Advanced Distressed Debt: Collecting Default Interest From Solvent Debtors

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.

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

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.

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Bankruptcy 'Double Dip'

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.

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

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

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Third Point's 2011 Letter

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

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A Value Investor's Take on Shorting

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:

1. 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)
2. 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. 
3. 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.  

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DDIC Update and a Suggestion for Future Application Ideas (Stubs)

The Distressed Debt Investors Club (DDIC) was started in late 2009 to bring together some of the best analysts (buy and sell side) and portfolio managers from the distressed debt community.  Since the site launched, there has been over 400 investment ideas written up by our 175 active members (you can view a list of all the ideas here: DDIC Ideas) as well as nearly 500 topics in our members only forum.  These ideas compromise everything from traditional distressed debt ideas, to merger arbitrage, to deep value equities, to spin offs, and to shorts, just to name a few.  Members get a CLEAR advantage over buy side competitors because the ideas on the site are simply fantastic and truly alpha generating.  Just in the past few months we've had multiple ideas increase by 100%, and many ideas increase well over 20%.  New members get the benefit of over 2 years of research that has accumulated on the site that grows bigger everyday.  I could not be happier with the success of the site.

I have stated in the past that my goal for the site was 250 active members and I am sticking to that.  The current member list comes from some of the most well known hedge funds, mutual funds, and investment banks in the world.  For those that are not members, all users of the site are anonymous to one another - I am the only one that knows members identities and our privacy policy and terms of use policy insure users will be 100% anonymous to DDIC members and guests. I am humbled to be part of such a fantastic group.

Last year I hired a compliance consultant to advise us on all things compliance related.  I am very satisfied with their work and believe chief compliance consultants that I have talked to in the past few months would concur.   For those applicants that need assurance of our policies, I have written quite a few letters to compliance officers detailing our procedures and our compliance with relevant disclosures and regulation.

If you have questions on the site you are welcome email me.  And if you do not think membership is right for you, I encourage you to sign up as a guest where you are able to read ideas on the site on a 50 day delay.

One question I get often from potential applicants is: "What kind of idea are you looking for?  Can you give me a name?"  As the name implies, the DDIC separates itself from other investment communities in that we focus on the debt side of the balance sheet.  While there is somewhat of a paucity of distressed ideas out there right now, the one sort of idea that will surely move you ahead of other applications is the distressed stub idea.  For those that aren't participating in distressed on a daily basis, a stub piece is a legacy claim from a previous bankruptcy that could recover value from lawsuits and litigation, a reduction in the general unsecured pool, the liquidation of future non core assets, patent and IP value streams, among other things.  These ideas are generally complex and off the radar of many funds which makes them often mis-priced.  While applicants can apply with any distressed idea they see fit, those applying with a stub idea will get preferential treatment in the application review.  

For those interested, here is a list of ideas that I would look favorably upon:

Abitibi

Adelphia (all flavors)

Aventine

Bank New England

BankUnited

BearingPoint

Bowater

Budget Group

Capmark

Champion Enterprises

Chemtura

CHS Electroncs

Delphi

Delphi

Eddie Bauer

Fairpoint

Fedders

Fleetwood

Fleming

Friede Gold

General Maritime

Grubb & Ellis

Idearc Bond Stub

Idearc Claim Stub

Indalex

KEMPER

LandAmerica Financial Group

Lear Bonds (old)

Linens N' Things

Local Insight Regatta

MFGI Stub

Midway Games

Mirant

Natoinal Steel

Nell (LYO)

Outboard Marine

Quality Stores

Quebecor

RJ Tower

RSL Communications

Scotia Pacific

SemGroup Bonds

Smurfit

Spansion

Spheris

Technical Olympic

Teleglobe

Thornburg

Verasun

Vion Pharmaceuticals

Washington Group

World Access

World Color USA
(and if you know of any I'm missing, I'd love to hear them)

For a stub, a typical write up would be 3 pages, that would encompass a situation overview, the driver of stub value, a simple (or complex model), and your assessment of probabilities, expected value, and ultimate recovery.  

I am trying my best to make this the absolute best community of investors out there.  I have no doubt in ten years the DDIC will be going strong with a database of distressed debt research that would be without compare.  If you have questions on the site or the application process, please email me at hunter [at] distressed-debt-investing [dot] com

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Distressed Debt Weekly Links of Interest

Here's what I am reading (and watching) this weekend at Distressed Debt Investing

One of my best finds yet: A constantly updated list of all outstanding and recent 363 auctions (Chilmark Partners)

All the details and background from ISDA on Greece's "credit event" (ISDA)

Monish Pabrai presenting at the Richard Ivey School of Business (The Ben Graham Centre for Value Investing)

Amazing article on Asia's richest man (The Globe and Mail)

Frightening Ambitious Startup Ideas (Paul Graham's Blog)

Paulson's letter to investors regarding their partial sale of Delphi (Market Folly)

Tom Gayner (Markel's CIO and someone I have tremendous respect for) speaks at the University of Maryland (notes provided by Professor David Kass' blog)

Annual Report of Martin Capital Management [Martin Capital Management]

Round up of all the 'Warren Buffet's' across the world [Santangel's Review]

New Conflict Rules for Debt Research [Integrity ResearchWatch Blog]

Japanese Net/Nets for the win [Oddball Stocks]

On lease rejections [Delaware Business Bankruptcy Report]

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Lehman Emerges from Bankruptcy

This morning, Doc # 26039 hit the Lehman docket stating:

"PLEASE TAKE NOTICE that all conditions precedent to the Effective Date of the Modified Third Amended Joint Chapter 11 Plan of Lehman Brothers Holdings Inc. and Its Affiliated Debtors, dated December 5, 2011 [ECF No. 22973], have been satisfied, and the Effective Date was declared for each of the Debtors on March 6, 2012 at 12:01 A.M."

And so Lehman has emerged with distribution to start flowing April 17th, which was slightly later than the market was assuming (bonds were down just slightly when the news hit the wire).  Here is a 2 year chart of the Lehman 6.875% bond which is part of the LBHI Class 3 Claims:

In its Third Amended Disclosure Statement, Lehman stated that Class 3 LBHI holders were to receive 21.1% recovery on their claims.  With the claims going out tonight at in the 28.5% context the market is suggesting the recovery will be substantially higher than contemplated in the plan.  This stems from the market believing that the non-cash assets held by Lehman will be worth more tomorrow than they are today.

In fact one of the reasons I think you saw a substantial rally in the past few months (outside of just general market strength) stemmed from market participants wanting to get ahead of any future distributions which would then just be reinvested in the Lehman complex (all else being equal).  Essentially the formula goes: Get distribution, buy more LBHI bonds, get further distributions, rinse and repeat until there is nothing left in the estate.  This happened in Enron for quite some time with the caveat that after distributions become sizable enough, liquidity drops precipitously across the structure.

My Lehman model has nearly 20 tabs.  What drives this is a complex web of value flowing subsidiary to the holding company less certain inter company claims among other things.  This is before considering all the various values of cash and other assets, as well as the size of the claims pool, all of which really need to be triangulated using data found in Lehman monthly operating reports (MORs).

For example, here is Exhibit A from DECLARATION OF STEVEN J. COHN IN SUPPORT OF MOTION OF LEHMAN BROTHERS HOLDINGS INC. FOR AUTHORITY TO USE NON-CASH ASSETS IN LIEU OF AVAILABLE CASH AS RESERVES FOR DISPUTED CLAIMS PURSUANT
TO SECTION 8.4 OF THE DEBTORS’ CONFIRMED JOINT CHAPTER 11 PLAN:

As you can see, the estimated claims for Lehman Brothers Holdings Inc is $270B with $221.8B allowed, $104.7B disputed (total claims of $326.5B).  Some of this range stems from mortgage reps and warranties that could be significantly larger which would add to the estimated claims pool hence lowering your recovery.

Net/Net, I calculate a value of somewhere, like most people, in the low to mid 30s.  Call it 32 to be fair and conservative (On a claims pool of ~$270B).

We know from the same document which references the claims pool that Class 3 holders are to receive 2.93% points in an initial distribution (as referenced above to occur on April 17th, 2012).  We also know, according to the Third Amended Plan, that distributions are to occur at the end of every September and March going forward until there is nothing left.

On the surface, if I told you you were going to receive ALL 32 points I've calculated in the next year, you'd be buying these bonds with every penny you had.  Unfortunately this is not the case with distributions expected over some future time period.  It could be two years, or it could be five years.  Frankly, its hard to guess when Lehman can sell off its real estate, private equity, or principal investments.

For simplicity (I don't actually believe this, but let's just try it), assume Lehman distributes the remaining 29.07 bond points equally over the next seven distributions (so eight total distributions).  With a purchase price today at 28.5 what is my IRR?  With my handy XIRR function, I calculate an IRR of ~6.5%.

But what if I assume, like I truly do, that the distributions will be front end loaded, with heavy distributions in both the March and September 2013 payments at the expense of the tail distributions.  Now my IRR is closer to 9.0% which is significantly more attractive, but still probably not cutting it.  What is so crazy about this investment is that just adding 1 point to the recovery from both the 3/30/2013 investment and 9/30/2013 investment (so a total recovery of 34 which is entirely plausible) my IRR gets closer to 14% which is highly attractive in this market.  Or better yet, keeping the recovery the same, but lowering my purchase price to 27.5 pushes the IRR closer to 12% which is respectable.

With the opportunity set so limited from both a distressed perspective and market in general perspective, as well as Lehman's low correlation with beta movements in the market, Lehman will still be a fixture in the distressed space for some time to come.  Like I said, my valuation of 32 is both fair and conservative and I could make an entirely reasonable argument that the number could be higher depending on how asset values and the ultimate claims pool shakes out.  Unless a torpedo in a massive mortgage put back or left field liability comes down the pipe I highly doubt an investor loses money in this structure purchasing in the 28 context.  That's not to say your IRR will be something to shake a stick at.  But given the opportunity set, I'd be surprised if funds do not continue to pounce on the structure if it drifts lower in any overall market sell off.

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The Road to 10,000

In one month, Distressed Debt Investing will celebrate its 3 year anniversary.  Last month was the largest month on record with nearly 150,000 visits to the site.  I cannot begin to thank readers and contributors for all their help, kind words, and assistance over the past three years.  I have a lot in store for content in the up and coming months with things like a full blown series on trade claims, a series on purchasing small businesses out of bankruptcy, more distressed debt and post re-org analysis, and a number of interviews with players in the distressed debt market, just to name a few.

When I started the site, I had no idea or expectations on what it would become. Frankly, I got very lucky and blessed with a fantastic audience (and a patient wife).

Now, I am asking a small favor.  You will see in the left rail, near the bottom of the page an RSS counter.  This shows how many people have signed up to read the blog over email or through an RSS reader.  While really all that matters is the quality of audience (mine is the best), versus quantity, I've set a challenge for myself.  In the next few months, I would like to get that reader to 10,000 (currently at a little less than 7.000).

I need your help.  Whether it be forwarding future posts to friends and colleagues, re-posting articles on your own websites, or simply subscribing yourself, I would love to see that number at 10,000 shortly.

If you have suggestions on future posts or ideas that you would like to see written up on the site, let me know.  I'm always open to suggestions.

Thanks again for all the support.

-Hunter

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Distressed Debt Weekly Links of Interest

Here is what we have been reading (and watching) this weekend at Distressed Debt Investing:

Monish Pabrai's discussion on his charitable work in India [Forbes]

Daniel Kahneman (who was discussed in Baupost's recent annual letter) on Charlie Rose [Charlie Rose Show]

David Merkel's fantastic discussion on 4Q 13fs [Aleph Blog]

The out performance of the P/B ratio [Fat Pitch Financials]

Access Plans Buyout Offer [Value Uncovered]

Goode Trades, a new blog I stumbled upon, that has OPENED MY EYES to the crazy world of the penny stock pumping business [Goode Trades]

Selling Shovels in a Gold Rush [Leigh Drogen's Blog]

Interesting commentary on TRIDQ [Diligent Investor Blog]  (note: Hunter is long TRIDQ)

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