11.26.2014

Emerging Manager Series: Advantage Capital

In the past we have interviewed a number of emerging hedge fund managers whose strategy and style of investment we particularly respect. In the latest edition of our emerging manager series, we caught up with Irv Schlussel of Advantage Capital. Irv launched Advantage in December of 2013 after two successful years managing an account at Telemus Capital. More information on Advantage Capital can be found on their website advantagecapm.com

Enjoy and have a wonderful Thanksgiving!

You started your career in equity research, how did you find yourself in distressed debt investing?

I began developing my interest in the distressed space when I was in college. The idea of investing in a situation where there was significant confusion and forced selling was quite appealing to me. I read the book “The Vulture Investors” by Hilary Rosenberg and then did a summer internship at the distressed firm Wexford Capital. After working at Wexford, I was sold and directed my career toward distressed. The distressed market has developed significantly from the 1980s and early 1990s, when investors purchased loans directly from the workout groups of commercial banks, but there continues to be significant opportunity in the space. When I graduated from Wharton in the early 2000s, the traditional path was to work in banking research or trading. UBS had an excellent training program, and working there helped me gain perspective prior to going to the buy-side and into distressed investing.

Perhaps consequently, your fund’s investments involve a combination of equity and debt investments. How does that help when special situations opportunities are sparse?

I think it is critical to have the flexibility to move across the capital structure and adapt to the opportunities that are available in varying market environments. Many of the core analytical and legal skills used in distressed can be applied to merger arbitrage and other litigation related opportunities. Even within a distressed capital structure, we sometimes find that having a smaller sized position in the equity results in a more asymmetric return profile when compared to investing in the debt. We focus our analysis on finding the most optimal positioning within a given capital structure and this has been a key component of the fund’s success thus far.

Your portfolio has a mix of hedged/arbitrage trades and directional fundamental positions, can you describe your criteria for using one or the other?

We think having a mix of outright and hedged positions is the key to successful portfolio management. We find it safer to deploy capital when we can identify a great hedge within a capital structure. In such a scenario, we focus our research on the catalysts that will make our trade work. We perform extensive fundamental research, but the hedged nature of our risk gives us greater flexibility in how we can size the position. We also develop a good sense of the time horizon of an event that will catalyze these hedged positions.

A good example of an appealing hedged opportunity was the merger arbitrage in the pre-chapter equity of the then bankrupt American Airlines. American was emerging from bankruptcy through a merger with US Airways. AAMRQ had sold off disproportionately to the value of new shares of US airways into which it would be converted. There was significant confusion in the market as holders of the then bankrupt AAMRQ were to receive the majority of their stock in the NewCo (AAL) over a period of four months. During this period, the AAMRQ stock would be delisted and cease trading. News of the delisting caused forced selling by many market participants who were not allowed to own delisted companies. We seized upon this opportunity to put on a hedged arbitrage position in which we bought AAMRQ and sold short AAL to reduce our risk. The merger spread on this position was in the mid-teens on a non-annualized basis and the weighted average time to close was about two months given the timing of distributions.       

Outright positions are usually driven by a significant mismatch between our perceived value of a security and the prevailing market price. When we have done significant work and believe we have an informational advantage, we are comfortable having directional risk in a given situation.

In the last three years when you’ve seen mega-funds take huge hits on situations such as the government sponsored enterprises and then have been stagnated in other investments due to a slow distressed market, Advantage has posted significant double digit returns ahead of the HFRI distressed and event driven indices. What has set your firm apart?

We think one of our strengths is the management of position sizing in some of the crowded distressed trades. We have a position in FNMA and continue to be favorable on the GSEs. We are more likely to take larger positions (7-10% of capital) in situations like Genco, GT Advanced Technologies, Verso, Syncora & YRCW. These situations are less crowded and we believe our involvement through participation on the committees and positioning in the information flow allows us to have an advantage.

You’ve been bearish on the corporate debt market while emphasizing “opportunities in idiosyncratic situations” that give rise to investments that have low correlations to the market. Can you give an example and how you came across an idiosyncratic distressed investment?

A great example of this is our position in Genco Shipping. Shipping had been on our radar for the past several years, as the industry has been distressed since the financial crisis, but has not had that much bankruptcy. Much of the shipping reorganization was pushed off, since the banks that lent to the industry were primarily European banks that were incentivized to avoid foreclosure. These banks opted to kick the can down the road to avoid having to mark the underwater debt to market.

When we first started looking at Genco in April of 2013 when its bonds were trading in the low 30s and the bank debt was primarily held by the Norwegian bank DNB. We were alerted to a pending restructuring of Genco in December 2013, as much of the bank debt changed hands and was purchased by a group of large hedge funds including Centerbridge and Apollo. These trades were rumored to have been priced in the low $90’s as broader market fundamentals were improving and shipping rates were on the rise. We took the view that these funds would not waive further covenant violations and had purchased the bank debt with the objective of forcing bankruptcy and owning the company. Genco had a $125 million convertible bond that we felt would have a blocking position in any restructuring.  We began purchasing bonds and set up a hedged position with a short in the equity. There was a clear mismatch between the debt & equity as we were buying the bonds in the 40s and shorting the stock at market cap of $90M. The catalyst for this position was a violation of the company’s bank debt covenants, which led to a reorganization and equitization of most of the liabilities. We sat on the creditors group in Genco, and were involved in the reorganization as a signatory to the Chapter 11 Plan Support Agreement. The plan of reorganization resulted in a conversion of the company’s debt into equity with a token recovery for the equity and a near par recovery for the bonds.

Conversely, you wrote about Exact Sciences as an equity short in your September letter and how it was the first name you published on when you were at UBS. That was 10 years ago. When do you decide that you know a company well enough to put your money into a thesis?

It depends on our comfort level and prior familiarity with an industry or particular company. There are situations in which we will do our initial work and initiate a small position that same day. That being said, we tend to wade cautiously into most situations. If something is appealing based on our preliminary research, we will take a smaller position while continuing to hone our thesis. If we increase our level of conviction as we do further research, we will increase sizing in accordance with liquidity and our view of the balance of risk and reward. It was easier to get comfortable with the Exact Sciences situation, as it is a company we have followed for over 10 years. Prior to initiating the short in Exact Sciences, we did a thorough “refresh” which included reaching out to physicians in the oncology field and having several conversations with the sell side. We confirmed our view that Exact was significantly overvalued and proceeded with our short.

You’ve written about sitting on creditors committees and the informational advantage that it provides. What is unique about how you sort through the information, and misinformation, that often comes as part of the Chapter 11 process?

Any given bankruptcy docket is filled with thousands of documents, the vast majority of which are noise and pertain to administrative matters. We think that as a starter, it is important to understand which documents are key. We always look at a company’s MORs, PORs, SOFAs, Disclosure Statements, 2019s & First Day Declarations. Services such as Reorg Research http://reorg-research.com/ have greatly improved the ability of a buy side firm to quickly monitor the docket and isolate important items. 

Sitting on a bondholder group or committee is an important step to being at the center of information flow. Having access to the attorneys and advisers involved allows us to get a great sense of how the chapter is proceeding and better understand the motivations of the various constituencies. We also closely watch 2019s and try to get a sense of who owns what and the extent to which they will defend their positioning. We think that having knowledge about the distressed firms involved is very helpful when trying to assess how a situation will play out. 

Recently there have been many market corrections and large drops in bonds as a reaction to only marginally weak earnings, and distressed investors are starting to see more opportunities. What is your prediction for the next significant distressed cycle?

We are of the view that we are closer to a turn in the credit cycle and the next wave of distressed investing opportunities. It is challenging to handicap the exact timing, but there are a number of signs that indicate that a turn is approaching.  There have been huge inflows into credit-related mutual funds driving a gradual move to tighter and tighter levels. More PIK Holdco notes were issued in 2013 than ever before, and this trend has continued into 2014.

We think that an eventual rise in interest rates will likely be a key catalyst as we have seen many poor companies able to refinance their liabilities in what has been a hot market for high yield new issuance. Just this morning I read the following headline on Bloomberg: “The $400 Billion Bond Mismatch Keeping Bears at Bay Endures”  The article mentioned that JP Morgan research is predicting fixed income “demand globally will outstrip supply by about $400 billion”.

New Issuance is ultimately purchased by mutual funds who have to buy to keep up with their inflows. Higher rates will make it more challenging for companies to continue to service and roll their liabilities. We anticipate and look forward to an associated uptick in the corporate default rate.

From an investing perspective, we believe that many distressed funds have spent the past few years focused on Lehman and the vintage of 2007 LBO’s (TXU, Caesar’s, Clear Channel, etc.). We anticipate that the downturn in credit will create opportunities in smaller capitalization companies with structures smaller than $3B. We think these smaller companies will find it harder to role liabilities than their larger peers. Advantage considers middle market distressed to be our “bread and butter,” and we think that the next cycle will be provide great opportunities for us to deploy capital as we grow our firm.

Are there people, events, things that have particularly influenced you as an investor?

Sitting on the trading desk at Xaraf Management (a trading group within Paloma Partners) in the crash of 2008 was a key experience in my professional development. It provided a perspective on just how bad things can get and how to approach trading in an illiquid cash bond market. The lack of liquidity magnified the degree of pain in the market as bids completely dried up. Those who were well capitalized were able to put on positions with great expected return and low risk, but most participants were too shell-shocked to be in a position to make investments. At Xaraf, we had done well in the market crash and were able to put on low risk basis trades that took advantage of the liquidity and leverage mismatch between cash bonds and CDS. I was also able to put on several low risk credit related risk arbitrage positions. During the crash, I saw the value of having dry powder when most don’t.

At Xaraf, I sat alongside and worked for Paul Pizzolato, who taught me the virtues of patience, position construction and sizing, and the value of liquidity in a down-market. I developed many skills at Xaraf, including unique approaches to merger arbitrage utilizing CDS and cash bonds to better optimize and hedge equity positions. Oftentimes, I would make the case for an investment and Paul would suggest that we wait and see if it gets cheaper. Many times it would, and we would find a far better entry point, which had a significant impact on returns. I have learned that there is a huge universe of potential investments, but the timing of entry and exit is critical regardless of thorough research and analysis. I learned the importance of being patient and waiting for the fat pitches.

At Wexford Capital I had exposure to Charles “Chuck” Davidson who was the right hand man of Michael Steinhardt for several years. Hearing Chuck’s perspective on investing and the experiences he had in the crash of 1987 had a lasting impression.
           
Can you talk about one idea you find particularly compelling today?

We think there is great upside to the bonds of the distressed Apple supplier GT Advanced Technologies, GTAT. GT has $434 million of convertible debt outstanding across two issues; a 2017 and 2020 both trading at 40. The company filed for bankruptcy on Oct. 6 in order to preserve value for creditors rather than continuing to hemorrhage cash as they attempted to fulfill the terms of an onerous contract to supply Apple with sapphire glass for the iPhone 6.

We believe there are sources of value that will drive recovery for the GTAT bonds. GTAT has significant cash, working capital, and the company’s SOFA filed on 11/21 disclosed that GTAT recently received a tax rebate of $29M.

Apple and the Company have reached a settlement which is pending confirmation by the court. An ad hoc group of creditors (of which we are a member) have filed an objection to this settlement as we believe it does not sufficiently repay the Company for the time, energy and money which was spent trying to perfect the Sapphire facility. The bonds could appreciate significantly if Apple agrees to recut this settlement with improved terms for GT Advanced.

One of the key ambiguities in the GTAT case surrounds the basic capital structure concept of “structural seniority”. The convertible bonds of GTAT sit at the holdings company and lack subsidiary guarantees. Funds from the issuance of the convertible bonds ultimately flowed down the capital structure from GT Advanced Technologies Inc. (“HoldCo”) to the various operating entities. There is approximately $125 in trade debt at the operating entities. A key question amongst investors and an ultimate driver of recovery will be the extent to which the Bonds have an intercompany claim that would make them pari-passu with some of the trade debt. We are of the view that at a minimum there is a strong legal argument to be made for substantive consolidation at the various GTAT entities. This argument was further coalesced on November 12th at the 341 meeting of creditors when it was disclosed that GTAT did not have a bank account in the name of the holding company and the proceeds of the convertible issuance went directly into the bank account of GTAT Corporation, an operating subsidiary.

We value the bonds at 60-70 in our base case scenario in which the court confirms the Apple Settlement. The settlement caps Apple’s claim against the company at $439mm and limits the claim to an operating company can that will sell the furnaces used for sapphire production. We model in $50M of value flowing back to the estate from the sale of furnaces. We value the core GT Advanced Solar businesses at $300mm.

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10.02.2014

Reorg Research - GSEs: Lamberth Opinion Dismissing Lawsuits Against FHFA, Treasury Deals Blow to Hedge Fund Case on HERA Jurisdiction

Reorg Research has actively covered the various GSE litigations ongoing in the District Court of the District of Columbia, the Court of Federal Claims, and Iowa. Using our technology, we were one of the first to break the dismissal filed by Judge Lamberth. More importantly though, we put out a comprehensive story and analysis that same night so our subscribing investors and traders across the distressed and event driven equity space were better informed than those trying to untangle the complicated opinion on their own.


Now that Perry has appealed the ruling (just hit the docket), we wanted to reproduce our review of the dismissal below. Enjoy!


Lamberth Opinion Dismissing Lawsuits Against FHFA, Treasury Deals Blow to Hedge Fund Case on HERA Jurisdiction

Relevant Documents:

Judge Royce Lamberth of the United States District Court for the District of Columbia granted the government motions to dismiss and denied the hedge fund plaintiffs' motions for summary judgment, brushing aside a class action lawsuit and three individual lawsuits with overlapping claims. 

The decision will most likely be appealed according to multiple sources. Both the D.C. District Court, where Judge Lamberth sits, and the D.C. Circuit Court, where the appeal will proceed, are highly respected around the country. While not binding on other jurisdictions, a final negative result for the funds could be highly precedential on other courts. 

Below are our initial impressions of the opinion, which will be augmented throughout the day tomorrow.

Overview

At heart of today’s opinion is a finding by Judge Lamberth that the bulk of the funds claims are barred by the Housing and Economic Recovery Act, or HERA. Specifically, the opinion concludes that HERA contains only an extremely narrow window for suits against FHFA as conservator. Rejecting the contention that even claims of “arbitrary and capricious” behavior by the FHFA are barred by HERA, Judge Lamberth concluded that the only types of declaratory relief that could survive HERA’s “express anti-injunction provision” are those premised on the FHA acting beyond the scope of its authority

Even construing the facts in the light most favorable to the funds, Judge Lamberth found that they could not allege that FHFA was acting beyond its authority. Importantly, he also found that FHFA’s subjective motivations are irrelevant in this inquiry. “The court must look atwhat has happened, not why it happened,” reads the opinion. (emphasis in original). Judge Lamberth also stresses that both sides are sophisticated 

Specifically on the critical question of FHFA’s authority, the opinion notes: “Of most relevance to the present litigation, HERA empowered FHFA, as conservator or receiver, to “immediately succeed to—(i) all rights, titles, powers, and privileges of the [GSE], and of any stockholder, officer, or director of such [GSE] with respect to the [GSE] and the assets of the [GSE].” Further, the HERA statute sets forth a limitation on court action that “may take any action to restrain or affect the exercise of powers or functions of [FHFA] as a conservator or a receiver.”

The opinion rejects claims by the funds that the conservatorship was a de facto liquidation and allegations that Treasury was improperly directing the FHFA. “The plaintiffs cannot transform subjective, conclusory  allegations into objective facts,” says Judge Lamberth.

Judge Lamberth finds that even claims that FHFA acted arbitrarily or capriciously are barred by HERA. He bases this on “a distinction between acting beyond the scope of the constitution or a statute, see § 702(2)(B) and (C), and acting within the scope of a statute, but doing so arbitrarily and capriciously, see § 702(2)(A).” Only the former allegations can proceed, and Judge Lamberth found (as noted above) that this simply could not be claimed on the facts put forward by the funds.

Factual Findings

Going even further than his legal conclusions, Judge Lamberth ties FHFA's actions as conservator to the GSEs recent profitability. Footnote 21 to the opinion reads: “Indeed, the GSE’s current profitability is the fundamental justification for the plaintiffs’ prayers for equitable and monetary relief. In other words, this litigation only exists because the GSEs have, under FHFA’s authority, progressed from insolvency to profitability.”

The Court also considered the technical aspects of the the government’s actions in regards to whether the Treasury purchased new securities through the Third Amendment. On this point, Judge Lamberth states that the Treasury’s authority as a market participant and the inherent sunsetting provisions (hold, exercise rights, sell) does not “preclude other non-security-purchasing activities otherwise permitted under an already agreed-upon, pre 2010 investment contract with the GSEs. To then say that the purchase authority sunset provision also categorically prohibits any provision within Treasury’s contracts with the GSEs that requires ‘mutual assent’ is to reach too far.”

Specifically, Lamberth writes  “the Court finds that Treasury did not purchase new securities under the Third Amendment. Under the Third Amendment—unlike the first two amendments—Treasury neither granted the GSEs additional funding commitments nor received an increased liquidation preference. Instead, Treasury agreed to a net worth sweep in exchange for eliminating the cash dividend equivalent to 10% of the GSEs’ liquidation preference. This net worth sweep represented a new formula of dividend compensation for a $200 billion-plus investment Treasury had already made. As FHFA further claims, the agency executed the Third Amendment to ameliorate the existential challenge of paying the dividends it already owed pursuant to the GSE securities Treasury purchased through the PSPA; it did not do so in order to sell more GSE securities.”

In regards to FHFA acting within its statutory authority, Judge Lamberth concludes that HERA gave “immense discretion” to the FHFA as conservator. Given the breadth of powers to the FHFA the Court’s decision is narrowed to the what instead of the why FHFA executed the Third Amendment. Specifically, “FHFA’s underlying motives or opinions—i.e., whether the net worth sweep would arrest a downward spiral of dividend payments, increase payments to Treasury, or keep the GSEs in a holding pattern” do not matter. 

Continuing: “However, when the Court is asked to determine whether FHFA acted beyond, or contrary to, its responsibilities as conservator under a statute that grants the agency expansive discretion to act as it sees fit, it is the current state of affairs that must weigh heaviest on this analysis. If the Third Amendment were really part of a scheme to liquidate the GSEs, then the GSEs would, presumably, be in liquidation rather than still be “immensely profitable.” Further, Lamberth notes that no precedent was cited stating that a net worth sweep is functionally equivalent to liquidation.

This follows then that claims for liquidation preference are not ripe. Specifically, “therefore, by definition, the GSEs owe a liquidation preference payment to a preferred shareholder only during liquidation. It follows that there can be no loss of a liquidation preference prior to the time that such a preference can, contractually, be paid. Here, the GSEs remain in conservatorship, not receivership, and there is no evidence of de facto liquidation.”

In an interesting footnote in relation to the ongoing debate of whether the GSEs could have pursued a PIK option in lieu of the Third Amendment, Judge Lamberth states that “the provision makes clear that 10% cash dividends were “required by” the stock certificates, and that 12% dividends deferred to the liquidation preference were only triggered upon a “failure” to meet the 10% cash dividend requirement. Thus, classifying the 12% dividend feature as a “penalty,” as Treasury does, is surely more accurate than classifying it as a “right.” 

Market Background

The plaintiff funds Perry Capital, Fairholme, and Arrowood who own either preferred or common stock in the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation - Fannie Mae and Freddie Mac, respectively. The plaintiffs had arguedthat the Federal Housing Finance Agency and U.S. Treasury exceeded their statutory authority under the Administrative Procedures Act and the Housing and Economic Recovery Act of 2008 when they made an amendment that required every dollar of GSE net worth above a certain amount to be paid to Treasury as a dividend. 

The common shares of the GSEs had been trading down steadily over the past month. Before the after-market-close decision, Freddie Mac quoted on the pink sheets under FMCC closed at $2.64 and Fannie Mae, FNMA at $2.69, down 7.37% and 6.6%, respectively compared with the previous day’s close. 

Other Legal Findings

Much of the opinion is devoted to HERA’s bar on declaratory judgment actions (which formed the bulk of the funds claims). Separately, today’s opinion addresses and rejects a number of other categories of claims:

Unconstitutional Taking: Regarding claims that the Third Amendment was an unconstitutional taking, Judge Lamberth found that plaintiffs can not allege a “cognizable property interest” because the funds took equity subject to “existing rules, understandings and background principles.” As such, Judge Lamberth notes the “specter of conservatorship” has long been part of the GSEs regulatory oversight. Further, according to the opinion, the funds “lack the right to exclude the government from their property.” (emphasis added). The GSEs are subject to “governmental control at the discretion of the FHFA’s director,” reads the opinion. 

Setting aside this legal bar, on the facts, Judge Lamberth finds “the plaintiffs cannot show that the Third Amendment rendered their prospects of receiving dividends any less discretionary than they were prior to the amendment.” All that holders were left with was the market trading value of the instruments, the opinion notes.

Derivative Suits: Per the opinion, HERA bars derivative claims against FHFA and Treasury because the D.C. Circuit has held that HERA transfers the ability to bring derivative suits to the FHFA as conservator or receiver of the GSEs. 

Judge Lamberth notes a narrow exception in the case law for allegations that FHFA acted with manifest conflicts of interest. But, he says, “[i]t is a slippery slope for the Court to poke holes in, or limit, the plain language of a statute, especially when, as here, the plaintiffs have not asked the Court to weigh in on the statute’s constitutionality. Therefore, the Court finds that HERA’s plain language bars shareholder derivative suits, without exception,” according to the opinion. 

In explaining why the exemption should not apply, the opinion states that “Treasury represented the only feasible entity— public or private—capable of injecting sufficient liquidity into and serving as a backstop for the GSEs within the short timeframe necessary to preserve their existence in September 2008.” 

Further, “a relationship-based conflict of interest analysis [] does not require the Court to ignore the harsh economic realities facing the GSEs—and the national financial system if the GSEs collapsed—when FHFA and Treasury executed the PSPAs in 2008. Courts, generally, should be wary of labeling a transaction with an investor of last resort as a conflict of interest,” the opinion reads. 

Breach of Contract: Additionally, plaintiffs’ claims requesting monetary damages for breach of contract, or breach of implied covenant of good faith and fair dealing claims were dismissed under certain threshold analyses. 

First, the opinion states the preference claims are not ripe. The opinion calls the analysis of the plaintiffs’ argument about the liquidation preference “uncomplicated.” The GSEs owe a liquidation preference payment to a preferred shareholder only during liquidation, and therefore “there can be no loss of a liquidation preference prior to the time that such a preference can, contractually, be paid. Here, the GSEs remain in conservatorship, not receivership, and there is no evidence of de facto liquidation.” The opinion sums up the point that since there’s no right to a liquidation preference during a conservatorship, the plaintiffs are “no worse off today than they were before the Third Amendment.” 

Second, the dividend claims fail to state a claim for which relief can be granted. The opinion points out that the dividends plaintiffs are claiming a “‘right’” that is “wholly dependent upon the discretion of the GSEs’ board …” and that there is no “absolute right to dividends.” In a footnote to the explanation, the court “expressly rejects the individual plaintiffs’ additional contention that the Third Amendment ‘effectively converted [Treasury’s stock] into common stock,’ which would ‘represent a distribution to the common shareholder ahead of and in violation of the contractual rights of Plaintiffs and other preferred shareholders.’” Another footnote says that the plaintiffs have not demonstrated that the FHFA acted in bad faith. 

Conclusion

The opinion concludes:

“It is understandable for the Third Amendment, which sweeps nearly all GSE profits to Treasury, to raise eyebrows, or even engender a feeling of discomfort. But any sense of unease over the defendants' conduct is not enough to overcome the plain meaning of HERA's text. Here, the plaintiffs' true gripe is with the language of a statute that enabled FHFA and,  consequently, Treasury, to take unprecedented steps to salvage the largest players in the mortgage finance industry before their looming collapse triggered a systemic panic. Indeed, the plaintiffs' grievance is really with Congress itself. It was Congress, after all, that parted the legal·seas so that FHFA and Treasury could effectively do whatever they thought was needed to stabilize and, if necessary, liquidate, the GSEs. Recognizing its role in the constitutional system, this Court does not seek to evaluate the merits of whether the Third Amendment is sound financial--or even moral-policy. The Court does, however, find that HERA's unambiguous statutory provisions, coupled with the unequivocal language of the plaintiffs' original GSE stock certificates, compels the dismissal of all of the plaintiffs' claims.”

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9.25.2014

Reorg Research is Hiring: Distressed Debt Analyst

Reorg Research is currently seeking a Distressed Debt Analyst to join our team of experienced, successful and highly motivated individuals at one of New York City’s fastest-growing and most successful start-ups. The analyst will be an industry generalist, covering in- and out-of-court restructurings, distressed and post-reorg situations.

Analysts will work alongside our Distressed Debt Legal Analysts and editorial staff and provide research and analysis directly to our subscribers, which include top hedge funds, investment banks, tradings desks, financial advisors and law firms.

The ideal candidate will have a minimum of 1-2 years of investment banking, advisory or desk analyst experience in the restructuring and/or distressed space. Candidates must possess very strong technical and analytical skills as well as excellent written and oral communication abilities. Experience in European geographies / international credit is a plus.

Essential Job Responsibilities:

  • Produce valuation and waterfall recovery models, research reports and topical intelligence articles for publication and distribution to our subscribers.
  • Maintain active dialogue and cultivate relationships with subscribers and industry contacts to supplement coverage efforts, including idea sourcing. Our analyst team talks to many of the top distressed hedge funds on a daily basis.
  • Support and collaborate with Legal Analysts and Editorial team to cover topical distressed situations, including court hearings.

Compensation and Perks: 

  • Competitive compensation package; stock options; full health, dental, and vision benefits.
  • Innovative, start-up culture at our amazing office in the Flatiron. 
  • Opportunity to work alongside a group of incredibly talented, passionate and fun individuals and be on the ground floor of a company poised to revolutionize the industries we serve. 
Interested candidates can send their resumes to recruiting [at] reorg-research.com


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7.29.2014

Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

In my estimation, and from talking to our clients, Reorg Research is providing the very best, most informed news, analysis, and commentary on the hottest topic in distressed: Puerto Rico. As I've told many people recently, this is a situation that we will be talking about for many years to come.

Last week, a few members of our team wrote a piece laying down some of the legal issues inherent in the some of the various litigations coming out of the U.S. District Court for the District of Puerto Rico. For more information on Reorg Research or to inquire about a subscription, please shoot us an email questions [at] reorg-research [dot] com. Enjoy!

Legal Fault Lines Over Puerto Rico Restructuring Law Come Into Focus

The battle against Puerto Rico's independent restructuring efforts is becoming more clear as a third opponent, BlueMountain, joined Franklin Templeton and Oppenheimer in litigation challenging the recently enacted Public Corporation Debt Enforcement and Recovery Act. With BlueMountain's complaint, funds managing more than $2.1 billion of the $8.6 billion PREPA bonds outstanding, the litigating parties represent a heavy percentage of PREPA bondholders actively opposed to the Recovery Act.

When viewed together, the complaints provide a clear picture both of what is at stake and what challenges the Recovery Act will face. The theme of the opposition is that the Recovery Act violates both the U.S. Constitution and the Puerto Rico Constitution as well as federal law. While both complaints seek to invalidate the law, BlueMountain also requests injunctive relief against any attempts by Puerto Rico or its publicly owned corporations to enforce or implement the Recovery Act.

The recently filed motions to dismiss filed by the Commonwealth of Puerto Rico and the Puerto Rico Electric Power Authority, or PREPA, also display the legal roadmap for efforts to defend the Recovery Act. PREPA and Puerto Rico stress that the Recovery Act is a valid exercise of the legislature, as evidenced by language introducing the legislation, which provides that the Recovery Act "is not a bankruptcy act, but an orderly debt enforcement act for the eligible public corporations."

Anti-Injunction Act

At least one thing appears certain: The litigation will not be resolved overnight. An initiation of procedures in the Puerto Rican courts under the new restructuring law by PREPA or any other eligible Puerto Rico publicly owned corporation could complicate things even more and push out any timeline for a resolution of the litigation because the ability of the U.S. District Court for the District of Puerto Rico to enjoin a proceeding under Puerto Rican law may be slowed by the Anti-Injunction Act (28 U.S.C. § 2283), which provides that "[a] court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgment." The applicability of this law to the unique situation of Puerto Rico's new restructuring law is uncertain, and fighting over the issue will likely take some time. If the Anti-Injunction Act applies, a Puerto Rican court process could conceivably continue in the face of legal challenges. That being said, the U.S. constitutional issues raised by Franklin, Oppenheimer and BlueMountain will likely be raised in the Puerto Rican proceedings, particularly at the eligibility hearing proscribed by section 306 of the Recovery Act.

Preemption and Conflicts with the Bankruptcy Code

The Bankruptcy Code of the U.S. Constitution provides that "[t]he Congress shall have Power To...establish...uniform Laws on the subject of Bankruptcies throughout the United States. . . ." Here, the parties disagree over whether the Bankruptcy Clause and/or conflicts between the Bankruptcy Code and the Recovery Act invalidate the newly enacted legislation based on preemption.

The parties do not dispute that the Bankruptcy Code expressly excludes Puerto Rico from eligibility under Chapter 9. However, what is less clear and the focal point of debate between the parties is whether the Bankruptcy Clause preempts Puerto Rico from creating its own restructuring laws and also whether those laws include impermissible conflicts with the Bankruptcy Code.

Puerto Rico and PREPA dispute the preemption arguments, citing to the 1942 Supreme Court case Faitoute Iron & Steel Co. v. City of Asbury Park, N.J., in which the court concluded that a state's police power justified New Jersey's enactment of its own public debt enforcement and adjustment statute. They cite Asbury for the argument that "state and local governments retain the power to pass their own restructuring statutes, so long as they do not conflict with federal law." Puerto Rico argues that the principals of Asbury Park comports with the "sovereign police power" set forth in the Puerto Rico Constitution, providing that "[t]he power of the Legislative Assembly to enact laws for the protection of the life, health and general welfare of the  people shall . . . not be construed restrictively."

Puerto Rico's also argues that its public entities "are not currently governed by any federal bankruptcy law," similar to banks and insurance companies who are expressly excluded from the Bankruptcy Code's eligibility provisions set forth in section 109(b). In this case, Puerto Rico argues that while Congress enacted federal bankruptcy law in the form of the Bankruptcy Code, Puerto Rico is excluded as a debtor from the Bankruptcy Code and its publicly owned business entities are "governmental units" ineligible to seek relief under chapter 11. Based on these exclusions, Puerto Rico argues that the Recovery Act is an appropriate exercise of its police power because it is effectively filling the gap created by the Bankruptcy Code.

In rejecting Puerto Rico's arguments that the Recovery Act does not conflict with the Bankruptcy Code, the plaintiffs cite to section 903(1) of the Bankruptcy Code, which was enacted following the decision in Asbury Park and precludes a state from binding a creditor to an adjustment or discharge of obligations without the creditor's consent. The complaints note that while Puerto Rico is excluded from the meaning of "State" for eligibility purposes, it is not excluded for purposes of other Bankruptcy Code provisions such as section 903(1). They say that the Recovery Act provides for binding adjustments without creditor consent, in clear contravention of section 903(1).

Puerto Rico, however, responds that "[s]ection 903 can and should be read to permit Puerto Rico to enact restructuring legislation that complements-and in no way conflicts with-its federal counterpart." In support of its argument, Puerto Rico argues that "because Puerto Rico's public corporations may not avail themselves of Chapter 9, Section 903-which, by its own terms, applies only when Chapter 9 is invoked-is wholly inapplicable to the Commonwealth." Puerto Rico's motion to dismiss goes on to characterize the plaintiff's reading of section 903 and the related definition of a "State" under section 101(52) as "absurd" because such an interpretation would deprive Puerto Rico of its ability to exercise its "traditional police power" and preempt Puerto Rico from enacting the restructuring legislation necessary to help it escape the "financial ruin" in which it finds itself.

Beyond preemption based on the alleged conflict between the Recovery Act and section 903 of the Bankruptcy Code, BlueMountain cites to the Supreme Court's 1929 decision in Int'l Shoe Co. v. Pinkus, which provides that "[s]tates may not pass or enforce laws to interfere with or complement the Bankruptcy Act or to provide additional or auxiliary regulations." The Recovery Act, BlueMountain argues, "is preempted because it improperly operates in a field that Congress has comprehensively occupied." Further, BlueMountain asserts that even if Congress has not completely preempted state regulation of bankruptcy, "the Act would still be preempted because its bankruptcy-like provisions would stand as an obstacle to accomplishing and executing Congress's purposes and objectives in enacting a uniform bankruptcy code."

At some level, this last argument presupposes that Congress' objective was to exclude Puerto Rican-owned entities from bankruptcy protection. Defenders of the new law imply, however, that PREPA and other island-owned companies fall into a "hole" in the Bankruptcy Code.

Contract Clause

The Contract Clause of the United States Constitution provides that "No State shall . . . pass any . . . Law impairing the Obligation of Contracts." The complaints of BlueMountain, Franklin and Oppenheimer argue that the Recovery Act "substantially impairs" the obligations contained in the PREPA bonds, most notably because it deprives the bondholders "of their contractual rights to payment in full of their claims." The parties challenge the Recovery Act as law that provides an impermissible discharge of a contractual obligation. In support of their arguments, the plaintiffs cite to the 1819 Supreme Court decision from Sturges v. Crowninshield, which held that New York law "so far as it attempts to discharge the contract on which this suit was instituted, is a law impairing the obligation of contracts within the meaning of the constitution of the United States."

Responding to the Contract Clause challenges, PREPA and Puerto Rico point out that "[t]he Contract Clause's prohibition on the enactment of laws impairing contractual obligations 'is not an absolute one' and 'does not make unlawful every state law that conflicts with any contract.'" Beyond the initial inquiry of impairment, Puerto Rico stress that any Contract Clause inquiry must go beyond impairment and must demonstrate that the Recovery Act is not "reasonable and necessary to the achievement of a sufficiently important government interest so as to render them constitutional exercises of the state's police power." Puerto Rico cites to the motives set forth in the Recovery Act, most notably the most-severe "fiscal emergency" in the Commonwealth's history as adequate support for the contractual impairment provisions of the Recovery Act.

Similarly, in the case of Asbury Park, the Supreme Court cited to Sturges, which provided that "a state insolvency act is limited by the Contract Clause of the Constitution in authorizing composition of pre-existing debts," but the Court also pointed out that any Contract Clause analysis "depends on what is affected by such a composition, and what state power it brings into play." The Supreme Court in Asbury Park applied a practical approach in addressing whether the Contract Clause "bars the only proven way for assuring payment of unsecured municipal obligations," discounting the contract impairment argument where "a most depreciated claim of little value has, by the very scheme complained of, been saved and transmuted into substantial value."

The Asbury Park decision implies that the Contract Clause is somewhat malleable and will yield to legislation up to a certain point. The question now is whether the Recovery Act has reached or exceeded that point for purposes of a Contract Clause challenge.

Takings Clause

The Franklin/Oppenheimer complaint also argues that the Recovery Act violates the Takings Clause of the Fifth Amendment and Fourteenth Amendments to the U.S. Constitution. The concept of adequate protection is a cornerstone of the Bankruptcy Code that provides "just compensation" upon the granting of a superior lien or a diminishment in a party's property, thereby giving effect to the Takings Clause. In response, Puerto Rico notes that the Recovery Act does not violate the Takings Clause, instead arguing that the legislation affecting creditors' property rights is within its authority as a sovereign. The motion to dismiss also points out that "the Act-like the Bankruptcy Code-satisfies the Fifth Amendment requirements of the U.S. Constitution by providing adequate protection for security interests."

Although the Recovery Act provides a definition of adequate protection that parallels the Bankruptcy Code, it also provides instances where adequate protection is discretionary, not mandatory, raising significant Takings Clause concerns. Most notably, subsection (d) of section 129 of the Recovery Act, which defines adequate protection, provides that:

"Notwithstanding any section of this Act conditioning the eligible obligor's or the petitioner's use or transfer of its property on adequate protection of an entity's interest in the property, if and when the police power justifies and authorizes the temporary or permanent use or transfer of property without adequate protection, the Court may approve such use or transfer without adequate protection."
Similar exceptions found in chapters 2 and 3 of the Recovery Act allow the debtor to forego adequate protection payments "to the extent that sufficient revenues are unavailable for  payment of such principal, interest or other amounts after full payment of such current expenses or operating expenses." This justification based on "police power" and public necessity would seem to go squarely against the Supreme Court's 1935 decision in Louisville Joint Stock Land Bank v. Radford, in which it concluded "[f]or the Fifth Amendment commands that, however great the Nation's need, private property shall not be thus taken even for a wholly public use without just compensation."

Stay of Federal Litigation

One of the more interesting arguments presented by both complaints is the permissibility of the Recovery Act's automatic stay on proceedings in federal courts.  With only a limited number of exceptions, the automatic stay under the Bankruptcy Code is incredibly broad with the power to stay almost all causes of action filed in both state and federal courts.

Here, Puerto Rico argues that the Recovery Act is outside of the umbrella of the Bankruptcy Code, expressly rejecting preemption arguments, while also seemingly enacting its own automatic stay with similar effects, namely staying all litigation, which presumably includes both state and federal causes of action. However, citing to the Supreme Court in Donovan v. City of Dallas,  the Franklin/Oppenheimer complaint points out that "state courts lack any power under the Constitution to enjoin proceedings in federal court."

While Puerto Rico argues that the federal courts should "'respect and not interfere with a state court's prior in rem jurisdiction," both Puerto Rico and PREPA may still remain subject to ongoing litigation in the federal courts regardless of a filing under the Recovery Act because of the litigation that has already been filed, particularly the constitutional arguments. Puerto Rico's intrastate comity arguments based on in rem jurisdiction may also fail when considering the relationship between state law receivership and the federal provisions of the Bankruptcy Code.

Standing and Ripeness

A major argument in Puerto Rico and PREPA's motions to dismiss the Franklin/Oppenheimer suit is that the plaintiffs lack standing to bring their claims because "neither PREPA - nor any other Puerto Rico public corporation - has sought relief under the Recovery Act" and, therefore, have not sustained the level of injury necessary to challenge the statute. Instead, PREPA characterizes the plaintiffs' claims as "wholly hypothetical, and predicated upon an invocation of the Recovery Act by PREPA that may never occur." The motions to dismiss also argue that the plaintiffs' constitutional challenges are both premature and unripe until PREPA, or any other Puerto Rico public corporation, seeks relief under the Recovery Act.

As if in response to the motions to dismiss, which were filed only a day before BlueMountain's complaint, the BlueMountain complaint argues that the bondholders have already suffered injuries as a result of the laws enactment, most notably by the Act's elimination of the bondholders' right to seek appointment of a receiver upon the occurrence a default under the 1974 Trust Agreement that governs PREPA's bonds. BlueMountain also cites to the already noticeably "depressed" value of the PREPA bonds as another form of actual harm resulting from the Relief Act.

Conclusion

Each of the above arguments, and many that have yet to surface, will undoubtedly cloud Puerto Rico's attempts to restructure its public corporations. A critical issue is timing. As the existing constitutional lawsuits unfold, PREPA faces the expiration of two short-term lines of credit in August, totaling $671 million and including a $550 million line with Scotiabank which must be repaid on Aug. 14. As noted above, disputes over the Anti-Injunction Act could take center stage in the immediate aftermath of a PREPA filing under the new law. That being said, a final resolution of the interplay between the federal Constitution and the new restructuring law will almost certainly involve many levels of appellate review.

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7.24.2014

Tina’s Wish Junior Committee Summer Event

The financial restructuring community has been a consistent and long-term supporter of The Honorable Tina Brozman Foundation for Ovarian Cancer Research (Tina’s Wish).  The foundation is named in memory of the late Tina Brozman, former Chief Justice of the Southern District Bankruptcy Court and co-head of the financial restructuring practice at Bingham McCutchen.

Reorg Research is proud to be a TEAL sponsor for the upcoming Tina’s Wish Junior Committee Summer Event on Monday, August 11th from 6-8pm at 601 Madison Avenue, 6th floor (between 57th & 58th Streets).  Come by to help support research dedicated to finding an early detection and prevention for ovarian cancer.

The evening will feature a brief and interesting presentation by Memorial Sloan Kettering Researcher, Dr. Dan Haller.

For more information and to pre-register, please visit www.tinabrozmanfoundation.org/summer

Looking forward to seeing you there!

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hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.