Advanced Distressed Debt Lesson - Double Dip

One of the key determinants of recovery in a Chapter 11 bankruptcy or distressed debt situation are the specific guarantees embedded in an indentures of a corporate bond. Like a guarantee on a home purchase or rental agreement, XYZ party guarantees the liability of ABC person. In corporate finance, these guarantees are carried by the various operating subsidiaries and holding companies of certain issuers. A less than diligent analyst may misread a guarantee into thinking it is more than it is and sometimes may not realize an entity has guaranteed a certain bond.

Let's take a theoretical example before we dive into Lehman Brothers, which I will be using as an example for this lesson. Let's say a WidgetCo has issued two senior unsecured bonds. WidgetCo, as the issuer, has no operations of its own. Instead it relies on its two subsidiaries, WidgetCo A and WidgetCo B, for upstream dividends to make its interest payments. Both operation contribute 50% of the cash flow (let's use $50M each).

Now WidgetCo gets in trouble for whatever reason. You as an analyst start digging through the documents and realize Senior Unsecured Bond 1 is guaranteed by both subsidiaries while Senior Unsecured Bond 2 is only guaranteed by one of those subsidiaries. In this instance...which bond would you like to own? Of course the bond guaranteed by both subs.

WidgetCo inevitably files. Holders of Senior Unsecured Bond 2 can only look at one sub for their recovery, while Senior Unsecured Bond 1 holders can look to both subsidiaries.

What does this have to do with a double dip? Generally speaking, a double dip is when a certain bond issue, generally issued at an operating subsidiary, looks to both the issuing operating subsidiary as well as the holding company for a recovery. In this case the holding company has guaranteed the debt. Let's take a look at a practical example.

For this, I point reader's to a recent filing in the Lehman bankruptcy. This motion was filed by the ad hoc group of Lehman Brothers creditors, which by their own admission hold $15.5 billion claims against LBHI (Lehman Brothers holdings). Here are their members:

• Calpers
• Canyon Capital
• Fir Tree
• Fortress
• Gruss
• King Street
• Owl Creek
• Paulson & Co
• Taconic
• Western Asset Management

Needless to say, in my opinion, there are some of the best names in distressed right there. And here is the motion which we will go through step by step....

Objection Preliminary Objection of the Ad H - Objection

And here is the chart of the benchmark LBHI bond (LBHI 5.625% due 2013):

For those that are too lazy to read, here is the jist of the objection:

• The current Lehman Brothers Plan and Disclosure Statement is set up so that creditors of each individual debtor of Lehman (LBSF, LBIE, LBCS, etc) looks to that debtor and its guarantors for value.
• The holding company of Lehman Brothers (LBHI) though, guaranteed most of the operating subsidiaries debt
• That said...from the motion:

"Based on Disclosure Statement analysis of the claims pool, claims of creditors of most, if not all, Debtors and other affiliates of LBHI will be permitted to participate to the full extent of their allowed amount in distributions under the Plan from both their primary obligor, and against LBHI, their purported guarantor."

There's your double dip claim.

So what is the ad-hoc committee arguing for? For substantive consolidation. Remember, in substantive consolidation, a debtor pools all its assets across individual entities against the entire spectrum of liabilities. With that in mind, these inter company guarantees are effectively eliminated. According to the motion:

"Based upon its own analysis of publicly available information, the Ad Hoc Lehman Group believes that resolution of the Inter-Debtor Issues could impact creditor recoveries in the tens of billions of dollars. A substantive consolidation of the Debtors’ U.S. subsidiaries alone would increase recoveries for LBHI creditors by billions, and litigation with respect to other intercompany claims could involve additional billions."

And given where the bonds are trading today, these additional billions translate into 5-10 point moves which, right off the top, is an additional 25-50% return. On $15.5B notional, 5-10 bond points is a lovely pay day. We do not know how this case will play out, but we will sure to keep you updated.