code contains exceptions for payments made in the ordinary course of business. The prior course of dealings between the parties, including the amount and timing of payments, and circumstances surrounding the payments, should be analyzed. Additionally, inquiries may be made into the collection activities or practices between the parties, whether the payments were designed to give the transferee an advantage over other creditors in bankruptcy, or whether there was any change in the status of the transferee such as the ability to obtain security in the event of nonpayment. If there has been any unusual pressure or collection activity by the creditor resulting in the payment, the payment would not be ordinary course of business. The transfer at issue is not required to be the type that occurs in every transaction between the parties. It is necessary only that the type of payment be somewhat consistent with prior dealings and transactions

Closing the Trade

Once the due diligence and legal review is complete, the PSA is finalized and the trade is executed via Delivery vs Payment (“DVP”) format. ). DVP occurs when, to complete a trade, there is a simultaneous exchange of securities, in this case they are not securities but the format is the same, for cash that ensures that delivery occurs if, and only if, payment occurs. To be true DVP, there must be an element of finality in the process, whereby neither side of the trade can unwind the transaction after settlement. The funds are then wired within one day of execution. Closing can occur anywhere from 10-30 days post initial confirmation of the trade. The standard practice is that once the trade has closed, the Transferee files a Notice of Transfer and Evidence of Transfer (supporting documentation to evidence the transfer of claim) with the Bankruptcy Court pursuant to Bankruptcy Rule 3001(e). Rule 3001(e) reads as follows:

Transferees trading on the “scheduled amount” prior to the filing of a POC must file a POC with court, although “evidence of transfer” is not required it recommend. Rule 3001(e) 1
Assignment of a claim after a POC has been filed requires both a Notice of Transfer and an Evidence of Transfer to be filed with court. 3001(e)2

The clerk of the court or claims agent has the duty to notify the Transferor. The Transferor has 20 days to object to the transfer. Within 15-30 days post closing buyer follows up with claims agent to ensure claims register properly reflects the new owner of the claims.

Conclusion

Investing in trade claims provides a unique opportunity set for distressed investors who already understand the bankruptcy process, are familiar with analyzing complicated capital structures and understand inter-creditor issues. While trade claims are an illiquid market, they are also highly uncorrelated to the stock and equity markets making them attractive to distressed and special situation funds. Furthermore, it is possible in many cases to bid on claims at a discount to an established plan recovery for the reasons: stated earlier: that many trade creditors do not wish, or are unable, to wait for the exit from bankruptcy for payment. With that said the market has grown more competitive and sophisticated in the last several years, so do you due diligence and invest wisely.

Equitable Subordination

convertarb — Wed, 08 Sep 2010 03:18:08 +0000

Distressed Debt Investing Website 09/08/10

Analyses of distressed investments often range from the relatively straightforward to the mind numbingly complex. For investments in companies with a simple capital structure, investors will focus on factors such as cash flows, collateral value and terms of the governing credit document.

In larger, more complex companies, investors might have to analyze many additional issues involving restricted and non-subsidiaries, guarantees, security, baskets, carve outs, and covenants, just to name a few. When a company files for bankruptcy protection, additional considerations arise requiring an understanding of the bankruptcy code. One of these considerations involves equitable subordination.

Equitable subordination is a doctrine outlined in Article 510(c) of the Bankruptcy Code. The language from the Code states that equitable subordination allows a court to “subordinate for purposes of distribution” all or part of an allowed claim to another allowed claim when equitable principles require. Interestingly, the Bankruptcy Code does not provide guidance on when equitable subordination should apply. The Court, instead, typically relies on a standard created by the Court of Appeals for the Fifth Circuit involving three conditions:

Inequitable conduct by the claimant
Misconduct causing injury to creditors or the bankruptcy estate or conferring an unfair advantage to the claimant
The finding of equitable subordination must be consistent with bankruptcy law

Distressed investors should bear in mind a few additional principles when evaluating potential equitable subordination issues. One is these issues involves the distinction between an insider and non-insider. An insider’s conduct is subject to a higher level of scrutiny than the conduct of a non-insider. Another issue involves the application of remedies in equitable subordination cases. In equitable subordination Orders, the Court will offset the harm suffered by creditors on account of inequitable, or unfair conduct. The Court, however, will not necessarily subordinate the full value of a claim as part of the remedy.

Equitable subordination is frequently alluded to in bankruptcy cases by investors who have witnessed a steep fall in the value of their securities. Courts, however, do not often find that questionable tactics prior to a bankruptcy filing meet the high standard of egregious misconduct required in equitable subordination cases. A recent exception to this rule of thumb is Yellowstone Mountain Club, a bankruptcy filing in the District of Montana. In this case, Debtor and the creditor committee claimed that a secured loan in the amount of $375 mm constituted a fraudulent transfer. Without getting bogged down in the legal details of the case, the Court ruled in favor of the Debtor and creditor committee, finding that the lender’s actions “were so far overreaching and self serving that they shocked the conscience of the Court.” As a remedy, the Court subordinated the lender’s secured claim to the claims of unsecured creditors in the case.

With a robust understanding of equitable subordination, distressed investors should tread carefully as they evaluate purchasing senior securities that may have unfairly disadvantaged junior securities in a capital structure.