Distressed Debt Investing

My Favorite Ideas from Ira Sohn

noreply@blogger.com (Hunter) — Thu, 24 May 2012 04:01:00 +0000

Last week we attended the Ira Sohn Research Conference where some of the best hedge fund managers in the world pitched some amazing investment ideas. For those that were not following, I was updating readers in real time on Twitter (@DDInvesting) trying to get information out as fast as humanly possibly.

In that regard, our notes from this year our going to take a different feel. For more comprehensive notes you can visit Jay at Marketfolly or Jacob at ValueWalk or Josh at The Reformed Broker. In addition, a number of the presentations are being floated around specifically Bill Ackman's presentation on JCP.

In terms of distressed debt portfolio managers, the panel of speakers included notable player Jonathan Kolatch, founder of Redwood Capital, who was very impressive. In fact I believe, and I might be mistaken, Kolatch used to work with Dave Tepper at Goldman Sachs (forgive me if I have that fixed up). Larry Robbin's Glenview Capital and John Paulson are also active players in the distressed debt market. It was great to hear from each of them.

So for each manager, I have boiled down the ONE take-away I came away with from the conference. Some of these are investment ideas and some are more general investing wisdom. Overall I encourage all of you who have never been to the conference to attend one soon - it is such a learning experience listening to best pitch their ideas. Enjoy!

Ken Rogoff - Harvard University

Professor Rogoff spoke about what he is known best for: severe finance crisis. His book "The Time is Different" talks about, in depth, many of the great financial calamities world economies have faced in the past. The most interesting or salient point he made: Looking at the charts, Greece has been in default for 50% of the years since the data was recorded. The situation in Greece (as well as other weaker European nations) is keeping a tight lid on the euro which is beneficial to German consumers and industry. If this dynamic wasn't the case, I think the fact that the country you are trying to save has been in default 50% of the time, you have to let it go.

Larry Robbins - Glenview Capital Management

I interviewed at Glenview many moons ago when their AUM was 1/5 of what it is today. I regret not closing that position because Robbins is simply a force of investment acumen. Robbins spent most of his time talking two trades: Long hospitals and life sciences (Tenet in particular) and short the "new high club" - treasuries, utilities (specifically ITC) and the defense sector. The takeaway from this presentation was simply the thoroughness of the ITC short. Glenview went as far as testifying in front of the regulators that ITC's capital structure allowed it to overcharge consumers. The short wasn't really valuation in nature (in my opinion the worst kind of shorts). It was based on technical information that required a lot of digging. And there is a catalyst here - a rate review / drop in rates so the shorts just don't have to sit around forever and wait for valuation to come down.

Jonathan Kolatch - Redwood

Kolatch spent his time discussing Argentina sovereign debt. He compared Argentina to other countries in Europe: Debt to GDP is half or less than most countries in Europe. There are less deficits. Rapid GDP growth. And bonds yield 15% - well higher that most countries. It was a very compelling presentation. Kolatch noted that if Argentina traded 300 bps behind Brazil, the trade offered a 36.5% IRR (in 3 years) with a 13.7% current yield. The takeaway here is summarized by how Kolatch described Argentina's nationalization of YPF. He agrees that its a bad thing, but the motivations might be different from what the market is handicapping and that creates opportunities and mispricings.

Dwight Anderson - Ospraie Management

This is the first time I've heard Tutor and Tiger Alumni Dwight Anderson speak. Anderson's talk focused on two ideas: Long Westlake Chemical, and a pair trade of long palladium / short platinum. The takeaway here, and similar to other Tiger alumni, is the understanding or better yet anticipation on what's going to happen next. The second-derivative thinking on Westlake was a beautiful thing to watch: Low nat gas prices are a benefit to Westlake and the benefit is no where close to being fully realized. Similarly the platinum vs palladium trade was thinking two steps ahead: Platinum mine production is accelerating later this year into net year, whereas palladium will be in a deficit, combined with structural changes in the consumption of the two materials in auto products. Really compelling stuff.

Meryl Witmer - Eagle Capital

Witmer learned the ropes with Michael Price and Max Heine of Mutual Series. She spent her time talking about two idea: Gildan and Viacom. In one of her opening slides, she discussed Eagle's general philosophy which focus on looking for strong management teams that are good capital allocators who buy back stock a "fire sale prices" running companies that generate good cash flow and maintain a healthy balance sheet. The emphasis on fire sale prices is interesting - so often the investment community pushes for companies to buy back stock irrespective of price. Yes, its probably better than making a dumb acquisition, but its far less important the value of cash in a downturn (whether buying own stock or someone elses). As investors we know this but we rarely put that to our management teams we cover.

Phillipe Laffont - Coatue

Lafont spoke about two stocks: Equinix and Virgin Media. Similar to other Tiger Cubs, Laffont looks for industry leaders. One of the most interesting things he said at the conference, which I had never really thought about: The market inappropriately values companies that will do a LARGE forward buyback. So a company like Virgin Media which in theory could buy back all its shares outstanding in the next five years is seriously undervalued. He didn't postulate why this is - it's probably because many market participants simply don't believe management.

John Wilder - BlueScape Resources

This was an amazing presentation on the dynamics going on in the natural gas market. One of the industries I have never covered is oil/gas, but I do look at the coal names (moreso now than a few weeks ago) which is relevant in so many ways. Wilder was quite bearish on the near term forward curve for gas. The one key point I took away from his presentation was a fantastic graph showing commodity prices versus GDP - natural gas demand has been relatively stable / flat and has not kept up with GDP growth. With little gas drilling economically viable at current pricing (outside the Marcellus) the demand side wildcard of LNG exports may not be all they are cooked up to be - the mystical "100 BCF/day won't happen in the near term.

Jeffery Gundlach - DoubleLine

The introduction to Gundlach noted that according to one study, DoubleLine is the fastest growing company in America. That is magical. I have covered Gundlach on the blog a number of times. If you haven't heard him speak, you are missing out. Gundlach talked about constructing portfolio that can handle all tail scenarios. To Gundlach, cooperation = bull market; contention = bear market - and we have a ton of contention right now. I listed his trades on Twitter, but for those not there: Long IBEX, 1 year Libor (10x levered), natural gas, cash; Short SPX, JWN, Apple, 2 year swaps. The portfolio he laid out makes a lot of sense and in a very bullish or very weak market, would probably do well.

David Einhorn - Greenlight Capital

This was a whirlwind presentation. You can see part of it here: Greenlight's Thoughts on Cash Heavy Companies. The amount of items covered here would be impossible to do any service to, on either the long or the short side. Probably one of the better ideas presented here was short Dicks Sporting goods on encroachment from Amazon. Again, 2nd order thinking here (which really was present throughout the presentation: US Steel short, Japan, Cairn Energy, etc).

Dan Ariely - Duke University

Dan Ariely is one of the leading experts in behavioral economics and self-control. His talk really centered on the latter. Ariely pointed out that self control, boiled down, is the dynamic between long term interests and short term interests: And the short term usually wins. As such, how do we overcome this? The take-away here is how loss aversion can affect us outside of investing. Studies show we have to win 2-3x what we equivalently lose to have the same emotional effect on ourselves. So instead of using "treats" to reward ourselves, instead use the loss of "treats." His example: When he told diabetic patients he'd give them $3 each day they took their meds, no one changed their habit. When he then told another group of patients that he deposited $100 in their bank and that each time they didn't take their meds, he'd take $3 out, there was an 80% increase in compliant patients. Amazing! The last point he made was really telling: Self control problems will only get worse in times; marketers will not make their products LESS tempting.

Steve Mandel - Lone Pine

Another Tiger Cub. And similarly he said: I believe leaders stay leaders and leaders win. His themes include being negative on fixed income, being long tech leaders, and being long share count shrinkers. The one name he mentioned was Kohl's which trades below 10x, has been affected by cotton prices (short term problem) and has a solid leadership team aggressively buying back stock at a discount to intrinsic value.

John Paulson - Paulson & Co

John Paulson likes to think big. And as I noted, his CVI trade was probably the best idea presented (despite the fact that you had to buy it at T+2 or T+1 to actually execute the trade). His thesis on CZR brought some interesting facts to life - i.e. the holding company owns assets (online gaming) outside of the levered enterprises and you're probably already covered there. He did note that CZR was an option play and placed a $138/price target on the name. He also spoke about AngloGold Ashanti, which in his opinion, is the cheapest way to play gold.

John Lykouretzos - Hoplite

Another Tiger Cub (Tiger Cub Cub - was a PM at Viking). This is the first time I have heard Lykouretzos speak. He presented on Starbucks and laid out a very very compelling thesis. Again Tiger Cubs like to play quality companies and really Starbucks is one of the best out there. He laid out a number of tenets of value and pointed out that growth in the U.S. store base + moving to consumer packaged goods could create tremendous shareholder value.

Bill Ackman - Pershing Square

On a day JCP was getting absolutely murdered, Ackman, as usual presented a detailed case study on why he is long JCP (and the next day his slate of directors was elected at CP). I do not want to do the presentation any disservice, so I'll link to it for those that have not seen it. The title is Think Big - and at the end he notes JCP could be worth $300/share. Thing big we shall! Here's the presentation.

Competing Plans in Bankruptcy

noreply@blogger.com (Hunter) — Tue, 22 May 2012 02:31:00 +0000

Over the last few years, we've seen a number of cases run parallel plans in bankruptcy - sometimes contentiously between creditors trying to argue they are the fulcrum and sometimes for legitimate business reasons. Distressed Debt Investing contributor George Mesires of Ungaretti & Harris LLP has written a piece talking about competing plans in bankruptcy. Enjoy!

Competing Plans in Bankruptcy
One of a debtor’s most powerful levers during a bankruptcy case is its exclusive right to file a plan of reorganization during the first 120 days of a bankruptcy case. This period, commonly known as the exclusivity period, coupled with the automatic stay, provides a debtor breathing room to focus its efforts on, among other things, formulating a plan of reorganization to exit bankruptcy. Exclusivity provides a debtor an opportunity to develop its plan of reorganization without the threat of its strategy immediately being derailed by competing constituents. Certainly the careful debtor may work with other constituents to build consensus around its plan of reorganization, but exclusivity gives a debtor the initial leverage over its creditors and other constituents during the important early few months of a bankruptcy case.

Often times, however, particularly in complex bankruptcy cases, 120 days is simply not enough time for a debtor to formulate its plan of reorganization, and in such circumstances, debtors often request, and courts routinely grant, extensions of the exclusivity period. Indeed, in many cases, debtors were granted seemingly indefinite extensions, a practice that led some critics to contend that exclusivity extensions unduly prolonged the time and increased the expense of chapter 11 reorganizations to the detriment of other constituencies. Even though the Bankruptcy Code permitted a party in interest to petition the bankruptcy court for authority to file a competing plan, such requests were rarely granted. Generally, if a bankruptcy case appeared to be on-track, courts deferred to the debtor so that the debtor could maintain control of the plan process.

To address the concern that debtors were hiding behind the cloak of exclusivity to the detriment of other constituents, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) amended the Bankruptcy Code provision relating to exclusivity by imposing an 18 month limit on a debtor’s exclusivity period. The amendment was intended to motivate a debtor and other constituents to develop a consensual plan, thereby reducing the time and expense of a protracted chapter 11 proceeding. Notwithstanding its laudable intent, the BAPCPA amendment relating to exclusivity may have, in fact, complicated the chapter 11 process by stripping bankruptcy courts of their discretion to extend exclusivity and automatically permitting other constituents to file competing plans after 18 months.

The Exclusivity Period
Pursuant to § 1121(b) of the Bankruptcy Code, a debtor has the exclusive right to file a plan of reorganization during the first 120 days after the commencement of a chapter 11 case. If a debtor files a plan during this exclusive filing period, section 1121(c)(3) of the Bankruptcy Code grants an additional 60 days during which the debtor may solicit acceptances of that plan, and no other party in interest may file a competing plan.

Section 1121(d) of the Bankruptcy Code provides that the Court may, in its discretion, “for cause,” extend these periods: “[o]n request of a party in interest . . . and after notice and a hearing, the court may for cause reduce or increase the 120-day period or the 180-day period referred to in this section.” 11 U.S.C. § 1121(d)(1).

Although the Bankruptcy Code does not define “cause,” a number of courts have looked to the Bankruptcy Code’s underlying legislative history for assistance in construing this term in this context. See, e.g., In re Ravenna Indus., Inc., 20 B.R. 886, 889 (Bankr. N.D. Ohio 1982); accord In re Amko Plastics, Inc., 197 B.R. 74, 77 (Bankr. S.D. Ohio 1996); Gaines v. Perkins (In re Perkins), 71 B.R. 294, 297-98 (W.D. Tenn. 1987); Teachers Ins. and Annuity Ass’n of Am. v. Lake in the Woods (In re Lake in the Woods), 10 B.R. 338, 342-45 (E.D. Mich. 1981).

Courts hold that the decision to extend the exclusivity period is left to the sound discretion of a bankruptcy court and should be based on the totality of circumstances in each case. See, e.g., 203 North LaSalle Street P’ship v. Bank of Am. Nat’l Ass’n (In re 203 North LaSalle Street P’ship), Nos. 99 C 7110 and 99 C 7108, 1999 1206619 at *4 (N.D. Ill. Dec. 13, 1999) (“[T]he Code commits the decision on extending the exclusivity period to the discretion of the bankruptcy court.”); First Am. Bank of N.Y. v. Southwest Gloves & Safety Equip., Inc., 64 B.R. 963, 965 (D. Del. 1986); In re Dow Corning Corp., 208 B.R. 661, 664 (Bankr. E.D. Mich. 1997); In re McLean Indus., Inc., 87 B.R. 830, 834 (Bankr. S.D.N.Y. 1987).

In determining whether cause exists for an extension of a debtor’s exclusivity period, courts have relied on a variety of factors, each of which alone may constitute sufficient grounds for extending the exclusivity period. Factors that courts have routinely considered to determine whether “cause” exists include: (a) the existence of good faith progress towards reorganization; (b) the size and complexity of the debtor’s case; (c) a finding that the debtor is not seeking to extend exclusivity to pressure creditors to accede to the debtor’s reorganization demands; (d) existence of an unresolved contingency; and (e) the fact that the debtor is paying its bills as they come due. However, in no event shall the exclusivity period be “be extended beyond a date that is 18 months after the [petition] date,” and the 180-day period “may not be extended beyond a date that is 20 months after the [petition] date.” 11 U.S.C. § 1121(d)(2).

BAPCPA Amendment Concerning Exclusivity
Following the BAPCPA amendment to § 1121, regardless of how well the bankruptcy case is progressing, bankruptcy courts no longer have any discretion to consider requests for an extension of exclusivity beyond 18 months after the petition date. Accordingly, after 18 months, any party in interest has the ability to file a competing plan of reorganization. The sudden ability of other parties in interest to file a plan of reorganization can have a dramatic effect on the negotiating posture of the competing constituents and significantly alter their negotiating leverage. Moreover, competing plans will likely add further complexity (both procedural and substantive) to the proceedings.

The Tribune bankruptcy case is probably the most prominent example of a post-BAPCPA case that became significantly more complex and protracted following the expiration of the debtors’ exclusivity period. Following the automatic expiration of exclusivity in August 2010, and efforts by a mediator to garner support for a single plan, four plans of reorganization were filed by various creditor groups. And nearly two years after the expiration of exclusivity, Tribune is still in bankruptcy. (Yet to be fair, confirmation hearings are set for next month). See also, Lehman Brothers (three competing plans); Tronox (two competing plans); Meruelo Maddux Properties (three competing plans). All of these cases posed significant procedural challenges after the competing plans were filed, mainly because the Bankruptcy Code is silent as to how competing plans should be presented to the creditor body. Should competing plans be presented to voters simultaneously or sequentially? What processes should govern dissemination of the vast amounts of information associated with competing plans?

Regardless of the outcome of these cases, one question that will remain unanswered is whether such cases would have been more efficiently administered had the bankruptcy court retained the discretion to extend the debtor’s exclusivity period, or whether amended § 1121 compounded the cost and length of the bankruptcy proceedings.

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@uhlaw.com.

TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

noreply@blogger.com (Hunter) — Fri, 18 May 2012 03:30:00 +0000

Before we get to the post: Ira Sohn thoughts/commentary will be posted over the weekend. In the meantime, Jay at MarketFolly has a comprehensive set of notes up. I wrote this on my Twitter feed: John Paulson's idea of the CVI contingent value securities was the most compelling - I'm still doing my research on it. Behind that was Bill Ackman's thesis on JCP: First time I've heard it and I get the premise of the pitch. I am long JCP stock as of yesterday.

To more relevant, distressed business. Contributor Josh Nahas, Principal of Wolf Capital Advisors, and I were speaking today. Earlier this week, the TOUSA decision was overturned by the appellate court. Aurelius, one of the best distressed funds around, benefited greatly on this ruling. This could be one of the more salient stories in distressed debt land this year and no one out there is as good in covering these situations like Josh. Enjoy!

TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

On May 15, 2012 The United States Court of Appeals for the Eleventh Circuit reversed the decision of Judge Alan S. Gold of the U.S. District Court for the Southern District of Florida in the Bankruptcy of homebuilder TOUSA Inc. The Circuit court upheld the previous ruling by the Bankruptcy Court that in fact the financing of the payment to Transeastern Lenders constituted a fraudulent conveyance. The issues in the case have has been closely followed by bankruptcy attorneys, secured lenders and distressed investors as the implications are far reaching, particularly as it relates to rescue financing for companies near insolvency. Link to ruling: http://react.bracewellgiuliani.com/reaction/documents/BasisPointsTousa11thCircuitOpinion.pdf

Not only did the Circuit court uphold the Bankruptcy Court’s finding that a fraudulent conveyance had occurred, but it also found that the Transeatern Lenders were repaid by the proceeds of that fraudulent conveyance and were subject to potential claw back litigation as “initial transferees”. In addition, the court found that the Transeatern Lenders bore some responsibility for diligencing the source of funds that was being used to repay them, and therefore should have known that their repayment was likely the result of a fraudulent transfer.

The distressed community has been split on the issues in TOUSA with most willing to acknowledge that the 2007 financing was highly suspect, while uncomfortable with idea that lenders should be held responsible for diligencing the sources of their repayment. Funds specializing in rescue financing and secured lending, as well as distressed funds who were in the Transeatern Loan, were the most disturbed by the ruling; while distressed investors, and certainly TOUSA’s unsecured bondholders, felt that a line was finally being drawn over perceived corporate maneuvering and asset shuffling prior to a Chapter 11 filing.

As a quick refresh for our readers (see earlier post for more details) TOUSA was a Florida based homebuilder focused on the construction of single-family residences as well as townhomes and condominiums. TOUSA Inc and its subsidiary TOUSA Homes LP had also entered into a JV with Falcone/Ritchie LLC (Transeastern) that was funded by the group of creditors referred to by the court as the “Transeastern Lenders”. However, when the housing market began to turn down, the JV failed.

As a result TOUSA wound up in litigation with lenders to the JV and ultimately agreed to a $420mm settlement. In order to pay for the settlement TOUSA raised a new first and second lien term loan facility. The loan was secured by essentially all of TOUSA’s unencumbered assets including its previously unencumbered subsidiaries, the “Conveying subsidiaries” (the subsidiaries were guarantors on the $700mm revolver). In January 2008, approximately six months after the closing of the new loan, TOUSA and its subsidiaries filed for Chapter 11 Bankruptcy protection. (1)

The Unsecured Creditors Committee (“UCC”) sought to have the new loan avoided as a fraudulent conveyance on behalf of the debtors’ estate and the proceeds paid out to the Transeastern Lenders returned for the benefit of the unsecured creditors. The UCC argued that the Conveying Subsidiaries had not received reasonably equivalent value in exchange for securing the new credit facilities. The unsecured creditors filed litigation to recover the value of said liens from the Transeastern Lenders under section 550(a)(1) of the Bankruptcy Code on the ground that the Transeastern Lenders were the entities to whose benefit the liens had been granted. (2)

Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida agreed with the claims asserted by the unsecured creditors and found that a fraudulent conveyance had indeed occurred. As part of his decision Judge Olson relied heavily on the evidence from the public domain regarding the condition of the housing market, TOUSA’s sagging stock price as well as the public comments of TOUSA executives regarding a potential restructuring that demonstrated the company’s precarious financial situation and called into question the solvency of the debtor prior to the 2007 refinancing.

On appeal Judge Gold heavily criticized the Bankruptcy Court’s reasoning and its reliance on anecdotal evidence and took the unusual step of quashing the bankruptcy courts ruling. Judge Gold found that the Transeatern Lenders had no duty to conduct what he deemed “extraordinary due diligence” and that the Conveying Subsidiaries received reasonably equivalent value. This value was almost entirely attributed to TOUSA avoiding bankruptcy as a result of the Transeatern Lenders being repaid and thus averting a a Chapter 11 filing..

The 11th Circuit disagreed with Judge Gold’s finding and held that a fraudulent transfer had taken place and that lenders should have a duty to conduct some level of due diligence as to the source of their repayment, particularly when the entity is in financial difficulty. While the Circuit court did not address specifically whether reasonably equivalent value was received by the Conveying Subsidiaries and affirmed that avoiding bankruptcy is a source of value, the court found in favor of the Bankruptcy Court’s ruling that the risk assumed by the Conveying Subsidiaries far outweighed the perceived benefits of avoiding bankruptcy.

The Circuit court also addressed the question of whether the Transeatern Lenders constituted initial transferees under section 550(a)(1) of the Bankruptcy Code subject to a clawback of funds as a “subsequent transferee” under section 550(b)(1) which provides for good faith defense against litigation seeking the recovery of funds. Ultimately the court ruled that the Transeastern Lenders met the definition of initial transferees which will likely make them subject to recovery actions by the UCC. The Court has now remanded the case back to the District court to determine what the appropriate remedies should be given that a fraudulent transfer has been ruled to have occurred.(3)

It appears that the Court is not looking to impose unrealistic expectations on all future lenders, nor is it questioning the value attributable to avoiding restructuring. Rather, they seem to be focused on the facts in TOUSA which appear to be particularly egregious and therefore should not be considered standard. Indeed, the Court’s analogy to TOUSA’s demise being more akin to a “slow-moving category 5 hurricane than an unforeseen tsunami.” seems to indicate that debtors will still be able to exercise their best judgment and pre-petition rescue lenders will not routinely be found liable for fraudulent conveyance, despite what opponents to the Bankruptcy Court’s ruling feared it would imply. However, debtors, lenders and their advisors will likely now be more cautious in situations where they are operating near the zone of insolvency.

Given that many distressed investors participate in rescue financing as well as in distressed loans that they believe may be refinanced, there are reasons to be concerned about a ruling that requires investors to diligence the source of funds being used to repay them. Nevertheless, distressed investors routinely find themselves in situations where they feel the debtor is given far too much leeway to maneuver its assets and engage in rescue financing when an orderly restructuring is in the best interests of creditors and is likely inevitable.

The courts both in and out of bankruptcy already provide the debtor with broad latitude in their financial decisions as per the business judgment rule and efforts by distressed investors to negotiate a consensual restructuring are frequently stymied as a result. Dynegy is a good analog for the TOUSA situation and most distressed investors (and the court appointed examiner) would agree that the kind of maneuvering that occurred in that case was disturbing and should be prevented from occurring in the future.

Finally, while potential fraudulent conveyance litigation is not usually the primary driver behind an investment thesis, it is a valuable chip in the negotiations with the debtor and the pre-petition lenders. Had the district court’s ruling stood, distressed investors would have faced an almost insurmountable hurdle in proving a fraudulent conveyance had occurred, and would have lost a valuable leverage point in negotiating with the debtor. Moreover, it would have likely emboldened debtors and their advisors to engage in even more pre-petition maneuvering rather than pursue a meaningful restructuring. Too often creditor value is eroded while management of financially distressed companies pursue unrealistic plans to avoid the inevitable restructuring.

Net/Net while the ruling has some potential negative effects for distressed investors focused on rescue lending or when betting on a distressed piece of paper being refinanced, the ruling itself will likely be a positive for distressed investors. Hopefully it will encourage debtors to engage its creditors in meaningful dialog prior to filing a Chapter 11 and avoid some of the more questionable transactions such as TOUSA, Dynegy and Tribune.

Notes:
(1) Judicial Backlash Adds to Challenges Faced by Lenders. Edward Estrada, Reed Smith. The Journal Of Corporate Renewal, July/August 2010
(2) Eleventh Circuit Upholds Bankruptcy Court’s Fraudulent Transfer Ruling in TOUSA Debra Dandeneau. Weil Bankruptcy Blog, MAY 16, 2012 http://business-finance-restructuring.weil.com/fraudulent-transfers/eleventh-circuit-upholds-bankruptcy-courts-fraudulent-transfer-ruling-in-tousa/#axzz1vANZnoP5

Distressed Debt: Rescap

noreply@blogger.com (Hunter) — Wed, 16 May 2012 05:43:00 +0000

Yesterday, May 14th, 2012, Rescap filed for bankruptcy in the Southern District of New York (Case No. 12-12020). The Honorable Judge Martin Glenn will be overseeing the proceedings. Currently the markets on Rescap look like this:

Recovery: 22-23.5
CDS: 76.5-77.5
9.625% Bonds: 95-96
Senior Unsecured Bonds: 22-24

For those interested in tracking the docket, you can find it here:

Rescap Docket

Rescap has been a name debated and discussed in distressed circles for as long as I can remember. I remember investment banks talking about it at their distressed conferences before the crisis. It has an interesting history that we will get to shortly. The good ole days when GMAC was called GMAC.

Rescap is the 5th largest servicer of residential mortgage loans in the United States behind the likes of BofA, JPM, Wells, and CitiMortgage. Rescap and non debtor but affiliated Ally (AFI) are the 10th largest originator or mortgages in the country. The bankruptcy plans lays it out pretty clearly: They will be selling down the assets and the assets they cannot sell will be run-off/wound down over time.

The corporate structure chart here is simply fantastic. It spans 6 pages which I've reproduced, into one Frankenstein sort of job with my MS Paint skills:

Exhibit 7 in the First Day Affidavit shows the history of Rescap and Ally Financial, now 74% owned by the U.S. government, from 2007 until the petition date. Its a fascinating read. Interesting fact: "Since January 1, 2007, AFI has made capital contributions of approximately $10.3 billion to ResCap."

For those that have not seen the Houlihan Valuation here are the salient components. First the assets that are pledged to the Ally Secured Facility the the Junior Secured Notes:

And the waterfall with footprints in text below:

The takeaway: According to this analysis, Total recovery to the 3rd lien notes is 105% with 12 points coming from an unsecured deficiency claim which is based on an assumption of:

$600M admin and priority claims
$9B of contingent liability claims (reps and warranties) -> Higher than the market was thinking
$1.4B of other general unsecured claims

Bloomberg reports that noteholders of the the 3rd lien include Paulson & Co and Appaloosa Management. It has also been reported that Berkshire owns a substantial amount of Rescap debt across the structure and over the past few years, many reports have surfaced that Berkshire was interested in purchasing parts (or possibly all) of ResCap.

On the Ally conference call today, Ally CEO Michael Carpenter stated:

In addition, ResCap entered into a comprehensive settlement agreement between Ally and ResCap that is subject to confirmation by the bankruptcy court. I'll get into it in a bit more detail in a minute, but importantly it contains provisions to release Ally both from theoretical claims from ResCap and third-party claims.

For years people have been talking about the ability for Rescap to bring down Ally (in fact the GMAC ring fence originially was designed to protect Rescap from GMAC believe it or not). Carpenter goes on to say:

The settlement agreement, which is subject to court approval, what it provides for Ally is first of all, the release of all claims between Ally and ResCap. Let me touch on that for a minute. Those of you who've heard me talk about two or three times have heard me repeatedly say, Ally and ResCap are two separate companies.

And ResCap's separability is ensured by the fact that historically it's been an SEC registrant, and the disclosures associated with that, but it has the Board of Directors with independent member. There are operating agreements that the various contractual contracts between, having to do with the servicing business are clearly contracts with ResCap not with Ally. And for all these and many other reasons, we believe that the liabilities of ResCap do not penetrate to Ally.

A number of questions followed on the legacy liability issues and how it relates to Ally.

What I think you'll see here is the unsecured bonds continue to leak after technical with the CDS auction and funds unwinding their basis packages (long protection, long cash) correct themselves and then you'll get litigation focused funds coming in (if they already not have) and trying to buy as many bonds as possible in a Tribune like trade. Think the argument goes, Rescap sold Ally these assets:

Health Care Finance Business
Resort Finance Business
Canadian Lending Operation
IB Finance
US and UK broker-deal operations

And Cerberus these assets:

Model Home Finance Business
Securities backed from Freddie / Fannie

as well as its ownership of Ally Bank moving to AFI. And in exchange it didn't get reasonably equivalent value. The look back period might be the only thing saving AFI here. I remember quite often the term coercive exchange being thrown around as well which can't really help anyone's case.

Let's think about the incentives here: Ally wants to do its IPO for various reasons. US Gov't wants to get paid back. Minority equity holders want liquidity. Management is probably getting a bonus if they do it. The discovery process to investigate these claims going back a number of years will take lots and lots and lots of time and money. And given that that class is ~$1 billion a 10 point tip would only be $100M relative to Ally's balance sheet which is many many times larger.

The unsecured bonds here have always been illiquid with legacy holders that did not participate in the coervice exchanges as well as basis package players. The bonds traded at 50 +/- 10 points at the beginning of the year. At 10 point tip there is only a 20% boost. A 10 point tip on a bond priced in the teens / 20 is much more appealing. In addition, you have the optionality in the reps and warranties claim coming in markedly lower than being forecasted today.

I've been asking around to see if any of the unsecured bond holders have started organizing or talking; if you hear anything, let me know.

2012 Ira Sohn: Follow us on Twitter for Real Time Updates

noreply@blogger.com (Hunter) — Wed, 16 May 2012 01:03:00 +0000

We want to give readers an update on our post last week on the 2012 Ira Sohn Conference. The conference is tomorrow and there is still time to register. This is an amazing cause. I hope you all consider attending. Here is the link to the conference registration.

A quick update: Distressed Debt Investing will be at the Ira Sohn Conference tomorrow taking diligent notes which we will post later in the week. If you want to follow us real time, we will be on Twitter, where I will be posting live updates on recommendations by the fantastic group of speakers.

Follow us: @DDInvesting

Lightsquared Files for Bankruptcy

noreply@blogger.com (Hunter) — Tue, 15 May 2012 02:47:00 +0000

Editor Note: I will be writing a post on Ally / Rescap tomorrow, Tuesday the 15th after the Ally call. At the end of the day, the 3rd lien 9.625% went out 94-95, down 4-5 points. I will also be writing a post this week, in a new template, for Houghton Mifflin.

Today, LightSquared Inc. ("LightSquared" or "the Company") and 19 of its subsidiaries filed for bankruptcy in the Southern District of New York (12-12080). As most are aware, LightSquared is the spectrum play of Phil Falcone's Harbinger Capital, which recently represented a large portion of Harbinger's assets.

For those interested, the docket (via the claims agent site) can be found here: LightSquared Docket. The Term Loan went out 67-68.5 (flat) at the end of the day. The bank debt has rallied as of late on news reports that Charles Ergen, owner of DISH Network, had purchased a substantial amount of bank debt in the name.

Some interesting points of reference from the First Day Declaration of CFO Marc Montagner:

From 2001 to today, LightSquared has invested approximately $4 billion of funds in its wireless network business plan (4G LTE open wireless broadband network)
Significant discussion of working with GPS industry and the subsequent issues with interference (that has also widely been reported in the press): "As it had done in all previous situations, LightSquared offered to work with the various governmental agencies and the GPS industry to rectify these issues and to expend significant resources in aid thereof. Unlike all previous situations, however, the GPS industry refused to compromise with LightSquared and instead sought to convince regulatory agencies to strip LightSquared of its ability to use its allocated spectrum for terrestrial purposes"
All parties, including LightSquared are awaiting an FCC decision, after a public comment period, for LightSquared's ability to use its spectrum for terrestrial purposes
LightSquared has cut 1/2 of its employees and reduced burn by 30%
Looks like there was an attempt at an out of court restructuring that went awry and LightSquared was forced to file Chapter 11
Here is the corporate structure:

LightSquared has deployed two of the most powerful mobile satellites ever constructed
Three lines of business 1) MSAT: Mobile Satellite Communications or the wholesale service [push to talk included] 2) MDS: Mobile Data Services. "low rate data service offering primarily used for applications such as fleet and load management, email, vehicle tracking, two-way messaging and broadcast messaging and 3) PNC: Private Network Carrier. Leasing bandwidth for custom satellite data solutions.
The play all along was that the proliferation of mobile would overwhelm the needs of current carrier's spectrums and LightSquared would save the day by providing their own 4G LTE network.
$2.3B of liabilities as of the February 29th. Book value is listed at $4.48B
Spectrum breakdown is given
Capital Structure: LightSquared Inc Facility: $278.8M allegedly secured by a first-priority security interest in (a) the One Dot Six Lease, (b) the capital stock of each Prepetition Inc. Subsidiary Guarantor (i.e., One Dot Four Corp., One Dot Six Corp. and One Dot Six TVCC Corp.). This facility is owned by Harbinger and there is $322M outstanding as of the petitoin date. LightSquared LP Facility of $1.5B. Amounts outstanding under the Prepetition LP Credit Facility are allegedly secured by a first-priority security interest in (a) substantially all of the assets of LightSquared LP and the Prepetition LP Subsidiary Guarantors, (b) the equity interests of LightSquared LP and the Prepetition LP Parent Guarantors (except LightSquared Inc.), (c) the equity interests of the Prepetition LP Subsidiary Guarantors and (d) the rights of LightSquared Inc. under and arising out of the Inmarsat Cooperation Agreement. As of the petition date, $1.7B of this facility was outstanding.

More details related to the history of the Company and the discussions with prepetition lenders, as well as first day motions follow. On Schedule 1 of the document, the list of Ad-Hoc Secured Group of Prepetition LP Lenders (represented by White & Case) were listed as:

Appaloosa Management
Capital Research
Fortress
Knighthead
Redwood Capital

Some of the most prominent distressed investors out there. LightSquared is being represented by Milbank with Moelis and Alvarez Marsal as their FAs. Harbinger is being represented by Weil Gotshal.

Docket #13 discusses adequate protection for prepetition secured parties. The document states that each prepetition secured party is "protected by an equity cushion" but in exchange for diminution of value in respects of the cash collateral, they will be given replacement liens, superpriority claims, and reimbursement of fees and expenses.

Further on in the document there is discussions on the value of LightSquared:

"As the Debtors’ advisors will attest at the Interim Hearing, in these Chapter 11 Cases, the Prepetition Inc. Lenders are sufficiently protected by an equity cushion of 33% at the low end and 63% at the high end. As the Debtors’ advisors will further attest at the Interim Hearing, the Prepetition LP Lenders are also sufficiently protected by an equity cushion of 68% at the low end and 82% at the high end. Both equity cushions are significantly above the amount typically found satisfactory by courts in this and other districts."

What is the LightSquared pre-petition debt worth? I mean - that's nearly impossible to answer without further clarity on the FCC issue. If FCC clears the way, the spectrum could be worth a significant amount, especially considering Sprint doesn't hold a blocking position anymore since it terminated its agreement with LightSquared in March of this year. With 51MHz of terrestrial and LBand ATC spectrum the value could be tremendous for players looking to hole up capacity on their networks. But if terrestrial is not in the cards, value would be significantly less simply for the amount of customers using the service.

The presence of DISH network and its savvy chairman Charles Ergen has gotten more people talking about this name in the past week. If you remember, DISH was involved in the DBSD North America and Terrestar bankruptcies in the past few years (both S-band, 2 GHz). For the wireless mavens out there, we have known for some time that the S-band has no know interference issues markedly different than the L-band.

Assets here: Satellites (one still needing to be launched) and a lot of spectrum which could be worth very little or a lot more. It looks like the majority of the spectrum is at LightSquared LP and SkyTerra (Canada), [which is 100% owned by Lightsquared LP]. At 70 cents on the dollar against $1.7B outstanding for the LP facility = lenders valuing LP at $1.2B. If you assume that without FCC approval of terrestrial use the spectrum is worth $0.05 MHz/pop, it looks like the market is given a decent probability that the FCC allows L Band spectrum use as originally intended by LightSquared which would then sell this spectrum at a significantly higher valuation than $0.05 MHz/pop.

This is a fascinating situation, and we will try to keep you updated especially once the FA's report on the equity cushion comes to light.

The best quotes from Oaktree's first conference call

noreply@blogger.com (Hunter) — Fri, 11 May 2012 01:59:00 +0000

Today, Howard Marks and other executives from Oak Capital held their first conference call since going public a few weeks ago. Much has been talked about the company since its IPO including a number of prominent funds disclosing ownership in the name including the Davis Funds, Maverick Capital, Scoggin, and Greenlight Capital just to name a few (some owning the equity when it traded on Goldman Sach's private exchange). The call was quite comprehensive, kicked off by Howard Marks discussing Oaktree's strategy and his thoughts on the market (my emphasis added):

In terms of the investing environment, I would characterize this as a relatively normal period. Having said that, I must say it makes me think of the guy who has his head in the freezer and his feet in the oven and, on average, feels okay. Today, the good news consist of the gradual recovery of the U.S. economy, as well as generally moderate asset prices and moderate investor psychology.

On the other hand, there are plenty of things to worry about in the macro and secular sense, including the outlook for the competitiveness of the developed world, economic growth, political leadership, deficits in debt, most immediately in Europe; and China's ability to hopefully slow its growth.

At Oaktree, we think of the market in terms of a pendulum that swings back and forth over time between unbounded optimism and limitless pessimism, and that's between prices which are too high and prices which are too low. Today we think we're in the middle of that range. We see good opportunities for most of our strategies, particularly in real estate and European distress for control. But on the other hand, distressed opportunities in the U.S. are less abundant.

As is normal for this point in the cycle, we're focused on the areas of the economy that are showing weakness. But we also are taking advantage of the more generous capital markets to exit investments and realize profits, particularly in the area of distress debt, where as of tomorrow we will have already distributed 94% of the drawn capital of Opps VIIb, our height of the crisis fund that only entered its liquidation period a year ago. But in our control funds, most of our portfolio companies are performing well and we see no need to rush realizations at anything less than full prices.

So, net/net:

Fairly valued market (pendulum in the 'neutral' state)
Cheap assets: Real estate & European distress for control
Overvalued asset: Distressed opportunities in the U.S.

I think this is a consensus among those on the buy side focused on domestic opportunities in credit and distressed. At the end of the day there's really not a ton to look at here in the United States, but valuations aren't WILDLY stretched to get ultimately bearish. Professional, I do not have a mandate to invest outside the U.S. One thing I've wanted to do for over a year now is get two writers that focus on international distressed opportunities to fill in that gap. If you are interested, contact me.

Next, CFO David Kirchheimer laid out some of the more technical aspects of Oaktree's disclosures. An interesting point that was made here is that they account for their 22% stake in Jeffrey Gundlach's DoubleLine Capital at only $19 million (assuming that's what they gave him for working capital). Obviously that is worth far more than that today.

John Frank, Managing Principal, then discussed current opportunities and fund raising efforts. On speaking about the strength of the market for SELLING their portfolio investments, this was a fantastic quote:

"Generally we seek to avoid buying in auctions, but we're delighted to sell through them."

Pin that one on your desk. In terms of real estate, it looks like Oaktree is doing many different things including things like commercial and land construction loans from banks in the FDIC at an average of 39 cents on the dollar. He also said that they are buying the equity of North America's larges private home builder (not sure the name). Outside of real estate, they are also launching a senior loan product that looks to be levered (TRS?).

Moving to the Q/A, some interesting takeaways:

They have a little of $12 billion of dry powder ready to invest if markets get shaky
They were buying positions coming out of some of the European banks and are involved with the Fitness First restructuring
Great quote from Marks: "We don't believe in predicting the future and we especially have – if we have an inkling of what's going to happen, we never know when. So, as we sit here today, we continue to believe that real estate will provide opportunities. And we believe that one of these days, Europe and U.S. corporate distress will provide the opportunities that we've been raising money for. But none – nobody at Oaktree is going to predict that it's going to happen at any given point in time, or is going to assert unqualifiedly that it's going to happen."
John Frank on their European operation:

"And a lot of what you read in the press is that the European banks, we all know the European banks have huge issues. And the, sort of, word on the street seems to be that the banks are going to become, to spew out this distress debt. In fact, we've not seen that to a huge degree. We've seen some of it. We haven't seen a lot of it.

So what our group in Europe is doing is working, really on a company level. There are particular companies that they follow. They have a war room where they have track a large number of companies quarter-to-quarter. And what they, the opportunity that they see is that the European banks, while they may not be willing to divest their bad loans at a low rate, what they aren't willing to do, and don't have an ability to do, is to put new money into situations.

So what our group is focused on are situations where companies have actual cash needs, have actual maturities that they have to meet or actual cash flow demands that they have to satisfy, and are in need of new capital. And our group works actively with the existing managements, with unions as necessary, with other community groups, to craft an overall solution."

And one final quote from Marks, that I think sums up his thoughts on the credit markets: "I think that I would say that the secondary markets are healthy but not gaga. You can get deals done, it's not land office business, but it's very healthy I think. And when I talked about moderate psychology, I mean there's a desire to put money to work, but there's also some skepticism, which – and I think that, that balance is healthy. So I would describe the credit markets as healthy."

Fantastic call. As always, its amazing to hear from the one of the world's greatest investors and a legend in the distressed community.

Distressed Debt Weekly Links of Interest

noreply@blogger.com (Hunter) — Sat, 05 May 2012 14:56:00 +0000

Here's what we are reading this weekend at Distressed Debt Investing

A new blog I found this week: The Brooklyn Investor: Very sharp, and impressive commentary, and a recent post on a negative stub value trade at HRG [The Brooklyn Investor]

David Einhorn is getting long Howard Marks [Market Folly]

An comprehensive guide on understanding proxy statements [Old School Value]

Another stub trade thesis recommending a long trade in Loews Corp [Value Uncovered]

Another new blog I stumbled upon that is putting out detailed notes of Peter Thiel's Startup Class at Stanford [Blake Master]

Editor Note: I am working on a Hawker post and hope to get it up tomorrow (Sunday). Have a great weekend.

2012 Ira Sohn Conference and Investment Idea Competition

noreply@blogger.com (Hunter) — Fri, 04 May 2012 01:28:00 +0000

On May 16th, the Ira Sohn Conference Foundation will hold its 17th annual Investment Conference with (as usual) an amazing list of speakers including:

Bill Ackman - Pershing Square
Dwight Anderson - Ospraie Management
Dan Ariely - Author of Predictably Irrational
David Einhorn - Greenlight Capital
Jeffrey Gundlach - DoubleLine Capital
Jonathan Kolatch - Redwood Capital
Philippe Laffont - Coatue Management
John Lykouretzos - Hoplite
Steve Mandel - Lone Pine Capital
John Paulson - Paulson & Co
Larry Robbins - Glenview Capital
Kenneth Rogoff - Harvard Professor
John Wilder - Bluescape Resources (former TXU CEO)
Meryl Witmer - Eagle Capital
And remarks by Michael Price

For those that have not attended an Ira Sohn Investment Conference in the past: It is simply an outstanding event for a wonderful cause. The Foundation, named after Ira Sohn who died of too early of cancer at the age of 29, uses its resources and fundraising to contribute to causes that move forward finding a cure for pediatric cancers as well as helping the lives of children (and their families) afflicted by these diseases. Recipients of grants and funding include New York-Presbyterian Hospital, Memorial Sloan-Kettering Cancer Center, a fellowship in Pediatric Oncology at Cornell Medical School, etc. To date, the conference has raised $20 million.

I highly recommend the event to all investment professionals that can attend. Not just for the amazing investment idea and pitches you will hear (it is one of the most educational experiences you'll have in your life - hearing the best of the best pitch their investment ideas) but also for a tremendous cause. For more information, please visit their homepage at: The Sohn Research Conference

Like last year, the Foundation will be conducting an Investment Idea Contest. The winner of the conference will present the winning idea in a ten minute presentation at the Sohn Conference. Judges includes Michael Price, Bill Ackman, David Einhorn, Joel Greenblatt, and Seth Klarman. Each of the 4 semi-finalist and finalist will receive two tickets to the conference.

Investment idea entries are due by next Wednesday, May 9th. I have been working on my idea and hope all readers will apply (all entry fees also go to the Ira Sohn Foundation). To learn more about the investment idea competition please visit the Ira Sohn Investment Competition and the Official Rules

Hope to see each of you there!

On Paradigm Shifts

noreply@blogger.com (Hunter) — Wed, 02 May 2012 03:14:00 +0000

Yesterday it was announced that Microsoft would make a strategic investment in Barnes and Noble's digital and college assets as part of Newco subsidiary. MSFT's $300M investment, for 17.6% of the entity, would value Newco as $1.7B, meaning BKS' stake would be worth $1.4B. Prior to the announcement , Barnes and Noble boasted a market cap of $825M. Obviously someone was wrong here.

A week before, a someone wrote of BKS on the Value Investor's Club. The write-up made a lot of sense, breaking down a sum of parts valuation of the enterprise. The argument had been made before: BKS is worth more broken up. But investors, as expressed by a short ratio of 50% of the flat held the viewpoint that BKS was the next Border's Group - a dying hard line retailer exposed to digital penetration of its main product. The thought that someone would value the the Nook business and college business at $1.7B would be implausible to these people.

I just got off the phone with a good friend of mine. We had a discussion whether, over the long term, being able to predict earnings beats / misses makes one a good investor. Maybe in the short run, especially those with acute trading skills. More importantly I postulated, being a good investor, in the long run, has a lot to do with spotting paradigm shifts. That's how you make 2x, 3x, 5x, 10x on your money. You don't make that sort of money on predicting whether MSFT will beat this quarter or the next.

At work, on my desk, I have Charlie Munger's quote laid out, smack in my face: "Invert. Always Invert." A thought experiment I like try with friends, interview candidates, or just passing the time: Come up with the long thesis for the highest short interests S&P 500 stocks out there. Currently that list includes:

Washington Post
RR Donnelley
Game Stop
Pitney Bowes
Frontier
Harris
Avalonbay
Federated Investors
Borgwarner
Plum Creek Timber

Let's take AvalonBay. AVB is up 20% in the past year driven by increasing rents in the high end apartment space. The short thesis (plural) is pretty well understood:

Rent growth is going to crack (for whatever reason) which will cause its trading multiples to collapse
Along the similar lines, their large development pipeline will not translate into the growth the sell side is expecting putting pressures on multiples
Its dividend yield is too low for a REIT. Higher interest rates will put pressure on the company from yield seeking investors

Let's invert these:

Rent growth is going accelerate which will cause trading multiples to expand
Their large development pipeline is not fully reflected in the price and multiples should expand
Interest rates will stay low for a significant amount of time and AVB is in a position to expand its dividend through FFO growth

Are any of these three situations 100% out of the question? Absolutely not. Do I believe they will happen? Me? Personally I do not. But I understand the rationale one way or the other and I can better size my position given the upside or downside potential in the 3 bearish cases and 3 bullish cases.

From an investment standpoint, the less your paradigm shift is accepted by the marketplace, the more money that can be made from that viewpoint. One of the most lucrative paradigm shifts in the past 5 years was that Chinese RTOs are, more often that not, frauds. While you had a few people here and there in the very early years question the legitimacy of these companies, the general consensus (look at old Seeking Alpha posts) were these were thriving businesses. A paradigm shift is really a switch from an accepted, mainstream call, to one that is contrarian in nature.

Why does a contrarian make the most money in the market? Because, believe it or not, it is the path of least resistance. Think of a spring. A spring is an amazing, amazing analogy for valuation. As you extend a string further from its neutral position, it gets harder and harder to pull it further until the spring just will not uncoil anymore. Just so, like in valuation, as valuations become more and more stretched, valuations just cannot go any further. And because of this, the contrarian doesn't have to be as right as much as his counterparts who play for singles. He can have a few 3 or 4 or 5 baggers, which come from a contrarian outlook, make up for many "small" wins.

I think another interesting example are the coal names. During the M&A flurry, coal names traded at a hefty, hefty multiple for such a cyclical business. To make 100% of your money from those levels would be disastrously hard. But today? ANR is flirting with an all time low in an environment where people could not hate coal more. If, or better yet, when coal normalizes, a 100% return would be a lazy Thursday.

Of course, being contrarian to just be a contrarian is a fool's errand. It espouses circular logic that inevitable would lead an investor to ruin as bad companies, inevitable cheap, do file, go away, and an investor is left with a permanent loss of capital. This is where concepts like investing in clean balance sheets or high up in the capital structure come into play because your chance of a good egg drops precipitously. Of course the 2-3-4 baggers become 1.5-2x investments but in the long run an investor that can turn out 50% on investments with limiting the zeros will far and away crush his competition.

Instead of thinking, "How are my EPS projections different than the Street's this quarter" think "In 3/5/10 years the general consensus is this company will be X. I think it will be Y". X could range the gamut from bankrupt to taking over the world. X will be priced in. Y is not priced in and the more radical, less accepted your vision is, the more money you can make off the investment.

Think about this next time you read a 10K and make a snap judgement about an investment. Try to argue both the bull and the bear thesis. This will make you a dynamic investor that can make money over the long run in any investing environment.

Booth's Distressed Investing and Restructuring Notes

noreply@blogger.com (Hunter) — Thu, 26 Apr 2012 12:44:00 +0000

On April 13th, Chicago Booth held its 7th Annual Distressed Investing and Restructuring Conference. The organizers of the event have graciously provided us extensive notes for the conference which we've laid out below. I heard it was an amazing event from many readers. Enjoy!

Opening Keynote Speaker: James Grant, Founder, Grant’s Interest Rate Observer

Mr. Grant began by addressing Ben Bernanke’s March 20, 2012 lecture at George Washington, where the Federal Reserve Chairman blasted the Gold Standard.
Mr. Grant expressed his thoughts that Distressed Investors were likely a much better group to efficiently allocate capital to the Banking Sector during the crisis than was the Federal Government. However, in a pinch, there is very little the Fed will not do to “save” us as illustrated by the $2 Trillion dollars it created out of thin air.
Bernanke’s Fed has defined price stability as a positive rate of inflation; less than 2% would be deflation. Mr. Grant pointed out that if Bernanke is a historian he is not the kind that reads and writes history. Milton Friedman, in his study of the last quarter of the 19th century, showed that price levels decreased between 1 and 1.5% while the economy experienced the greater technological advancements than any previous 25 year period in history. Nevertheless, Bernanke seams unaware of the benefits of creative destruction and bargains (value/distressed investment opportunities). Mr. Grant illustrated this point (Creative Destruction) by referencing the opening of the Suez Canal, which caused certain economist in London to wonder if they should have filled “the thing” up with dirt as it rendered storage related segments of the London economy irrelevant.
Continuing his point on how the Federal Government allocated capital differently than a distressed investor would have, Mr. Grant mentioned that during the last quarter of 2008 TALF lent money at a rate of 1% during the same time period that banks were lending to each other at 3.5%; Morgan Stanley borrowed $100+ billion, which was much higher than its market cap.
Mr. Grant is convinced that the Fed (Ben Bernanke) does not fully understand the markets or the crisis. The statement that “the only solution is for regulators to monitor all financial institutions” is horrible; historically banks did not only take risks but they bore those risks as well.
Mr. Grant’s final comments addressed the possible consequences of suppressed interest rates as he expressed his believe that Bernanke is wearing interest rate “Beer Goggles”. He likened the current regulatory situation to the Seaman’s Act of March 1915, which set new requirements for lifeboats and was drafted in reaction to the Titanic disaster. On July 24, 1915 the SS Eastland, a passenger ship, due to the additional weight burden of the Seaman’s Act mandated lifeboats, rolled over while tied to a dock in the Chicago River killing 844 passengers and crew members. Our new crisis engendered policy response financial regulations will have negative consequences. Similar to the Seaman’s Act of 1915, the risks associated with these regulations were not incorporated in the thought processes that ultimately lead to their creation.

Legal Panel: Sponsored by Davies Polk & Wardwell LLP

Moderator: Donald Bernstein, Davis Polk & Wardwell LLP

Panelists:
Douglas Baird, University of Chicago Law School
Anup Sathy, Kirkland & Ellis LLP
Damian Schaible, Davis Polk & Wardwell LLP
Eugene R. Wedoff, United States Bankruptcy Judge, District of Northern Illinois

The legal panel discussed three primary topics: (1) Credit Bidding, (2) Insider Trading, and (3) Regulatory Licenses as Collateral

Credit Bidding:

After a court’s decision on the value of a claim, the creditor may still receive more than the ruling amount in the event of an asset sell.
Credit bidding, the ability for a creditor to bid their debt with their cash alongside bidders that only bid cash, may be eliminated by the courts; 7th Circuit River Road Hotel case.
Panel Consensus -> Credit bidding should remain an option as: an all cash bid may not be possible for a cash strapped firm, bidders have the right to finance however they would like (credit bidding is self-financing), creditor syndicates have mixed financial backgrounds and should have financial flexibility to better coordinate, government entities may have no other way to bid due to the inability to raise fund.
In regards to the bidding structure, Judge Wedoff discussed the issue of eliminating some of the bidders from the auction. However, doing this would create a non-market price.

Insider Trading:

Borrower provided non-public information used inappropriately can lead to a firm’s claim being eliminated following the infraction
There are contracts that allow all parties to trade after the fact as they demand that the firm publically release all information that the insiders had access to during the restructuring/stressed situation.
Some firms have come in and out of blackout periods to trade. However, judicial decisions indicate judges’ inpatients with investors who have done this. Also, firms with the same information have made very different (sometimes offsetting) investment decisions signaling that insider information may not always provide an investing edge.
Some firms have chosen to hire a trusted third party to act on their behalf’s so they may remain able to trade the name in the market. One panelist expressed doubt in this solution due to its potential principal/agent issues.

Regulatory Licenses as Collateral (licenses and air travel):

When you have a regulatory asset that cannot be sold, can you use the economic benefits associated with those assets (licenses)?
FCC licenses cannot be sold. However, a lien can be levered on the income that can be generated from the license. As a firm cannot pledge the license the question is can a firm pledge the proceeds associated with the license? A case in Colorado concerning an FM station received a court ruling of “no” to the question citing that (1) the license has not been sold and (2) all licenses must be approved by the FCC.
One panelist vocalized the believe that the Colorado Court should have ruled differently and cited joint venture corporations that have similar structures and economics (Southern District of New York upheld this argument). Judge Wedoff believes that in such a scenario you would not be able to enforce the lien. However, the world loves “work-arounds” and in reality licenses can be placed in SPVs that can than pledge the economic value.
Can Slots (the right to take off and land during certain times), Gates (where passangers board and un-board), and Routes (flight paths into airports, which are limited) be pledged as assets?
Bonds have been issued that were secured by Slots, Gates, and Routes. The American Airline Case will eventually tell us if they can be posted as collateral. However, as one panelist stated, gates are likely a canard while slots and routes may be ruled as regulatory licenses (proceeds may be pledged but not the licenses).

KEYNOTE SPEAKER: Jonathan Lavine, Managing Partner & Chief Investment Officer, Sankaty Advisors, LLC

Distressed investors should constantly run their decision trees to located and evaluate potential opportunities. Distressed companies and distressed sellers provide compelling opportunities. A retailer CFO stated “the availability of money is more important than the cost of money”. This means high returns may be extracted from supplying liquidity to an illiquid situation. Firms that never go bankrupt can provide compelling investments; bank debt (leverage loans) outperformed junior debt during the recession.
An investors decision trees should include the following questions: how healthy is the industry, does anyone care if the company disappears. Ask yourself what must you as an investor need to believe; will anyone care about the displaced industry (horse buggies) when new technologies are introduced to the market (Ford’s Model T)?
Why do firms go bankrupt? (1) liquidity crisis (but good company),(2) insolvent (bad capital structure with viable business model), (3) unviable (bad business model). Typically defaults peak 18 to 30 months after peak issuance.
The biggest mistake a distressed investor can make is assuming that tomorrow the world will be like it was yesterday. Tomorrow the world may be as it was 10 years ago or it could be in a state we have never seen before.
ETF’s may provide fire sell opportunities. Global macro factors, such as Chinese inflation, may provide opportunities as well. If Chinese labor prices rise while our income is fixed, higher prices at Walmart would mean we are importing Chinese inflation, which could engender distressed opportunities.
Sankaty is looking at what the elections in the US & France (and elsewhere), sovereign balance sheet leverage, commodity price increase (oil, gold, etc), financial oppression, and the drop in natural gas prices may do to asset valuations.

Restructuring Case Study: TerraStar Networks. Sponsored by The Blackstone Group

Moderator: Steve Zelin, Senior Managing Director, The Blackstone Group

Panelists:
C.J. Brown, Managing Director, The Blackstone Groupl
Douglas Brandon, General Counsel, TerrStar Networks
Rachel Strickland, Partner, Willkie Farr & Gallagher LLP
Arik Preis, Partner, Akin Gump Strauss Hauer & Feld LLP

Terra Star was formed to take advantage of terrestrial networks by filing the gaps of land line based cell coverage. After bankruptcy the strategy was to hold its FCC license for as long as possible as it would likely have significant value.
An auction was executed with 75 non-disclosure agreements sent out to extract the most value from the asset. However, only 3 non-disclosure agreements were returned signed.
The auction was a naked auction (no leader to provide a starting bid amount), which can lead to very small bid amounts. In this case, the result was a successful bid of 22 cents on the dollar for assets that proved to be worth roughly 60 cents. Thus, the return was ultimately about 300%.
Collective action proved difficult in this case due to the classic problem of concentrated benefits and defused costs. At the end of the day, only one company was willing to put up the money and was rewarded handsomely.

Investment Banking Panel. Sponsored by Peter J. Solomon Company

Moderator: Nat Gregory, Professor, University of Chicago Booth School of Business

Panelists:
Dan Aronson, Lazard
Mona Baruah, Rothschild
John McKena, Miller Buckfire
Durc Savini, Peter J. Solomon Company

Bankruptcy court damages businesses, is costly, and very contentious. However, to resolve the issues out of court you need 100% consent and many times you will have a hold out problem.
Pre-packaged bankruptcy is fully negotiated and is documented whereas a pre-negotiated deal does not solicit votes.
Every year since the onset of the financial crisis there has been an increase in pre-packaged bankruptcies, while restructurings have trended down. The substitution away from full restructuring is in large part due to time constraints and the interruptions restructurings force onto businesses.
Chapter 11 equates to spending a lot of money and to conserve value and prevent a bankruptcy free fall it is better to avoid this scenario. However, in a constrained DIP situation the bank controls everything and liquidity is not available for middle markets companies due to Dodd-Frank.
A good business with a bad capital structure is a strong candidate for a pre-packaged deal. However, a pre-packaged bankruptcy may take two months so if you are cash strapped you may not be able to afford this option.
The success of any deal depends heavily on intrapersonal skills, ensuring that participants actually own the bonds and have the power to make the deal. No party wants to receive the worst deal and everyone wants the best deal while no insider information may be used to make the deal (if the deal sours all information must be made public).
SEC is very strict on the details; real non-copied signatures, no faxes, hard deadlines, etc
Loan to own investors may be good for situations where time is very valuable as they will get things done, which protects against a bankruptcy free fall. However, these investors do not always maximize value.

Distressed Investing Panel

Moderator: David Small, Grosvenor Capital Management

Panelists:
Matt Dundon, Pine River Capital Management
James Ganley, Carval Investors
Kathleen Steele, Zell Credit Opportunities Fund

Each member of the panel presented a specific distressed investment example that their respective firm’s participated (is participating) in. The discussion included a broad walk through of these investments with focus on the key issues associated with each opportunity.
An electric generation company in Boston was discussed broadly with an emphasis on a few points. Predicting the fulcrum security is crucial as is avoiding the loss (management selling) of assets that are crucial to post distressed value realization.
A national moving company was also discussed. The company had an interesting dynamic in that it also provided executive relocations services, which included home sells. These homes were being put back to the company in significant numbers due to a lack of enforcements of agreements that would have dramatically reduced the number of company owned homes on the balance sheet. Systematically reducing the number of homes on the balance sheet through agreement enforcement meaningfully improved the firm’s credit profile as did other operational and procedural changes.
The panel was optimistic about continued opportunities in the distressed space but insisted that relationships and the ability to move into different sectors when necessary is crucial to gaining access to the most attractive deals.

The Supreme Court Hears Arguments on Credit Bidding

noreply@blogger.com (Hunter) — Wed, 25 Apr 2012 02:15:00 +0000

On April 23rd, the Supreme Court (SCOTUS) heard oral arguments on the issue of credit bidding that has been discussed on Distressed Debt Investing a number of times: Credit Bidding and the Supreme Court and Advanced Distressed Debt Lessons: Credit Bidding. Credit bidding is relevant to distressed debt investors for a number of reasons and can swing who gets what (most importantly, the fulcrum security) in a Chapter 11 proceeding. With the contrary rulings in the Seventh Circuit as compared to the Fifth Circuit and Third Circuit (probably the most famous for distressed investors: Philly News), it was a matter of time before SCOTUS took the issue up. Some have called this the most important business bankruptcy case in nearly 15 years.

For those that would like to see the transcript of the hearing, which is a fascinating (but complex) reading, can find it here: SCOTUS Hearing Transcript re Credit Bidding

The case at issue specifically in from of the Court is RadLax Gateway Hotel, LLC v Amalgamated Bank. In the case the Seventh Circuit ruled with Amalgamated Bank that River Road bankruptcy case (Northern District of Illinois) could not be confirmed because it did not allow Amalgamated Bank to credit bid its claim. River Road argued that because Amalgamated Bank was receiving "indubitable equivalent" value of its collateral (a term not defined in the code) it did not need to be allowed to credit bid. The bankruptcy court shot this down quickly. The Debtors appealed and the Seventh Circuit ruled with the bankruptcy court, specifically pointing out in their ruling they disagreed with the rulings in the Fifth and Third Circuit.

For those that do not know, an amicus brief is information offered to the court by a non-party in the case. For the SCOTUS hearing, an amicus brief was filed, in support of the secured creditor's position (i.e credit bidding should be allowed), by an impressive group including the LSTA, the American Bankers Association, Mortgage Banks Association, to just to name a few. In addition, the United States filed an amicus brief in support of lenders position.

A favorite point of mine in the United State's amicus brief: "

The ability of a federal agency to bid cash is therefore strictly circumscribed by the scope of its congressional appropriation. But because federal law also requires the United States to take a lien on collateral when it extends certain kinds of loans, the United States is often a secured creditor in bankruptcy proceedings...If the United States and federal agencies are unable to bid cash at the sale of their collateral due to a lack of appropriated funds, and are prevented from exercising their statutory right to credit bid, the auction price of such asset would be depressed, and the United States would ultimately receive less value for its security interests"

The LSTA, in a press release stated:

"The Loan Syndications and Trading Association, joined by nine other trade associations, submitted an amicus brief to the US Supreme Court in the RadLAX Gateway Hotel case, arguing that secured creditors cannot be prevented from “credit bidding” in an auction of their collateral in a “cram down” plan of reorganization. The LSTA argues that credit bidding is a critical tool for protecting a secured creditor from having its collateral undervalued. If the creditor is not satisfied with the competing bids, it can obtain the property by bidding more, using the amount of its unpaid debt as currency in the auction.

"In this case, the debtors are attempting to steer the collateral to a bidder with insider ties at a substantial discount at the expense of the secured creditor," commented Elliot Ganz, Executive Vice President and General Counsel of the LSTA. "The Bank-ruptcy Code is specifically designed to prevent this type of mischief and ensure that secured creditors get the value they are entitled to receive."

While its always hard to tell which way the court will rule, the transcript reads like SCOTUS is leaning towards the lenders position, with debtors counsel taking a bit of a flaying by most of the 8 judges present (Kennedy had recused himself). A world without credit bidding would completely flip upside down what I had been taught to view bankruptcy (i.e. loan to own works because the credit bid has significant leveraging power) and distressed investing. If I had to make a bet, I'd say that management teams of Chapter 11 debtors would rather not have credit bids: i.e. you create the equity at a lower valuation (all else being equal) because lenders will rarely cash bid anywhere near their credit bid (good money after bad). I'd expect we'd hear back soon from SCOTUS on the case. This has been a fascinating one to watch over the past few years.

Pinnacle Airlines Bankruptcy: Equity Objects to the DIP

noreply@blogger.com (Hunter) — Thu, 19 Apr 2012 05:14:00 +0000

In the beginning of April, Pinnacle Airlines (PNCLQ or the Company) filed for bankruptcy protection in SDNY. You can find the docket here: Pinnacle Airlines Bankruptcy Docket. This afternoon, Nantahala Capital and Hudson Bay Capital Management, who collectively own approximately 2.5M shares on PNCLQ, filed an objection to the Debtors' DIP motion (Docket #138).

The document is a short, but a fascinating read into this case. While I have not yet written about the case and have yet to establish a position (I cannot reasonably quantify the Delta damages unsecured claim), I have used the case as an example of misaligned management incentives. More on this later.

The equity holders objection stems from the fact Delta being "the Debtors' most significant (and possibly only) customer, lessor of virtually all of the Debtors' assets, largest trade creditor and DIP lender..." might cause certain problems for PNCLQ and effectively give Delta every bit of negotiating power over the Company. And because Delta has all the power in the relationship, the filing goes on to point that "no other constituency has or can have any meaningful participation in these Chapter 11 Cases." And this includes the equity holders up until this point. I have heard discussions are going among between equity holders about forming a ad hoc committee and sending their issues to the U.S. Trustee and it looks like this filing is the first action we've seen on the docket from equity.

One of the more eye-popping quotes from the docket: After discussing certain payments that Delta was to pay PNCLQ as a result of their Mesaba acquisition ($18-20M), the filing goes on to say:

"On information and belief, Delta did not pay these amounts, precipitating the Debtors' liquidity crisis; and, as part of the DIP facility, these amounts are forgiven and/or compromised."

For those that do not know what a "sub rosa" plan is, this document lays it out perfectly. A sub rosa plan can be related to a 363 sale or a DIP financing (like in this case). It is effectively a defacto plan disguised as a financing arrangement without all the benefits of a formal bankruptcy plan (disclosure statement, ballot, other people able to participate in one way or the the other).

While I will not get into the valuation of PNCLQ, I'd like the reader to think about who, other than Delta, this plan benefits? Does it benefit the shareholders? The price action of the stock suggests otherwise. Let's look at the management team's holdings as of the filing date.

CEO: Sean Menke: 132,782 of 19,221,312 shares outstanding: 69 basis points
COO: John Spanjers: 13,711 shares or 7 basis points
General Counsel: Brian T. Hunt: 100,424 shares or 52 basis points

The CFO let in early March 2012 to go to Spirit Airlines.

On March 20th, the Company released an 8-K amending the Management Compensation Agreements with the CEO and COO (Menke and Spanjers, respectively). The CEO's base salary was increased from $425,000 to $675,000 and the COO's base salary was increased from $275,000-$400,000. The agreement also removed the long-term incentive (cash reward) for the CEO for 2012 which was "based on corporate performance relative to pre-established annual objectives". I assume they weren't going to hit those objectives. There has been a significant amount of noise in the press on this same issue.

John Spanjers was the President of Mesaba, which was owned by Delta (previously Northwest) when Pinnacle acquired it in July 2010. The COO of PNCLQ left shortly thereafter and was replaced by Spanjer who has held the position of COO since. For a little history lesson, Mesaba filed for bankruptcy in 2005 in Minnesota. Mesaba was the largest subsidiary of a company called MAIR Holdings (ticker: MAIR). At that point, Northwest was Mesaba's only customer and after Northwest filed in September 2005, cash wasn't really flowing into Mesaba's pockets. In effect, Spanjers has been to this song and dance before and has seen the playbook.

If I had to wager, Pinnacle, if left unchecked, will file a plan and disclosure statement that will give somewhere between 5-10% of the reorganized equity to management and the board as an incentive, with a huge slug of this going to the CEO and COO, assuming they stay independent. In addition, there will be hefty incentive cash payments along the way for filing a plan, hitting covenants, etc. Why would not want to dramatically increase your equity stake in a less levered, more streamlined airline, while at the same time impressing the people at Delta with your leadership skills (and saving them lots of money). Very little downside to that trade.

Remember - we always have to look at incentives of the actors in the play. If management and equity holders incentives do not line up, you have to watch the rug getting pulled out from underneath you.

Why Investors Should Pay Attention to the JOBS Act of 2012

noreply@blogger.com (Hunter) — Mon, 16 Apr 2012 03:57:00 +0000

On April 5th, 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. In my opinion, this may be one of the most important pieces of legislation enacted in the past 20 years. And investors of all sorts: angels, value, distressed, etc., should be paying attention.

It has surprised me that discussion of the JOBS Act has not perpetuated the "investing blog" universe given the ramification of this new legislation. I am hoping this post will be a springboard for institutional investors and writers to begin discussion of the bill and its implications for those in the professional money management business. I'd encourage you to forward this post to those who may be interested. And as always, if you have questions, please send me an email at hunter [at] distressed-debt-investing.com

Introduction to the JOBS Act
While there are quite a number of provisions in the final JOBS act legislation signed into law, the two that I will focus on in this post are:

The removal of the general solicitation ban: You will now be able to publicly announce, through any medium available (TV, radio, newspaper, Facebook, LinkedIn, blogs) that you are raising capital for anything from a hedge fund, to private equity fund, to a convertible note for a start-up you are thinking about under Rule 506 of Regulation D and under Rule 144A under the Securities Act. This is a complete game changer for capital raising in this country
Crowdfunding: Companies will now be able to raise up to $1 million dollars a year in small increments from a large pool of investors. Crowdfunding is nothing new: If you have ever heard of Kickstarter or Indiegogo, you know what I am talking about. People have been contributing small amounts of money to many causes over the past few years. But never before were you allowed to offer equity in exchange for the capital received. Crowdfunding in exchange for equity will turn the current channels of crowdfunding and angel investing upside down, and will provide enormous opportunities for professional investors and entrepreneurs alike.

In 90 days from enactment of the legislation, the general solicitation ban will be removed, and in 270 days, crowdfunding in exchange for equity will begin across this country.

I cannot contain my enthusiasm for the JOBS Act. I hope this post will show you why.

Background of the JOBS Act

In the middle of 2010, a friend of mine who is involved in the angel investing community here in New York forwarded me a petition that was being sent to the SEC to allow for small sums of money to be raised in exchange for equity from a large group of investors. At this point, Kickstarter was a raging success and was getting more and more press for the size of deals going through the site. The backers of the petition called it the "Crowdfunding Exemption." Up to this point, the SEC was staunchly against crowdfunding in exchange for equity (and arguably still is). Expert testimony was heard in Congress in the middle of 2011. People really started to take notice in September 2011 when the White House announced the President's Start America Initiative, which would change current regulation to allow for crowdfunding among other things that eventually ended up in the JOBS Act. HR 2930, the "Entrepreneur Access to Capital Act" was passed in November 2011 with bipartisan and White House support. Eventually, and with a real push from Senator Scott Brown in Massachusetts, the Senate, after many revisions, committees, and testimony pushed through version of the crowdfunding bill. The final bill, which stemmed from HR 2930, with amendments from the Senate passed in late March 2012.

General Solicitation
Previously, the SEC has emphasized that there is a pre-existing relationship with potential investors. For anyone that has filled out an accredited investor survey, this is one of the ways in which funds historically have developed this "pre-existing" relationship. Furthermore one of the reasons that 99% of funds out there have password protected sections is to ensure that these funds aren't soliciting investors in violation of Rule 502(c).

Under the new legislation, within 90 days of enactment (so call it in a little less than 80 days), the SEC must change the rules of Rule 506 private placements to allow for general solicitation through any medium. A caveat here is that all ultimate purchasers must be accredited investors. If I wanted to raise a fund, I could take out an ad on CNBC, or put up banner ads across the internet, or take out a ad in the WSJ or New York Times. As long as my ultimate purchasers are accredited, I am good to go. The SEC is also required the eliminate the prohibitions on solicitation for Rule 144a securities.

There are so many implications to this that it would take pages and pages of text. The possibilities and opportunities are endless. Information is going to flow so much more fluidly, which I think is a good thing. While there still may be some reasons to limit general solicitation (i.e. keep your investors small and strategic), a small fund that has amazing results will be able to broadly communicate their success with the public at large. Larger funds with deep marketing teams have historically had the advantage just by owning the channels to the accredited community. Now those channels are being torn wide open.

And the change to operating companies is simply fantastic. This is Shark Tank on steroids (fantastic show). If I have a great business idea, and needed capital, historically I could go to friends and family (pre-existing relationships) or possibly something like AngelList or Gust if I had any idea about the angel investment community. Now the opportunity for possible lucrative investments will not be held in the clutches of those just in the know. Furthermore, if opens up potential "vertically integrated" investments from strategics on Day 1. If I have built an application that is targeted to help retailers sell their product, why not go right to the retailers to raise capital? You might even get acquired right from the get-go.

And you have to think that hedge funds will have public presences on the internet, with letters, performance, and marketing materials for all the world to see.

As one would expect, the key criticism opponents to the bill bring up is the risk of fraud. I have no doubt that "fly by night" schemes will increase. But given that the ultimate purchasers will be accredited and in theory qualified, the positives here massively outweigh the negatives. I do expect an entire new cottage industry to develop that will serve as a combination of forensic as well as private investigator on the fund managers and entrepreneurs to eliminate as much fraud as possible.

Crowdfunding
The second item in the legislation that I am excited about is crowdfunding. By amending Section 4 of the Securities Act, a new registration exemption will emerge in crowdfunding.

In the past, the Kickstarters of the world (there are hundreds) allowed people to raise money from individuals in exchange for everything BUT equity. The JOBS Act does away with this, and now individual investors (they do not have to be accredited) can fund projects and start ups in exchange for equity. As one would expect there are many stipulations in the legislation to protect the general investing public: For example, individuals with incomes or net worth less than $100,000 will only be able to invest a few thousand dollars annually. For other investors, the amount is the lesser of $100,000 or 10% of an investor's annual income. The capital will be raised through what the SEC is calling "funding portals" which will have to register with the SEC in order to facilitate crowdfunding.

There are many more stipulation on the companies raising the money. The max capital that can be raised each year is $1,000,000, and that's only if you have fully audited financials (you can raise $100,000 with the CEO signing off and $500,000 with a CPA signing off). In addition, there are informational disclosure requirements including names of holders of more than 20% of the shares, names of officers and directors, and a description of the business plan. Crowdfunding issuers cannot advertise their offerings except to direct potential investors to the crowdfunding platform for specific terms. This will allow the SEC to maintain a close watch on the crowdfunding market (i.e. through portals versus non registered offerings).

A liability provision has been put in place in the legislation that, in my opinion, is probably the worst piece of the legislation. Any purchaser buying these securities can bring a lawsuit against the company raising capital and will be returned his/her capital if there were material misstatements or omissions in the crowdfunding document offerings. I wish this were changed (i.e. Why wouldn't I always sue in the investment failed?) but I understand the reason it was included.

If you purchase one of these securities (it doesn't just have to be equity), you will be required to hold it for one year, though you will be able to transfer the security back to the issuer or to accredited investors. To me, this means SecondMarket is going to be absolutely killing it - they are the All Stars of trading private companies' equities and I think this will just bolster their offering. Even with SecondMarket, I truly believe there will be MASSIVE amounts of inefficiencies in the secondary market that an astute investor should be able to capitalize on.

Until now, very few people were able to get in at the ground level for lucrative venture investments. I think this opens it up dramatically and benefits both investors and entrepreneurs. Many people in the angel and venture capital community DO NOT like this legislation since it stomps all over their turf / playground. Now skilled investors will have a fair shake and look at many different sorts of investments that they would otherwise never have seen. Some companies will still choose to go the traditional angel / venture capital route as it offers many strategic/advice/mentoring/connection advantages. But I think crowdfunding will turn the angel and venture capital world upside down.

The SEC has a 270 day review period to make sure all the rules / regulations / systems are ready for crowdfunding. I'd expect the first capital raises to begin on January 1st, 2013.

Conclusion
This bill will completely change capital raising in this country. It will allow more entrepreneurs to raise capital and create jobs than every before. It will allow more investors to participate in the upside for start up and high growth companies than ever before. It will create significant inefficiencies in the marketplace that I think discerning value investors can take advantage of.

While I did not get to the other aspects of the bill, after reading them a number of times, they are just as exciting as the two mentioned above. I will probably do a summary post on it in the near future.

I hope the investing blogosphere starts spending more time on the JOBS Act. I am trying to get myself involved in as many ways possible, from advising start-ups, to providing services to companies thinking about crowdfunding, to getting ready to personally invest through the crowdfunding platform, and finally to eventually raise capital through one of these channels. If you'd like to know more about the work I'm doing or want to get involved, please contact me.

I've said this to many people in the past few weeks: This is our gold rush. And I couldn't be more excited.

Reddy Ice Bankruptcy and $AGUNF

noreply@blogger.com (Hunter) — Fri, 13 Apr 2012 03:24:00 +0000

Today, Reddy Ice (RDDY or "the Company") filed for bankruptcy in the Northern District of Texas (Dallas). It was revealed in the press release that the company had secured a $70M DIP and $50M in exit financing with a plan supported by "the majority of the principal amount of First Lien Notes, Second Lien Notes, and Discount Notes." The docket can be found here: Reddy Ice Docket. For reference, at the close, Reddy Ice's 11.25% were trading 91-92 (with accrued) and the 13.25% were trading at 15-17 (flat).

The company has filed its Plan of Reorg and Disclosure Statement. But first, let's take a peak at the Declaration of Steve Janusek, CFO of Reddy Ice, in support of bankruptcy petition and first day motions (Docket #27). Reddy Ice is the largest manufacturer and distributor of packaged ice in the United States. They are the ones that make and sell the bags of ice at super markets and convenience stores. In 2011, the Company sold 1.7 million tons of ice with a particular geographic focus in the southern United States (this is important for reasons to come later).

The filings lays out the company's capital structure, as of 3/31/2012, which I've laid out below:

Please note: That according to Docket 21: "As of the Petition Date, the Company owed approximately $50 million plus interest, fees and expenses, and had no availability, under the Prepetition Credit Agreement."

The Company, according to the filing, began discussions in 2011 to explore alternatives to address its capital structure with an informal group of First and Second Lien note holders including Centerbridge. This is where things get interesting:

In addition to addressing the Company’s declining EBITDA and current debt, the Restructuring is also intended to provide the Company with the opportunity to pursue a strategic acquisition (the “Strategic Acquisition”) of all or substantially all of the businesses and assets of Arctic Glacier Income Fund and its subsidiaries (“Arctic”). As is the case with the Company’s business, Arctic has encountered financial difficulties due to adverse trends in our industry in recent years. On February 22, 2012, Arctic filed for protection under the Companies’ Creditors Arrangement Act in Canada and Chapter 15 of the Bankruptcy Code in the United States. Arctic has initiated a Sale and Investor Solicitation Process (“SISP”). The purpose of the SISP is to seek sale proposals and investment proposals from qualified bidders and to implement one or a combination of them in respect of Arctic’s property and business.

On March 28, 2012, the Company submitted a non-binding letter of intent to Arctic regarding participation in the SISP. The letter of intent contemplates the Company’s acquisition of substantially all of Arctic’s business and assets. On April 5, 2012, the Company was advised by the financial adviser to Arctic that the Company has been approved to move to phase 2 of the SISP. The successful bidder will be selected at the end of phase 2 of the SISP. The Company’s interest in Arctic remains subject to, among other things, completion of due diligence, negotiation of acceptable transaction documents, and receipt of sufficient
commitments for debt and equity financing for the acquisition. Centerbridge has indicated its interest in providing the entire amount of the equity financing for the Arctic acquisition.

Arctic Glacier (symbol: AGUNF) bankruptcy proceedings in Canada can be found here: Arctic Glacier CCAA Proceedings. For full disclosure, I am long AGUNF and I will explain why shortly.

The rest of the support filing goes on to talk about the proposed restructuring which is highly dependent on whether Arctic Glacier is purchased. For example, if AGUNF is acquired, Reddy can issue pari first lien debt to finance the acquisition. If it isn't Centerbridge will convert $68.2M of First Lien notes into preferred stock of Reddy Holdings with a liquidation preference of $75M. In addition, Reddy stock holders are getting a 12 cent distribution with an additional 5 cents if AGUNF is acquired.

According to the concurrently 4Q financial release, FY 2011 Adjusted EBITDA was $45M down from $51.8M last year. Further, in a Reg FD filing, the Company notes they did $103M of EBITDA in 2006:

Assuming a fully drawn revolver, the Second Liens at 16 cents on the dollar is creating Reddy Ice at somewhere around $375M of value ($372 - cash on BS + rights offering). At $45M of EBITDA, this translates into a multiple of 8.5x. Projections show 2012E EBITDA at $57.2M or 6.5x. In the valuation analysis in the Disclosure Statement:

"Reddy Holdings and Reddy Corp have been advised by Jefferies & Company, Inc. (“Jefferies”) with respect to the estimated value of Reddy Corp’s operations on a going-concern basis (the “Enterprise Value”). Jefferies has concluded that the Enterprise Value of Reddy Holdings and Reddy Corp, as of the assumed effective date of March 31, 2012 (as used in this Appendix E, the “Effective Date”), will range from approximately $382 million to approximately $434 million, with a midpoint of approximately $408 million."

So we are definitely close here and if anything are being conservative. What does this mean for the value of AGUNF? Assuming they pay 8.5x, or similar comp to what Reddy is trading for, the value is 19 cents per unit:

But, what I think people are missing here is two fold:

Reddy can pay a VERY high multiple for this business for the mere fact of the amount of synergies combining the two entities would entail. The amount of coverage the combined entity would have would be unparalleled. And we know that when AGUNF was marketed a few years ago, there were MANY bidders for the asset.
The forecasted DIP draw of $42M: This business burns a ton of cash in the 1st and 2nd quarter of the year and generates a ton of cash in the 2nd half of the year. Just by cutting the DIP draw down to $20M gets your recovery at 8.5x to 26 cents a unit. Further the company has been WAY under budget in terms of DIP draws since the filing.

So I am long (and have been since the filing). To me the biggest risk here is the presence of West Face as senior secured lenders. For those not in the distressed world, West Face are amazing investors that I frankly am afraid just want this thing for themselves. If they were not involved, I would make this a much larger position.

I'll keep everyone updated on both the Reddy Ice and AGUNF bankruptcy proceedings as they play out.

Speech Notes: Howard Marks at NYSSA

noreply@blogger.com (Hunter) — Mon, 09 Apr 2012 19:52:00 +0000

On April 5, Howard Marks, legendary investor and Chairman of Oaktree Capital Management, spoke at New York Society of Securities Analysts. He is also the author of the book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Distressed Debt Investing was in attendance as he presented his views on the topic of “Human Side of Investing.”

According to Howard Marks, the discipline that is most important is not accounting or economics, but psychology. He started off with a quote from Yogi Berra, “In theory, there is no difference between theory and practice; but in practice, there is.” And this difference is what is at the essence of the human side of investing. Even though the business schools teach that the markets are objective and efficient, and generally follow the “Capital Market Line (CML) curve (“riskier assets always provide higher returns”), it was handily disproved in both contrasting time periods of Q2 2007 and Q4 2008. Essentially, the upward sloping CML does not work in practice. In practice, riskier assets must appear to provide higher returns, else they won’t attract capital. But that does not mean that those promised returns arrive in reality. If the risky assets provided higher returns, then they can’t be deemed risky after all. In Q2 2007 the risk premium was very inadequate, whereas in Q4 2008 it was overly excessive. The truth is that market is made up of people with emotions, insecurities, and foibles, and they often make mistakes. They tend to swing to erroneous extremes.

One has to be very careful about the value and price relationship. If you buy without discernment to the price, the returns would be all over the place – sometimes good, and sometimes bad. In theory, people want more of something at lower prices and less of something at higher prices. However, in practice, people tend to warm to investments as they rise and shun them when they fall. In markets, the demand curve looks the opposite of how it looks in microeconomics theory based on supply and demand.

The normal investor behaves like a pendulum with constant swings between optimism and pessimism, between risk tolerance and risk aversion. Although, the statistical “mean” location for the pendulum swing is in the middle, that happy medium is rarely seen in the markets, just as the pendulum spends almost no time at its “mean” during the swing.

Next, he talked about the 3 stages of bull market. The first stage occurs when few smart people begin to believe that there will be improvement. The second stage occurs when most people recognize that improvement is actually taking place. The third stage occurs when everybody and their brother believe that things will continue getting better forever. And that’s how bubbles come into existence. The belief becomes that the price of a particular asset will only rise forever, that it can’t go down. But when the pendulum swings like it did in 2008-09, bear market happens. The 3 stages of bear market, conversely, are: first, when few people realize that things are overpriced and will prices likely will fold; second, when most people see that he decline is taking place; and third, when everybody believes that things will only get worse forever. That last stage was the apt description of the credit markets in fourth quarter of 2008 and equities in first quarter 2009. Any asset can be attractive or unattractive depending on the stage in which it is bought, i.e. depending on how much optimism or pessimism is embodied in the price. The adage we should remember is: “What a wise man does in the beginning, the fool does in the end.” What we should be is a contrarian. We should be a seller in the third stage of the bull market, and buyer in the third stage of the bear market. He quoted Mark Twain: “When you find you are on the same side as the majority, it is time to reform.”

Contrarianism is very important but very difficult. To make his point, he quoted David Swenson who runs investments for Yale’s endowment fund: “Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolio which frequently appear to be downright imprudent in the eyes of the conventional wisdom.” However, if one wants to be a successful contrarian, one has to believe that conventional wisdom by itself is a bit of an oxymoron because what is conventional is often not wise because most people start believing in something only when it is the third stage of either market extreme.

What is it that permits bubbles and crashes to happen frequently? Howard Marks pointed the reason to be failure of investor memory especially since when the investor’s memory is faced with greed/fear, memory loses. When people forget the past, they tend to repeat the same mistakes done previously. He recommended reading his latest memo, “Déjà vu all over again” in which he discusses contrarian signals. He went on to say that behaving pro-cyclically is one of the greatest, most frequent mistakes. We should strive to be anti-cyclical, but it requires strong memory and contrarian bent.

Another important thing is understanding and knowing what you don’t know. A lot of people do not know what they don’t know, and essentially overestimate what they know. Investing is a business full of testosterone and they think that you are not a man if you don’t know what’s exactly going to happen in say, five years. In fact, some people think they know everything, some people think they are supposed to know everything, and a lot more act as if they know even when they don’t. Mark Twain put it the best: “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that ain’t so.”

He then referred to the memo he wrote 8-10 years back, “Us Versus Them,” describing two schools – the “I Know” school, and the “I Don’t know” school. He is a proud, card carrying-member of the latter. It is very important to understand the difference between the two schools. “I Know” school is confident about its forecast of the future, and “I Don’t Know” school is skeptical about that forecast. The former can only prepare for one outcome, whereas the latter hedges against uncertainty and prioritizes avoidance of losses over the maximization of gains. The latter approach is more likely to result in a successful investment career. Therefore, the motto at Oaktree is to “Avoid the losers; the winners will take care of themselves.” As long as the portfolios are built to avoid losers, they will do okay.

Most of the times, investors think that only the most likely thing is going to happen and they really only prepare for just one outcome. Howard Marks doesn’t seem to think highly of economists as they do not draw ranges or probabilities of the forecasts they give out, and are more often than not proven wrong. He implored that while investing one should never forget the story of the 6 feet tall man who drowned in a stream which, on average, was five feet deep. It is not enough to know what the average outcome will be; instead one has to have an idea of the likely shape of the outcome distribution curve. One of the things investors should always be ready for is the unlikely disaster and should not ignore the “tails.” Unlikely things happen all the time, and the likely things do not happen all the time; we need to build our portfolios to account for that. This is not easy as Charlie Munger says, “None of this is easy, and if anyone thinks it is easy, he is stupid.” It is not easy in investing to make above average returns as most of the people do single scenario investing which ignores that more things can happen than will happen. The most likely outcome does not happen that often. And that is what Howard Marks thinks risk actually is. It is not standard deviation or volatility of returns; for him it is losing money.

There are 3 ingredients for success in investing: aggressiveness, timing, and skill. If you have the first two, you don’t need the third. But that’s unlikely to remain the case in the long run as it is very hard to do the right thing, at the right time consistently in the investing business. He then went on to talk about the two twin imposters in investing: Short term outperformance, and Short term underperformance. They really don’t tell anything about an investor’s ability to outperform in the long run. He referred to the memo he wrote in 2006 after the melt down of the hedge fund, Amaranth, in which he dissects the events from his vantage point. He thinks that Amaranth’s problems didn’t start in 2006 when it went down a 100%; the problems started in 2005 when it went up a 100%. Going up or down 100% can be two sides of the same coin, and can be result of combination of sheer aggressiveness and luck/timing. If a person goes up a 100% one year, it does not guarantee that he will go up significantly again next year.

He recommended reading the book “Fooled by Randomness” by Nassim Taleb, and understanding not only black swan phenomenon but also the concept of “alternative histories,” especially as it pertains to judging investors for the long term given that there is a lot of randomness in the world. Just because something should happen does not mean that it would happen. One of the things Howard Marks believes is that the correctness or the quality of a single decision can’t be judged by one outcome alone because of that randomness. One has to assess the decision-makers outcomes over a somewhat longer period of time to assess that person’s skill.

Lastly he concluded by saying that forces that influence investors also push them towards mistakes. Investing in obvious things, things that are easily understood, things that are doing well, etc. – these are all easy to do. These things become names everybody wants to invest in. But just by that virtue, most of the times these assets become overpriced and unlikely to be bargains. Bargains that investors find in their lifetimes are likely to have hidden appeal, not be easily understood, and be unpopular. Things that appear hard to invest in are where bargains are found. Bargains do not appeal to herds. Any given asset can be a good buy or a bad buy depending on the price. There is no such thing as a “good idea” until you know the price.

In the Q&A session, he shared his view that he did not believe that equities currently have excessive optimism built into the prices. He also thought that the high yield is relatively more attractive now than it was in 2007 despite the similarly low yields as the spreads are generous right now versus the treasuries. It is hard for investors to get away from the business of relative selection. Next, he suggested that as a professional investor you should not let the clients put you up on a pedestal, but rather should set reasonable expectations with them. On the question of why CEOs of companies consistently overestimate performance, he felt that a lot of CEOs are good salesmen who might belong to the “I Know” school. (By the way, unsurprisingly, he thought CNBC is big on that school as well.) On how to protect against black swans, he suggested using portfolio diversification, basically buying those assets that would behave differently in a certain environment. However, this can be hard to do especially if one is mandated to only be in a particular asset class, but one has to nevertheless try to reduce the correlation. Finally, currently he is reading Sebastian Mallaby’s book, “More Money than God.”

7th Annual Distressed Investing and Restructuring Conference at Chicago Booth

noreply@blogger.com (Hunter) — Thu, 05 Apr 2012 18:17:00 +0000

For each of the last two years, Distressed Debt Investing has covered Chicago Booth's Annual Distressed Investing and Restructuring Conference. We are always impressed by the content and quality of the speakers, and this year is no exception. The keynotes this year will be given by Jim Grant, of Grant's Interest Rate Observer, Jonathan Lavine, Managing Partner of Sankaty, and Jon Pollock, Co-CIO at Elliott. Like in previous years, the conference has panels with practitioners from every corner of the distressed debt world.

The event will be held on April 13th at the University Club of Chicago. We will be there this year again, taking notes. We hope to see you there!

For more information and registration, please visit this year's conference page at: http://student.chicagobooth.edu/group/dirg/conference/index.htm

Three Year Anniversary

noreply@blogger.com (Hunter) — Wed, 04 Apr 2012 00:56:00 +0000

Yesterday marked the third year I have been posting at Distressed Debt Investing. I cannot begin to tell you how grateful and humbled I am to have the group of readers that I do. This blog started out to simply bring light to a unique sliver of the investing universe that did not get the coverage it deserved. After nearly 2 million page views, and over 7000 email/RSS subscribers, the site has transformed into something I could not have fathomed three years ago. I have met so many fascinating people that have made me a better investor (and I'd like to think a better writer). I am forever thankful.

I hope this year to be the biggest yet for Distressed Debt Investing. The blog has a brilliant group of writers that are contributing guest articles, we have a slate of fantastic series, interviews, and research pieces coming out, the DDIC continues to grow nicely, and I am revamping the resume and case study services to offer live, in-person classes as well as new service offerings for those looking for help securing buy side jobs. I plan on hiring a few interns / part time contractors to assist me with the build out of new features on the sites (1st job listing this week). I also have had the privilege to meet some of my readers and talk to you about some of the bigger goals and projects I am working towards for the site. It's been a fantastic honor.

Thank you so much for your support over these past three years. This would not have been possible without the amazing readership I have been blessed with.

All the best,

-Hunter

Recent Distressed News - April 1, 2012

noreply@blogger.com (Hunter) — Tue, 03 Apr 2012 03:36:00 +0000

I promised way too many readers a post today related to the MYRIAD of distressed debt news stories that hit the wire this weekend / today. They include:

PNCL bankruptcy
Q-Cells filing in Germany
Sino-Forest bankruptcy (and the comical lawsuit against Muddy Waters)
News from the Dynegy bankruptcy
Reddy Ice delaying their 10K
EK's MOR
Hawker incremental (L+1200, 2% Floor!) + forbearance
Revel Entertainment's soft opening
Delays in Tribune

...and a few others. I will try to do a post on PNCL's bankruptcy (docket here: Pinnacle Docket) as well as giving summary of the above in the next few days. Stay tuned (while I try to stay above water!).

Advanced Distressed Debt: Collecting Default Interest From Solvent Debtors

noreply@blogger.com (Hunter) — Wed, 28 Mar 2012 03:50:00 +0000

Earlier this month, the Distressed Debt Investing blog posted an entry on the recent Washington Mutual decision issued by the United States Bankruptcy Court for the District of Delaware, which addressed the issue of whether unsecured claimants holding claims against a solvent estate are entitled to postpetition interest at the contract rate or the federal judgment rate. In the Washington Mutual case, the court held that the federal judgment rate (which is often much lower than a contractual rate of interest) was the appropriate rate of interest. Today’s blog entry considers the same issue, but in a case involving secured creditors (versus unsecured creditors).

This is a timely topic because with the higher incidence of default in many loan portfolios and growing emphasis at financial institutions on “revenue enhancement opportunities” in almost all business lines, lenders should be increasingly concerned as to whether they are being appropriately compensated for this additional risk in their portfolios from the defaulted assets. One method to enhance yield is to put more emphasis on collecting interest at the higher, default rate upon the occurrence of an event of default, especially one triggered by an insolvency event. Luckily, the United States Bankruptcy Court for the Southern District of New York handling the General Growth Properties cases recently provided some guidance on that very issue. In re General Growth Properties, Inc., 451 B.R. 323 (Bankr. S.D.N.Y. June 16, 2011); In re General Growth Properties, Inc., 2011 WL 2974305 (Bankr. S.D.N.Y. July 20, 2011). Even though these decisions have been appealed, they nonetheless are instructive and have already been raised in cases pending in other districts.

As most lenders realize, the general rule under the Bankruptcy Code is that a creditor is not entitled to post-petition interest; however, Section 506(b) explicitly provides that an over-secured creditor is entitled to interest on its claim – but does not specify the applicable interest rate. The General Growth court noted, and the debtor and lenders agreed, that there is a rebuttable presumption that an over-secured creditor is entitled to interest at the contract rate. In addition to this statutory basis for permitting post-petition interest, there is a judicially created exception founded on the principle that creditors should receive interest as a compensation for delay due to the bankruptcy prior to any distributions to equity holders, although that result has been modified in some cases by equitable considerations (e.g., creditor misconduct and determinations that a high contractual default rate constitutes a penalty).

Both of the General Growth cases involve the applicable creditor’s objection to its treatment under the plan of reorganization because it did not receive post-petition interest at the default rate. Due to the large amounts of money involved in the cases (amount disputed is about $100 million), they have generated some significant attention among lenders.

The loan in the first case was not in default prior to the filing of the case, and the debtor sought to “reinstate” the debt under the plan of reorganization without paying default interest. While a significant portion of that court decision addressed issues incident to debt reinstatement matters, the opinion also contains a helpful analysis as to whether an ipso facto clause (automatically accelerating the loan at the filing of the case) can trigger the right to receive post-petition default interest.

The subject promissory note contained the fairly typical formulation that (i) a default occurs upon the borrower filing a bankruptcy petition, (ii) the occurrence of such an event automatically, without the sending of notice or any other action, caused the entire principal amount of the loan to become immediately due and payable and (iii) interest on this outstanding principal balance would accrue at the default rate. The debtor argued, among other things, that the ipso facto clause was invalid, and thus, at the time of the filing of the case there was not a default that required the payment of interest at the default rate.

As a statutory matter, Section 365(e)(1) of the Bankruptcy Code provides that ipso facto clauses are invalid only if included in executory contracts or unexpired leases, and the promissory note was obviously not an unexpired lease and was not an executory contract because the only remaining obligation thereunder was the repayment of the outstanding loan by the debtor. The court held that ipso facto clauses in agreements other than executory leases or unexpired leases are not automatically invalid and that, upon an examination of the facts and circumstances in the instant case, payment of default interest was appropriate because the debtor was highly solvent, the plan was confirmed on a basis that reinstated the debt and the debtor had already emerged from bankruptcy. Therefore, the lenders’ right to collect the additional interest had clearly not impaired the ability of the debtor to exercise its rights to file for bankruptcy protection and gain a fresh start through the reorganization process.

Some may argue that this decision should be restricted to debt that is reinstated pursuant to a plan and therefore does not have a broader application, such as to loans that matured during the pendency of a bankruptcy case. However, the same bankruptcy court rejected that view when it adopted its reasoning in a second matter. The loan in this second General Growth proceeding was already in default at the time the debtor filed for bankruptcy, although the creditors had not yet filed an acceleration notice (the underlying credit agreement contained the same mechanism as in the first matter described above). In its discussion of upholding the ipso facto clause and automatic acceleration, the court explained that failing to uphold such provisions would deter creditors from withholding an acceleration notice during pre-petition workouts, which acceleration could trigger cross-defaults under other agreements and have the effect of pushing the borrower into seeking bankruptcy protection. The court noted that the refusal to enforce the automatic acceleration would have the effect of penalizing the lenders for attempting to negotiate a consensual resolution when such result is not clearly mandated by the Bankruptcy Code. Thus, the court determined that the loan had been automatically accelerated.

The court went on to state that the creditor was also entitled to post-petition interest at the default rate. Since the presumption that an over-secured creditor is entitled to interest at the contractual rate can be overcome, the bankruptcy court reviewed the circumstances in which courts have typically modified the contractual arrangements between private parties: (a) creditor misconduct, (b) the default rate would be unfair and cause harm to unsecured creditors, (c) the default rate was a penalty and (d) the default rate would hinder a fresh start. The court determined that such facts did not apply, and therefore it held that the presumption was not rebutted and the creditor was entitled to default interest.

While these decisions are currently on appeal, they should still give secured creditors comfort that their contractual rights for default interest upon a bankruptcy default are likely to be upheld if the debtor is solvent. Underlying both of these decisions is the fact, undisputed by any party, that the debtors were exceedingly solvent upon their emergence from the bankruptcy cases, so the ultimate result may differ greatly depending on the debtor’s solvency. (The possibility of ultimately not having the right to default interest, of course, may be a relevant consideration to lenders considering how to structure their compensation in an out-of-court restructuring that could give a currently solvent debtor that is losing money and headed to insolvency more time to “turn it around.”)

Finally, these decisions serve as a useful reminder that a creditor should insist, whether as a sole lender, part of a “club deal” or a member of a syndicated financing, that the documentation governing its loans provide that all of the loans are automatically accelerated upon a bankruptcy default to preclude any argument that acceleration is not effective without sending a notice that could be prohibited by the automatic stay.

Epilogue: General Growth Properties’ brief in support of its appeal is due on May 18, 2012. Briefing will continue this spring and summer. We will keep readers apprised of any developments and of the decision when it is issued.

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@uhlaw.com. Don Schwartz is the chair of Ungaretti & Harris’ Finance and Restructuring practice, and can be reached at dlschwartz@uhlaw.com. Rob Drobnak is a partner in the practice group, with a focus on lending and restructuring, and can be reached at radrobnak@uhlaw.com.

Introducing our new Trade Claims Series: An Interview with Andrew Gottesman from SecondMarket

noreply@blogger.com (Hunter) — Sun, 25 Mar 2012 15:29:00 +0000

A year and half ago, contributor Josh Nahas wrote a post for us on the trade claims market. Since then, I often receive requests to spend some more time talking about the claims side of distressed debt. With that being said, I am happy to announce that through 2012 I plan on doing a great number of posts focusing on interviews with practitioners in the market including buy side analysts, traders, lawyers specializing in the claims market, scourers, just to name a few. Given that a great majority of our readers spend a larger part of their time dealing in straight credit, I think this will be a fantastic series for those learning this business.

I met Andrew Gottesman last year. He is head of the bankruptcy claims trading business at SecondMarket. SecondMarket provides a valuable service to both buyers and sellers of bankruptcy claims, a market that had next to no transparency five or ten years ago. Now, buyers and sellers of claims have a better way to transact, with more visibility and granularity, along with a reputable medium in SecondMarket. Andrew is fantastic at what he does and I am grateful for allowing us to interview him for the site. Enjoy!

Interview with Andrew Gottesman - Directory of Bankruptcy Claims Trading at SecondMarket

Please give us a little bit about your background. How did you end up at Second Market?

My background in the field is actually the opposite from the way most people do it. I started my restructuring career as a bankruptcy lawyer in 1999 with Willkie Farr and Gallagher. After some time, I moved over to Schulte Roth & Zabel where I stayed until 2006. I left Schulte to clerk for the Hon. James M. Peck at the SDNY Bankruptcy Court. Most people clerk before they go to the big firms but I took the opposite tack. I truly enjoyed my time clerking but the business side of the industry was always calling me. I came to SecondMarket as an entrée to the claims trading world in 2009.

Can you talk about how Second Market is revolutionizing/changing the trade claims business?

SecondMarket is a marketplace for all types of alternative investments, like private company stock and bankruptcy claims. We are trying to bring technology to bear to make bankruptcy claims trading more accessible and efficient. Claims will never be a “click and execute” product because of the unique nature of each claim. We are trying to make it easier for buyers to do their credit and claim level diligence while giving sellers easier access to the market.

Describe who are buying claims? Is it funds, smaller players, etc? How are you sourcing claims?

Clams buyers mostly come in 3 buckets, but there’s plenty of overlap. Bulge bracket broker dealers regularly buy claims and sell them from their inventory to their hedge fund customers. Large distressed and multi strategy hedge funds buy claims directly or through brokers like SecondMarket. There are also smaller, claims focused funds who mainly source and purchase claims directly. Each of these buckets may buy and sell to one another. It’s a relatively small universe of buyers and brokers who interact regularly.

What is the most common rationale you hear for people selling their claims?

Sellers don’t always open up about their rationale but there are common threads. Sometimes folks are looking to offload the risk of a depressed or further delayed payout in a case where they don’t believe the story. Many creditors simply need cash before an anticipated distribution or are tired of dealing with the headache of following a case. For others holding a claim creates an accounting issue they need to solve.

Contrast the process of 503b9 claims purchasing versus a more general trade claim that might be at the bottom of the stack.

Everyone likes 503(b)(9) claims because they enjoy priority of payment. Diligence involves ensuring the face value and assertions made by the claimant in the proof of claim (the documents filed with the court to assert the claim) are accurate. The process isn’t drastically different when buying those claims, although sometimes there is a mechanism set up by a debtor to review, agree and pay those claims. Timing still needs to be factored in because, without a court approved system in place for the payment, there’s no set time frame to pay 503(b)(9) before confirmation.

Is Second Market transacting in the various flavors of claims? OPEB, Reclamation, Deficiency?

We are involved in every class of claims. It pays to be nimble.

Can you talk about the due diligence period in buying / sell trade claims? What should investors be doing here?

As with most issues in the claims market, the diligence you need depends on the unique circumstances of each claim and each case. On the case level - buyers need to look beyond a fundamental credit analysis. It’s important to have a good sense of the intangibles hidden in each case to form an accurate view of a recovery. Process, timing, and sometimes the personality of the actors can interact in unexpected ways to influence ultimate distribution and return on investment. On top of a recovery analysis, buyers need to understand the potential for the reduction in the face amount of claims they are buying. That claim level diligence revolves around ensuring that the face amount of the claim is as stated and that there’s nothing to inhibit or offset a full distribution.

Talk about some of the bigger risks in buying trade claims? What are some land mines investors should watch out for?

There are many risks involved with buying claims. Each is unique to the case and the claim. The bankruptcy process is meant to set up a fluid negotiation. Buyers are not privy to these negotiations, so things can change in ways you may not expect. An investor may be able to influence outcomes if they amass a sizable position, but mostly you mare left to read the tea leaves. This is where experience pays off. People who have been around the block a few times can make more informed decisions on potential outcomes. Additionally, claims sellers are understandably optimistic about the status of their claims, so the back up to their claim needs to be scrutinized carefully. Sellers hardly ever consider things like potential preference exposure or offsetting claims the debtor may have against them. Either one of those things can and will reduce the recovery available to that claim holder and buyers need to protect themselves accordingly.

What's the outlook for the claims business going forward?

I believe there is a bright future for this asset class as a whole. The claims market has “grown up” a lot as a result of cases like Lehman Brothers and MF Global. More and more market participants view claims as a legitimate, accessible and non-correlated asset class. The major players in the space are more sophisticated a better capitalized than they once were. These players are able to change and react to new inputs more creatively than in years past. Sellers have gotten also gotten more sophisticated since Lehman Brothers. Sellers are asking more questions and they are aware that there are more options in how to sell a claim and to whom they can sell it. The outcome of all this will be more liquid markets in more cases. An outcome that I believe benefits everyone.

Andrew, thank you for your time. Fantastic stuff.

Bankruptcy 'Double Dip'

noreply@blogger.com (Hunter) — Tue, 20 Mar 2012 06:18:00 +0000

About a year ago, I wrote a short post on an advanced distressed debt concept: the double dip. Over the weekend I read a fantastic, and much more in depth piece on double dips at the American Bankruptcy Institute penned by Mark Kronfeld, a partner at Owl Creek Asset Management. Mark has allowed me to repost the article here. Strap on your seat belts - this is an amazing and highly educational post where I am positive you'll take some learning lessons away from.

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.

*Reprinted with permission from author

Footnotes:

(1) The author would like to thank Matt Williams, a partner at Gibson Dunn & Crutcher LLP, for his assistance in connection with this article.

(2) For instance, corporations might establish wholly owned foreign finance subsidiaries to issue non-U.S. dollar-denominated debt in order to mitigate exchange rate risk or to access diversified sources of funding or for tax benefits. Offers and sales conducted outside of the U.S. can also be structured to be exempt from the liability provisions of the U.S. Securities Act of 1933.

(3) Although § 509 allows claims for contribution, reimbursement and subrogation in certain circumstances, a pre-petition agreement can waive such rights. O’Neil v. Orix Credit Alliance (In re Northeast Contracting Co.), 187 B.R. 420, 427 (Bankr. D. Conn. 1995).

(4) See McDermott v. City of N.Y., 406 N.E.2d 460, 462 (N.Y. 1980) (“[W]here payment by one person is compelled which another should have made...a contract to reimburse or indemnify is implied in law.”).

(5) The plan ultimately provided that 20 percent of the allowed LBT guarantee claim would be reallocated to other classes of creditors in connection with resolution of a dispute over substantive consolidation.

(6) 11 U.S.C. § 502(b).

(7) In re Gessin, 668 F.2d 1105, 1107 (9th Cir. 1982) (creditor’s claim against guarantor not reduced by amount received from principal debtor).

(8) Courts generally, and absent certain exceptions, respect corporate formalities and the separateness of related or affiliated corporate entities.

(9) Because the claims are held by two separate entities, the intercompany claim and the guarantee claim should arguably be recognized as distinct, allowable claims. See, e.g., Northwestern Mut. Life Ins. Co. v. Delta Air Lines Inc. (In re Delta Air Lines Inc.), 608 F.3d 139 (2d Cir. 2010) (holding that claims of two creditors related to same underlying facts were not duplicative because claims arose pursuant to separate legal obligations and total recovery would not exceed 100 percent).

(10) A subrogee under § 509 is entitled to assert § 553 setoff rights for post-petition payments on a pre-petition guarantee. In re Jones Truck Lines Inc. v. Target Stores, 196 B.R. 123, 129 (Bankr. W.D. Ark. 1996).

(11) Pursuant to federal and applicable state law, guarantees can be avoided as constructive fraudulent conveyances if the guarantor was insolvent or rendered insolvent at the time it issued the guarantee and did not receive reasonably equivalent value in exchange for issuing the guarantee. 11 U.S.C §§ 544(b) and 548.

(12) In re Augie/Restivo Baking Co. Ltd., 860 F.2d 515, 518 (2d Cir. 1988).

(13) The bankruptcy court will attempt “to discern whether the parties called an instrument one thing when in fact they intended it as something else.” Cohen v. KB Mezzanine Fund II LP (In re SubMicron Sys. Corp.), 291 B.R. 314, 323 (D. Del. 2003), aff’d, 432 F.3d 448 (3d Cir. 2006).

(14) In re Smurfit-Stone Container Corp., Case No. 09-10235 (BLS) (Bankr. D. Del. Feb. 4, 2010) [Docket No. 4735]. It has been asserted that where the principal obligor is a Canadian unlimited liability company (ULC), § 135 of the Nova Scotia Act Representing Joint Stock Companies may provide for an independent claim against the ULC’s parent entity. The nature of the § 135 claim and the “triple-dip” scenario is beyond the scope of this article.

Advanced Distressed Debt Lesson: Federal Judgment Rate (FJR) and Bankruptcy

noreply@blogger.com (Hunter) — Mon, 19 Mar 2012 03:38:00 +0000

A month ago, I introduced a new set of writers to Distressed Debt Investing: Martin Bienenstock, Phil Abelson, and Vincent Indelicato from Dewey & LeBouef which penned their first (amazing) piece on Bankruptcy Rule 2019. This month, they wrote a fantastic piece on the federal judgement rate and its application in Chapter 11 bankruptcies, which came to the forefront in the Washington Mutual bankruptcy. Enjoy!

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.

Martin Bienenstock
Phil Abelson
Vincent Indelicato

Third Point's 2011 Letter

noreply@blogger.com (Hunter) — Thu, 15 Mar 2012 11:39:00 +0000

Dan Loeb is out with Third Point's 2011 letter. As always, its a fascinating read; even moreso this year with Third Point's activist campaign and now shareholder proxy with Yahoo! Thanks to MarketFolly for posting the letter. Enjoy!

Third-Point-Q4-2011

A Value Investor's Take on Shorting

noreply@blogger.com (Hunter) — Tue, 13 Mar 2012 04:51:00 +0000

A few weeks ago, I received a question from a reader:

"Would it be possible for you to do a post outlining what you’ve read and/or what your thoughts on shorting are? I know its sort of frowned upon in the value community so I thought it would be interesting to get your perspective and what you’ve read of others on the matter. Perhaps you could also discuss how you would evaluate the tradeoff between going long put options and shorting a given security outright?"

18 or so months ago I wrote a post entitled: "Distressed Debt Investing's Book Recommendations: Equity Shorts" in which I recommended and gave summary reviews on five books dedicated to the practice of shorting. And when I was just a wee little (with one of my first posts), I wrote about how I approached shorts from a fundamental research standpoint. While I wasn't short DRI at the time of the post, it turned out to be a pretty decent short for short time being down 10% versus the market up 20% a few months later. To be frank, a lot of my thinking around shorting has evolved since that post. With that said, I do stand by this passage:

"You make money in the market by having different expectations about the future than the general consensus. If you think 2010 and beyond free cash flow will be substantially higher than the analyst community, you would be more apt to buy the stock."

One of the reasons shorting has a stigma in the value investing community come from comments Seth Klarman (among other prominent value investors) made about the asymmetric upside and downside that shorts impose on funds. Here is a chart that haunts a number of the best funds in the world (and a few analysts that got laid off because of it):

This is the chart of Volkswagen which is one of the greatest, if not the greatest short squeezes in recent investment history. For those looking for the back story, simply Google: Volkswagen hedge funds

Equity shorts have unlimited downside and finite upside (100%). With that said, in a very old letter to investors, Seth Klarman wrote:

"Of course, diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preferences for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none" (my emphasis added).

No where there do I read Klarman being 100% against shorts: Just shorts that expose him to infinite loss.

Personally, I very rarely put on naked short positions in my personal account. Given the size, I can be much more nimble than a large fund. With that said, more often than not, I am employing three distinct strategies:

Shorting a stock while buying a way out of the money call on the name. While I give up some performance, my downside is capped (and even if my position is not 100% delta hedged correctly, potential loss is significantly reduced)
Bearish vertical call spreads. I use this strategy more when the borrow is tight (enormous rebate) or impossible to find at one of my brokerages. In this scenario, I will often sell at the money calls, while buying calls further out of the money. I am taking a directional bet that both positions will expire out of the money. In this scenario, your loss is capped at the difference between the strike price of the two contracts used * number of contracts * 100.
Buy puts. This is highly dependent on things like implied volatility of the various puts, as well as the tenor, liquidity, and strike prices. It is also highly dependent on being able to put to a catalyst to get the position moving to offet the premium which might be quite high given the volatility or lack of borrow in the name.

While my thinking on this has changed over the past few years as an investor, I will never short a company on valuation alone. Unless there is a catalyst, I simply do not want to get involved. The one exception to that are companies that have no chance of survival based on a flavor of the month technology - Does anyone remember the old Raser Technologies? While I will not name a specific name tonight, currently I am short a renewable fuels company as well as a company involved in stem cells. In effect, the business models of these companies are broken because they cannot survive (make payroll) without extensive infusions of capital (i.e. a ponzi scheme).

The shorts I REALLY like (outside China reverse merger frauds) are the ones where quality of earnings is remarkably weak or there is some other kind of accounting irregularity. This is where diligent analysts separate themselves from the crowd. Even better when short interest is low, there are many buy versus hold/sell recommendations, and seemingly you are the only one that cares that inventory is growing much faster than sales, or the company is the only one in its industry using FIFO (which hurts in down markets), or a company has changed an accounting assumption like depreciable life. I also love when I see completely misaligned incentives between management and shareholders.

Credit and equity shorts are fundamentally different in many aspects. For instance, I can be short a BBB credit via CDS and do very well if the company gets LBOd. If I was short the equity, it would have been painful. CDS also benefits from a more manageable risk/return profile as credit spreads can't go to zero and expose investors to infinite loss. Further, shorting bonds is treacherous in the borrow can be pulled with a snap of a finger and the propensity for a fund to do this that is establishing a large position to gain control of a situation is high. It has happened to me in the past and its devastating (not to mention the high carry costs). CDS also has the added benefit of being high leveragable with the minimum ticking costs versus the extreme payouts. Just ask Bill Ackman, John Paulson, or Mike Burry.

It is my estimation that an individual investor need not use hedges to protect against market uncertainty. Instead, if you deploying 6 figures of capital or less, you should taking negative positions (using one of the three strategies I noted above) in individual names. If you are right on your due diligence, and the story is indeed negative, it would take an awful lot of tide turning for these individual stocks not to go down in an overall down market. If you are truly worried about the market, and can't fight individual stocks to hedge with, you probably should be out of the market waiting for the fat pitch. But in my thinking, every individual investor out there can turn over a few stones and find a few stories to short. Maybe its a company in an industry you know well or possibly a company whose management team sank the last ship they were a part of. If everyone thinks the company is overvalued, that might not be your best bet (market hurts the most people at any one time - pain trade is higher in that scenario). Instead look for situations that are fundamentally misunderstood (or a fraud) where there are a lot of cheerleaders who have no idea what they are doing, and that can be hedged as to not risk an financial ruin EVEN if you right in the long-run.