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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

Dynegy bankruptcy filing – history

convertarb — Sun, 08 Jan 2012 21:38:00 +0000

In the case of Dynegy, the lack of restrictive covenants led to the company changing its corporate structure to take assets away from the unsecured bondholders of DHI. DYN

On November 7, 2011, Dynegy reached a restructuring support agreement (RSA) with a group of bondholders that combined hold $1.4B of DHI’s total $3.4B of unsecured bonds. In conjunction, Dynegy placed certain of its subsidiaries including DHI and DYN Northeast Power Generation into bankruptcy. Dynegy’s parent and holding company was not part of the bankruptcy filings. The RSA, if approved by two-thirds of the amount of unsecured bonds outstanding and one-half of voting claimants would entitle DHI unsecured bond holders and owners of leasehold interests in Dynegy’s Roseton and Danskammer assets:

$400M cash

$1.0B , 7 year 11% secured notes at Dynegy Inc.

$2.1B convertible notes at Dynegy Inc. These notes have a PIK (pad-in-kind) feature embedded in them and accrue interest at 4% through 12/31//2013. 8% in 2014 and at 12%, thereafter. These notes are mandatorily converted into 97% of DYN outstanding shares at 12/31/2015. They may be retired at up to a 7% discount or for $1.95 billion.

Specifically to the holders of the subordinate 8.316%: The plan contemplates, a 25 cent on the dollar treatment in lieu of contractual subordination ($200M outstanding for a total claim consideration of $50M)

Distressed Debt Website Analysis:

Throughout the day today, there were many many markets being made on both the cash bonds and the triggered CDS of Dynegy. It felt like the 8.375% senior unsecured notes due May 1, 2016 were the most liquid cash bonds of the day which went out 75.75-76.25 Here is a chart:

Quick note: This bond will trade slightly higher than the rest of the complex due to the larger claim as a result of accrued interest.

As you can see, bond prices rallied very hard today and over the past two-three weeks.

The question then becomes: What is this thing worth. It really hinges on three things:

What you believe the price of the new 11% Secured Notes will trade to
What you believe the price of the new Convert notes will trade to
And to a lesser extent – the probability / chance that Roseton-Danskhammer rejection claims are significantly more than $300M and the whole plan has to be re-worked

Stepping back a bit: There is $3,570M face value of bonds outstanding at Dynegy including the aforementioned sub notes. I then gross up this value based on accrued pre-petition interest. For instance, the 8.375% notes have $1,046,834,000 outstanding. Each bond has about 4.4 points of accrued interest meaning the total claim is $1,046,834,000 * 1.044 ~ $1,093,000,000.

Each bond is grossed up by the accrued interest. Then I adjust the sub notes to 25% of claim as discussed in the restructuring support plan agreement. I then assume $300M of rejection claims from Roseton-Danskhammer.

This is somewhat important because according to the restructuring support agreement:

“If the aggregate claims arising from the rejection of the Roseton / Danskammer leases are allowed by the bankruptcy court in an amount that is less than $300 million, the aggregate principal amount of New Secured Notes shall be reduced by an amount to be agreed for every dollar such claims are less than $300 million. If the allowed claims exceed $300 million and the condition to consummation of the chapter 11 plan requiring such claims to be capped at $300 million is waived as set forth below, the aggregate principal amount of New Secured Notes shall be increased by an amount to be agreed for every dollar such claims exceed $300 million. The adjustment amount to be agreed for increases in the New Secured Notes shall be the same as the amount for decreases in the New Secured Notes.”

Bringing this all together, I see approximately $3,850M claims. Of this, each bond will have a different percentage of % claim based on the size of the bond and its accrued interest. Our 8.375% notes for instance have 28.3% of the claims.

We must then apply this 28.3% to the value of the package being received:

28.3% * $400M of cash = $113.2M
28.3% * $1 Billion of Notes = $280.3M * Assumed Trading Price of Bonds. I actually am more bullish on this piece of paper than the market given how much equity I think there is at GasCo and CoalCo (which secures the new notes). I assume that they trade at par+ (whereas many people are saying in the low to mid 90s). So $280.3 * 100 = $280.3
28.3% * $2.1 Billion of Convertible PIK Notes = $594.3M * Assumed Trading Price of Bonds. This is where things get real messy, and truly believe the swing factor here given the size and uncertainty of what will happen with this security.

With the market trading price of the existing 8.375% senior note at 76, the market is implying (assuming par on the secured notes), that the convert will trade to ~74 cents on the dollar. (To check math: $113.2 + $280.3 + (74% * $594.3) = $833.3 /$1,093 = ~76.

To me, that feels right (mostly based on the PIK, and subordinated nature of the security), but I think there is upside there for 2.5 reasons:

Aforementioned equity value of GasCo and CoalCo flows through to the Converts after deducting for 11% Notes. I would expect an IPO of one or both entities after litigation is resolved.
The incentive factor here: If the converts are not called prior to 12/31/2015, they are then convertible into 97% of DYN’s equity. It is imperative for equity holders to deal with this security prior to that. Of course, when you got Carl Icahn calling the shots, you never know what you are going to get as a bond holder

And reason 2.5 -> If you are bullish on the power market, this is a very (VERY) levered way to play recoveries in the power market (where demand, in theory, eventually should increase in a time when no new supply is coming to the market.

With that said, at today’s prices there is not enough pessimism priced into the bonds to get me overly excited. I would play in small size and then wait for some sort of scare on the litigation front or the power markets to add to my position. This will be a fascinating bankruptcy to follow after what happened with Mirant 5 years ago. We will keep you updated as the trial (s) proceed.

In September 2011, Dynegy completed its second restructuring step by transferring Dynegy Midwest Generation (CoalCo) out from under DHI to Dynegy Inc. Dynegy’s board valued the CoalCo equity stake at $1.25B after taking into account all debt obligations of CoalCo, including CoalCo’s new $600m, five year senior secured term facility. Dynegy offered to exchange for $1.25B unsecured notes of DHI for new Dynegy 10% secured notes and cash. Bond holders rejected the exchange.

The weak covenants of the DHI unsecured notes contain no protection against the transfer of CoalCo. They have an investment grade style covenant package with no upstream guarantees. The only recourse bondholders have is to argue for fraudulent conveyance but lost their case.

In July 2011, Dynegy announced plans to refinance its existing credit facilities and reorganize its assets into a GasCO subsidiary and a CoalCo subsidiary, while leaving the Roseton-Banskammer lease structure at DHI. BAC thinks DYN will take a page from TXU’s 2010 playbook: implementing negotiated and offered discount debt exchanges to squeeze DHI’s outstanding bonds into a smaller but more sustainable capital structure, using multiple layers in the capital structure and corporate structure and other tactics to transfer value to shareholders from bond holders.

In December 2010, Icahn makes a $5.5 cash offer that was ultimately unsuccessful.

In November 2010, Blackstone raised its offer to $5.00 cash per share but was still unsuccessful.

On August 10, 2010, Blackstone agreed to acquire Dynegy for $4.5 per share, or $540m; including outstanding debt, the transaction has a total value of $4.7B. As part of the deal, Blackstone will sell four Dynegy natural gas fired power plants for $1.36B, which essentially gives Blackstone a free asset, cash plus a free call option on future power prices and dark spreads. BAC thinks the remaining assets have a interest coverage ratio of only 1.0x.

The reason Blackstone could do this is because of weak bond covenants that do not prevent such a sale.

AMR files for bankruptcy

convertarb — Sat, 03 Dec 2011 14:43:08 +0000

11/29/11

AMR filed for bankruptcy protection on 11/29/11 in a surprise move because the company still had $4B in cash. During the company’s third quarter earnings call in mid-October, then Chairman and CEO Gerald Arpey made it clear that bankruptcy was not their preference or goal. Over the Thanksgiving weekend, AMR’s board decided that chapter 11 was the best route because its costs were much higher than its competitors and this was a way to bargain with their pilots union on a new contract. Gerald Arpey decided to retire and was replaced by Thomas Horton. JPM’s credit put a good research note describing the bankruptcy on 11/30/11. Their thoughts on the 7.5% bonds is summarized below.

The 7.5% first lien routes/gates/slots bonds due 2016 are the most interesting security to analyze. It’s big and liquid with $1B outstanding. The structure is controversial, in that liens are not perfected on all of the collateral. The collateral, as of the February offering, includes 198 slots per week at Heathrow (or about 14 pairs per day), 70 slots at Tokyo Narita (5 pairs per day), 14 slots at Tokyo Haneda (1 pair per day), 14 slots at Shanghai Pudong (1 pair per day), 14 slots at Beijing (1 pair per day), and 82 slots at JFK related to this service (or about 6 pairs per day). The 7.5% bonds traded at about 80 prior to the bankruptcy and then down to 66 before bouncing back up to 72 a few days later.

There are a few risks with this security:

1) AMR may try to reject the collateral. This seems unlikely given the strategic importance of these routes to the business traveler centric AMR network.

2) Unsecured creditors try to claim that the deal is under-collateralized, which may be a tough argument given the $2.3B appraisal on the collateral as of February from Morton Beyer & Agnew, a reputable third party. However, not that this valuation is based on a DCF model, not a slot pair market value.

3) Unsecured creditors argue that the liens are not perfected, therefore the 7.5% holders aren’t secured, and thus they should be lumped into the general unsecured claims pool. There is not enough information or precedent to determine with any sort of certainty if this argument will fly with the judge, although we are fairly confident that unsecured holders will push for this catergorization of the 7.5% holders.

4) AMR decides later in the case that it indeed needs a DIP credit facility and that the 7.5% collateral is required collateral. We also think AMR could push for this outcome if they believe unsecured creditors will be successful in their arguments, as that would undermine AMR’s ability to refinance route/gate/slot secured debt going forward. A DIP involving these assets could take the form of a priming DIP where the DIP holders take a super senior lien or it could go down the pay to play road where the 7.5% holders are taken out only to the extent they roll their exposure into a new DIP loan.

AMR has three unsecured issues

6.25% converts due 2016 ($460m), 9% bonds due 2012($75m), 9% bonds due 2016 ($59m)

The converts traded down from 42 to 20, the 9% of 2012 from 73 to 20, and the 9% of 2016 from 39 to 20. Obviously, the bankruptcy filing was a big surprise since the 2012 bonds were trading at 73 with the hope that they would be repaid at par at maturity. On 11/30/11, UBS desk analysts calculated a quick and dirty recovery value of 31% based on 6.25x 2014 EBITDA of $3,350M for a net distributed value of $22,684M. After secured claims and other payments, the residual value for unsecured creditors is $3,411M with a claims pool of $10.972 (bonds +pension, OPEB, etc) for a 31% recovery. See more information in the desk analyst note (not supplied here).

AMR has many secured bonds and EETC issues. I will put the analysis here but there is a lot more detail in the JPM credit note on 11/30/11. It will be interesting to see how the bankruptcy plays out.

AMR EETC recovery

convertarb — Tue, 29 Nov 2011 23:26:20 +0000

This post was taken from Distressed Investing’s website.

AMR: EETC Recovery 11/29/11

This morning, AMR Corporation (“AMR”), and its subsidiary American Airlines, Inc. filed for bankruptcy protection in the Southern District of New York.

To say that this was a surprise to the market would be a bit of an understatement. To give you a sense of how far out of left field the timing of the bankruptcy filing was, the December 2011 CDS traded yesterday at 5.5 – 8.5 points up front. It closed today at 83 points up front. If you polled the majority of sell side analysts out there, they would have told you that AMR had the liquidity to survive at least until mid-2012 and possibly beyond.

Call me a sicko, but to me, AMR’s capital and corporate structure is a thing of beauty to the distressed analyst. To put it simply: There are so many different securities to play ranging from EETC, to secured / unsecured municipal debt, to converts, to the general unsecured pool, to pass through certificates, etc. Each with their own recoveries requiring discrete analysis. It is majestic.

Here is an example. AMR has over $3 billion dollars in municipal debt. Each of these securities could be unsecured or secured by leases on gates or owned maintenance facilities. A good friend pointed out that CUSIP 01852LAB6, an Alliance Texas Airport Authority Bond, with ~$125M outstanding was due to be paid this coming Thursday. It’s unsecured. Pain.

As of now, I will be completely honest and point out that the majority of my time over the past few months (since the AMR bankruptcy scare in October), has been on the EETC side. I will end the post with some overall thoughts on the controversial 7.5% notes secured by international routes and some questions on the general unsecured pool. But for now, let’s dig into EETC securities.

EETCs (Enhanced Equipment Trust Certificate) are secured securities backed by the financing of individual airplanes. When an airline or lessor like ILFC purchases a plane from Boeing or Airbus, they finance the purchase. They do this on a number of planes. These financings, from the pool of purchased planes, are then packaged equipment notes, pooled, and then placed into a EETC structure and sold to institutional investors. These securities are classified as pass through securities because as each individual equipment note backed by an airplane financing pays interest and principal payments, these payments are passed through to the overarching EETC to pay interest and amortization payments.

Depending on the individual structure, EETC are tranched into A, B, and C tranches. The A’s will be the senior piece of paper and will recover first in a bankruptcy / default scenario (cross-subordination). With that said, the A tranches will almost always have the longest weighted average life as amortization payments of the EETC go to pay the C, then the B off first. Loan to values scale with the tranches, so an A tranche may be marketed at 60%, a B tranche at 75%, and a C tranche at 90%. Because of this, as well as the contractual seniority, A’s come with a lower coupon despite the longer tenor. A G tranche in EETC land refers to a EETC tranche wrapped by the likes of Ambac or MBIA.

A final quick note, on amortization: all amortization and principal pay downs are not created equal. There are instances when a EETC structure will contain a lot of great planes, but also a lot of terrible planes. An investor should recognize that each underlying financing references an individual aircraft. Those financings have different maturities and the LTV of a EETC structure can change dramatically if those equipment notes backing good planes mature first (i.e. you are in a stub of bad equipment notes.

Each EETC is different, and newer vintage EETC have protective benefit to lenders in the form of cross default and cross collateralization. If AMR defaults on one equipment note backing an airplane in a EETC, the cross default means ALL equipment notes are triggered in that same EETC. Cross collateralization means that deficiencies in one equipment note can be offset by gains in another equipment note. These concepts are very important to the AMR bankruptcy as the 2009-1, 2011-1, and the 2011-2 EETC structures feature both cross default and cross collateralization provisions.

Another unique characteristic of the EETC structure is referred to in the market as a “liquidity facility.” These facilities, backed by highly rated banks, provide for the payment of interest on the various tranches of the EETC for 18 months. This allows creditors that have taken ownership of rejected planes time to refurbish, provide maintenance for, and re-market (sell) planes with the intended purpose to avoid distressed, under-the-gun sales.

Finally, and topical, as AMR has filed for bankruptcy are the concepts of 1110 (a), 1110 (b), and 1110 (c). Under 1110(a), aircraft have their own place in bankruptcy law in that debtholders can take back the aircraft 60 days after a bankruptcy filing if airline does not cure the default (i.e. pay interest and amortization on the note). This is where the concept of affirm or reject comes in to play and where investors can start differentiating themselves in terms of the knowledge they bring to a particular bankrupt airline’s situation. The aforementioned 1110 (b) can be thought of as a renegotiation between the airline and the pass through note holders (and involves adequate protection payments for use of plane). And 1110 (c), or a rejection, is when a plane is returned to the lender.

There are more nuances to the structure (purchase option for subordinate tranches, adjusted expected distributions, CODI claims, etc), but for now, this will do, and as AMR exercise their right to accept or reject collateral in various structure, we can flesh out the details. In its letter to aircraft creditors, AMR said this:

We cannot afford to retain all the aircraft currently in the American and American Eagle fleets at their current rates, and so we have no choice but to make substantial reductions in the cost of the aircraft which we retain. Moreover, in view of the large number of aircraft we have on order from Airbus and Boeing, we also seek to accelerate our fleet renewal strategy and, as a result, we do not require the use of all aircraft currently in our fleets. Additionally, to conserve our liquidity, subject to the requirements of the U.S. Bankruptcy Code, during the 60-day Section 1110 period, we plan to make payments when due of aircraft rent and mortgage principal and interest payments only on certain aircraft in our fleets.

To put it lightly, AMR, out of all the domestic carriers, has an extensive order book. Here is the disclosure from the most recent 10Q

Here is the playbook for AMR during this bankruptcy:

Reject old, fuel inefficient airplanes (MD 80s) that will be replaced by the 737-800 family (not all will be rejected, but most will)
Renegotiate every labor contract out there to make yourself more cost competitive with the industry. In fact, AMR actually put in a graph in the aforementioned affidavit displaying how weak their margins are to competitors
Rationalize your network in terms of routes and gates (i.e. leave Chicago for instance). This may require asset sales in addition to flat out defaulting on municipal debt.
Reject the pension and put it to the PBGC

The question then for investors becomes: Where can I get the best bang for my buck? In EETC land, the question of reject or accept under 1110 becomes paramount. For instance, the 6.977% notes are the 2001-A vintage. They are trading in the mid 50s. There is $177M bonds outstanding. Backing those bonds are 32 MD-83s delivered in the last 90s. To figure what this EETC tranche is worth, you need to take a number of things into consideration:

Will they accept or reject these planes? Maybe they accept a few and continue paying interest on the underlying equipment notes and reject all the rest. As every one of these MD 83s are owned by Boeing, it is more likely they reject than accept (airlines, for various tax reasons, are somewhat reluctant to reject planes they own). But if you believe they will accept a lot of this collateral, you would be more bullish all else being equal
If they do reject planes, how much are those planes worth after they pass maintenance tests and monies are spent for re-marketing (you could also melt the planes for steel value)
If the amount of debt is not covered by the asset sale process, you would have a general unsecured claim to the AMR estate. You then need to figure out how much that claim is worth and add that to your recovery.
A smaller, but important consideration: Interest will be paid on this EETC for 18 months via the liquidity facility. This paid interest becomes a super senior claim over your A-tranche (i.e. if the liquidity facility provider pays out $100 dollars in payments, $100 dollars of debt is now ahead of you in the waterfall). This can be important in very low dollar price bonds as you are creating a very cheap option after deducting the present value of interest payment

Determining if a plane will be rejected or accepted is more of an art of science. Many, many factors come into play here include (but not limited to):

Type of structure the equipment note backing the plane is a part of. For instance, an airline may be less likely to reject a plane backed by an equipment note in a EETC that has cross default provisions, all they could lose all planes in that structure
The important of the plane in relation to the overall fleet and future fleet build out plans. As noted above, AMR is purchasing a significant number of 737-800s, meaning they are less likely to reject these planes.
The unique aspects of a plane in terms of its range and capacity. If an airline used to have significant need for wide-body planes, and now doesn’t because of route / slot / gate changes, they may be more likely to reject those planes
The maintenance schedule of a particular plane may be onerous in the coming years and be a cash flow drain on the airline which means its more likely to be rejected
Cost of financing the underlying equipment note versus market rate. This can be extended to the overall EETC structure – i.e. could AMR go out in the market today and get a better deal for some of their high coupon EETC structures?

The value of a plane in a re marketing exercise is really a function of supply and demand. One thing I look for are planes that many different airlines use. Some planes only fit 3-4 carriers making them harder to sell into the broader market place. Demand for 737-800 is quite high and queue times for delivery is 5-6 years out, meaning these planes would easily be remarketed. There are a number of appraisal companies out there that will tell you what they think each and every kind of aircraft out there is worth today, next year, and 5-10 years out. As a rule of thumb, I lop of 15-25% off the top on these appraisals for a sanity check.

With all that said, that is how you approach AMR’s EETC structures. I definitely think some are interesting and are high current yielding pieces of paper.

Over the next few weeks, I will be spending time digging through and laying out every piece of paper that I can find to ascertain market opportunities. As noted above, there is A LOT to work through, and one analyst could spend an entire year or three just understanding each underlying municipal, EETC, Pass Through, Secured, etc piece of paper. With that, I’ll end the post with a few questions that linger in my mind that I will try to tackle over the next week (and if you have any thoughts, please feel free to email me to discuss)

What is exactly the pension underfunded status and how large an unsecured claim will the PBGC put to the estate? What effects do recent changes to pension legislation as it pertains to airlines have on this number?
If the liens backing the 7.5% were not perfected, do the unsecured’s make a case that they should see benefits from that collateral? What really is the value of that collateral? $20M per slot pair according to Air Canada’s recent valuation for Heathrow. But what about Japanese, where AMR is weak, and China routes?
The 13% Notes, while not a traditional EETC structure, kind of scare me. Does it make sense to reject slightly older 737-800s to restructure a small, but very high cost piece of paper? The 10.5% Notes are a slightly different story – and with such a large contingent of 757-200s in the structure, which AMR has admitted they are rationalizing next year, are equally frightening
Who is going to own the equity in this thing when all is said and done? A hodge podge of unsecured creditors including the PBGC? How does this affect the NOL, which I believe is around $8 billion dollars.

And these are really just structural questions. The big question on everyone’s mind is: After all is said and done, what kind of EBITDA margins are we talking here? Is it 5%? 7%? Given the size of the revenue line here a 100 basis point move in margins is massive when you capitalize it a 4-5x.

This is going to be a fun one. I can definitely say that I have more than enough to be working on in distressed debt land with the recent filings of AMR, DYN, PMI, and MF, along with a number of legacy situations. Great time to be involved in distressed debt investing.

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.

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.

Blackstone tries to steal Dynegy

convertarb — Mon, 16 Aug 2010 22:34:52 +0000

HEARD ON THE STREET

AUGUST 16, 2010, 4:45 P.M. ET

Blackstone Might Rewire Dynegy’s Balance Sheet

By LIAM DENNING

It isn’t often a 62% premium offers reason for grumbling.

Blackstone Group‘s takeover offer for Dynegy effectively gives it two-thirds of the company’s generation capacity plus cash for no money down. That is because NRG Energy has simultaneously agreed to buy about a third of Dynegy’s megawatts for $1.36 billion, or about $800 million more than the price tag for Dynegy’s equity.

Why didn’t Dynegy sell the assets to NRG and keep the money itself? Probably because it did this a year ago for no discernible gain. In August 2009, Dynegy sold about a quarter of its capacity to LS Power to boost liquidity. That didn’t stop the stock dropping from about $10 then to less than $3 before Blackstone showed up.

If shareholders are miffed, it is Dynegy’s bondholders that have real reason to worry. Should Blackstone decide to dividend the entire proceeds of the NRG deal back to itself, Dynegy will be left carrying its existing debt load on a smaller stream of profits. That would raise the company’s already high credit risk. But then Blackstone, sitting on a potential $800 million instant profit and with no other shareholders to protect, need not worry too much about that.

Alternatively, Blackstone could use some of that profit to buy in some of those bonds. Doing so would reduce Dynegy’s debt burden and, possibly, its cash interest costs, potentially boosting Blackstone’s return when it sells the company down the road.

This likely would only make sense, however, if Blackstone bought the bonds below even today’s market values of between 60 and 80 cents on the dollar. Shareholders might wish they got a higher premium. Bondholders may end up scrambling to limit their losses.