Advanced Distressed Debt Lesson #1

Over the next few months, in addition to regular postings, I would like to delve into some of the more archaic distressed debt investing concepts and technicalities. While a strong ability to value companies (especially those that are facing tough times) will get one far in this business, being able to see the intracies of bankruptcy rulings, credit agreements, indentures, etc will enable you to looks at more delicate and difficult situations where many investors will avoid due to the sheer complexity. At times I will use current or past examples, and at others I will speak conceptually of lessons I have learned over the years. Remember, I am not a lawyer - just a practicing professional investor that has a few thoughts and opinions.

We will begin with negative pledges. A negative pledge is a restriction, embedded in a bond's covenants that prohibits liens on certain properties unless the bonds are equally and ratably secured. The key with a negative pledge is defining "certain properties." In all indentures and credit agreements, capitalized terms will be defined in a "Definitions" section. For example, in one of Darden's Indenture:
"The Company will not, and will not permit any Restricted Subsidiary to, incur, issue, assume or guarantee Indebtedness secured by any Liens of the Company or any Restricted Subsidiary upon any Principal Property, or upon shares of capital stock or evidences of Indebtedness issued by any Restricted Subsidiary and owned by the Company or any Restricted Subsidiary, whether owned at the date of this Indenture or thereafter acquired, without making, or causing such Restricted Subsidiary to make, effective provision to secure all of the Securities then Outstanding by such Lien, equally and ratably with any and all other Indebtedness thereby secured, so long as such Indebtedness shall be so secured."
The problem with this statement is that every capitalized term has a definition, and those definitions may be wide open. Let's see what Principal Property means. Going to the definition section:
“Principal Property” means all restaurant or related equipment and real property, in each case which is owned by the Company or a Subsidiary and which constitutes all or part of any restaurant located within the United States or Canada.
Hmm. What about assets overseas (if there are any?). What about intellectual property? What about accounts receivable? What about stock? A stock pledge can be very valuable at times. Seems like quite a bit of things could be pledged to secure debt if things got bad.

Not only is the defintion aspect of this game difficult, but the carveouts compound them further. In the above example, let me just go through and list the carveouts (for those now aware, carveouts are exceptions to explicity stated covenants). Skip this part if you are bored easily - the takeaway, which I will expand on further below, is that their are a lot of carveouts in these documents.
The foregoing restrictions shall not apply to indebtedness secured by Liens existing on the date of this Indenture or to any of the following:

(1) Liens on any Principal Property acquired, constructed or improved by the Company or any Restricted Subsidiary after the date of this Indenture which are created or assumed contemporaneously with such acquisition, construction or improvement, or within 180 days before or after the completion thereof, to secure or provide for the payment of all or any part of the cost of such acquisition, construction or improvement (including related expenditures capitalized for Federal income tax purposes in connection therewith) incurred after the date of this Indenture;

(2) Liens of or upon any property, shares of capital stock or Indebtedness existing at the time of acquisition thereof, whether by merger, consolidation, purchase, lease or otherwise (including Liens of or upon property, shares of capital stock or Indebtedness of a corporation existing at the time such corporation becomes a Restricted Subsidiary);

(3) Liens in favor of the Company or any Restricted Subsidiary;

(4) Liens in favor of the United States of America or any State thereof, or any department, agency or instrumentality or political subdivision of the United States of America or any State thereof or political entity affiliated therewith, or in favor of Canada, or any political subdivision thereof, to secure partial, progress, advance or other payments, or other obligations, pursuant to any contract or statute or to secure any Indebtedness incurred for the purpose of financing all or any part of the cost of acquiring, constructing or improving the property subject to such Liens (including Liens incurred in connection with pollution control, industrial revenue or similar financings);

(5) Liens on any property created, assumed or otherwise brought into existence in contemplation of the sale or other disposition of the underlying property, whether directly or indirectly, by way of share disposition or otherwise; provided that 180 days from the creation of such Liens the Company must have disposed of such property and any Indebtedness secured by such Liens shall be without recourse to the Company or any Subsidiary;
(6) Liens imposed by law, such as mechanics’, workmen’s, repairmen’s, materialmen’s, carriers’, warehousemen’s, vendors’ or other similar liens arising in the ordinary course of business, or governmental (federal, state or municipal) liens arising out of contracts for the sale of products or services by the Company or any Restricted Subsidiary, or deposits or pledges to obtain the release of any of the foregoing;

(7) pledges or deposits under workmen’s compensation laws or similar legislation and Liens of judgments thereunder which are not currently dischargeable, or good faith deposits in connection with bids, tenders, contracts (other than for the payment of money) or leases to which the Company or any Restricted Subsidiary is a party, or deposits to secure public or statutory obligations of the Company or any Restricted Subsidiary, or deposits in connection with obtaining or maintaining self-insurance or to obtain the benefits of any law, regulation or arrangement pertaining to unemployment insurance, old age pensions, social security or similar matters, or deposits of cash or obligations of the United States of America to secure surety, appeal or customs bonds to which the Company or any Restricted Subsidiary is a party, or deposits in litigation or other proceedings such as, but not limited to, interpleader proceedings;

(8) Liens created by or resulting from any litigation or other proceeding which is being contested in good faith by appropriate proceedings, including Liens arising out of judgments or awards against the Company or any Restricted Subsidiary with respect to which the Company or such Restricted Subsidiary is in good faith prosecuting an appeal or proceedings for review; or Liens incurred by the Company or any Restricted Subsidiary for the purpose of obtaining a stay or discharge in the course of any litigation or other proceeding to which the Company or such Restricted Subsidiary is a party;

(9) Liens for taxes or assessments or governmental charges or levies not yet due or delinquent, or which can thereafter be paid without penalty, or which are being contested in good faith by appropriate proceedings;

(10) Liens consisting of easements, rights-of-way, zoning restrictions, restrictions on the use of real property, and defects and irregularities in the title thereto, landlords’ liens and other similar liens and encumbrances none of which interfere materially with the use of the property covered thereby in the ordinary course of the business of the Company or such Restricted Subsidiary and which do not, in the opinion of the Company, materially detract from the value of such properties; or

(11) any extension, renewal or replacement (or successive extensions, renewals or replacements), as a whole or in part, of any Lien existing on the date of this Indenture or of any Lien referred to in the foregoing clauses (1), (2) or (5) to (10), inclusive; provided, that (i) such extension, renewal or replacement Lien shall be limited to all or a part of the same property, shares of stock or Indebtedness that secured the Lien extended, renewed or replaced (plus improvements on such property) and (ii) the Indebtedness secured by such Lien at such time is not increased.
Notwithstanding the foregoing, the Company and its Restricted Subsidiaries, or any of them, may incur, issue, assume or guarantee Indebtedness secured by Liens without equally and ratably securing the Securities of each series then Outstanding, provided, that at the time of such incurrence, issuance, assumption or guarantee of Indebtedness, after giving effect thereto and to the retirement of any Indebtedness which is concurrently being retired, the sum of (i) the aggregate amount of all outstanding Indebtedness secured by Liens which could not have been incurred, issued, assumed or guaranteed by the Company or a Restricted Subsidiary without equally or ratably securing the Securities of each series then Outstanding, except for the provisions of this paragraph, plus (ii) the Attributable Value of Sale and Leaseback Transactions entered into pursuant to the penultimate paragraph of Section 1009, does not at such time exceed the greater of (x) 10% of Consolidated Capitalization of the Company or (y) $250,000,000.
That less paragraph will be the one you generally want to focus on. Let's try to break it down just a little bit. "Notwithstanding the foregoing" means if we missed it above, here it is. And if you read it closely, you can decipher that it means that we CAN secure indebtedness, and not secure the bonds, if the amount of debt secured by liens plus a possible sale leaseback does not exceed 10% of Consolidated Capitalization or $250,000,000. Then you have to go to Consolidated Capitalization and figure out that definition, and the cycle repeats itself.

Why is this all important? Companies file for banrkuptcy for a few reasons, but the main one being they run out of money. Trade wants cash up front, banks want their money back, wages need to be paid...but there just isn't any money left. Before this cycle of doom arrives, a company will look to the capital markets to raise capital, sometimes at any expense.

And that means the company is going to be look for ANY asset it can pledge to make loan to values look good in an offering document. But if you have already bought the bonds hoping to be the first or second creditor out in a bankruptcy, and the company comes in and lops on another 1 or 2 turns of secured debt, you relative position in both valuation and bargaining strength drops dramatically.

You have to understand what the company has to prime you. Because they will if things get bad and they want to stave off bankruptcy. If there is a loophole in the covenants or indenture, it is your job as an investor to find it and either avoid the bonds (or short the bonds if the negative pledge is too restrictive) or understand the risks in holding the security.

No one truly enjoys reading indentures and credit agreements. But I promise you, some distressed debt investors out there are doing it right now, looking for loopholes to get an edge.


Anonymous,  9/14/2009  

All I have to say is you are the man.

-Scott Willis

Anonymous,  9/25/2009  

Very interesting! Please keep them coming.


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.