L.A. Dodgers Bankruptcy - DIP Proceedings

The Los Angeles Dodgers recent history has been a story stuck somewhere between Sports Illustrated and Page Six. Since 2009, Dodger owners Frank and Jamie McCourt have been locked in a very public divorce with the primary point of contention being the couple’s ownership of the baseball team. Until recently, the McCourt’s divorce drama seemed like it was inching towards resolution.

Now the Dodgers story seems more appropriate for a post on Distressed Debt Investing. In late June, a liquidity crunch forced the team into Chapter 11.

According to Dodgers Treasurer Jeffrey Ingram’s First Day Declaration, a “perfect storm” created the liquidity crunch. Ingram attributed the shortfall to three elements: 1) revenue reserves required by prior financing arrangements, 2) deferred compensation prefunding requirements and 3) weak attendance.

Ingram’s last point certainly has validity. Dodger attendance has plummeted since 2009 when the team went 95-67 before losing to Philadelphia in the NL Championship series. In fact, since the 2009 season average attendance at regular season Dodger home games has fallen 21.4% to 36,485 per game. This number is particularly notable as Dodger home games averaged 46,100 in the 5 seasons leading up to 2011.

Prior to the bankruptcy filing, the Dodgers attempted to secure a loan from Fox Sports to solve the impending liquidity issue. Fox Sports had retained the cable broadcast rights for Dodger games after selling the team to McCourt in 2004. Fox’s rights agreement is not set to expire until 2014, however the broadcaster has a “Right of First Negotiation” provision through November 2012. In exchange for the $385.0 million loan, the Dodgers agreed to extend Fox’s broadcast rights up to 17 years.

Approval of the Fox deal required consent from Major League Baseball. In June, Baseball informed the Dodgers the deal would not get approval. Instead, Baseball wanted the Dodgers to hold off negotiations for the broadcast rights until Fox’s First Negotiation provision expired. The implicit reasoning behind Baseball’s stance being a bidding war for the rights might lead to a more lucrative deal. Additionally, the Commissioner’s office noted they had reservations about a portion of the funds potentially being used to fund the McCourt divorce settlement. ($55.0 million of Jamie McCourt’s $100.0 million settlement would be funded via proceeds from the Fox Loan.)

The first inning of The Dodgers Chapter 11 proceedings has been no less interesting than the events preceding the filing. Last Friday, Judge Kevin Gross denied the team’s motion for DIP financing.

When the Dodgers filed in late June, Highbridge Principal Strategies had agreed to lend the team up to $150.0 million through a delayed-draw term loan. The court approved the DIP facility on an interim basis allowing the team to draw an initial $60.0 million. Major League Baseball subsequently objected to the Dodgers DIP motion as the league had also offered the Dodgers financing on better terms.

A comparison of the two facilities highlights the “plainly superior” Baseball offer:

Note: Initial Terms of the Highbridge facility were L+700 however, Highbridge lowered the interest rate by 1.0% when Unsecured Creditors Committee objected. The Unsecured Creditors subsequently dropped their objection.

A Memorandum Order from Judge Gross explained his rationale for denying the motion. The Judge’s decision was supported by two points: 1) The Dodgers were able to obtain unsecured financing and 2) the Debtors could not claim their decision to borrow from Highbridge was “business judgment.”

In regards to the first point, Gross explained how section 364(b) of the Bankruptcy Code disqualified the Highbridge Loan:

“The Court may not approve any credit transaction unless the debtor demonstrates that it has attempted, but failed to obtain unsecured credit. The Debtors not only failed to attempt to obtain unsecured financing (offered by Baseball), they refused to engage Baseball in negotiations because, they explained, Baseball has been hostile to Debtors.”

The second aspect of Gross’s ruling was McCourt violated a component of the business judgment rule. This rule generally allows corporate directors to exercise discretion when making business decisions such as whether a loan makes sense. The specific component Gross felt McCourt and the Dodgers did not satisfy relates to independent judgment:

“The evidence shows that if…McCourt did not seek court approval for the Highbridge Loan, he would personally owe $5.25 million to Highbridge. Such potential personal liability clearly compromised McCourt’s independent judgment…Additionally, Debtors refused to negotiate terms with Baseball to obtain a better and unsecured loan because of Mr. McCourt’s poor relationship with the Commissioner.”

The outcome had to be disappointing from the perspective of Highbridge. While a 9.0%+ return might be considered modest, the quality of the underlying assets is high. In 2010, Forbes magazine estimated the value of the Los Angeles Dodgers was approximately $727.0 million. Using the Forbes valuation as a benchmark suggests a $150.0 million DIP Loan would have significant asset coverage. Moreover, depending on the circumstances, the DIP lender could hold key negotiating leverage for a marquee asset.

The ruling also puts McCourt at a significant disadvantage. For the last few years, he has had a contentious relationship with Baseball. Leading up to Judge Gross’s decision, Baseball had accused McCourt of gross mismanagement and appointed a monitor to oversee the team. Indeed, McCourt’s rocky relationship with the league is puzzling. Most certainly, Judge Gross summed up McCourt’s strange attitude the best, “It is unclear to the Court how Debtors think they can successfully operate a team within the framework of Baseball if they are unwilling to sit with Baseball to consider and negotiate.”

A Catch-22 in the Credit Markets

This morning, HCA announced they were intending to issue $1 billion of notes (split between secured and unsecured tranches). Mind you these bonds had no restricted payment basket covenants or unsecured debt incurrence covenants. The talk around 3:30PM was 6.375-6.5% on the secured 1st lien tranche and 7.375%-7.5% on the senior unsecured tranche. This talk was sent out by the JPM (lead book runner) sales team with indicated books closing at 4:30PM

Instead, HCA issued $5 billion (!) or a 5x up-size on deal at the wide end of talks. This has to be some sort of record for an up-size. The bonds went out 100.5 - 101.25 for the 6.5% and 100.5 - 101 on the unsecured 7.5%.

I forgot to point out that HCA's equity dropped 20% yesterday...

To me, the reasons investors are buying this offering is that HCA's paper is some of the most liquid in the high yield universe, it is well followed across the street, it is a very large complex with nearly $15B of market cap beneath you, and its one of those credits you won't (in theory) get killed in and should tighten if high yield spreads on the whole tighten. Are you going to make a ton of money here? Absolutely not. But you aren't going to lose a lot of money, and can allocate lots of capital to this deal and feel ok about it if you are a high yield manager who is awash in cash from coupons, calls, and maturing debts.

With all that said, one of the most frustrating aspects of investing in primary high yield credit is that the best issuers, except in very rare cases, have the worst covenants in their deals. Take this deal for instance, and forget about the upsizing; could a marginal, unknown issuer come to market with an unsecured piece of paper without restricted payment covenants or debt incurrence covenants? They could try, but the underwriter would be stuck holding the bag.

Maybe I am in the minority here, but I have passed on many deals of very well run companies that deserve premium equity valuations (i.e. of high returns on capital, significant barriers to entry, recurring revenue streams, etc) due to poorly structured covenants underpinning the deal. Call me overly conservative, but if an indenture is structured to allow a company the ability to screw over creditors and lenders, management and equity investors will most surely step up to the plate to do just that when it fits their needs.

In my opinion, when deals like this get struck investors are less focused on the downside and more focused on the potential return of a deal. This is myopic thinking that leads to excess risk taking across the corporate credit spectrum. Unfortunately, when the world is rosy, no one really cares about covenants.

Adding insult to injury, because "better" companies in theory fare downturns with less operational pain than weaker companies, it can be sometimes difficult to really see if weaker structures do lead to spread under performance. With that said, when investors incorrectly surmise the quality of an issuer with a weak covenant package, prices will most assuredly fall dramatically and an investor may have exposed himself to a permanent loss of capital.

In bearish markets, underwriters will strengthen covenant packages to attract investors to new high yield offerings when capital is scarce and precious. This is the time when investors, especially those that HAVE to play on the primary side, should be backing up the truck. This is not that time. Instead, today, I'm trying to thread the needle with purchasing high quality companies, with significant asset coverage, and reasonable covenants at yields above the overall market. I've found a few deals here and there that I believe investors misunderstood during the marketing process or were too small for investors to really get excited about. It keeps me busy while I pore through the secondary market looking for event-driven opportunities with a catalyst and a favorable upside / downside dynamic.

Notes from NYSSA's Distressed Investors Market Panel

Last week, NYSSA held a Distressed Investors Market Panel where a number of market participants discussed the current climate and trends in the distressed market. Distressed Debt Investing was there taking notes which we've copied below. Enjoy!

NYSSA Distressed Debt Panel - Notes

NYSSA held its Distressed Debt Investors Market Panel on July 19, 2011 at its headquarters near Times Square in NYC. The Distressed Debt Investors Club was a media sponsor, and its writers helped organize and were present at the event. The event was well received by the audience of 85, mainly credit analysts.

The moderator was Joshua Nahas, Principal at Wolf Capital Advisors. The panelists included

• David Jackson, Senior Analyst at $6 billion AUM PENN Capital Management
• Varun Bedi who leads transaction origination, structuring, and execution activities for Tenex Capital Management, an investment fund focused on operationally intensive opportunities and special situations
• Andrew Milgram, the managing partner at a distressed and special situations hedge fund, Marblegate Asset Management
• Derrick Pitts, managing director in the Financial Restructuring Group at Houlihan Lokey
• Justin Smith, Senior Covenant Analyst at Xtract where he oversees the review and analysis of complex debt documents.

The panelists covered a broad range of topics such as what were the lessons learned from the previous credit cycle and the financial crisis we underwent, how deep are we in the credit bubble currently, where is value in distressed markets today, and how bad could the maturity wall prove to be.

Andrew Milgram started out asserting that one of the main lessons to be learned for distressed investors (and buy-side in general) from the financial crisis was to avoid stark mismatches between the underlying investments and fund structures which exacerbated the losses and forced selling when redemptions started dramatically. Times were extremely tough for everyone, but disciplined investors won whereas the ones who “owned two of everything” suffered most of the losses. Andrew also mentioned that mid-market bank debt is a disaster waiting to happen since some lenders have kicked the can down the road as some of the restructuring in the last cycle was done poorly and left some of the underlying problems intact. This will be the one of the roots for the next distressed cycle.

Derek Pitts suggested that from his advisory perch he could see that there was so much velocity in the transactions that the value of due-diligence was often times neglected, and investors didn’t really know what they owned. For example, the second lien holders often did not bother to have intercreditor agreements, let alone go through and understand them prior to restructurings.

Justin Smith echoed similar observations and lamented that things seem to have reverted back to usual in that understanding the credit documents thoroughly is again taking a backseat. Investors seem to have learned the lessons much less than the issuers and their private equity sponsors in that the new credit documents now seem to build in flexibility for issuers and sponsors, and things like “equity cures” have become rather standard. He would advice the investors to understand and appreciate the risks from the outset.

From a middle market private equity fund perspective, Varun Bedi said that despite the fact that some of the smarter and bigger PE funds (such as Apollo and Blackstone) joined the hedge fund managers in buying distressed debt of their portfolio companies at attractive levels so that they could continue controlling their assets and not fight the hedge funds over them, not all the PE shops (especially the ones that do not have much liquidity/money that is locked up) can make the switch without running into trouble. The smaller PE shops should continue to focus on retaining their edge in terms of operating skills, which are hard to acquire in short term. On the operational side the opportunities came for his fund since history repeated itself - in previous upmarket small to mid cap firms tried to grow using debt and their managements started focusing solely on maximizing equity values. This worked well for 20-30% of the firms, but for the rest just as working capital requirements and cash burn increased, liquidity dried up and the firms got into trouble. Firms don’t seem to have learned the lessons and this will again provide opportunity in the mid-market.

Next up, the panelists were asked on their views on the macro fundamental outlook given what’s gone on with quantitative easing (QE1 and 2), equity markets essentially getting back to flat after spending $2T, etc. Dave Jackson mentioned that due to Fed interventions there has been misallocation of financial resources and there will be unintended consequences due to that. He observed that the long term interest rates are rising for the first time in 30 years, and investors need to be aware of that new environment when they make decisions and keep in mind the open question, what will happen when the Fed exits the marketplace. The hands of the Fed are somewhat tied now if there is a next liquidity crisis due to another sizeable credit shock. Andrew mentioned that the period of late 70s, early 80s is pretty instructive as the risk of policy mistakes is very high both in US and Europe currently. Many parts of Europe clearly need restructuring. Derek added that these dislocations we had in the past couple of years will take a decade or more to resolve themselves fundamentally work themselves fully through the system. During this period there will be some pockets of opportunities (outside of housing, general employment, etc), and people will flock to those creating mini-bubbles in those pockets eventually. The economy will continue to give out a lot of mixed signals, and investors will need to be very careful in pocking their spots.

On the topic of middle market distressed, it was mentioned that most firms do not have much differentiation and pricing power. Varun replied that enough though the space is getting crowded, his fund is still able to find good deals based on enticing prices in the <$500mm revenue companies. The price on a deal makes it worth it for them to take on companies facing severe operational issues. They specialize in getting the companies in the very low percentiles into middle percentiles; do not focus on revenue growth which is very hard to come by in today’s environment, but on EEBITDA margin expansion. They essentially are in a “relentless pursuit of mediocrity,” as this formula has provided good returns for them. Starting last August 2010, banks started letting go of (rather than just amend, extend, and pretend) the operationally weaker companies on their portfolios since they are healthier now and also are scared of Fed coming in and auditing their books, so banks have been selling what would we “non-passable” credits.

Derek said that the number of liquid distressed opportunities is low, and that the banks are still holding on the some questionable assets. Investors are in turn, putting more money in their existing situations so that they can be in a better position to make their investment thesis play out by solidifying their seat on the table. Investors are looking for strategic advice from restructuring advisors to help them play out their thesis and communicate more with the issuers and sponsors, rather than just advice on troubleshooting or saving principal they might feel is at risk.

On the health of banks, Dave Jackson thinks that loan growth will be the source of future earnings generation at banks. He did not think that CMBS is going to be a big source of losses at banks as it is different from RMBS due to 75% LTV requirements which are much stricter than in the housing market. One would need to see very high loss frequencies, otherwise commercial real estate loans would not prove to be as bad as some in the market are thinking. Banks’ balance sheets are getting better if only because they are increasing earnings through reserve releases. Dave thinks that banks will get more selective going forward in terms of what they sell. Derek mentioned that only the mez lenders in commercial real estate space might be in trouble while most other tranches would be fine.

Other Miscellaneous topics:

• Justin felt that the weakened covenant packages in the current cycle have increased but they are not the norm across the board. He mentioned that “the companies fail to realize that the capital structure today is not the capital structure of tomorrow.” General theme, however, he is seeing is of “flexibility”
• Companies and sponsors are building flexibility in the documents; Key for investors is to understand that flexibility and risks associated with that.
• On the topic of whether bankruptcy judges might be more circumspect in approving DIP cases in the next distressed cycle since DIP lenders made a lot of money (in some cases 3x in 6 months) despite the judges being told that company had very little chance of survival absent the DIP financing, the panel felt that judges won’t be comfortable ruling against companies’ assessment of its situation and if DIP availability is the best available financing in the market at the time, they would stop those financing from happening. Essentially, the feeling was that the judges can’t rule against the type of last ditch financing the market dictates.
• In terms of Fraudulent Conveyance, Justin brought up the recent case of Dynegy which he felt was very interesting. Dynegy’s situation looks like a case of FD but the documents might prove otherwise. He pointed that the unresolved question there is whether there will be substantive consolidation? The panel felt that regardless of the fairness of the TOUSA decision in which United States District Court for the Southern District of Florida quashed the Bankruptcy Court’s previous decision, the market views the decision as welcome as it took away some of the uncertainty.
• For an inflation hedge, Andrew likes to be involves with companies that are price makers more than price takers. Dave likes leverage loans as they provide collateral, priority, and very importantly interest rate protection.

Next was the question of Wall of Maturity - is it real, or has it just been moved out a couple/few years? Andrew said that it is essential to decompose the pieces constituting that wall. Big pieces (such as TXU, etc) will restructure themselves most likely, but the smaller pieces might face trouble. One big determinant he cited was potentially reducing demand from CLOs which is the next 2-3 quarters are slated to get into their “harvesting” period, and thus will likely be sellers. He felt that the lowest quality credits will be the worst impacted. In the high yield market, he is generally concerned about the demand for the paper. Derek felt that the wall has flattened towards the out years but meaningful maturities remain in the next 2-5 years. He also felt that if the yields become attractive enough, innovation in the financial markets would ensure that a 2.0 version of CLOs would emerge. He further felt that the companies that are unable to extend/refinance in this cycle would be better dead than alive, especially in the middle market. He believes that the wall is not unsolvable absent any sovereign default issues. Others felt that we are in year 2-3 of bad issuers coming to market, and this could continue for another couple of years as the overall % of these issuances is still low but increasing. The timing of the inflection point will depend on when maturities of these type of credits abound.

When quizzed on what they saw as the current opportunity set, panelists had varied views which reflected their vantage points. Varun likes trucking (along with other “crappy” industries) due to fragmented market where improvements in operational efficiency can set a company apart and increase EBITDA margins. He also likes health services industry due to fragmented and mismanaged nature of the industry. He will only invest in health services situations where he can fix things up while fighting deflation. Dave tries to find companies that have some “taint” but where he feels that the companies will be able to restructure. An on-the-run situation he recommends Central European Distillation Corp – he expects to earn 16-19% IRR by 2012.

Andrew likes the middle market space as it is highly disaggregated. He sees potential value in shipping industry players, second tier market commercial real estate which the banks could potentially look to get off their balance sheets, and gaming (which he described as “the gift that keeps on giving.”) Derek also is seeing activity in gaming, shipping, and mezzanine type CMBS structures. In addition, he advocates looking at the municipal space which obviously needs much localized knowledge. Within municipals, he suggests looking at revenue bonds (sewers, stadium, parking garages, etc).

The panelists obviously covered a lot of ground during the event. It was good to get differing perspectives from distressed hedge fund, private equity, high yield focused credit, restructuring advisory, and legal document analysis professionals. One of the themes was that although mispriced opportunities are fewer today, they do exist generally in the middle market. It is important for investors not to underestimate the importance of due diligence, understanding their rights and obligations laid out in the credit documents, and patience. Once the supply exceeds demand due to fewer investors for weaker credits that were part of “kicking the can down the road” phenomenon due to incomplete/inadequate restructurings done by banks and other lenders during the financial crisis, the opportunity set should become much wider for investors with appropriate investment fund structures.

Mining the Portfolio

On July 1st, a consortium consisting of Ericsson, Apple, Microsoft, Research in Motion, Sony, and EMC bid $4.5 billion dollars to win Nortel's patent portfolio. This offer was well in excess of Google's stalking horse bid of $900M that was put before the bankruptcy court in August. I'd argue that 90% of the players in the distressed debt market felt the number would be larger than Google's offer (the bonds were implying a larger purchase price), but very few people thought the number would be as large as it turned out to be.

I bring this up to introduce a concept I feel is of paramount importance to bottoms-up investors. Mining the portfolio, in essence, is taking information and news from current portfolio holdings, and using it, and the second order effects stemming from that information, to allocate capital in other investments.

The traditional example investors see on a (increasingly more) frequent basis, is when one company gets acquired in an industry, similar companies see their stock prices increase as the market revalues the entire industry to the transaction multiple. To me, this is a difficult game to play because the speed at which the market digests the information and revalues the entire sector. But sometimes, the market may still be pricing similar securities incorrectly even when the news is on the front page of the WSJ.

Take IDCC for instance. Here is a 30 day chart of IDCC. I've marked July 1st with an arrow:

A diligent investor (I know a few that did just this), took the Nortel comp, did the digging on how IDCC's 4G/LTE patent portfolio was in fact better than Nortel's, and started to put the pieces together. And made a ton of money when management did the right thing putting the company up for sale.

In the same vein, Carl Icahn amended his 13D with Motorola Mobility (MMI). He writes in the filing:

"On July 20th and 21st, 2011, the Reporting Persons discussed with the Issuer their view that the Issuer should explore alternatives regarding its patent portfolio to enhance shareholder value. The Reporting Persons believe that the Issuer's patent portfolio, which is substantially larger than Nortel Networks' and includes numerous patents concerning 4G technologies, has significant value. In addition, there may be multiple ways to realize such value given the current heightened market demand for intellectual property in the mobile telecommunications industry. The Reporting Persons intend to have further discussions with the Issuer. "

As Michael Price frequently says, he spends most of his time reading proxy filings and disclosure statements to figure out what ACTUAL dollars are being spent on companies and securities versus a theoretical exercise of applying a multiple to run rate cash flows and calling it a day.

Other "first order" sorts of events would be earnings surprises by comps in the industry, a competitor announcing a price increase of a certain product, a consolidation in an industry changing the balance of power between customers / suppliers (see Medco / Express Scripts), etc. Because, in theory, an analyst should know his companies and industries inside and out, he or she should should understand these first order effects, and be able to communicate how they change the potential revenues, cash flow, or valuations of companies impacted.

Second order effects is a little more tricky, but I believe the opportunities are more interesting. It is always difficult to draw a line saying, "Because this happened, there is a 100% chance this will happen." In my opinion though, the uncertainty makes for increased inefficiencies which leads to larger mispricings. Furthermore, an analyst or portfolio manager than can connect the dots, will find that by deeply understanding the names in the portfolio, these second order effects begin to pop up frequently.

For example, let's say you covered the lodging industry in 2008. Everything is bad. World coming to an end so to speak. You have a few short positions on and are loving life. You talk to some management teams who are utterly pessimistic about the industry and they tell you all building projects have been canceled. First order effect = Results are going to be terrible in the near term. Second order effect = Less supply on market leads to higher prices when the economy recovers and given lodging has massive operating leverage, this will lead to enormous growths in cash flow and transaction prices for properties. The art in all of this is when to cover your short and play for the second order effect, especially since many of these sorts of things are contradictory to the 'next piece of news' information that will drive the security price in the near term.

In fact, mining the portfolio is probably the only reason I will allow myself to talk to management teams. Like Walter Schloss, I understand that the CEO is the best salesman of his company. He does it EVERY SINGLE DAY; probably multiple times (investor meeting, putting a client over the finish line, etc). But asking a CEO how XYZ company is affecting the pricing dynamic or which management team really doesn't understand the current business climate, can pay huge dividends in terms of places for further research.

The question you need to ask yourself is "What are the implications of this piece of news / this data point?" Back those implications with facts and raw data and you could be on to something. Instead of reading sell side reports, I think you should be looking through your portfolio holdings, and seeing how you can leverage all the research and knowledge you have in a particular company or industry (you must have a good amount of knowledge if it's already in the portfolio I hope), into another money-making investment.

Post Re-Org Equity: Spansion (CODE)

Every few months, I post an idea from the Distressed Debt Investors Club to give potential guests and members a feel for the ideas on the site. Remember, we have unlimited spots for guests that have a 50 day delay access to the database. We only have about 50 member spots left which give you access to the entire database and the forum (which I post on 2significantly more than this medium).

Last week, a member wrote up Spansion (CODE), a post-reorg equity with a target of $30/share with potential upside from there on additional royalty sales. Enjoy!

Company Name / Ticker: Spansion / CODE

Synopsis

The core thesis is that you have a hugely cash generative business, that is characterized by stable predictable orders, benefitting from a global trend towards increased electrical automation and increased content in all manner of industrial applications. EBITDA growth is continuing to grow steadily yoy each quarter in the core business, and now with the licensing revenues, CODE should have nearly double digit rev growth for the next two years and over 20% growth in EBITDA this calendar year. Incrementally you are long optionality based on litigation strategies and licensing opportunities on the IP portfolio. At $30, Spansion would be at 5.2x ’11 EBITDA and trading at an 11.6% ’11 FCF yield and we have yet to add value from royalties from Elpida sales or other incremental value from future licensing opportunities.

Write-Up

Business Description:

Spansion is a leading nonvolatile flash manufacturer. The primary focus of the company is NOR flash, which has superior reliability and fast read times, which makes it used widely for code storage, boot up instructions, and execute in place (XIP) applications in all manners of electronics. The company has ~36% mkt share in the embedded market. Spansion's segments are approx. 41% consumer and gaming, 22% auto and industrial, 12% computer and comms, 19% wireless and M2M, 5% other. The company will benefit by continued electronic content and active safety control features in autos, smart meters, increased industrial automation, and 3D TVs and gaming etc. They also are licensing their technology to Elpida in an important JV to build NAND. The embedded markets are characterized by steady demand and ASPs, high customer retention, little interest in advanced node technologies, and 5 to 10yr product lives.

Background:

Spansion was originally formed by AMD and Fujitsu. In the years leading up to its restructuring, it was a company run by engineers for engineers. Tremendous amounts of money spent on R&D, non-core business lines, and capital spending while primarily competing with Samsung and Numonyx to provide NOR flash for the hyper competitive handheld market. Low margins (if positive at all), tremendous cyclicality, and huge capital intensity were constants. Unlike many modern restructurings, Spansion actually went through both a financial restructuring and a true business restructuring. Some key aspects of the business restructuring included the following:

• Exiting the bulk of the wireless business to focus on embedded markets
• Reducing headcount ~60% and focusing R&D on core business & product extensions
• Abandoning SP1 their new fab built in Japan, and creating a hybrid model whereby Spansion utilizes there fab in Austin, TX for ~65% of their product. This keeps it at running at near 100% capacity with an “asset-lite” model for the rest of their wafers. They utilize the same model with assembly and test facilities (2 owned but utilize 3rd parties as well).

As a consequence of the restructuring, Spansion cut sales approximately in half, but took gross margins from 4% to mid 30s and they are on their way to north of 40%. This was accomplished by focusing on the embedded market. By focusing on the embedded market, they are selling into customers whose product life is 5-10 years. The orders are stable and predictable and once they are designed in, it tends to be very sticky. They have excellent visibility as they do not produce much of any spec product, and this is corroborated empirically by 8 consecutive quarters that have met or exceeded guidance. Due to the longer term nature of the products made by the embedded market, the business has low capital intensity. In fact, the company suggested that these attributes were always attributes of the embedded business, but it was invisible to outsiders based on poor segment level disclosure and the cash generated by the embedded business was swamped by the cash furnace that was the wireless division.

Capital Structure as of 3/31/11:

Cap leases $1.7

Secured TL $251

Unsecured Bond $200

Cash and securities $308

Investment Thesis:

Spansion spent over $1B on R&D in the 3 years leading up to the bankruptcy. They already have process technology and IP for the next 2 smaller node sizes. This gives them a roadmap to produce more advanced flash products (transitioning from 110 to 90 to 65 to 45nm) for the better part of this decade. Spansion can now in effect, monetize much of the expenses incurred by previous investors. This is driving all sorts of new products specifically targeting existing and new markets. They brought 4 to market in 4Q10, with 17 expected this year. All at 65nm (at the forefront of NOR flash) and designed with the embedded market in mind. This is driving significant design wins that is expected to boost their embedded market share from 36% up into the 40%+ area (Numonyx is #2 with ~20%, and at the higher densities this duopoly is even more significant). These new products have driven numerous design wins which is one reason Spansion has quantified $15-30mm in top line as the estimate for 2011 from the Japanese tsunami and still haven’t lowered their guidance. Incremental demand in 2012 for the rebuilding efforts should further bolster pricing and volume. Also, Spansion now believes they will sell $75-100mm in NAND flash from their JV with Elpida in 2012. They see this as a ~$500-600mm mkt which think they will get ~approx. 1/3 of the share. This does not include any possible licensing royalties from NAND sales by Elpida. Spansion also recently settled all of their outstanding litigation with Samsung, which is providing for $150mm in revenues over 6 years. Also as part of the settlement, they stipulated an outstanding claim in the bankruptcy estate. Spansion agreed to buy back that claim and retire the shares.

Their products are known for their reliability, durability and ruggedness. This is one reason Spansion does so well in the auto industry, where products must meet not only strict specifications, but also be qualified and supplied by reliable suppliers. The content per vehicle is going up. The designs are done. All new safety and security systems, infotainment, and in fact every time you see an electronic screen in the cabin, it generally requires NOR. It’s necessary because it has instant boot up time and it doesn’t drop bits like other memory (NAND). These same traits are why NOR is going into industrial automation, advanced Set top Boxes, communications equipment, smart meters etc. etc. In fact, the same “drivers” of business that people like in companies like FSL, ADI, LLTC, TXN etc. all generally benefit Spansion.

In addition to the core business, which is growing with expanding margins, there are new opportunities to monetize Spansion’s 1696 US patents (873 foreign, as well as 502 and 840 applications are pending both in the US and abroad respectively). The royalties from Samsung will bolster the top line and cash flow by $25mm and ~$20mm per year (NOLs shield in US, some leakage in Korean sub) respectively. I believe we will see Spansion attempt to go after some or all of the following: MU, Toshiba, Hynix using the Samsung settlement as a guide to try to extract further value going forward.

Another example of Spansion being able to “monetize” its IP is with a JV with ELPIDA. ELPIDA is a significant DRAM manufacturer and had interest in entering the NAND market. ELPIDA and Spansion have formed a JV with a licensing agreement that provides royalty payments and product near cost to Spansion for its non-exclusive use of its Mirror-bit technology which is slated to ship product before the end of 2011. This NAND is not intended to compete against Samsung, Toshiba or Micron in the hyper competitive NAND found in handhelds, computers or tablets. This is “ruggedized” 1-2GB 43nm SLC NAND that is targeting niches in industrial applications where increased performance and reliability are needed. It appears to be a complimentary product and doesn’t appear to be likely to cannibalize NOR given early indications from design engineers. In discussions with Micron, they corroborate CODE’s contention that there is real demand for this new aspect of the NAND market. The $75-100mm target will be very backend loaded in 2012, but should ramp from there assuming the product timeline doesn’t slip. CODE should be able to keep low to mid 30’s on the GM on this (lower, b/c they will have to pay some small margin to Elpida above cost. Elpida is working on 3x and 2x nm NAND to compete with the big guys. The TAM for NAND is growing rapidly as is estimated at ~$25B. If Elpida can carve out even a piece of this mkt, and with a mid single digit royalty, this could provide a solid tailwind just on royalties alone. Spansion has no capital commitments to the JV. Spansion holders have optionality on this new product which I do not believe is discounted today.

All microcontrollers use NOR. Historically microcontroller manufacturers have utilized in-house NOR exclusively for consumption embedded into their microcontrollers. This NOR is bulky, not technology advanced, and there is likely to be opportunities to license Spansion’s technology to microcontroller companies looking for superior performance and smaller form factors. It’s unclear and probably unlikely that there is anything imminent on this front, but this has been confirmed to me by large microcontroller companies as being a truly sensible partnership opportunity. Spansion has actually indicated that they are now starting to field incoming interest from other companies on this front. This optionality is not widely understood and certainly not discounted.

The core thesis is that you have a hugely cash generative business, that is characterized by stable predictable orders, benefitting from a global trend towards increased electrical automation and increased content in all manner of industrial applications. EBITDA growth is continuing to grow steadily yoy each quarter in the core business, and now with the licensing revenues, CODE should have nearly double digit rev growth for the next two years and over 20% growth in EBITDA this calendar year. Incrementally you are long optionality based on litigation strategies and licensing opportunities on the IP portfolio.

These are based on conservative estimates and do include an estimate for what the NOLs are worth. There is good disclosure and given the bulk of the PV of the NOLs are usable within 3 years I get a PV of only the Federal NOLs of $165mm.

Multiples are primarily a reflection of three things: FCF conversion rate, volatility of operating results, and growth. Spansion has excellent FCF conversion based on its low capital intensity and its model. This is not a DRAM or NAND company! The volatility of cash flows has been very low over the last 8 quarters. No big surprises and no misses. It’s an annuity like business. Public comments from MU corroborate this when they discuss the nature of the embedded markets at Numonyx, and Spansion’s flexible model reduces operating leverage cyclicality. Spansion is growing, despite multiples lower then those of the yellow pages and newspapers. iSuppli suggests 3% CAGR for the embedded NOR market through 2014, which Spansion suggests does not pick up the whole market. Spansion is growing embedded NOR revenues (81% of revs) north of 10%, with the wireless business coming down (19% of revs) 10-15%. This has the core business up 6-7% on the topline prior to the Samung royalties. Add in the new royalty stream, and you have sales growth of 8.8% this year and 8.7% next year.

MU is a memory company and has a division that is ostensibly Spansion’s best comp. But in aggregate, nothing about MU’s business looks similar from a financial perspective. Its hugely capital intensive, exhibits tremendous cyclicality, is hyper competitive with companies with more resources, has poor if not negative ROIC, and short product life cycles. It’s almost the mirror opposite of Spansion. Spansion’s business attributes much more resemble the analog companies. ADI, LLTC, MCHP, ATML, ONNN trade with EV/EBITDA multiples ranging from 8-11.5x and FCF yields ~4.5-7.5%. Spansion will probably never fully escape its memory stigma, and is not well followed as it operates in a weird little niche that regular tech analysts don’t understand or spend any time on. So it will realistically probably never close the entire gap of relative value, but as the cash continues to pile up, which it has been doing for over 2 years, it will become harder to ignore. At $30, Spansion would be at 5.2x ’11 EBITDA and trading at an 11.6% ’11 FCF yield and we have yet to add value from royalties from Elpida sales or other incremental value from future licensing opportunities. This seems to me to be a rather conservative PT still at a significant discount to the analogs, if they continue to grow mkt share or gross margins, there is upside to this number.

Catalysts:

• Stock sold off hard after Japanese earthquake, and despite solid guidance quantifying the effects, skepticism in the market will fade over next couple of quarters - even more so 2012 demand to rebuild should be a tailwind
• Removal of the overhang from the resolution of the claims pool and final distribution of reserve pool shares
• Significant earnings growth as gross margins climb up over 40% bolstered by the transition to 65nm products and increased overall sales. This should help sentiment as this arbitrary level is used as a benchmark by many tech investors and might help change perception and thus the multiple.
• I actually thought the stock would get a much better reaction to the positive Samsung outcome. All of the street estimates are too low for ’11 and ’12 as they have not updated numbers to incorporate the Samsung royalties or the NAND sales later next year.
• The run off of fresh start accounting will drive GAAP gross margins and earnings higher as increased D&A resulting from inventory step up, cycle off and higher cost inventory no longer boosts COGS - street coverage have been focused on these and i think will be forced to revise targets higher

Risks:

• If SPI or serial peripheral interface NOR (primarily made by Macronix and Windbond) can somehow come up market to more directly compete with parallel interface NOR at higher densities which is where Spansion and Numonyx really dominate, that could change the stable ASP that characterizes the embedded NOR market. While possible, nothing currently suggests this is likely.
• If Spansion does something ill advised with its cash as it continues to accumulate. This is a bigger risk to me, but hopeful that the 2 board members from Silverlake can act somewhat to mitigate this. Spansion has done accretive buybacks of claims in the bankruptcy, and this most recent retirement from Samsung is a continuing this.
• MRAM, FRAM, phase change or some other memory technology comes along that displaces NAND and/or NOR. This has been a discussed risk for 20 years with no demonstrated increased likelihood of displacing current flash memory technologies. Adoption of NAND with error correction in industrial applications is a risk as well. However there is no sign that industrial chip set designers view that as a superior solution as they continue to use NOR.

BAC versus the ABX

At the IRA Sohn Conference this year, Jeff Gundlach, of Doubleline Funds put up a chart of Bank of America versus the ABX 2007-1 AAA tranche. Here is that graph:

Pretty tight correlation. A month or so ago I pointed out that non-agency mortgages were attractive and an uneconomic seller (the Fed) was really weighing on the market. With the Fed putting on hold any further Maiden Lane II auctions, the market has really taken a leg up. And because of that, the above relationship is falling apart:

This graph is normalized since January 1st, 2011 - I thought it better shows the dramatic out-performance of the ABX vs BAC equity.

For full disclosure, I have been buying BAC leaps in the last few weeks (Jan 2013 @ 15 strike). Call me crazy, but all the data I have gathered and read indicated the banks are ready to lend to their customers on the residential mortgage side. All "lending surveys" out there show an easing of conditions for everything but resi mortgages, but the tide is turning here and I believe this metric will go positive soon. Furthermore, the valuation argument is quite compelling. Eventually, loss provisions will normalize, and at run-rate operating earnings the equity looks like a steal (I have it at $2/share normalized EPS)

Finally, there is so much negativity in this name. Here are the list of reasons I've heard or read to not invest in Bank of America:

• They are going to have to raise more capital to meet all Tier 1/Basel 3 requirements
• They will have to settle with all the bond guarantors at billions of dollars each / Other put-back issues
• Their housing exposure dwarfs the other money center banks and home prices still have a long way to go before reaching bottom
• Litigation coming from every which way (AGs -> robo signers for instance)
• The debt ceiling won't be raised and the world comes to an end (Side note: That August 2nd date is silly...if push comes to shove, the Fed will accept expiring bills as repo collateral to give the morons in Washington a few weeks)
• China Construction Bank trade likes a dog
• They aren't well positioned for a rise in rates
• Etc. Etc.

Why the leaps you ask? I very rarely invest in leaps just because the potential downside is 100% (option expires). In this case, I feel like I've given myself enough time for the market to reprice BAC's equity to a more normalized level and I've converted my upside downside from say 1:1 being long the stock (b/c BAC's equity, in theory could still go to zero) to 3-4:1 for most likely a binary situation. For the conservative investor you could buy 2 year protection on BAC at 100 basis points running and simply go long the equity. I've been spending a significant time on financials the last few months and will try to update my thoughts here as trades unfold.

Lehman Brothers Bankruptcy

A number of years ago, when I knew nothing about distressed, my portfolio manager sat me down and said, "Our friends at XYZ hedge fund [name redacted] are telling me these Enron bonds are interesting - start working through it." Over the next 6 months I cut my teeth (hard) on figuring out how much bond holders would receive and what return that translated to. It was one of the best exercises that I've ever been put through as an analyst.

In my opinion, the best situations for distressed debt investors to make out-sized returns are when the bankruptcy filing is unexpected. I remember when Solutia filed in 2003 and Parmalat soon after. In both situations, no one had any idea what to make of the situation. Uncertainty creates opportunity. Chaos as it were. In that vein, of every situation I've encountered in my professional career, Lehman, and its various 'flavors' has been one of the most complex.

On a daily basis I am receiving over 200 trader runs on various Lehman instruments. The most liquid of these instruments are the LBHI bonds, or Lehman Brothers' holding company. In addition, you have runs on "LBSF", "LBCS", "LCPI", "LBIE", "LBT", "LBCC", "LOTC", LBHI Euro, LBHI Yen etc etc. While these instruments are more illiquid, each may hold the possibility of a solid risk adjusted return.

Earlier in July, a diverse group of creditors agreed to a settlement that will (more than likely) enable Lehman to exit Chapter 11. Similar to Enron, this settlement resolves around a partial substantive consolidation (80/20) split. This settlement was agreed upon by a "Who's Who" of hedge funds and prop desks (dubbed the PSA Creditors):

Angelo, Gordon & Co., L.P.

Barclays Bank PLC

Barclays Bank S.A.

BNP Paribas

Canyon Capital Advisors LLC

CarVal Investors UK Limited

Contrarian Capital Management LLC

Credit Suisse International

Credit Suisse Loan Funding LLC

Credit Suisse Securities (Europe) Limited

Cyrus Capital Partners, L.P.

Davidson Kempner Capital Management LLC

DB Energy Trading LLC

Deutsche Bank AG

Elliott Management Corporation (also Elliott Associates, L.P.

Elliott International, L.P. The Liverpool Limited Partnership)

Fir Tree, Inc.

GLG Ore Hill LLC

Goldentree Asset Management, LP

Goldman Sachs Bank USA

Goldman Sachs International

Hayman Capital Master Fund, L.P.

King Street Capital Management GP, L.L.C.

Knighthead Capital Management, L.L.C.

Morgan Stanley & Co. International PLC

Morgan Stanley Capital Group Inc.

Morgan Stanley Capital Services LLC

Mount Kellett Master Fund II, L.P.

Oak Tree Capital Management, L.P.

Och-Ziff Capital Management Group LLC

Paulson & Co. Inc.

Silver Point Capital, L.P.

Societe Generale

Societe Generale Asset Management Banque

Societe Generale Bank and Trust

Taconic Capital Advisors L.P.

The Baupost Group, L.L.C.

The Royal Bank of Scotland plc

Varde Partners, L.P.

York Capital Management Global Advisors, LLC

This group of creditors held over $100 billion (!) of claims against Lehman Brothers.

While the value proposition was definitely there when the LBHI bonds were trading in the teens, another aspect of this case was that A LOT of capital could be put to work with very little correlation to the market with very little downside. And that is still probably the case.

Like in all bankruptcies, the disclosure statement here lays out contemplated recoveries for the various creditor constituencies. And like most bankruptcy cases, these recoveries cannot be relied upon to make actual trading decisions. For instance, LBHI Senior Bonds are contemplated to recover 21.1% whereas in the market as of this afternoon the bonds were trading (depending on the specific bond) between 26 - 26.5%. While in "dollar value" that may not look like a lot, in reality it's a ~25% difference. Why the disparity?

• As in most cases with financial assets as collateral for creditors, there is a perception that there has been a sense of conservatism and that, over time, these assets throw off cash that increases recoveries to creditors
• The fact that no one really knows the recovery on foreign inter company receivables. We do know that the recovery of inter company receivables from foreign affiliates, at less than 10% is far below similar (domestic for instance) recoveries contemplated in the disclosure statement - It's also a HUGE number where a 1% bump means $500M more recovered for LBHI
• Litigation awards that could go any which way

These are just a few factors. In addition, returns to investors depend dramatically on when cash actually gets paid out. The fact that the plan / disclosure statement is on the docket means the likelihood of more timely distributions increases. It will be a sad day when this case finally comes to a close (I believe it accounts for something like 70% of all trade claims).

Linked In Groups

For those that do not know, about a year ago I started a Linked In group focused on distressed debt investing - specifically related to corporate securities. I had found most groups on Linked In were related to CRE, which albeit interesting, is not what I wanted to focus on with this site. Currently, there are over 2,000 members in the group. For those are interested in that group, here is the URL: Distressed Debt Investing Linked In Group

Also - this week I started a new group focused on analysts and portfolio managers that cover the insurance industry (both on the buy and sell side). As some of you know, and have been discussed in the past, despite being a generalist on a day to day basis, I have the most knowledge and connections in the insurance industry and thought it would be a good way to network with other analysts and portfolio managers. Here is that URL: Insurance Analysts Linked In Group

Distressed Debt Weekly Links of Interest

What I am reading this weekend:

Third Avenue 2nd Quarter Commentary for their various funds (will have a post up on this soon) [Third Avenue Management]

Ambac's Disclosure Statement [Ambac Chapter 11 Docket]

Citron Research's short thesis on ZAGG [Citron Research]

An incredible piece on change of control provisions in bankruptcy, specifically in the Young Broadcasting [Bankruptcy Law Blog]

Notes from Charlie Munger's last "Wesco meeting" [Inoculated Investor]

Fantastic piece on how cheap old tech is versus recent tech IPOs [Washington Post]

Most comprehensive notes I've seen yet from May's BRK Annual Meeting [Dr. David Kass' blog]

Advanced Distressed Debt Concept: Credit Bidding

One of the more complicated tenets of bankruptcy proceedings that has seen a number of circuit courts disagreeing is that of credit bidding. Credit bidding, under section 363 (k) of the Bankruptcy Code, allows a secured lender the ability to "credit bid" its claim to ensure that the collateral backing the secured claims are not sold for less than the secured claim itself. One of the more famous cases dealing with credit bidding was the Philadelphia news case. In that case, the US Court of Appeals for the Third Circuit (important because Delaware is in the Third Circuit), ruled that a bankruptcy plan may allow a sale of the debtor's assets (that are subject to a lien) without giving secured lenders the chance to credit bid as long as the secured creditors receive "indubitable equivalent" of their claim.

Recently, the United States Court of Appeal for the Seventh District ruled in River Road Hotel Partners, LLC v. Amalgamated Bank that a secured creditor has the right to credit bidding, essentially in direct opposition to the aforementioned Third Circuit's ruling. What does this mean? That this issue may go to the Supreme Court.

To explain this very difficult, but incredibly important issue better, I reached out to George Mesires of Ungaretti & Harris, who has allowed me to re-post a fantastic piece he's written explaining the importance and implication of the Seventh District's ruling. Enjoy!

Finance and Restructuring Update: Seventh Circuit Hands Secured Lenders a Major Victory - Splits the Circuits by Holding that Secured Creditors Have Right to Credit Bid Under Plan Sales

Introduction

On June 28, 2011, the United States Court of Appeals for the Seventh Circuit affirmed the Bankruptcy Court for the Northern District of Illinois’ decision and held that a secured creditor has a statutory right to credit bid its debt in the sale of assets proposed under a non-consensual plan of reorganization pursuant to Section 1129(b)(2)(A) of the Bankruptcy Code. See River Road Hotel Partners, LLC v. Amalgamated Bank, Case No. 10-3597, __ F.3d __ (7th Cir. June 28, 2011). The case is significant for at least two reasons. First, the Seventh Circuit is the first judicial circuit to recognize that a secured creditor has the absolute right to credit bid at an auction sale held pursuant to a plan of reorganization if such sale seeks to sell the assets free and clear of liens. Second, the Seventh Circuit decision splits from its sister circuits (the Third and Fifth Circuits) and potentially makes the unsettled question of law ripe for consideration by the United States Supreme Court.

In its decision, the Seventh Circuit splits from the Third Circuit’s decision in 2010 in Philadelphia Newspapers and the Fifth Circuit’s decision in 2009 in Pacific Lumber, which held that, as a matter of law, a debtor may preclude a secured creditor from credit bidding when a debtor sells its assets pursuant to a plan of reorganization and provides the creditor with the indubitable equivalent of its claims. See In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3rd Cir. 2010); see also In re The Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009). Citing favorably to Judge Thomas L. Ambro’s dissent in the Philadelphia Newspapers case, but conducting its “own independent analysis of 1129(b)(2)(A)’s meaning,” the Seventh Circuit held that the plain language of Section 1129(b)(2)(A) does not authorize the confirmation of a plan of reorganization that denies a secured creditor the right to credit bid in connection with a plan sale.

Background - Sales of Assets Outside the Ordinary Course in Bankruptcy

In bankruptcy, a debtor may sell its assets outside of the ordinary course of business in two ways: (i) under section 363 of the United States Bankruptcy Code the (“Bankruptcy Code”); or (ii) pursuant to a plan of reorganization under section 1123 of the Bankruptcy Code.

Under Section 363, unless the court for cause otherwise orders, a secured creditor may credit bid its claim. Credit bidding is the ability of a secured lender to offset its claim against the purchase price of the property. See 11 U.S.C. §353(k); 3 Collier on Bankruptcy ¶363.09 (Alan N. Resnick & Henry J. Sommers eds., 16th ed. 2010). For a secured lender, credit bidding helps to ensure that the collateral is not sold for less than the face amount of the debt, and can preserve the ability of the secured creditor to participate in any appreciation of the value of its collateral. In other words, the secured creditor uses some or all of the amount of its claim as a source of payment at an auction such that if the secured creditor is the winning bid, no exchange of money need occur and the amount of the bid is offset against the amount of the outstanding debt. Credit bidding protects the secured lender against attempts to sell the collateral too cheaply if the secured creditor thinks the collateral is worth more than the sale price.

Alternatively, a debtor can sell its assets pursuant to a plan of reorganization. A plan of reorganization can be approved over the objection of creditors, including a secured creditor, under the “cramdown” provisions of the Bankruptcy Code. To cramdown a secured creditor, among other things, the reorganization plan must be “fair and equitable” to the secured creditor. The “fair and equitable” standard may be satisfied by showing that the plan provides: (1) that the holders of such claims retain the liens securing such claims and receive deferred cash payments having a present value equal to the value of their collateral; (2) for the sale of the collateral free and clear of liens (with such lien attaching to the sale proceeds of the sale) but subject to the secured creditor’s right to credit bid (the “Sale Prong”); or (3) for the realization of the secured creditor’s claim by some means which provides the secured creditor with the “indubitable equivalent” of its claim (the “Indubitable Equivalent Prong”).

The River Road Hotel Partners Case

In the River Road Hotel Partners case, the debtors proposed selling substantially all of their assets, consisting mainly of the InterContinental Hotel Chicago O’Hare, pursuant to a plan of reorganization. As part of its plan, the debtors sought to deny the lenders the ability to credit bid their debt as a matter of law under the Indubitable Equivalent Prong, and for cause under Section 363(k).

In its bid procedures motion, the debtors cited the plain language of 1129(b)(2)(A)(iii) and Philadelphia Newspapers to seek to deny the lenders the ability to credit bid as a matter of law. Even if the court denied the debtors’ request to preclude the lenders from credit bidding under section 1129, the debtors argued that the lenders should be precluded from credit bidding for cause. The debtors cited the following factors, among others, as establishing cause under Section 363(k): (i) there exist disputes regarding the priority of competing secured creditors; (ii) granting an unsecured creditor the right to credit bid would chill the bidding process; and (iii) the lenders “precipitated” the debtors’ chapter 11 cases by “improperly refusing to provide funding” under the loan agreements.

On October 5, 2010, Judge Bruce W. Black of the bankruptcy court denied the debtors’ bid procedures motion citing Judge Ambro’s “well-reasoned dissent” in Philadelphia Newspapers. In that dissent, Judge Ambro noted that “it seems Pickwickian to believe that Congress would expend the ink and energy detailing procedures in clause (ii) that specifically deal with plan sales of property free of liens, only to leave general language in clause (iii) that could sidestep entirely those procedures.” Philadelphia Newspapers at 329. Judge Ambro also reasoned that denying the lenders the ability to credit bid would only benefit stalking horse acquirors by allowing such acquirors to potentially acquire assets below market value. Further, the court found that the debtors failed to demonstrate “cause” sufficient to justify barring the lenders to credit bid at auction.

After certification of appeal to the court of appeals in October 2010, the Seventh Circuit’s ruling on June 28, 2011 held that “the plain language of 1129(b)(2)(A) does not clearly authorize confirmation of the Debtors’ reorganization plans” because the statute does not have a single plain meaning – “there are two plausible interpretations of the statute: one that reads Subsection (iii) [the Indubitable Equivalent Prong] as having global applicability and one that reads it as having a much more limited scope.” River Road Hotel Partners, LLC v. Amalgamated Bank, 10-3597, __ F.3d __ (7th Cir. June 28, 2011) (citing i, 599 F.3d at 324-27 (Ambro, J., dissenting)). Looking beyond the text of Section 1129(b)(2)(A) – as it must if the statute does not have single plain meaning – the Seventh Circuit was influenced by the way auctions are recognized and the way secured creditors are treated elsewhere in the Bankruptcy Code. In both Section 363(k) and 1129(a)(2)(B)(ii) a secured creditor is permitted to credit bid, which “promises lenders that their liens will not be extinguished for less than face value without their consent … Because the Debtors’ proposed auction would deny secured lenders the ability to credit bid, they lack a crucial check against undervaluation. Consequently, there is an increased risk that the winning bids in these auctions would not provide the Lenders with the current market value of the encumbered assets [i.e., indubitable equivalent value].” River Road Hotel Partners, __ F.3d __.

The Seventh Circuit found also that canons of statutory construction weighed against the debtors’ proposed interpretation of 1129(b)(2)(A). Specifically, the debtors’ interpretation would render the first two Subsections of 1129(b)(2)(A) superfluous: if “Subsection (iii) permits a debtor to sell an asset free and clear of liens without permitting credit bidding, then it is difficult to see what, if any, significance Subsection (ii) can have. Similarly, the Debtors’ interpretation would permit properly-designed reorganization plans to sell encumbered assets without satisfying the conditions set forth in Subsection (i). We cannot conceive of a reason why Congress would state that a plan must meet certain requirements if it provides for the sale of assets in particular ways and then immediately abandon these requirements in a subsequent subsection.” River Road Hotel Partners, LLC v. Amalgamated Bank, 10-3597, __ F.3d __ (7th Cir. June 28, 2011).

Since 2009, debtors have sought to leverage the Pacific Lumber and Philadelphia Newspapers decisions and seek to deny secured creditors the right to credit bid under plan sales. The Seventh Circuit’s ruling should be deflating to emboldened debtors, at least in the Seventh Circuit, and provide some assurance that secured creditors in the Seventh Circuit may exercise their right to credit bid under both Section 363 of the Bankruptcy Code and an auction sale proposed under a plan of reorganization. However, because this judicial decision does split the judicial circuits, there may now be disparate results, making this issue ripe for resolution by the Supreme Court.

List of Special Situation/Post Re-Org Equities Traded on the Distressed Desks

Over the long weekend, I went through my dealer and broker runs to come up with a equities that are either:

1. Post Re-Org Equities
2. Equities trading at distressed levels
3. Companies currently in bankruptcy
4. Equities that used to trade at distressed levels and are still held by a number of distressed funds.

You will notice on the list below that if the issuer stock is not traded publicly, I have marked it as "Privately Traded on Desks." These situations require investors to sign a confi agreement to receive information on the company. They are usually very illiquid (Delphi being a very good exception) and more often than not, if a desk is telling you to buy these securities, it means they have a large seller on the other end. Fortunes are made in these securities in bull markets, but when things go south, you will see them quoted down to unheard of levels. And because they are so rarely traded, you have to rely on the marks given to you by the desks. Yes you can fight them on it, but its rarely a worthwhile effort. They are sometimes called "hedge fund hotels" and "roach motels" (at least when you can't get out of the security).

Of the listed equities below, they would make excellent application ideas on the Distressed Debt Investors Club. There are 40 spots left of the 250 member limit. We currently have over 3,000 buy side and sell side guests. If you are interested in applying, please contact me. Without further ado, here is the list of special sit stocks traded off the distressed desks:

ABH - AbitibiBowater

ABVT - AboveNet Inc

ACW - Accuride

[Privately Traded on Desks- S1 Filed] - Aleris Inc

[Privately Traded on Desks- S1 Filed] - Ally Financial

ALLY 8.125 - GMAC Capital Trust Preferred

ALLY 8.5 - Ally Financial Perps

ARHN - Archon Corp

ACAS - American Capital

[Privately Traded on Desks] - American Media, Inc

[Privately Traded on Desks] - Angiotech Pharmaceuticals

[Privately Traded on Desks] - Anvil Holdings

[Privately Traded on Desks] - Ashmore Energy

AVRW - Aventine Renewable Energy

AUMN - Golden Minerals

BKEP - Blueknight Energy Partners

BLC - Belo Corp

[Privately Traded on Desks] - Building Materials Holdings Corp

[BLLY or Privately Traded on Desks] - Bally Total Fitness

BGPIQ - Borders Group

[Privately Traded on Desks - 144A] - Broder Brothers

BUFR - Buffets Restaurants

[Privately Traded on Desks] - CDX Gas Inc

CHTR - Charter Communications

CCHJW - Charter Warrents

CCMMW - Charter Warrents

CHHP - C&D Technologies

CCMO - CC Media Holdings

[CEMJQ - Privately Traded on Desks] - Chemtura Stubs

CHMT - Chemtura Equity

CNB 7.875 - Colonial CAP Trust Preferred

CNB 8.875 - Colonial BancGroup Preferreds

CIT - CIT Group

CDELA - Citadel Broadcasting Class A

CDELB - Citadel Broadcasting Class B

CDDGW - Citadel Broadcasting Warrents

CMLS - Cumulus Media

CODE - Spansion Inc

COSH - Cooper-Standard

[Privately Traded on Desks] - Crescent Resources

DAN - Dana Holding

[Privately Traded on Desks] - Deep Ocean Group (f/k/a Trico Marine)

DEXO - Dex One Corp

DIMEQ - Wamu/Dime Bancorp Warrant

DRL - Doral Financial

DPH - DPH Holdings (Delphi)

[Privately Traded on Desks] - ECI

[Privately Traded on Desks] - Education Media & Publishing

[Privately Traded on Desks] - Elkhorn Mining

EPL - Energy Partners

[Privately Traded on Desks] - Express Energy Services

FCSC - Fibrocell Science

FDML - Federal-Mogul

FMCC - Freddie Mac & All Flavors of Preferreds

FNMA - Fannie Mae & All Flavors of Preferreds

FRP - Fairpoint Communications

FSNN - Fusion Telecommunications

FTWR - FiberTower

[Privately Traded on Desks] - Freedom Communications

GGP - General Growth Properties

GLBC - Global Crossing

GLBS - Globus Maritime

GLPW - Global Power Equipment Group

GM - General Motors

GM 4.75 - General Motors Convertible Preferreds

GM/WS/A - General Motors A Warrants

GM/WS/B - General Motors B Warrants

GRA - WR Grace

GSAT - Globalstar

GRKT - Greektown Superholdings

GSIG - GSI Group

GCVRZ - Sanofi Adr

[Privately Traded on Desks] - Haights Cross Communications

HAWKQ - Seahawk Drilling

[Privately Traded on Desks] - Hayes Lemmerz

HEARQ - HearUSA Inc

[Privately Traded on Desks] - Hellas Telecommunications

HWLT - Hawaiian Telecom

[Privately Traded on Desks] - Hawkeye Renewables

[Privately Traded on Desks] - Affinity (fka Herbst Gaming)

HHC - Howard Hughes

ICOG - ICO Global

[Privately Traded on Desks] - ION Media

[Privately Traded on Desks] - Insight Health

ITWG - Internationational Wire Group

[Privately Traded on Desks] - Journal Register

[Privately Traded on Desks] - KGen LLC

LEA - Lear Corp

LYB - LyondellBasell

LALWF - LyondellBasell Warrents

[Privately Traded on Desks] - Mark IV Industries

[Privately Traded on Desks] - Marsico Capital

MASWF - Masonite Worldwide

[Privately Traded on Desks] - MediaNews

MERC - Mercer International

[Privately Traded on Desks] - Merisant Worldwide

[Privately Traded on Desks] - Mesa Air Claim

[Privately Traded on Desks] - MGM Studios

MMPIQ- Meruelo Maddux

MTOR - Meritor Inc

[Privately Traded on Desks] - MXEnergy Holdings

MX - Magnachip Semiconductors

[Privately Traded on Desks] - North Atlantic Drilling

NNHE - Neenah Enterprises

[Privately Traded on Desks] - Newark Group

[Privately Traded on Desks] - Newhall Land Development

NRTLQ - Nortel Networks

NTKS - Nortek

NVIGF - Navigator Holdings

NOF NO - Northern Offshore

[Privately Traded on Desks] - Oriental Trading

[Privately Traded on Desks] - Pacific Ethanol LLC Units

[Privately Traded on Desks] - Penton Media

[Privately Traded on Desks] - Philadelphia News

ORMT - Ormet

PBSOQ - Point Black Solutions

PHOS - Phosphate Holdings

PPC - Pilgrim's Pride

PNC/A - Postmedia Network Canada

PTGI - Primus Telecom

QLTY - Quality Distribution

QUAD - Quad/Graphics

[Privately Traded on Desks] - Readers Digest

ROIAK - Radio One

[Privately Traded on Desks] - RHI Entertainment

RMYI - Remy International

[Privately Traded on Desks] - Satelites Mexicanos (SATMEX)

SALM - Salem Communications

SBGI - Sinclair Broadcast

SEAOF - SeaCo Ltd

SEMG - SemGroup

SIX - Six Flags

SFI - iStar Financial

SGGH - Signature Group Holdings

SGU - Star Gas Partners

SOA - Solutia Inc

SPB - Spectrum Brands

[Privately Traded on Desks] - Stallion Oil

[Privately Traded on Desks] - Star Tribune

SPMD - SuperMedia

TMB CN - Tembec Inc

TSTRQ - TerreStar

TPCG - TPC Group In

TRMAQ - Trico Marine Prepetition Equity

TROX - Tronox Inc

[Privately Traded on Desks] - Trump Entertainment

TPCA - Tropicana Entertainment

[Privately Traded on Desks] - Tropicana Las Vegas

USCR - US Concrete

[Privately Traded on Desks] - US Power Gen

[Privately Traded on Desks] - US Shipping

VRML - Vermillion

VC - Visteon Corp

VTSS - Vitesse Semiconductor

WALK - Walking Co Holdings

WAVE - Nextwave Wireless

WM 5.375 - Wamu Trust Convertible Preferred

WAMUQ - Wamu Preptition Equity

[Privately Traded on Desks] - WCI Communitities

[Privately Traded on Desks] - Wolverine Tube Reorg Equity

XOHO - XO Holdings

XRM - Xerium Technologies

VKSC - Viskase Cos

[Privately Traded on Desks] - Vitruvian Exploration

[Privately Traded on Desks] - Young Broadcasting