Big day / weekend for distressed debt investors with three relatively decent size filings in Lodgenet, School Specialty, and PowerWave. Still seeing runs kinda all over the place given the lack of liquidity in some of the names. I'll be back with more on each of these throughout the next two days.
Read more...Over the past few years, Distressed Debt Investing has attended iGlobal's Forum Global Distressed Debt Investing Summit here in New York City. Each year the conference highlights issues highly topical to the distressed debt community while featuring a number of fantastic speakers. This year there will be speakers from the likes of Fortress, Highland, Marblegate, Marathon, Moab, Versa, WL Ross, Bowery, Watershed, and Halycon just to name a few.
Like last year, the agenda also highlights the issues most pertinent to credit investors today. Things like the opportunity for distressed debt overseas, what industries look most interesting in the tight spread environment of today, and the macro outlook and their impact on our market.
For more information, you can find the conference website here: 4th Global Distressed Debt Investing Summit. Hope to see you there!
For the past few months, David Karp, partner at Schulte Roth & Zabel, has contributed a number of fascinating articles on issues pertinent to trading in distressed debt, both domestically and overseas. I have gotten to know David over the past few months and he undoubtedly is one of the best in the field at what he does best: making sure funds and their investments are protected when transacting and executing trades in distressed debt and claims.
He's back with another fantastic, and timely, post. This one concerning a very recent decision related to claims trading in an oldie, but a goodie: the KB Toys bankruptcy and ASM Capital (defined below as Purchaser). This is a long one, but funds and desks transacting in claims will learn a great deal from the post. Enjoy!
Advanced Distressed Debt Trading & Trade Dispute Litigation: Debtor vs. Secondary Market Claims Purchaser
Our last post, Advanced Distressed Debt Lesson: Trade Dispute Litigation: What Distressed Investors Need to Know, focused on a claim buyer’s rights against a claims seller in the event that the specific claim sold is or becomes impaired. This post discusses the risk of impairment in the context of a dispute between the debtor’s liquidating trustee and a claims purchaser. On Jan. 4, 2013, the U.S. District Court for the District of Delaware upheld a bankruptcy court ruling that a so-called “section 502(d)” claim impairment travels with a claim in a typical claims trading transaction, rather than staying with the seller as a “personal disability.” In re KB Toys Inc., et al., Civ. No. 12-716 (D. Del. entered Jan. 4, 2013). Regardless of this district court ruling on these highly debated issues, or the outcome of any potential appeal to the Third Circuit, traders and analysts should focus on the diligence pointers provided by this case, which demonstrate that this trip to court by the claims purchaser might have been avoided.
KB Toys, a mall-based toy retailer, filed for Chapter 11 protection in early 2004. Between the Chapter 11 petition date and confirmation of its plan of reorganization in the summer of 2005 (followed by a second Chapter 11 filing and liquidation in 2008), “Purchaser” acquired 34 trade vendor claims ranging in size from $792.00 to $2.6 million, for a total combined face amount of approximately $7.5 million.
When purchasing multiple claims to build a position, it is not uncommon for claims investors to utilize a “portfolio theory” approach to aggregating claims against one debtor and spreading the risk that an individual claim is or will become impaired across a bundle of small claims, with the expectation that actual losses on any “bad” individual claim would be exceeded by higher returns on the bundle. Appearing to use this strategy, the Purchaser acquired each of the 34 claims on a short-form assignment agreement consisting of one to two pages of basic representations, warranties and indemnities. That being said, the Purchaser’s forms used for the KB Toys claim purchases, redacted copies of which were filed with the court, vary slightly between the different trades and are on a modified short-form recourse structure, meaning the risk of an impairment of a claim should remain with the claims seller through a put right and indemnification for breach of representations and warranties. For a more detailed discussion of recourse structures and claims trading risk allocation structures, see Claims Traders Beware: More Risk Than You Bargained For! Each of the nine purchase agreement forms for the disputed claims included a put right and four out of nine included indemnification for the seller’s breach of representations and warranties, which included, among others, that the claim was valid in the amount specified and that no objections to the claim existed.
In late July 2009, after the Purchaser had settled more than 30 trades and accumulated more than $7 million in face value of claims, the KB Toys trustee filed an omnibus objection to certain claims based on section 502(d) of the Bankruptcy Code. Section 502(d) requires the court to "disallow any claim of any entity from which property is recoverable" under an avoidance action, such as a preference claim "unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable." See 11 U.S.C. § 502(d). The Purchaser may have been surprised to see nine of its claims listed in that objection. The nine claims listed, the largest of which was for only $163,000, totaled about $672,000 or approximately 9.5 percent of the Purchaser’s total position.
In many cases, one of the hallmarks of a portfolio strategy for claims purchasers is less claim and seller-specific diligence and lighter purchase documents in order to facilitate a quick trade and settlement. Light diligence aside, the Purchaser might have easily discovered, in advance of buying the claims, that many of the claims it was buying were subject to potential section 502(d) disallowance. As required of all Chapter 11 debtors, KB Toys had filed a Statement of Financial Affairs (“SOFA”) that listed all payments to creditors of more than $600 in the 90 days immediately preceding the petition date. KB Toys’s SOFA listed the nine claimants from which the Purchaser purchased the claims at issue, including the dates and amounts of the payments from KB Toys to the creditors. While we will delve more deeply into avoidance action law below, certain payments from a debtor in the 90 days prior to its filing can be avoided by the trustee or debtor-in-possession. Had the Purchaser reviewed KB Toys’s SOFA, it would have been aware that those original sellers were potentially subject to preference actions by the trustee and, therefore, their claims were also potentially subject to disallowance under section 502(d). In addition, the original holder of the largest claim was already subject to a default judgment in the amount of $18,181 obtained by the trustee in advance of the Purchaser purchasing the claim. This fact was readily discoverable in a search of the debtor’s case docket.
The public record is unclear on what, if any, efforts the Purchaser took to collect from the original claimholders under the assignment agreements’ put-right or indemnification provisions. We can speculate that such efforts have not been successful to date, as the Purchaser has since gone to great lengths to challenge the trustee’s objection to its nine claims since it was filed in July 2009 — arguing, among other things, that the trustee’s section 502(d) defense does not travel with the claim to the transferee.
As is the case with most assignment of claims agreements, the Purchaser’s assignments are governed by New York law. Unfortunately for market participants (and their counsel), but perhaps fortunate for the Purchaser, the state of New York law as to whether or not claim impairments are specific to the claim can be characterized as murky, at best. This is due to the oft-criticized decision known as Enron II. Enron Corp. v. Springfield Assocs., LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) (“Enron II”). In the Enron case, the debtor sought to use section 502(d) to disallow claims held by secondary market transferees. As with the Purchaser’s claims, one of the issues for the court to consider in Enron was the extent, if any, to which a claim subject to section 502(d) disallowance in the hands of the transferor remains subject to section 502(d) disallowance in the hands of a transferee that was not involved in the avoidable transfer that gave rise to the 502(d) defense. The bankruptcy court, in Enron I, held that, since the claims in the hands of the transferor would be subject to section 502(d), the transferees are subject to the same claim disallowance under section 502(d). Enron Corp. v. Avenue Special Situation Funds II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) (“Enron I”).
In the appeal of the Enron I decision, Enron II, the district court considered “whether . . . disallowance under 502(d) can be applied, as a matter of law, to claims held by transferees to the same extent they would be applied to the claims if they were still held by the transferor based on alleged acts or omissions on the part of the transferor.” Enron II, 379 B.R. at 427-28. In its opinion, the district court considered the legislative objectives of the statute and cited the “twin aims” of disallowance under section 502(d): to assure equality of distribution of the estate assets and to coerce compliance with judicial orders. Id. at 435. The district court then attempted to make a distinction between the effect of a “sale” versus an “assignment.” The district court described an assignment as a transfer in which the assignee stands in the shoes of the assignor, taking the claim with whatever limitation it had in the hands of the assignor. See id. at 436. In other words, in an assignment of a claim, all limitations and disabilities of the claim and the transferor travel with the claim to the transferee, whereas in a sale, some limitations and disabilities can travel with the claim, but personal disabilities of the claimant remain with the claimant. Id. The district court looked at the language of 502(d) and determined that the emphasis on the entity suggested that 502(d) is a personal disability of the claimant that travels by assignment. Id. at 443. As to whether or not the Enron transfer was a sale or an assignment, the district court held that this determination required examination by the bankruptcy court of the “nature of the transfers.” Id. at 445-46. However, before the bankruptcy court could make a determination of that issue, the parties settled the claims, leaving claims and distressed debt trading market participants scratching their heads and wondering what exactly makes a transfer an assignment versus a sale.
This leads us back to the Purchaser’s purchases (or were they assignments?) of the KB Toys claims. Faced with the KB Toys trustee’s objection to the nine claims on section 502(d) disallowance grounds, the Purchaser naturally responded by waving the Enron II flag. In response to the trustee’s objections, the Purchaser argued to Judge Carey in the Delaware bankruptcy court that, based on Enron II, the claims at issue were transferred as “sales” and that the language of section 502(d) focuses on the claimant and, therefore, is a personal disability of the claimant that did not travel with the claim in the sale. In re KB Toys, Inc., 470 B.R. 331, 335 (Bankr. D. Del. 2012). Conversely, the KB Toys trustee questioned the analysis of Enron II and the resulting policy concerns and argued that, even if accepting Enron II, the transfers to the Purchaser were assignments and that the Purchaser had at least constructive knowledge of the claims, making the Purchaser’s purchases of the claims not in good faith. Id.
With analysis harkening back to the pre-1978 Bankruptcy Act (and even to case law from 1902), Judge Carey concluded that legislative history and case precedent support the notion that disabilities travel with the claim to the transferee. Id. at 335-37. Judge Carey echoed the analysis in Enron I and questioned the “sale versus assignment” distinction advanced in Enron II. Id. at 337-41. Judge Carey noted that the distinction has been highly criticized and observed that, “even if there exists a clean and principled way to distinguish between assignment and sale, the exercise, in this context, is unhelpful and unrevealing of the appropriate outcome.” Id. at 341.
Judge Carey also rejected the Enron II policy assertion that burdening the transferee with the disabilities imposed on the claim would upset the trading markets as a “hobgobin [sic] without a house to haunt,” because buyers of debt are highly sophisticated and fully capable of performing due diligence before any acquisition. Id. at 342. Even without any due diligence, market players are fully aware of the ever-present possibility of avoidance actions based on preference liability or fraudulent conveyances. Id. Judge Carey observed that the Purchaser could have discovered the potential for disallowance with very little due diligence and could have factored that into the price. Id. The fact that some of the assignment agreements had indemnification for disallowance evidenced the Purchaser’s understanding of the possible risks and its leverage to appropriately protect itself. Id.
Judge Carey also rejected the Purchaser’s argument that it should be protected from disallowance as a purchaser in good faith, reasoning that a purchaser of bankruptcy claims is well aware of the debtor’s financial difficulties and is entering a market in which claims are allowed and disallowed in accordance with the Bankruptcy Code. Id. at 343. In short, purchasers of bankruptcy claims are not entitled to the protections of a good faith purchaser. Id. Judge Carey was careful to point out in a footnote, however, that the ruling only relates to trade claims purchased from an original holder and not to other types of transfers, such as publicly traded notes, etc. Id. at 342 n.14.
The Purchaser then appealed Judge Carey’s ruling to the District Court for the District of Delaware and the appeal papers more or less rehashed the same issues and arguments as presented to the bankruptcy court. Oral argument on the appeal was held on Jan. 4, 2013 and Judge Richard G. Andrews upheld Judge Carey’s ruling. According to the hearing transcript, Judge Andrews’s view of the language of section 502(d) is that it could be read either way, but he nevertheless agreed with the rest of Judge Carey’s analysis. Judge Andrews was particularly focused on the policy rationale that the Purchaser should bear the risk of a section 502(d) impairment because it is in a better position to protect itself, as opposed to other unnamed creditors whose claims would be diluted if transfers had the effect of cleansing claims of such impairments. Feeling that he would not have much to add on the matter, Judge Andrews refrained from issuing a written opinion but welcomed the Purchaser to seek appeal to the Third Circuit to perhaps move closer to a definitive resolution of this issue. We would like to be able to say this ruling, or the outcome of any potential appeal to the Third Circuit, provides clarity on the state of the law in this area, but a Delaware district court ruling, or even a Third Circuit decision on appeal, will not have the precedential force to change the fact that Enron II is still out there and, despite widespread criticism, is still the law in New York.
No matter the outcome, the KB Toys case is a good reminder to the market that disallowance under section 502(d) is a real risk. The sale/assignment, personal/non-personal disabilities distinctions are too vague and legally opaque to be relied on by purchasers of claims. There are many more practical and reliable techniques available for purchasers to protect themselves. First, through due diligence. Even when accumulating small trade claims, work with your attorneys to create a diligence checklist for each debtor you are considering, review the SOFA, the case docket, and do an Internet search on the seller to see if you uncover any potential "insider" (as defined under the Bankruptcy Code) connections to the debtor, which could increase the preference period from 90 days to one year. Second, protect yourself in the trade documents (which you should do in most cases, regardless of the due diligence outcomes). Make sure your documents have strong seller representations, including that the claim is not (and will not be) subject to “disallowance (including, without limitation, pursuant to section 502(d) of the Bankruptcy Code),” avoidance, subordination, or be otherwise impaired. Have a clear indemnification provision for breach of representations and claim impairments. Of course, document-based protections do come with the credit risk of the seller, which brings you back to due diligence.
What should you do if your due diligence does uncover potential section 502(d) issues? Run for the hills? Not necessarily. There are some circumstances in which claims could be attractive even with the potential for section 502(d) disallowance. The potential section 502(d) disallowance can be settled, whereby the amount paid to the seller is used to resolve the trustee’s avoidance action in order to get the claim allowed. Or, the avoidance action could be priced into the trade or the seller might be willing to escrow the avoidance action claim amount until the claim objection is resolved. The bottom line is that even where a purchaser is quickly aggregating small claims through a “portfolio theory” approach, an upfront investment in pre-trade diligence and transaction structuring far outweighs the time, cost and expense required if a dispute arises and it finds itself in court.
David J. Karp is a partner in the New York and London offices of Schulte Roth & Zabel LLP, 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 a frequent 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. Neil Begley, an associates at SRZ, assisted in the preparation of this entry.
Every few months, I post a recent idea from the Distressed Debt Investors Club. Started a year or so after I launched the blog, the DDIC has grown to be an amazing community of buy and sell side analysts covering everything from distressed, special situation equities, cap structure arbs and outright shorts. For a list of ideas on the site you can go here: DDIC List of Ideas. Because of turnover (members are required to post an idea once every 6 months), we are always looking for talented analysts to join our community. A thorough investment idea is a requirement for admission. For those interested, you can apply here: http://distresseddebtinvestorsclub.com/home/apply/member
Post reorg equities often interest the special sit equity community of funds. And Tribune (TRBAA) is getting a lot of coverage from both distressed desks as well as on the run equity shops. Last week, a member of the DDIC wrote up his thesis on the stock. Enjoy!
Idea: TRBAA
Company Name: Tribune
Type: Post Reorg Equities
Synopsis
Tribune is a media conglomerate with TV stations, newspapers, and valuable interests in Food Network, CareerBuilder and Classified Ventures.
Fortunately, the majority of the value comes from the non-publishing assets (compared to 2007 when 70% of the core operating EBITDA was from publishing) - unfortunately, that's because the publishing business has shrunk rapidly.
I think Tribune is fairly valued here at around $49, although there is upside from:
Today, The Ad Hoc Committee of Senior Noteholders of Edison Mission released a 2019 statement disclosing who is involved in the case.
The funds listed are:
The title of this post comes from a quote from a buy side friend working at one of the largest hedge funds out there. I 100% agree with his assertion. Howard Marks also agrees (see his most recent letter here: http://www.oaktreecapital.com/MemoTree/Ditto.pdf). He writes:
"Regardless of the reason, things are happening again today - especially in the credit world - that are indicative of an elevated, risk-prone market:I find it interesting: Many many people realize the market is heavily overvalued in terms of compensation of return versus risk, but they still are buying. Maybe they NEED to buy because they are an insurance company or pension that can't find yield anywhere else that high yield bonds. Or maybe they NEED to allocate capital because they are getting inflows from retail/new investors. Maybe they think all is clear for the foreseeable future and hence are happy to clip a fat coupon for the interim period. I am hearing primary markets are simply a food fight amongst large funds trying to get whatever allocation they can get a hold of to put money to work for coffers that seem to be only growing from demand in the asset class.
- Total new issue leverage-finance volumes - loans and high yield bonds - reached a new high of $812 billion in 2012, according to Standard & Poor's, surpassing by 20% the previous record set in pre-crisis 2007.
- The yields on fixed incomes securities have declined markedly, and in many cases they're the lowest they've ever been in our nation's history. Yield spreads, or credit risk premiums, are fair to full - meaning the relative returns on riskier securities are attractive - but the absolute returns are minimal. I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yield to call or yields to worst start with numbers - 'handles' - of 3 or 4 percent. The yields are down to those levels because of strong demands for short paper with perspective returns in that range. I've never seen anything like it.
- As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicated the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage."
"Equities are still being disrespected, and equity allocations reduced. They they are not being lifted by comparable income-driven buying."
Today I received Dan Loeb's Third Point Fourth Quarter 2012 Investor Letter. As usual its a fantastic read (embedded below). As has been reported in recent weeks, Third Point made an absolute killing getting long Greek sovreign debt. Assets under management now top an impressive $10B.
A favorite quote from the letter: "We dug deep beyond the frightening headlines and conducted in-depth research on the state of political and economic affairs globally, helping us develop a variant view and giving us confidence to deploy capital. Our ability to generate returns was boosted by a breakdown in correlations, and this shift provided the key for us to deliver alpha across asset classes, sectors and geographies."
Loeb goes on to discuss their position in Herbalife and lays out a very compelling case for a long position in the stock. His take-away: "Applying a modest 10-12x earnings multiple suggests Herbalife’s shares are worth $55-$68, offering 40-70% upside from here and making the company a compelling long investment for Third Point. Given that the Company has historically traded more in the 12-14x range (and traded at 16-20x earnings through much of 2011 and early 2012), the opportunity for the Company to tell its side of the story tomorrow at its Analyst Day in New York, and the significant short interest, we believe shares could even trade well above our current price target."
Loeb also discloses positions in Morgan Stanley and Tesoro Corporation. You can read the long arguments in the letter below. Enjoy!
thirdpoint.4q12investorletter.010913
After adjourning its first hearing today, THQ reconvened at 3:00PM and announced that a compromised was made among various parties. A form of order has yet to be presented but the general takeaways:
After an very, very long hearing, Judge Mary Walrath, a favorite of mine, did not approved the DIP motion or bidding procedures motion in the THQ case. She instructed parties to discuss and work out their issues over the weekend and set a new hearing on Monday. I will be writing a more thorough post this weekend on the day's events.
Read more...As investors, we are bombarded with information. Whether it be macro news, political turmoil, or earnings releases (just to name a few), its oftentimes hard for investors to filter out the noise from things that actually change the intrinsic value of securities. With so many things happening through the year, the one thing I'll remember about 2012: equity recoveries in bankruptcy.
Do not get me wrong. When I tell friends or family about what stocks I am invested in, most of them think I am speculating on some pump and dump scheme of a failing company. Maybe I monitor Twitter or Yahoo message boards for the next stock that's going to EXPLODE. Look at most of the stock message boards for companies entering the Chapter 11 process and you may go blind and/or cry.
2012 was different. In 2012, there were huge returns to be made by diligent investors invested in the bankrupcies of certain equities. During 2012, I was invested in (and in many case still invested in via the liquidation trust)
I have been following the THQI bankruptcy very closely over the last few weeks since its filing in Delaware on December 19th. Pursuant to the first day motions of CEO Brian Farrell, the company is to be sold to Clearlake Capital (Clearlake) for an aggregate contribution of approximately $60.5M, comprised of cash, assumption of liabilities, and promissory notes. In addition, Clearlake, along with pre-petition lender Walls Fargo will provide financing to THQ during its bankruptcy process. What surprised me was how fast the process was going especially given the potential large values of THQ's IP.
Clearlake is the stalking horse bidder in THQ's sale. According to the sales motion on the bankruptcy docket, Clearview will acquire substantially all of the Debtors' operating assets. The exact sale consideration that Clearlake is offering is as follows:
i) Fund payment in full of secured claims, including repayment of the DIP facility, projected to be approximately $29M
ii) Pay $6.65m in cash at closing
iii) Assume certain liabilities estimated at approximately $15M
iv) Deliver to the debtors a promissory note for $10M (at a 2% rate) due in 7 years for the benefit of creditors
for a total consideration, on paper, of approximately $60.5M. I view it lower than this due to the fact that a 2% note would be worth far less than 100 cents on the dollar. The DIP here, with 2.5% fee for a January 18th maturity (and a 15% PIK
rate to boot), looks overly punitive given the short window here.
To give you a sense of the valuation, here is the Debtor's projections per the first day filings:
"During August and September, 2012, Centerview and the Debtors’ management began a so-called marketing “process” focused on finding an investor to either: (i) fund the Debtors’ business plan or (ii) acquire the Debtors’ entire business (as a whole). During this “process,” the Debtors and their advisors focused their attention on contacting “growth-oriented” financial investors (i.e., venture capital and private equity firms) and, by marketing the company as a whole, effectively precluded strategic investors from participating in a sale process. The financial investors that the Debtors and their advisors did approach included only a few firms known for “distressed” investing, which likely further hindered the process."
