Advanced Distressed Lesson: Claim Value, OID, and Make-Whole Provisions

Earlier in November, the bankrupt Great Atlantic & Pacific Tea Company ("GAP") announced a deal that would enable the company to exit from bankruptcy. Financed by prominent stakeholder (equity and debt) Yucaipa, well-regarded event driven fund Mount Kellett, as well as funds managed by Goldman Sachs Asset Management, GAP was to receive $490 million split between new second and third lien notes as well as new equity to facilitate the company exiting from bankruptcy.

One of the beneficiaries of this plan and new investment was the company's existing 11.375% Second Lien Senior Secured Notes. A little less than a year ago, we noted our interest in the same security: GAP Bankruptcy and Comps. As you can see from the below chart, in spite of a stagnant U.S. economy, a choppy high yield market, and unrelenting European malaise, this security has delivered a solid return to its investors:

With that said, Wells Fargo, in its capacity as trustee for the 11.375% Senior Secured Notes, and the ad-hoc group of Senior Secured Note Holders (who hold 69.5% of the outstanding principal of the notes) filed a limited objection to the capital raise.

According to the most recent statement of Brown Rudnick, counsel to the ad-hoc consortium, members of the ad-hoc group as of November 11th, are:
  • ALJ Capital Management LLC
  • AQR Capital Management, LLC
  • Artio Global Management LLC
  • Barclays Capital
  • Capital Ventures International
  • CNH Partners LLC
  • Davidson Kempner Capital Management LLC
  • Guggenheim Partners, LLC
  • Royal Capital Management LLC
  • Visium Asset Management, LP
  • Whitebox Advisors, LLC
I have pasted the limited objection below. It should be noted that on November 14th, Judge Robert Drain ruled that the financing, as currently contemplated may go forward, irrespective of the objective. That being said, the Disclosure Statement hearing is to be held in the middle of December, and the arguments and merits note holders objections may come up again at that hearing.

Here is the jist of the objection: The current securities purchase agreement with Yucaipa, Goldman Sachs, and Mount Kellett provides that secured note holders are too receive cash OR replacement second lien notes in an amount equivalent of their allowed claim. In addition, the plan is able to cramdown the Second Lien Notes to accept whichever way they are treated (cash or new notes). This is important in that the amount of new money coming in would change dramatically if the Second Lien Noteholders receive new notes instead of cash.

Why would the plan contemplate such treatment? According to the objection:
The “cramdown option” in the SPAs is designed solely to exert leverage over the Secured Noteholders in resolving the amount of their claims. Specifically, the Secured Note Parties have asserted, as part of their claim, amounts due under their indenture (the “Secured Notes Indenture”), other than principal and accrued interest, upon redemption of the Secured Notes prior to their initial maturity date – colloquially referred to as the “make-whole” claim. Upon information and belief, the Debtors and/or the Investors dispute the “make-whole” claim. If this is indeed the case, the Secured Note Parties submit that, in the interests of transparency for the Court and all constituents, the Debtors should disclose and take steps to resolve that dispute, rather than proceeding with an amorphous, half-baked “cramdown option” that may call into question whether the deal the Debtors are asking this Court to approve is indeed the deal that will ultimately go forward – or in reality is less than half of the deal.
And this is where it gets interesting: What is the value of the allowable claim of the Senior Secured Note Holders? Again from the objection we read:
Significantly, the amount of principal and accrued interest owing to the Secured Noteholders is in excess of $300 million, even before including other amounts to which the Secured Noteholders are entitled under the Secured Notes Indenture (Those other amounts include, inter alia, default interest and interest on overdue interest pursuant to Section 4.01 of the Secured Notes Indenture, a “make whole” premium owing upon redemption of the Secured Notes prior to August 1, 2014 pursuant to Section 3.07, and reimbursement of the Secured Notes Trustee’s expenses (including professional fees and expenses) pursuant to Sections 4.22(e) and 7.07.)
First off, let's tackle the OID issue in this case. The 11.375% Notes were issued in August 2009 at a price of 97.385% of par. The difference between 100 and 97.385 is the original issue discount or OID for short. OID amortizes through the life of the security. As was debated and ruled on in 2007 during the Solutia bankruptcy, secured debt issued at a discount is not entitled to the entire par amount of their claim. Instead: "a note issued at a discount is not allowable for its face amount. Rather it is allowable at the face amount less the unaccrued portion of the OID."

Then comes the issue of whether the security is over or undersecured. If the security is undersecured, the commencement date of the bankruptcy would essentially be the stopping point of accretion for the OID. If the security is oversecured, and post-petition interest has been granted, it makes sense that the OID would continue to amortize during the bankruptcy process through the effective date of confirmation; though this was never technically ruled on during the Solutia bankruptcy.

In GAP's bankruptcy, we are dealing with the latter. In rough numbers, there was 2.615 of OID for the 6 year maturity of the notes. The bonds were issued on August 4th 2009, GAP filed for bankruptcy in December 2010, and the confirmation hearing is set for February 6th, 2012. This means roughly 40% of the OID will have amortized by the confirmation date or 1.1 points. Face claim is thus 1.1 points + issue price (97.385) ~ 98.5.

Then, we need to calculate accrued interest on the security. The coupon is 11.375% annually or semi-annual coupons of 5.6875 points. The last coupon was on August 1st, 2010 (with coupons coming on February 1st and August 1st). With a February 6th confirmation date, there would have been 3 missed interest payments (Feb 2011, Aug 2011, Feb 2012). But according to the indenture, "Interest will be computed on the basis of a 360-day year of twelve 30-day months." There will have been 18 months since the last coupon meaning accrued interest would be ([1+(11.375% / 12)] ^ 18) - 1 or 18.5 points of accrued interest for the claim. At this point we have a total claim value of 98.5+18.5 ~ 117.

Now this is where things get really interesting, and probably deserve its own post. You will remember that the secured note holders are entitled to a make whole premium. According to the indenture:
Prior to August 1, 2012, the Company may redeem the Notes at its option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days’ prior notice electronically delivered or mailed by first-class mail to each Holder’s registered address, at a redemption price equal to 100% of the principal amount of the Notes redeemed plus the Applicable Premium as of, and accrued and unpaid interest, if any, to, the applicable redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date).
The capitalized Applicable Premium is then defined in the indenture as:
“Applicable Premium” means with respect to any Note on any redemption date the greater of (i) 1.0% of the principal amount of such Note and (ii) the excess (if any) of (a) the present value at such redemption date of (1) the redemption price of such Note at August 1, 2012 as set forth under Section 3.07(c) plus (2) all required interest payments due on such Note through August 1, 2012 (excluding accrued but unpaid interest), computed using a discount rate equal to the Treasury Rate on such redemption date plus 50 basis points over (b) the principal amount of such Note.
In standard market parlance, T+50 before August 1st, 2012. The aforementioned penalty under Section 3.07(c) is 105.688% meaning an extra 6-7 points (105.6 + interest from Feb-August at T+50) of claim value to the Senior Secured Note Holders.

Make wholes (and call protections) for that matter are widely debated topics in the bankruptcy world. The three cases that are pertinent to the discussion (and debate) are Premier Entertainment, Calpine, and Chemtura. Rather than post a wildly lengthy post on the topic, I am going to direct readers to a series put on by the Weil Bankruptcy Blog that does an AMAZING job covering all details from each case (not for the feint of heart):

It should be noted that in the objection to the securities purchase agreement, the Second Lien note holders pointed to the decisions in Chemtura and Premier Entertainment:
The “make-whole” claim is based on Section 3.07 of the Secured Notes Indenture, which provides for the payment of a premium, based on a formula, to the Secured Noteholders in the event that the Debtors redeem the Secured Notes prior to August 1, 2014. “When a loan is redeemed before maturity or (sometimes) upon default, a make-whole provision requires a borrower to pay a premium to compensate the lender for the loss of anticipated interest that might result.” In re Chemtura Corp., 439 B.R. 561, 596 (Bankr. S.D.N.Y. 2010). Pursuant to Section 506(b) of the Bankruptcy Code, an oversecured creditor is entitled, as part of its secured claim, to “interest on such claim, and any reasonable fees, costs or charges provided for under the agreement or State statute under which such claim arose.” 11 U.S.C. § 506(b). “In general, a prepayment premium is recognized as encompassed in the term ‘charge.’” In re Premier Entm’t Biloxi LLC, 445 B.R. 582, 618 (Bankr. S.D. Miss. 2010); see also In re Imperial Coronado Partners, Ltd., 96 B.R. 997, 1000 (9th Cir. BAP 1989) (a “prepayment premium is clearly a ‘charge provided for under the agreement’” under which such claim arose)). The Secured Note Parties reserve all rights with respect to the assertion of the “make-whole” claim.
It remains to be seen what will be the true "allowed claim" when the ink is dry on the finalized disclosure statement and bankruptcy plan. Both parties (the debtors/junior creditors and the Senior Secured Noteholders) are somewhat jockeying for position and ultimately, I believe, some sort of settlement will be reached. It is hard to handicap the whole "cash or new securities" relative to the disclosure statement on the table, but its hard to imagine the existing Secured Noteholders get stuffed with new 2nd liens and not fight relentlessly for different treatment. But that is why the 11.375% notes are not trading at a higher dollar price: the inherent uncertainty of a wildcard treatment in the plan.


Anonymous,  11/22/2011  

I think your bond math might be off by a little. Why are you compounding monthly? Shouldn't it be calculated more like this:

([[11.375%/2}+1]^3)-1 which would give you 18.05%, about 50 bps less than the monthly compounding.

360/30 is not usually indicative of monthly compounding, unless there is something unusual in the indenture.

I really enjoyed the post, thanks.

Anonymous,  11/28/2011  

I've seen this before, but the bankrupcty courts to which I have been privy have stated that the no-call provisions do not apply to bankruptcy due to the immediate redemption of the bonds (principal + accrued interest only) upon debtor petition filing. In any case, are we talking about a signficant amount of an unsecured claim anyway of the make-whole provision, how would you determine the value of that claim, and given it's unsecured nature, the potential recovery will be small if the senior lenders are taking a haircut on any restructuring.


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.