Over the past ten years, capital and corporate structures have become more and more complex with heavy issuance of unique debt instruments and layering in of entities to shield liabilities from various operating subsidiaries. This construct has significant impact and implications for bankruptcy confirmations and processes as well as the interplay between classes vying for different terms of confirmation. The Business Solutions, Governance, Restructuring & Bankruptcy of Proskauer Rose, frequent contributors to Distressed Debt Investing, tackle this and related issues in an exclusive article for our readers below. Enjoy!
The Puzzle of the Impaired Accepting Class
The recent wave of complex real estate and hospitality distress illuminated one potential impediment to any chapter 11 bankruptcy case; namely, the inability to confirm a plan of reorganization in the absence of an impaired accepting class of creditors at any special purpose entity (“SPE”) debtor.
Pursuant to Bankruptcy Code section 1129(a)(10), if a class of claims is impaired under a plan, then at least one impaired class must vote to accept the plan without counting insider votes. Although the Bankruptcy Code is quite clear that each debtor’s plan must have at least one impaired accepting class, a few decisions have raised the question of whether section 1129(a)(10) requires acceptance by one impaired class for each debtor individually or group of affiliated debtors.
While bankruptcy courts in New York and Arizona have confirmed “joint plans” that consist of numerous debtors with just one non-insider impaired accepting class at one debtor (see below), two recent bankruptcy court decisions in Delaware rejected this jurisprudence as violating the requirements of Bankruptcy Code section 1129(a)(10). See In re Tribune Co., 464 B.R. 126, (Bankr. D. Del. 2011); In re JER/Jameson Mezz Borrower II LLC, 461 B.R. 293 (Bankr. D. Del. 2011).
Indeed, in one of the decisions rejecting the “joint plan” approach, the Delaware Bankruptcy Court emphasized that Collier, one of the leading bankruptcy treatises, “contains no discussion of the ‘per plan/per debtor’ issue.” See Tribune, 464 B.R. at 182.
The Tribune and Jameson holdings explicitly rejected the joint plan approach endorsed by the Bankruptcy Court for the Southern District of New York in In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009) and In re Enron, 2004 Bankr.LEXIS 2549 (Bankr. S.D.N.Y. July 15, 2004), and ruled the impaired accepting class requirement of section 1129(a)(10) applies to each individual debtor. Notably, a recent bankruptcy court ruling in Arizona, In re Transwest Resort Properties, No. 10-37134 (Bankr. D. Ariz. Dec. 16, 2011) departed from Tribune and Jameson, and confirmed a joint chapter 11 plan with one impaired accepting class of creditors at only one of the debtors under the plan over the objection of the mezzanine lender. Although the mezzanine lender appealed the Transwest decision, the Arizona District Court dismissed the appeal on equitable mootness grounds, thereby leaving the section 1129(a)(10) issue undecided.
Significantly, in Charter, the use of one impaired accepting class for one debtor to count as an impaired accepting class for an affiliated debtor was pivotal to the entire reorganization. No plan could have been confirmed without that ruling. Charter settled before an appellate court ruled. Conversely, in Enron, the debtors, lacking an impaired, accepting class were inconsequential to the overall reorganization and no one objected to confirmation on the ground those debtors did not individually satisfy section 1129(a)(10). It is very possible that other bankruptcy judges in New York and Arizona will not follow Charter and Transwest.
Notwithstanding the overwhelming likelihood that section 1129(a)(10) will be on a per debtor basis, the presence of SPE borrowers alone does not render the section 1129(a)(10) hurdle insurmountable. In an effort to satisfy the impaired accepting class requirement and design a confirmable chapter 11 plan, debtors may create a separate classification of claims at each SPE borrower by either (i) impairing a class of claims that already exists at those entities (i.e., trade claims) or (ii) causing those entities to incur additional indebtedness or consolidating those entities into one entity that already has its own impaired accepting class of creditors.
That said, SPE organizational documents and mortgage loan agreements often contain (i) prohibitions on the transfer/consolidation of assets and (ii) limitations on the incurrence of additional indebtedness. These, however, may not frustrate the ability to implement these strategies without lender consent because the implementation is simply a default that will not matter if the entity commences a chapter 11 case.
9.18.2012
An Open Letter to CFOs Across America
Dear CFO -
I hope this letter finds you well. My name is Hunter and I started and currently run a collection of sites focused on credit - specifically distressed and speculative credit. Our readers come from across the world and include every major U.S investment bank and many hedge funds, law firms, and asset managers in the country. I've spent the majority of my career working in leverage finance as an investor allocating and providing capital to sub-investment grade issuers and companies in bankruptcy.
You might be wondering why I am writing to you today. As an active participant in both the primary and secondary credit markets, I spend a significant amount of time gauging the risk appetite of investors that provide financing in the U.S. bond and bank debt markets, up and down the risk and ratings spectrum. Simply put: You are doing your investors and your company a disservice if you are not tapping the credit markets as soon as possible. If you are not planning a new bond or bank debt offering, call your relationship manager at your preferred investment bank of choice and put the wheels in motion. Whether it be refinancing your capital structure, financing an acquisition, dividend, or share repurchase, or simply stuffing the war chest for a rainy day, I behoove you to issue into this market.
If you read the news and watch CNBC, you may assume all is wrong in the world. Unemployment rates are high, Europe is a mess, China's booming economy seems to be slowing, Middle East tensions run high, oil prices and food prices are rising, a significant fiscal cliff will hit America beginning in January 2013, etc. Of course, there are things to be positive about: Chairman Ben Bernanke is poised to grow the domestic economy with further monetary stimulus, Apple is selling a lot of IPhones, and the stock market continues to make new highs.
From your perspective, and for your shareholders perspective, one thing to be immensely positive about is the seemingly endless demand for credit coming from institutional buyers. Maybe its because we have been told that interest rates will stay low for the foreseeable future and investors are looking for yield. Maybe its because corporate balance sheets are robust. Its hard to actually pinpoint the exact reasons. With that said, you, as steward of your corporation's finances, need to use this voracious demand to you and your company's advantage.
Here are a few salient goals you can accomplish with tapping the credit markets today:
I hope this letter finds you well. My name is Hunter and I started and currently run a collection of sites focused on credit - specifically distressed and speculative credit. Our readers come from across the world and include every major U.S investment bank and many hedge funds, law firms, and asset managers in the country. I've spent the majority of my career working in leverage finance as an investor allocating and providing capital to sub-investment grade issuers and companies in bankruptcy.
You might be wondering why I am writing to you today. As an active participant in both the primary and secondary credit markets, I spend a significant amount of time gauging the risk appetite of investors that provide financing in the U.S. bond and bank debt markets, up and down the risk and ratings spectrum. Simply put: You are doing your investors and your company a disservice if you are not tapping the credit markets as soon as possible. If you are not planning a new bond or bank debt offering, call your relationship manager at your preferred investment bank of choice and put the wheels in motion. Whether it be refinancing your capital structure, financing an acquisition, dividend, or share repurchase, or simply stuffing the war chest for a rainy day, I behoove you to issue into this market.
If you read the news and watch CNBC, you may assume all is wrong in the world. Unemployment rates are high, Europe is a mess, China's booming economy seems to be slowing, Middle East tensions run high, oil prices and food prices are rising, a significant fiscal cliff will hit America beginning in January 2013, etc. Of course, there are things to be positive about: Chairman Ben Bernanke is poised to grow the domestic economy with further monetary stimulus, Apple is selling a lot of IPhones, and the stock market continues to make new highs.
From your perspective, and for your shareholders perspective, one thing to be immensely positive about is the seemingly endless demand for credit coming from institutional buyers. Maybe its because we have been told that interest rates will stay low for the foreseeable future and investors are looking for yield. Maybe its because corporate balance sheets are robust. Its hard to actually pinpoint the exact reasons. With that said, you, as steward of your corporation's finances, need to use this voracious demand to you and your company's advantage.
Here are a few salient goals you can accomplish with tapping the credit markets today:
- Lower your cost of financing
- Extend maturities
- Loosen terms
- Remove covenants
- Add cash to the balance sheet for that big acquisition you've been dreaming about.
If you are a more risky credit and have been told in the past that "the market isn't quite ready for you", I'm here to tell you things have changed. Tier 2 and Tier 3 investment banks and syndicate desks are bringing bonds and bank debt that are oversubscribed by institutional investors. Issuer's whose debt traded at double digit yields just a year ago are bringing 10 year paper with a 5-6% coupons. Investment grade issuers are seeing record tight pricing for their paper, and in spite of that, investor demand is insatiable. In the last few days, more dividend and shareholder friend deals have been announced in the bank debt market since the go go times on late 2006 and early 2007. Don't like covenants? Not a problem in this market.
Like all of us, you want to get ahead in this world. You want to do whats best for your company. You want to lower expenses, grow cash flow, and provide flexibility for your company for the uncertain road ahead. Take it from me: Issue a bond or bank financing. You won't regret it.
All the best,
-Hunter
9.16.2012
Prospecting for European Distressed Loans
It is my pleasure to introduce a new monthly contributor to Distressed Debt Investing: David Karp, partner at Schulte Roth & Zabel. David's practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. It is our pleasure to have him as a contributor.
For his entry, David discusses issues in buying and selling European distressed loans. This is an amazingly enlightening piece. I encourage all investors that are involved in Europe or are considering deploying capital to read. Enjoy!
Prospecting for European Distressed Loans
As reported throughout the financial trade press this past summer, many U.S. investors are prospecting for European distressed loans on the secondary market. While the game plan for some of these investors appears to be to invest in the fulcrum credit and implement one or more creative restructuring strategies that have been well honed by investing in the U.S., Europe is an altogether different playing field. Even as Germany, Spain, Italy and France have made recent changes to their insolvency regimes aimed at improving restructuring options — including out-of-court alternatives, debt-to-equity swaps and increased opportunities to provide debtor-in-possession financing — complex country-specific, and in many cases untested, insolvency laws and vast cultural distinctions will form the basis for a challenging recovery analysis. Before delving into recovery issues, investors must be well versed in the increased trade risks in the European market that can derail their active investment strategy just as they are getting started.
While pre-trade issues need to be vetted in numerous areas, including regulatory restrictions on lending, collateral perfection and withholding taxes, one area of great concern and complexity is whether or not the borrower’s door is even open for an investment fund to become a lender via secondary market purchase. Many European borrowers view the relationship with their lender group as a private and long-term membership club completely distinct from public bond issuances, and cringe at the thought of sharing proprietary information with investment funds pursuant to a credit agreement. As a result, when European borrowers receive a request for an investment fund to enter their lender group, they are increasingly using their consent rights to deny the request and maintain control of the make-up of the group. What constitutes “consent being unreasonably withheld” is an unsettled point of English contract law, which governs most bank debt trading agreements across Europe.
What happens when a fund confirms its purchase of bank debt and the borrower subsequently doesn’t provide consent for the fund to become a lender of record? The fund may be forced to settle by participation, which, in Europe, is structured as a derivative relationship. In this context, the seller is delivering an unsecured claim to a buyer referencing the underlying borrower and lender relationship. In contrast, the U.S. form of “true participation” is intended to vest the buyer with an ownership right in the proceeds the lender paid to the borrower and then passed to the participant. Loan traders entering the European secondary market need to be cautious as they are more likely to wind up as a participant due to consent being withheld by a borrower, which results in: (i) double credit risk (from the seller and the borrower), (ii) no privity with the borrower or ability to be active in a restructuring, and (iii) a less-liquid position than being in senior secured bonds or, for that matter, a lender of record. For many investors, this increased counterparty credit risk, decreased control and decreased liquidity is enough to ruin the investment — and the trade has not even yet settled. Investors should be especially cautious regarding this asset class because general practice in both the U.S. and U.K. secondary bank debt and claims trading markets is that a trade is binding upon oral or written agreement on material terms. (See N.Y. Gen. Oblig. Law § 5-701(b)(2)(i) and (ii), and the recent U.K. decision of Bear Stearns v. Forum Global Equity (2007), in which the court confirmed the binding nature of a telephone conversation between traders agreeing to terms of a purchase of Parmalat notes.) In other words, “a trade is a trade.”
Borrower Consent Pitfalls
Many loan agreements syndicated during the 2004–2007 high-liquidity period were drafted on “borrower-friendly,” “covenant light” terms that often included, among other things, secondary transfer provisions requiring the borrower to consent to any new lender under the agreement. Increasingly, borrowers with consent rights are exercising them as a strategic measure for controlling the composition of their lending syndicate. While many loan agreements stipulate that borrower consent cannot be “unreasonably withheld,” the historic lack of case law establishing what constitutes “unreasonable” behavior in a commercial context meant investors were left unsure as to whether they had legitimate grounds for challenging a borrower’s refusal of consent. A recent U.K. case — in which a potential borrower sued Terra Firma Capital Partners (the private equity owners of Tank & Rast Holding GmbH, a German infrastructure group) in the High Court of England for denying borrower consent to a competitor to whom Terra Firma did not want to provide access to syndicate confidential information — was unfortunately settled out of court without any guidance from the High Court on whether Terra Firma had legitimate grounds to withhold consent. However, in the recent decision of Porton Capital Technology Funds and others v. 3M UK Holdings Ltd. and 3M Company (2011), the High Court in England did set out certain guidelines (based in landlord-tenant case law) for determining whether consent was unreasonably withheld in the given circumstances. Applying these guidelines to secondary bank debt transactions, where borrower consent is withheld and subsequently challenged as being unreasonable, the following approach may be utilized by the courts when making a determination:
Status of Participations in U.K. v. U.S. (LMA v. LSTA)
The Loan Market Association (“LMA”) and Loan Syndication and Trading Association’s (“LSTA”) mandatory settlement provisions dictate that if a trade cannot settle by legal transfer, there will be an automatic “fall-back” to settlement via funded participation. The LMA form of funded participation is governed by English law and contemplates a debtor/creditor relationship between the seller (grantor) and buyer (participant). Under this type of arrangement, the buyer has no beneficial interest in the underlying credit agreement, nor any relationship with the borrower. Instead, the buyer has only a right to receive the economic equivalent of any payments made by the borrower under the credit agreement, with the seller passing on such amounts to the buyer pursuant to the terms of the participation agreement. As the participant has no interest in the underlying debt, it has no contractual standing against the borrower if the borrower defaults under any of its payments. Additionally, the buyer also bears credit risk exposure against the seller should the seller become insolvent during the life of the participation. In such a scenario, the buyer only has an unsecured claim against the seller under the funded participation and cannot claim a proprietary interest or entitlement in or to the underlying loan proceeds. The result of this structure for the buyer is a “double credit risk” scenario, placing the buyer in an inherently more risky position than if it were to acquire bank debt by way of an LSTA “true participation” arrangement.
The LSTA form of funded “true participation” is a New York law governed structure, intended to give the buyer an ownership interest in the actual proceeds paid by a borrower to the seller. Whether a participation constitutes a “true participation” under New York law is a fact-based analysis that takes into account various factors including, among others: (i) the relevant language of the underlying agreement, (ii) the amount of control the seller retains or is perceived to retain over the assets after the closing of the relevant transaction and (iii) whether the transaction shifts the risks of loss and/or benefits of ownership to the transferee. The LSTA form intends to meet this criteria and assign the participant all of the rights of grantor to payment under the loan agreement. In the event that the grantor becomes subject to insolvency proceedings, payments are intended to be isolated from its insolvency estate, resulting in more limited counterparty credit risk for a participant under a “true participation.” This structure was recently tested and proven effective in the Chapter 11 case of Lehman Brothers Commercial Paper when the Bankruptcy Court issued an order establishing that all “all cash, securities and other property distributed or payable in respect of true participations or sub-participations … are not property of the Debtor’s estate and shall be promptly turned over to the beneficial holders thereof.” (Emphasis added; see In re: Lehman Commercial Paper Inc., 08-13900 (S.D.N.Y. Oct. 6, 2008) (Order Pursuant to Sections 105(a), 363(b), 363(c), and 541(d) of the Bankruptcy Code and Bankruptcy Rule 6004 Authorizing Debtor to (A) Continue to Utilize its Agency Bank Account, (B) Terminate Agency Relationships)).
There was some initial concern among investors that LMA-style participations would be subject to additional regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in the U.S. due to the derivative nature of such participations, which would have subjected loan participations even partially conducted in the U.S. to U.S. federal securities law including anti fraud and anti manipulation rules potentially rendering ineffective big boy provisions relied on by the market. However, carve-outs to Dodd-Frank for LMA-style loan participation were created by the Commodity Futures Trading Commission (“CFTC”) and the Securities Exchange Commission (“SEC”) (collectively, the “Commissions”) in response to lobbying efforts of the LMA and LSTA. While, initially, the Commissions provided a carve-out only for “true” participations, after an additional push from the LMA, they came back with a formulation that carved out all participations. The Commissions jointly adopted new rules and interpretations to define the terms “swap” and “security-based swap” found in Section 721 of Dodd-Frank, specifically excluding from these definitions certain contracts, including loan participations.
In order to qualify for this exclusion, a loan participation must “represent a current or future direct or indirect ownership interest in the loan or commitment that is the subject of the loan participation.” Per the final regulations, four characteristics must be present:
Investor Take-aways
While investors can attempt to negotiate additional terms at the time of trade that enable them to walk away from a trade if legal transfer cannot be effected, the effort will likely be met with resistance and difficult to achieve as standard operating procedure. Alternatively, if the overall aim is to take on larger bank debt exposure against a particular borrower, it may be best to commit to a minimum threshold piece first as a way to discern how difficult the transfer process is going to be. However, it is important to note that in many European credit facilities, an existing purchase does not grant lenders an automatic right to increase their position and bypass borrower consent.
Ultimately, like many European trade issues, borrower consent risk needs to be actively managed on a case-by-case basis. It is crucial for investors to address this issue before saying “Done” or they will be fighting an even steeper uphill battle with both their counterparty and the borrower.
David J. Karp is a partner in the New York and London offices of Schulte Roth & Zabel, where his practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. David is an avid speaker and writer on distressed investing related issues, recently co-authoring “European Insolvency Claims Trading: Is Iceland the Paradigm?” for Butterworths Journal of International Banking and Financial Law and “Trade Risk in European Secondary Loans” for The Hedge Fund Law Report. David is an active member of the LMA, APLMA, INSOL Europe and the LSTA where he is a member of the Trade Practices and Forms Committee. Jamie Schwartz, an associate at SRZ, assisted in the preparation of this entry.
For his entry, David discusses issues in buying and selling European distressed loans. This is an amazingly enlightening piece. I encourage all investors that are involved in Europe or are considering deploying capital to read. Enjoy!
Prospecting for European Distressed Loans
As reported throughout the financial trade press this past summer, many U.S. investors are prospecting for European distressed loans on the secondary market. While the game plan for some of these investors appears to be to invest in the fulcrum credit and implement one or more creative restructuring strategies that have been well honed by investing in the U.S., Europe is an altogether different playing field. Even as Germany, Spain, Italy and France have made recent changes to their insolvency regimes aimed at improving restructuring options — including out-of-court alternatives, debt-to-equity swaps and increased opportunities to provide debtor-in-possession financing — complex country-specific, and in many cases untested, insolvency laws and vast cultural distinctions will form the basis for a challenging recovery analysis. Before delving into recovery issues, investors must be well versed in the increased trade risks in the European market that can derail their active investment strategy just as they are getting started.
While pre-trade issues need to be vetted in numerous areas, including regulatory restrictions on lending, collateral perfection and withholding taxes, one area of great concern and complexity is whether or not the borrower’s door is even open for an investment fund to become a lender via secondary market purchase. Many European borrowers view the relationship with their lender group as a private and long-term membership club completely distinct from public bond issuances, and cringe at the thought of sharing proprietary information with investment funds pursuant to a credit agreement. As a result, when European borrowers receive a request for an investment fund to enter their lender group, they are increasingly using their consent rights to deny the request and maintain control of the make-up of the group. What constitutes “consent being unreasonably withheld” is an unsettled point of English contract law, which governs most bank debt trading agreements across Europe.
What happens when a fund confirms its purchase of bank debt and the borrower subsequently doesn’t provide consent for the fund to become a lender of record? The fund may be forced to settle by participation, which, in Europe, is structured as a derivative relationship. In this context, the seller is delivering an unsecured claim to a buyer referencing the underlying borrower and lender relationship. In contrast, the U.S. form of “true participation” is intended to vest the buyer with an ownership right in the proceeds the lender paid to the borrower and then passed to the participant. Loan traders entering the European secondary market need to be cautious as they are more likely to wind up as a participant due to consent being withheld by a borrower, which results in: (i) double credit risk (from the seller and the borrower), (ii) no privity with the borrower or ability to be active in a restructuring, and (iii) a less-liquid position than being in senior secured bonds or, for that matter, a lender of record. For many investors, this increased counterparty credit risk, decreased control and decreased liquidity is enough to ruin the investment — and the trade has not even yet settled. Investors should be especially cautious regarding this asset class because general practice in both the U.S. and U.K. secondary bank debt and claims trading markets is that a trade is binding upon oral or written agreement on material terms. (See N.Y. Gen. Oblig. Law § 5-701(b)(2)(i) and (ii), and the recent U.K. decision of Bear Stearns v. Forum Global Equity (2007), in which the court confirmed the binding nature of a telephone conversation between traders agreeing to terms of a purchase of Parmalat notes.) In other words, “a trade is a trade.”
Borrower Consent Pitfalls
Many loan agreements syndicated during the 2004–2007 high-liquidity period were drafted on “borrower-friendly,” “covenant light” terms that often included, among other things, secondary transfer provisions requiring the borrower to consent to any new lender under the agreement. Increasingly, borrowers with consent rights are exercising them as a strategic measure for controlling the composition of their lending syndicate. While many loan agreements stipulate that borrower consent cannot be “unreasonably withheld,” the historic lack of case law establishing what constitutes “unreasonable” behavior in a commercial context meant investors were left unsure as to whether they had legitimate grounds for challenging a borrower’s refusal of consent. A recent U.K. case — in which a potential borrower sued Terra Firma Capital Partners (the private equity owners of Tank & Rast Holding GmbH, a German infrastructure group) in the High Court of England for denying borrower consent to a competitor to whom Terra Firma did not want to provide access to syndicate confidential information — was unfortunately settled out of court without any guidance from the High Court on whether Terra Firma had legitimate grounds to withhold consent. However, in the recent decision of Porton Capital Technology Funds and others v. 3M UK Holdings Ltd. and 3M Company (2011), the High Court in England did set out certain guidelines (based in landlord-tenant case law) for determining whether consent was unreasonably withheld in the given circumstances. Applying these guidelines to secondary bank debt transactions, where borrower consent is withheld and subsequently challenged as being unreasonable, the following approach may be utilized by the courts when making a determination:
- The burden is on the proposed new lender to prove that withholding of consent by a borrower was unreasonable;
- A borrower does not need to show that its refusal of consent was right or justified, simply that it was reasonable in the given circumstances;
- In determining what is reasonable, the borrower may have regard to its own interests;
- A borrower with consent rights is not required to balance its own interests with those of the proposed new lender or to have regard to the costs that the proposed new lender might be incurring.
Status of Participations in U.K. v. U.S. (LMA v. LSTA)
The Loan Market Association (“LMA”) and Loan Syndication and Trading Association’s (“LSTA”) mandatory settlement provisions dictate that if a trade cannot settle by legal transfer, there will be an automatic “fall-back” to settlement via funded participation. The LMA form of funded participation is governed by English law and contemplates a debtor/creditor relationship between the seller (grantor) and buyer (participant). Under this type of arrangement, the buyer has no beneficial interest in the underlying credit agreement, nor any relationship with the borrower. Instead, the buyer has only a right to receive the economic equivalent of any payments made by the borrower under the credit agreement, with the seller passing on such amounts to the buyer pursuant to the terms of the participation agreement. As the participant has no interest in the underlying debt, it has no contractual standing against the borrower if the borrower defaults under any of its payments. Additionally, the buyer also bears credit risk exposure against the seller should the seller become insolvent during the life of the participation. In such a scenario, the buyer only has an unsecured claim against the seller under the funded participation and cannot claim a proprietary interest or entitlement in or to the underlying loan proceeds. The result of this structure for the buyer is a “double credit risk” scenario, placing the buyer in an inherently more risky position than if it were to acquire bank debt by way of an LSTA “true participation” arrangement.
The LSTA form of funded “true participation” is a New York law governed structure, intended to give the buyer an ownership interest in the actual proceeds paid by a borrower to the seller. Whether a participation constitutes a “true participation” under New York law is a fact-based analysis that takes into account various factors including, among others: (i) the relevant language of the underlying agreement, (ii) the amount of control the seller retains or is perceived to retain over the assets after the closing of the relevant transaction and (iii) whether the transaction shifts the risks of loss and/or benefits of ownership to the transferee. The LSTA form intends to meet this criteria and assign the participant all of the rights of grantor to payment under the loan agreement. In the event that the grantor becomes subject to insolvency proceedings, payments are intended to be isolated from its insolvency estate, resulting in more limited counterparty credit risk for a participant under a “true participation.” This structure was recently tested and proven effective in the Chapter 11 case of Lehman Brothers Commercial Paper when the Bankruptcy Court issued an order establishing that all “all cash, securities and other property distributed or payable in respect of true participations or sub-participations … are not property of the Debtor’s estate and shall be promptly turned over to the beneficial holders thereof.” (Emphasis added; see In re: Lehman Commercial Paper Inc., 08-13900 (S.D.N.Y. Oct. 6, 2008) (Order Pursuant to Sections 105(a), 363(b), 363(c), and 541(d) of the Bankruptcy Code and Bankruptcy Rule 6004 Authorizing Debtor to (A) Continue to Utilize its Agency Bank Account, (B) Terminate Agency Relationships)).
There was some initial concern among investors that LMA-style participations would be subject to additional regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in the U.S. due to the derivative nature of such participations, which would have subjected loan participations even partially conducted in the U.S. to U.S. federal securities law including anti fraud and anti manipulation rules potentially rendering ineffective big boy provisions relied on by the market. However, carve-outs to Dodd-Frank for LMA-style loan participation were created by the Commodity Futures Trading Commission (“CFTC”) and the Securities Exchange Commission (“SEC”) (collectively, the “Commissions”) in response to lobbying efforts of the LMA and LSTA. While, initially, the Commissions provided a carve-out only for “true” participations, after an additional push from the LMA, they came back with a formulation that carved out all participations. The Commissions jointly adopted new rules and interpretations to define the terms “swap” and “security-based swap” found in Section 721 of Dodd-Frank, specifically excluding from these definitions certain contracts, including loan participations.
In order to qualify for this exclusion, a loan participation must “represent a current or future direct or indirect ownership interest in the loan or commitment that is the subject of the loan participation.” Per the final regulations, four characteristics must be present:
- The grantor of the loan participation is a lender under, or a participant or subparticipant in, the loan or commitment that is subject of the loan participation;
- The aggregate participation in the loan or commitment does not exceed the principal amount of such loan or commitment;
- The entire purchase price for the loan participation is paid in full when the loan participation is acquired and is not financed; and
- The loan participation provides the participant all of the economic benefit and risk of the whole or part of the loan or commitment that is the subject of the participation.
Investor Take-aways
While investors can attempt to negotiate additional terms at the time of trade that enable them to walk away from a trade if legal transfer cannot be effected, the effort will likely be met with resistance and difficult to achieve as standard operating procedure. Alternatively, if the overall aim is to take on larger bank debt exposure against a particular borrower, it may be best to commit to a minimum threshold piece first as a way to discern how difficult the transfer process is going to be. However, it is important to note that in many European credit facilities, an existing purchase does not grant lenders an automatic right to increase their position and bypass borrower consent.
Ultimately, like many European trade issues, borrower consent risk needs to be actively managed on a case-by-case basis. It is crucial for investors to address this issue before saying “Done” or they will be fighting an even steeper uphill battle with both their counterparty and the borrower.
David J. Karp is a partner in the New York and London offices of Schulte Roth & Zabel, where his practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. David is an avid speaker and writer on distressed investing related issues, recently co-authoring “European Insolvency Claims Trading: Is Iceland the Paradigm?” for Butterworths Journal of International Banking and Financial Law and “Trade Risk in European Secondary Loans” for The Hedge Fund Law Report. David is an active member of the LMA, APLMA, INSOL Europe and the LSTA where he is a member of the Trade Practices and Forms Committee. Jamie Schwartz, an associate at SRZ, assisted in the preparation of this entry.
9.11.2012
Insights from the Courthouse: Patriot Coal Venue Change Proceedings Day 1
Today marked the start of hearings in one of the most important issues in the Patriot Coal case: venue change. The issue is so important that the hearing is being telecast in both West Virginia and St Louis, something I've seen only a few times in bankruptcy proceedings. As has been reported, many parties including the UMWA and the U.S. Trustee office have motioned (or joined in on the motion) for a venue change. Likewise, many parties have filed joinders to the Debtor's objections to the venue change motions brought by the UMWA and the U.S Trustee. The UCC and DIP agent have also filed a motion objection to the venue change motions.
Before I begin, I want to go on record saying Judge Shelley Chapman is brilliant. It really is an honor (pardon the pun) to hear her go to work dissecting issues in a case as important as this. To those only following tangentially, this will be a very important ruling for future case law. Judge Chapman wants to get this right, especially in light of all the political issues that have arose in the past year over "venue shopping." If she rules that PCX can keep the venue in SDNY, many cases in the future will reference her decision, assuming it stands up on a most certain appeal by various parties specifically the U.S. Trustee's office.
It was marginally difficult to listen to Susan Jennik, who is representing the UMWA in the case, go head to head with Judge Chapman. Jennik was getting grilled. Prior to this hearing, I thought the venue would be changed but probably to somewhere other that West Virginia (that only has one bankruptcy judge) and is definitely inconvenient to travel to relative to some place like St Louis. 20 minutes into Ms. Jennik's discussion I thought I was definitely going to be wrong here. Her slip, which I am sure will haunt her, was bringing up the concept of a 'learning curve' in coal cases as it relates to SDNY versus a venue like West Virginia. This is a judge that is handling two incredibly technical cases beautifully (Lightsquared and Ambac) - the notion that an SDNY court won't be able to rule coherently and intelligently on a coal case is hard to conceive.
Judge Chapman posed a number of difficult questions to Ms. Jennik. One I thought was quite poignant related to whether the UMWA would have brought a venue change motion if the costs to the estates were higher in a West Virginia bankruptcy vs a SDNY bankruptcy proceeding. Judge Chapman did note that no one had yet presented her facts or evidence of the numbers or costs in the case but it does bring up the interesting notion that the management team might be looking out for all parties holistically by considering costs in choosing venue.
From the U.S. Trustee offices, Andrea Schwartz fared far better than Jennik. I was impressed with her abilities in the courtroom especially her ability to bring the Court back to her "smoking gun" as it were: The two New York entities were created on the eve of the bankruptcy, have very little assets, and no operations. The statute is being "manipulated." For whose benefit, she didn't quite come up with a strong answer but in light of Judge Chapman's challenging questions, I think she did a good job. (You can read the U.S. Trustee's principal arguments here: http://patriotcaseinformation.com/pdflib/509_12900.pdf). A key here is that the U.S. Trustee's argument is "in the interest of justice" which is different than the UMWA's objections.
Yet to be heard is the Debtor's counsel as well as I'm sure many other parties that will want to lay out his/her arguments to the Court. I am not sure if we get a decision tomorrow, but it is my inkling that Judge Chapman will rule from the bench and then follow with a written opinion given the gravity of this decision.
A venue change to West Virginia is, in my opinion, disastrous for the senior bonds. The "box theory" would fall apart in a substantial consolidation of the operating companies (sub con all opcos, keep holdco distinct) and legacy creditors would benefit greatly. In my opinion, management has significant negotiating leverage with the 1113/1114 claimants in a non-sub con situation. And that might be quite lucrative if they can engineer a rights offering with bondholders and give themselves a slug of the equity via a management incentive plan.
Interestingly, just yesterday, Brown Rudnick filed a Rule 2019 statement as it is representing the ad hoc consortium of Senior Noteholders who own $102.5M or 41% of the issue. The names of the funds and their holdings are listed below:
Before I begin, I want to go on record saying Judge Shelley Chapman is brilliant. It really is an honor (pardon the pun) to hear her go to work dissecting issues in a case as important as this. To those only following tangentially, this will be a very important ruling for future case law. Judge Chapman wants to get this right, especially in light of all the political issues that have arose in the past year over "venue shopping." If she rules that PCX can keep the venue in SDNY, many cases in the future will reference her decision, assuming it stands up on a most certain appeal by various parties specifically the U.S. Trustee's office.
It was marginally difficult to listen to Susan Jennik, who is representing the UMWA in the case, go head to head with Judge Chapman. Jennik was getting grilled. Prior to this hearing, I thought the venue would be changed but probably to somewhere other that West Virginia (that only has one bankruptcy judge) and is definitely inconvenient to travel to relative to some place like St Louis. 20 minutes into Ms. Jennik's discussion I thought I was definitely going to be wrong here. Her slip, which I am sure will haunt her, was bringing up the concept of a 'learning curve' in coal cases as it relates to SDNY versus a venue like West Virginia. This is a judge that is handling two incredibly technical cases beautifully (Lightsquared and Ambac) - the notion that an SDNY court won't be able to rule coherently and intelligently on a coal case is hard to conceive.
Judge Chapman posed a number of difficult questions to Ms. Jennik. One I thought was quite poignant related to whether the UMWA would have brought a venue change motion if the costs to the estates were higher in a West Virginia bankruptcy vs a SDNY bankruptcy proceeding. Judge Chapman did note that no one had yet presented her facts or evidence of the numbers or costs in the case but it does bring up the interesting notion that the management team might be looking out for all parties holistically by considering costs in choosing venue.
From the U.S. Trustee offices, Andrea Schwartz fared far better than Jennik. I was impressed with her abilities in the courtroom especially her ability to bring the Court back to her "smoking gun" as it were: The two New York entities were created on the eve of the bankruptcy, have very little assets, and no operations. The statute is being "manipulated." For whose benefit, she didn't quite come up with a strong answer but in light of Judge Chapman's challenging questions, I think she did a good job. (You can read the U.S. Trustee's principal arguments here: http://patriotcaseinformation.com/pdflib/509_12900.pdf). A key here is that the U.S. Trustee's argument is "in the interest of justice" which is different than the UMWA's objections.
Yet to be heard is the Debtor's counsel as well as I'm sure many other parties that will want to lay out his/her arguments to the Court. I am not sure if we get a decision tomorrow, but it is my inkling that Judge Chapman will rule from the bench and then follow with a written opinion given the gravity of this decision.
A venue change to West Virginia is, in my opinion, disastrous for the senior bonds. The "box theory" would fall apart in a substantial consolidation of the operating companies (sub con all opcos, keep holdco distinct) and legacy creditors would benefit greatly. In my opinion, management has significant negotiating leverage with the 1113/1114 claimants in a non-sub con situation. And that might be quite lucrative if they can engineer a rights offering with bondholders and give themselves a slug of the equity via a management incentive plan.
Interestingly, just yesterday, Brown Rudnick filed a Rule 2019 statement as it is representing the ad hoc consortium of Senior Noteholders who own $102.5M or 41% of the issue. The names of the funds and their holdings are listed below:
- Beacon Asset Management: $1M in Senior Notes
- Claren Road Asset Management: $17.5 in Senior Notes
- Knighthead Capital Management: $14M in Senior Notes
- Mason Street Advisors: $25.15M in Senior Notes
- Merrill Lynch & Co: $11.5M in Senior Notes
- PineBridge Investments: $6.92M in Senior Notes
- TPG Credit Management: $6.02M in Senior Notes
- Whitebox Advisors: $20.388M in Senior Notes
PCX bonds have held in well relative to other areas in the coal space. Below is a chart of PCX bonds, ANR equity, and ACI equity *, normalized to the start of PCX's bankruptcy case. As you can see PCX bonds have outperformed (PCX bonds are the dotted line):
The hearing on venue change continues tomorrow and we will provide an update on the proceedings.
(* Disclosure: I am long ACI leaps)
9.10.2012
High Yield Market: All Time Low Yields
According to both the Barclays high-yield index and the CS HY index, yields in high yield have reached an all time low of ~6.6%. Further, over the last few weeks, traders and syndicate desks have been whispering of a simply gargantuan amount of high yield and leveraged loans coming this month. Certain desks have been advocating a move to CCC assets as they still yield approximately 100 bps over their all time low seen on...wait for it...May 2007.
Being underweight any market that just rips in your face never feels good. And since many funds have been underweight both equity and speculative credit this year, many are speculating a year-end chase as funds try to catch up on performance by allocating capital to the yieldiest credits in hopes of further spread tightening.
To be completely honest, this rally has felt marginally healthy to me. There have only been a few dividend deals and you haven't seeing historically weaker investment banks or desks bringing speculative deals. Seasoned issuers are coming to market with refinancing and M&A or capital structure alterations (loans refinanced into bonds). Pricing and structure have been the real stumbling block for me over the past few months. Coupons and all in yields are definitely not compensating investors for the duration of the asset class these days and covenant quality has gotten worse and worse and worse with each deal that clears. It often feels like, in larger deals, that large players are just putting in orders because 1) They have significant cash as a result of inflows to put to work and 2) The secondary market is horribly illiquid.
Some desks are beginning to get cautious. Generally speaking, most strategist's targets for high yield returns have been hit for the year. To me this portends further tightening or at least grinding through year end (still have quite a bit of carry left for the year) or at least the election unless an exogenous event happens in interim. The balance of pessimism and optimism across markets feels pretty balanced which historically are good things for the market.
Despite this, I am sitting on a large amount of cash. My PA has gone from very long with a smattering of shorts to a large cash position combined with a few liquidations and more shorts. The only place I see pain is in the coal and shipping space (and busted IPOs that I wouldn't look at anyways). The HILO on Bloomberg (over 50M market cap) was 260 high and 16 lows. Here is a chart of the number of distressed bonds traded (distressed = over 1000 bps spread). Not terribly enticing.
I think you you begin to see more M&A come down the line (already seeing it with Plains today) and maybe some speculative LBOs or MBOs that will come with covenant lite structures and terms. All to feed the beast that have been inflows this year and a re-start of the CLO machine.
There's simply not enough blood in the streets for me to get excited. Every investment you make has some sort of beta / market component to it. Maybe that is only a very small percentage (say a liquidation or Lehman like situation) and some have a very heavy market component (think go-go-go equities). I am 100% focused on the former category right now and am paying close attention to both legacy and new bankruptcies to see if there are interesting places to play. That, and of course, shorting has been a big priority for me over the past few weeks as I look for aggressive accounting or thematic trades to play out and revaluations to occur in select sectors.
Fun times indeed. Am I the only one that is gloomy on an up day in the markets?
Being underweight any market that just rips in your face never feels good. And since many funds have been underweight both equity and speculative credit this year, many are speculating a year-end chase as funds try to catch up on performance by allocating capital to the yieldiest credits in hopes of further spread tightening.
To be completely honest, this rally has felt marginally healthy to me. There have only been a few dividend deals and you haven't seeing historically weaker investment banks or desks bringing speculative deals. Seasoned issuers are coming to market with refinancing and M&A or capital structure alterations (loans refinanced into bonds). Pricing and structure have been the real stumbling block for me over the past few months. Coupons and all in yields are definitely not compensating investors for the duration of the asset class these days and covenant quality has gotten worse and worse and worse with each deal that clears. It often feels like, in larger deals, that large players are just putting in orders because 1) They have significant cash as a result of inflows to put to work and 2) The secondary market is horribly illiquid.
Some desks are beginning to get cautious. Generally speaking, most strategist's targets for high yield returns have been hit for the year. To me this portends further tightening or at least grinding through year end (still have quite a bit of carry left for the year) or at least the election unless an exogenous event happens in interim. The balance of pessimism and optimism across markets feels pretty balanced which historically are good things for the market.
Despite this, I am sitting on a large amount of cash. My PA has gone from very long with a smattering of shorts to a large cash position combined with a few liquidations and more shorts. The only place I see pain is in the coal and shipping space (and busted IPOs that I wouldn't look at anyways). The HILO on Bloomberg (over 50M market cap) was 260 high and 16 lows. Here is a chart of the number of distressed bonds traded (distressed = over 1000 bps spread). Not terribly enticing.
I think you you begin to see more M&A come down the line (already seeing it with Plains today) and maybe some speculative LBOs or MBOs that will come with covenant lite structures and terms. All to feed the beast that have been inflows this year and a re-start of the CLO machine.
There's simply not enough blood in the streets for me to get excited. Every investment you make has some sort of beta / market component to it. Maybe that is only a very small percentage (say a liquidation or Lehman like situation) and some have a very heavy market component (think go-go-go equities). I am 100% focused on the former category right now and am paying close attention to both legacy and new bankruptcies to see if there are interesting places to play. That, and of course, shorting has been a big priority for me over the past few weeks as I look for aggressive accounting or thematic trades to play out and revaluations to occur in select sectors.
Fun times indeed. Am I the only one that is gloomy on an up day in the markets?
9.04.2012
China Medical Technologies Files for Chapter 15
Readers of the blog will remember a post a few months ago where I alerted readers to my short position in China Medical Technologies. At that time the stock was trading at around $6 share and proceeded to go parabolic eventually topping out ~$12/share before collapsing. The move to the upside was triggered by a number of factors most notably buy-ins across a number of brokerages. Buy-ins were followed by more buy-ins and things got a little crazy. Eventually, as they often do, things came back to reality, the SEC forced a halt on the stock, a Cayman Island liquidation order was put into place, shareholder and bondholder lawsuits abounded, and now the Chapter 15 proceeding. After getting color of the proceedings going on in the Cayman Islands I tried to short more stock last week but was unable to find a borrow. Disappointing to say the least.
I've embedded below the Chapter 15 motion. Some fantastic quotes from the document:
As the company's market cap is still ~$60M, it will be interesting if the largest shareholder listed on Bloomberg (AER Advisors and the Deutsche family) will be involved in the proceedings. We will be following the proceedings.
China Medical Technologies Chapter 15 Proceeding
I've embedded below the Chapter 15 motion. Some fantastic quotes from the document:
- "In short, by the early part of 2012, from the standpoint of CMED’s outside directors, auditors, shareholders and creditors, CMED ceased to be a functioning corporate entity and had totally “gone dark.”
- "Despite extensive searches by the Liquidators (which included inquiries to hundreds of banks in the Cayman Islands, United States, Hong Kong and the PRC as described below), the Liquidators have not yet been able to locate any of the funds purportedly paid by the Transferee Companies or even to establish that any of those funds ever reached CMED. Our investigations are continuing."
- "The Liquidators’ investigations further indicate that the Transferee Companies are partially owned or controlled by associates of Wu and that Wu and members of Wu’s family may have received a portion of the value fraudulently transferred from CMED and the CMED Operating Companies. With the loss of control of the CMED Operating Companies, by the transfer of control from CMED’s 100% owned subsidiaries, the CMED lost its only source of revenue and was rendered hopelessly insolvent."
- "CMED’s chief remaining assets, its shares in its single directly owned subsidiary and 100% indirectly owned subsidiaries, are in the Cayman Islands. To date, despite an investigation that has included inquiries to over 300 banks in the Cayman Islands, the United States, Hong Kong and the PRC, the Liquidators have been unable to locate any other CMED assets anywhere in the world outside the Cayman Islands."
As the company's market cap is still ~$60M, it will be interesting if the largest shareholder listed on Bloomberg (AER Advisors and the Deutsche family) will be involved in the proceedings. We will be following the proceedings.
China Medical Technologies Chapter 15 Proceeding