Happy New Year from Distressed Debt Investing

2012 was simply an amazing year. Credit markets reaped substantial gains, a number of bankrupt situations were incredibly profitable for many diligent investors, the blog had nearly 1.5M page views, and I met, spoke, and developed wonderful relationships with a number of readers throughout the year. I am very grateful for the readership, kind words, investment ideas, comments and suggestions that many of you send to me - the year wouldn't have been nearly as good without, what I consider, the most intelligent readership out there.

2013 will be bringing about significant, positive changes for my various sites. DDIC members will be receiving an email shortly announcing some of these plans. There will be some huge announcements in the 1Q of this year that I'm excited to share with you.

All that said, I want to wish everyone a Happy (and profitable) New Year for 2013! Thank you for all of your support!

-Hunter

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Distressed Debt Advanced Lesson: CODI

Consideration of cancellation of debt income (CODI) is a factor that have affected how bankruptcy plans have been implemented and constructed in a number of major Chapter 11 cases over the past few years. With that said, recently the IRS released their final regulations for determining the issue price of a debt instrument which has a direct effect on amount of cancellation of debt income to be calculated. A few weeks ago, LCD ran a fantastic article penned by the LSTA discussing these new regulations and how they will affect amendments in the syndicated loan market. The LSTA has allowed me to reprint the article below. For more information, readers can contact Tess Virmani at the LSTA. Enjoy!

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In October, the LSTA reported that the IRS released the final regulations on debt exchanges. While this may sound less than riveting, in reality the new Cancellation of Indebtedness Income (CODI) final rules (“CODI Rules”) will profoundly impact the syndicated loan market when borrowers seek to amend or modify their loans.   To briefly review, under the final regulations, virtually any amendment of a loan would be treated, from a tax perspective, as the retirement of the pre-modified loan in exchange for the “modified loan”, which is treated as newly issued (a “deemed exchange”). The “issue price” for the modified loan is different depending on whether the pre-modified loan is “publicly traded”. If it is publicly traded, the issue price is the market price of the pre-modified loan at the time of the modification. If it is not publicly traded, the issue price is par. As explained below, the “publicly traded” status is critical and could have significant adverse tax implications for stressed and distressed borrowers and/or distressed investors. Here are the Top 10 takeaways:

1. Virtually any amendment, revision, compromise or workout leads to a “deemed exchange” triggering the CODI Rules. Indeed, the threshold here is very low, with any change in maturity, change in obligor, shift in recourse to non-recourse and changes in annual yield as low as 25 bps cause a “deemed exchange”. (According to LCD data, there were more than $700 billion of such amendments since 2008. The average spread change on these loans was more than 100 bps, thus usually triggering CODI.)
2. The CODI Rules make it abundantly clear that most of the loans in our market, i.e. large syndicated loans for which market prices are quoted, are now deemed “publicly traded” whether or not they are actually actively traded.
3. Loans and tranches of loans under $100M, whether or not actively traded, are considered not publicly traded under a new per se rule. 
4. If a debt instrument is publicly traded, the price of the exchanged debt is deemed to be the market price at the time of the exchange.
5. If the debt instrument is not publicly traded (or under $100M), the exchange price is par.
6. A borrower must recognize – and pay tax on – current CODI equal to: i) in the case of a publicly traded loan, the difference between the issue price of the old loan and the market price at the time of the exchange, or ii) in the case of a loan that is not publicly traded (or under $100M), the difference between the issue price and the par price of the new debt at the time of the deemed exchanged, even though there is no actual cancellation of debt and no source of cash to pay the tax liability.
7. A lender may have a current taxable gain equal to: i) in the case of a publicly traded loan, the difference between the price at which the debt was purchased and the market price at the time of the exchange, or ii) in the case of a loan that is not publicly traded (or under $100M), the difference between the price at which the debt was purchased and the par price of the new debt at the time of the deemed exchanged, even though it did not sell its position.
8. A borrower is obligated to determine whether a loan is publicly traded and if so, what the price is, and the borrower is obligated to advise its lenders of that price. Furthermore, lenders are bound by the borrower’s determination. (CODI Rules contain an anti-abuse provision so that borrowers may not simply determine the loan is not publicly traded to avoid the CODI Rules.)
9. For a borrower, to the extent it has current losses or deferred tax assets (like net operating losses), it can offset the CODI against those. Also, as a result of the deemed exchange, it also gets original issue discount (“OID”) in an amount equal to the amount of the CODI. In many cases, it can amortize the OID on a constant yield basis over the remaining life of the modified loan. However, this would still leave the borrower with a timing mismatch, i.e., a taxable gain in year one and deductions over a period of a few years. This will surely impact borrower restructurings.  Also, there could be circumstances that prevent the borrower from amortizing the OID.
10. For a lender, unless it sells the loan in the same year as the loan modification, it, too, will have a timing mismatch, having to recognize income for the deemed exchange in year one, while not being able to recognize a loss until an actual sale of the loan. Moreover, according to a memo by Cleary Gottlieb, the lender “may be required to treat part of its gain as ordinary income, under the market discount rules”, creating a “character mismatch” (ordinary income vs. capital loss) that might result in a net tax cost to the lender. 

A practical example may illustrate the dangers. Assume a loan was originally syndicated at par, is currently trading at 80 and was purchased by a lender at 60.  Under the CODI rules, if the loan is publicly traded, the borrower will recognize – and pay tax on – 20 cents of CODI (from par issue price to 80 “repayment” price) and the lender will recognize – and pay tax on – current income of 20 cents (from 60 purchase price to 80 “repayment” price).  If the loan is not publicly traded, the borrower will not recognize any CODI and the lender will recognize – and pay tax on – 40 cents of current income (from 60 purchase price to par “repayment” price).  Importantly, if a loan is quoted above par (currently 47% of loans in the index), then the borrower is entitled to a current deduction in the amount of the premium if such old or new loan is "publicly traded" and the lender generally would be required to measure its gain based on the par-plus market price.

It is unclear how the market will respond to the CODI Rules - if it will curb amendment activity (particularly opportunistic deals), further encourage a move to covenant lite loans, or increase wariness of distressed investors in middle market deals - but one thing is certain, these new tax consequences will have to be examined closely each time a loan is modified.

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Edison Mission Files for Bankruptcy

Earlier today, Edison Mission filed for bankruptcy in the Northern District of Illinois. This was long expected by the distressed debt and restructuring community. In fact, in the first day affidavit (embedded below), states:

 "Given EME’s financial outlook, earlier this year, EME’s board, management, and professional advisors began exploring various restructuring alternatives with EME’s two major stakeholders: EIX, as EME’s sole shareholder; and a group of holders of the Senior Notes. After approximately six months of vigorous, arm’s-length negotiations, EME, EIX, and the holders of a majority of the Senior Notes by outstanding principal amount (collectively, the “Consenting Noteholders”), reached an agreement that provides the foundation for a comprehensive settlement transaction between the parties that is designed to maximize the value of the Debtors’ estates and ultimately result in a substantial deleveraging of EME’s balance sheet (the “Settlement Transaction”)

Edison Mission bonds closed the day up a few points, but up about 4 points points from before news sources reported an imminent bankruptcy filing. The bonds are currently quoted two ways:

• TSA - Transaction Support Agreement bonds or bonds that have signed off on the TSA
• Non-TSA bonds - Bonds attached to parties that have not signed the transaction support agreement

 From the sidelines it looks like the two bonds are pricing on top of one another (depending on the flavor), but the TSA bonds are bid without. This is a result of the TSA agreement which states a "Consenting Noteholder" agrees only to sell his/her bonds to another "Consenting Noteholder" or if the buyer is not a party to the TSA, that buyer must sign the TSA. These stipulations though do not forbid parties to the TSA from going out and buying other bonds.

Here is the Exhibit 3 of the First Day Affidavit (Transaction Support Agreement (including the Equity Term Sheet and the Restructuring Term Sheet exhibits thereto):

TSA EIX

You can see signature pages in the back listing parties involved in the case. They include:

• AllianceBernstein
• Arrowgrass
• Avenue
• Barclays Capital
• BlueMountain Capital
• Canyon Capital
• Cincinnati High Yield Group of JPM Investment Management
• Citi Capital Advisors (Distressed Debt Strategies Group)
• Claren Road
• Credit Value Partners
• Distressed Debt Trading Desk of Citigroup
• Jefferies High Yield Trading
• Litespeed
• Nomura
• Och-Ziff
• River Birch
• SVP
• TCW
• York Capital - (It is rumored that York is one of the bondholders running the show here)

In another filing exhibit (Docket 36), there is also a list of noteholders committee members as disclosed by the Debtors to its financial advisers for potential parties of interest. This is dated 9/14/2012. There are some missing funds from the above list relative to this one:

I'm not sure if these means these parties have sold out of the bonds or simply did not sign the TSA.

The plan currently contemplated would be bondholders taking over the equity in Edison Mission from EIX with the current tax sharing agreement to remain in place. The tax sharing agreement is incredibly salient in this case given the way money has flown to and from Edision Mission over the past few years which was dramatically altered due to tax code changes regarding accelerated depreciation.

Along with that, Edison Mission's cash flow potential is driven by nat gas prices. As an IPP with ~50% of its generation coming from coal, if nat gas is strong in the outer years, EME cash flows increase dramatically. You can see some projections Houlihan put together in an 8K below:


Interestingly, the wind assets that EME control did not file for bankruptcy. The wind assets are tremendously valuable. Some other assets (California gas fired plants) in the structure are also tremendously valuable. Depending on how you value those two pieces of the puzzle + tax allocation payments + cash, the market is ascribing very little value (or not value at all) to the Midwest Gen assets.

The first day hearing is tomorrow, 12/18 at 1:30PM in Chicago. We will update readers as the case unfolds.

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