St. Louis, Here We Come: Implications of Patriot Coal Venue Change Decision

Today, Judge Shelley Chapman ordered that the Patriot Coal bankruptcy case be transferred to the United States Bankruptcy Court for the Eastern District of Missouri. We first wrote about a venue change here: Patriot Coal Venue Change proceedings.

For those interested in following along, I've embedded the order below (a must read in my opinion):

Patriot Coal Venue Change Order

The 8.25% Notes started the day 50-52 and closed 47.5-49.5. The converts were also quoted lower but I'm not sure how much actually traded.

Why were the bonds down? One desk analyst noted: "There isn't much case law in St. Louis, so the judge has more latitude to do what he pleases." The remainder of this post will try to drill down on the implications of a venue change to St Louis. As an aside, I have not heard yet if the Debtors will appeal this decision, but given how narrowly Judge Chapman wrote her opinion, it is hard to imagine it getting overturned.

As first discussed here on the blog (Patriot's hidden value for the guaranteed notes), there was a case to be made that if you separated the corporate structure of Patriot Coal into "clean" and "burdened" (clean being no legacy liabilities, burdened meaning many legacy liabilities), one could make the case that significant value would flow directly from operating assets to the guaranteed bonds without a rejected opeb claims getting a piece of that particular box. The bonds subsequently rallied as the "box theory" began to take hold.

Unfortunately, there is something that could put a bullet between the eyes of the box theory: substantial consolidation ("sub-con"). And unfortunately, the 8th circuit has a very small sample set (one to be exact) in sub-con decisions. Conversely, SDNY and the 2nd circuit have voluminous amounts of case law and definitive litmus test for sub-con.

There is currently a bankruptcy case being held in the District of Minnesota (also the 8th circuit) that discusses the 8th circuit's history with sub-con (Petters Company, Inc. - Case No. 08-45257). You can find the discussion here: Substantial consolidation in the 8th circuit. Some salient take-aways:

• The 8th Circuit applies a three-prong test for sub-con
• The 8th Circuit has addressed sub-con only once. A case in 1992 (First Nat’l Bank of El Dorado v. Giller)
• From the docket: "In determining the propriety of substantive consolidation, the Eighth Circuit identified several factors for review, including “(1) the necessity of consolidation due to the interrelationship among the debtors; (2) whether the benefits of consolidation outweigh the harm to creditors; and (3) prejudice resulting from not consolidating the debtors.”

The decision in Petters will ultimately have a major effect on the outcome of Patriot Coal and bond recoveries as I expect retirees and other creditors (converts?) to argue for sub-con to increase their recoveries (spread the clean assets over all the burdened liabilities). In Petters, those opposed to sub con have argued that given the limited history of sub con decisions in the 8th circuit, the court should rely on tests from other districts. For instance in the 2nd circuit, sub-con may be ordered if:

• creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or
• the affairs of the debtors are so entangled that consolidation will benefit all creditors.

Applying this test to Patriot Coal, from a third party observer's standpoint I would venture a guess that those suppliers that extended credit to Patriot didn't look at individual LLC's financials to determine credit worthiness - instead they probably looked at the corporation as a whole. We know the debtors are not so entangled given the frank reading of SOFAs that came out a few months ago (assets and liabilities were clearly defined). But again, this is using the 2nd (and 9th) circuit test which means little in this decision until we have more clarity on Petters

Before I move on from sub-con, I want to hit on one remaining point: partial sub-con is an established practice in other bankruptcy cases (and circuits). One could argue that if Patriot Coal was substantially consolidated, everything would collapse to one box which would, in effect, disenfranchise the guaranteed notes relative to the holdco converts (that are not guaranteed and at the bottom of the heap). I doubt that happens and instead believe, if a sub-con were to occur, it would be all the operating entities of PCX being consolidated, leaving hold-co in its own box and therefore structurally subordinated to everything.

Of course, sub-con is not the only thing that matters in this case. It is incredibly important but there are other value drivers here. In fact, one issue very much stuck out for me from Judge Chapman's ruling: The comments on issued related to Peabody's spin of Patriot. There were a number of comments in particular I thought relevant:

• "The agreements relating to Patriot’s October 31, 2007 spin-off from Peabody included a Delaware choice of law provision."
• "Counsel for the Debtors remarked at the Hearing that the 'circumstances surrounding Patriot’s spinoff from Peabody will most assuredly be looked at with extraordinary seriousness by both the Debtors and the Creditors’ Committee.'”
• "Moreover, the corporate headquarters of Peabody are also in St. Louis; this fact is significant in light of the issues that have been raised by the UMWA with respect to its spin-off of Patriot and its responsibility to provide promised cradle-to-grave health care benefits to Patriot employees and retirees who worked for Peabody prior to the spin-off."

 Causes of action (or at least discovery) against Peabody for the Patriot spin will probably be pursued (similarly discovery and actions against Arch Coal for the sale of Magnum will probably also be pursued). While bankruptcy venue itself does not have ramifications on the look back period for fraudulent transfers. Instead its based on a myriad of sometimes impossible factors to surmise. I, frankly, do not have a 100% clear picture on what statute would be used in the Peabody spin of Patriot. Would it be St. Louis? Would it be Delaware? Would it be New York? Each of these locations have different look back periods and that 2 year difference (4 vs 6) is enormous in this particular case. In fact, if readers have a strong opinion here, please reach out to me to discuss.

My bias on the 8.25% bonds is currently negative for some of the reasons mentioned above but also because I do not want to be long super high cost thermal coal along with being long high vol met coal (of, on average, lower quality B coals). I think this case's timeline will play out a lot longer than people anticipate which, in the face of difficult structural and regulatory trends (and negative cash flow), could erode the value of the debtor's estates. I think there are better ways to play met coal (one particular low cost met producer comes to mind) in the coming years.

We will continue to follow the case and update readers on the Patriot Coal bankruptcy.

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19th Annual Distressed Investing Conference

In past years, Distressed Debt Investing has attended and providers readers notes and commentary from the Beard Group's 19th Annual Distressed Investing Conference. Last year was a fantastic event (and prescient with a panel on shipping that was covered last year) and this year the panels and speaker again look top notch. Of particular interest to me are the panels on municipal debt restructurings, claim valuation, and "family office distressed investing", a topic I am hearing more and more about as family offices look to add new asset class and strategies to the mix.

What I've always loved about this conference is the healthy mix of stakeholders from the restructuring community that contribute and add value to the panels: buysiders, advisers, private equity, claims agent, consultants, and law firms. Each with their own perspective that will be of value to any investor navigating the ever difficult market we find ourselves in. For those interested in buy side commentary, the conference is featuring panelists from Schultze Asset Management (George Schultze himself), MatlinPatterson, Virtus Capital, and Elliot just to name a few.

Distressed Debt Investing will be in attendance and we hope to see you all there. For more information on the conference you can view the brochure here:

19th Annual Distressed Investing Conference Brochure

You can also find more information here at the conference website: 19th Annual Distressed Investing Conference

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Some Takeaways from Citi's Distressed Desk

Last week, Citi held their annual credit conference, an event I have attended for many years and always have thoroughly enjoyed. I would love to spend time writing a post on keynote speaker Michael Milken's fantastic keynote speech at lunch but thought it would make sense to spend time on some takeaways from commentary by Citi's distressed desk.

Scott Balkan, the head of the desk, kicked off with some insightful comments about the current positioning and state of the market. He noted that distressed funds across the board had a specific predisposition to safer trades. He used the analogy of two distinct trades (I'm paraphrasing the numbers below):

• Trade A: Security trades at 10. Three outcomes: 12, 15, 18
• Trade B: Security trades at 10. Three outcomes: 5, 12, 100

Scott noted that funds are reluctant to consider trade B and risk loss of capital despite the enormous upside in the tail scenario. I've touched on this topic before when discussing convex versus concave investing strategies.  Because of this dynamic, Scott noted that options (tail events to the upside), are more than likely mis-priced in the market and therefore present opportunities for the diligent investor.

Citi conducted a survey with their clients earlier in the year regarding positioning, cash balances, etc. On of the more interesting takeaways from the survey was very fund funds think their cash position is below average. But at the same time very fund funds think the current opportunity set is above average. No respondent said the opportunity set was very high. For me this is somewhat hard to reconcile.

One of Scott's final points was that most investors are fine being late. This corresponds with investors being predisposed to safer trades. The hardest investment to put on in any market is the falling knife. And because, across the board, funds are ultra focused on short term performance, funds are avoiding that falling knife. Another opportunity for diligent investors.

Citi's desk analysts then presented a number of ideas in the current market place. I will say the presentations across the board were fantastic. While I will not relay what securities the analysts discussed or which way they were positioned (ask your Citi sales coverage), the situations discussed included (but not limited to):

• Ambac
• AMR
• Sharp
• OSG (OSG had filed that morning! Everyone perked up started talking notes when they analyst began speaking)
• TXU

Overall, as usual Citi put together great ideas for distressed investors to chew on in a very difficult investing environment. Scott Balkan did note the desk is doing simply enormous volume and as I know a number of the distressed analysts personally, they deserve the volume given their quality of research, market color, and commentary. Great stuff.

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My Favorite Quote from the Most Recent Baupost Letter

This week, in the wake of Sandy and the intermittent power outages, loss of internet, and general feeling of "can't get anywhere" due to subway restrictions, I've had time to catch up on a lot of reading. Luckily one of the items I had printed out before the storm was Baupost's most recent letter to its investors. While I will not post the entire letter I did want to pull out my favorite paragraph from the letter (I also wanted to point out that Klarman notes that 3rd quarter gains were led by the Lehman securities in the ongoing liquidation and that cash balances were at 33.5%)

 Many in the press have already commented and cited Seth Klarman's abhorrence for QE3 laid out in the letter.  The paragraph preceding the QE3 annihilation is what I find most interesting (my emphasis added):

"The overall market environment seems increasingly risky to us, as securities prices are rising despite weak and generally deteriorating global fundamentals. U.S corporate earnings are expected to be lower this quarter. Higher markets in the face of eroding fundamentals can be a toxic combination. A market rising for non-fundamental reasons (i.e., QE and ECB bond repurchases) is always one that demands a healthy dose of skepticism"

As noted in many posts in the past I am deeply involved in the primary markets in all US credit products: Investment grade, high yield, and bank debt. And as appetite for primary paper picks up, pricing (yields) tightens, terms get weaker, and the risk/return scales falls to where investors are not getting compensated for the risk they are taking. As primary markets strengthen, so do secondary markets as a rising tide lifts all boats (though one could argue secondary market strength could really be the driver of primary market strength. Either way, all boats are rising). With both primary and secondary markets strengthen, a prudent investor would reduce his or her exposure to the asset classes in question. Instead, we've seen more investors pile into the asset class as retail fund flows and a general "can't be left behind" feeling has pervaded the market.

I am definitely not a "perma-bear." But when I look out into the marketplace and see quite a few hold-co PIK toggle dividend deals getting done in drive-by fashion with 8 and 9 handles, it stands to reason that risk isn't being priced correctly in the market place. Non fundamental reasons whether it be fund flows or as Klarman points out a "Central Bank" put seem to be the reason.

Another reason I think is the general shortening of professional investor's time frames. In the most recent Graham and Doddsville, Joel Greenblatt goes on to say, on shortening of investor's time horizons: 

"I think the reason for this is that your investors – your clients – generally just don’t know what the investment manager’s logic was for each investment. What they can view is performance. It’s pretty clear that for mutual funds, for instance, the performance of a given fund over the last 1, 3, 5, and 10 years has very little correlation with the future performance for the next 1, 3, 5, and 10 years. So institutional investors are left with predicting who’s going to do well in the future, which they attempt to do by looking at the manager’s process. For most clients, the manager’s process is not transparent and the rationale behind investment decisions is not clear. Clients tend to make decisions over much shorter time horizons than are necessary to judge skill and judgment and other things of that nature. So I think time horizons are getting shorter, not longer. We’re not in danger of people expanding their time horizons when they’re judging managers. I think time arbitrage will be the “last man standing,” pretty clearly. "

If the short term opinion is that QE will be forever with us, and central banks across the world will provide endless levels of liquidity, then the next move, all else being equal is higher. Investors inherently will believe themselves to be smarter than the crowd and will tell themselves "We will know when to get out FIRST." or "We are the best TRADERS out there. We will know when the time has come to cash in OUR chips."

The "chase" factor, especially for under performing funds is starting to take hold. I often ask friends and colleagues: "Is the pain trade up or down?". A few months ago everyone would have said up. Now I am getting more and more mixed answers. Investors are much longer than they were a few months ago for all the same reasons. Many stocks can go much higher in one year, but then collapse in three years. And I think that's one of my biggest problems with the world today: The only margin of safety is continuous Fed and central government stimulus.

A margin of safety means you buy a stock that you think is worth $10/share, using conservative assumptions, for substantially less than that. You don't get the $10/share valuation using aggressive growth projections or valuation multiples. Conservative assumptions is the opposite of 'hope' and I tend to think this market has priced in a lot of hope.

All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.

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