About a year ago, I wrote a short post on an advanced distressed debt concept: the double dip. Over the weekend I read a fantastic, and much more in depth piece on double dips at the American Bankruptcy Institute penned by Mark Kronfeld, a partner at Owl Creek Asset Management. Mark has allowed me to repost the article here. Strap on your seat belts - this is an amazing and highly educational post where I am positive you'll take some learning lessons away from.
In Diagram 1, the parent company (guarantor) creates a finance subsidiary (issuer/principal obligor) whose purpose is to issue debt and transfer the proceeds to the parent. The subsidiary is created solely for the business concerns of the parent and has no tangible assets. (2)
Assume for purposes of Diagram 1 that - as is common - the parent guarantee is a “guarantee of payment” for the full principal amount. It is therefore immediately triggered and enforceable upon the subsidiary’s default. This is in contrast to a “guarantee of collection,” which contains certain conditions precedent to enforceability. Moreover, even though guarantees often contain guarantor waivers of all rights of subrogation, indemnity and reimbursement against the principal obligor (3), assume that the guarantee in question does not have such a waiver and, in the event that the parent actually pays on the guarantee, it will have a claim for reimbursement against the subsidiary for any amounts paid under applicable state common law. (4)
A recent example of this occurred in Lehman Brothers. Prior to the petition date, Lehman Brothers Treasury Co. BV (LBT), a finance subsidiary, issued more than $30 billion in notes and immediately upstreamed the proceeds to its parent, Lehman Brothers Holdings Inc. (LBHI). As in Diagram 1, the LBT notes were guaranteed by LBHI. In the subsequent insolvency proceedings, the LBT noteholders asserted a direct claim on the guaran tee against LBHI and sought to recover indirectly from LBHI on account of the intercompany claim flowing to LBT. Both claims were allowed pursuant to the plan. (5)
Why Does the Double-Dip Work
Why do the bondholders get the benefit of two claims for a single advance? First, when a primary obligor and a guarantor are liable on account of a single claim, the claimant can assert a claim for the full amount owed against each debtor until the creditor is paid in full. This is a function of applicable state law and the Bankruptcy Code, which provides that a claim must be allowed “in the amount of such claim in lawful currency of the United States as of the date of the filing of the petition.” (6) Post-petition payments by a guarantor or obligor do not reduce the claim against the other. (7) The bonds get a full $1 billion claim against the parent and the subsidiary, regardless of any partial recoveries received.
Second, absent substantive consolidation (8), subordination or recharacterization, claims resulting from unsecured intercompany loans are generally entitled to the same pro-rata distribution in bank ruptcy as every other unsecured claim. Therefore, the $1 billion intercompany claim is entitled to a distribution from the parent’s bankruptcy estate (9), which distribution flows down to the subsidiary and out its bondholders.
Third, until the underlying creditor is paid in full, the Bankruptcy Code (via §§ 502 and 509) effectively disallows and/or subordinates the guarantor’s claim for reimbursement against the principal obligor, making it impossible for the guarantor to assert a claim that competes with the recovery of the principal creditor. In the parent company/finance subsidiary structure previously discussed, the parent has a claim against the subsidiary for reimbursment to the extent it makes a payment on the guarantee, and in the example,
that claim has not been waived in the underlying documentation. Were that claim allowed against the subsidiary, it would set off against and reduce the intercompany claim. (10)
Section 502(e)(1)(b) provides that the guarantor is not entitled to an allowed claim for reimbursement against the principal obligor if such claim is “contingent” (i.e., if the guarantor has not paid on the guarantee). Moreover, even if the guarantor pays a portion of the amount due (rendering the claim no longer “contingent”), § 509(c) subordinates the claim of the guarantor until the primary creditor is paid in full (either from the debtor or from any other source). Similarly, while § 509(a) provides that a guarantor who pays a portion of the principal claim can subrogate to the claim of the original creditor (the indenture trustee for the bonds), that subrogation right is also subordinated to payment in full of the underlying creditor. Because the claim is disallowed (if contingent) and subordinated (if not contingent), it can never be set off against the intercompany claim until the bonds are paid in full.
Complications relating to guaran tees may impact the double-dip, and the terms of the governing guarantee must be examined. Is it a guarantee of payment or collection? Is the guarantee joint and several? Was the guarantee (and/or intercompany transactions performed) given prior to the expiration of any applicable statutes of limitations for fraudulent conveyance? (11)
The governing law under the guarantee should also be examined, as well as the law applicable to the entire structure. The discussion above assumes application of U.S. and state law generally, but many finance subsidiaries are incorporated in foreign jurisdictions. If foreign law applies to either the guarantee or intercompany claim, the double-dip could be jeopardized. For instance, certain jurisdictions may, as a matter of law, subordinate intercompany claims.
Risks of substantive consolidation must also be analyzed because substantive consolidation, if utilized by the bankruptcy court, will eviscerate guarantees and intercompany claims. Under the doctrine of substantive consolidation, intercompany claims of the debtor companies are eliminated, the assets of all debtors are treated as common assets and claims against any of the debtors are treated as against the common fund. (12) Courts analyzing substantive consolidation disputes have considered numerous factors, including commonal- ity of ownership, directors and officers; whether subsidiaries were inadequately capitalized; the existence of separate employees and businesses; the existence of corporate formalities; commingling of assets and functions; the degree of difficulty in segregating assets and liabilities; and creditor expectations. Substantive consolidation of a U.S. entity and a foreign entity may, however, pose particular challenges.
Other factual issues need to be under stood as well. When a finance subsidiary is the issuer, the debt proceeds are typically transferred to another entity such as the parent. The means by which the transfer is made must be examined as part of the double-dip analysis. Upstream dividends and/or downstream capital infusions will generally not give rise to intercompany claims. If there is no intercompany claim, there is no double-dip.
However, to the extent any “dividends” or “capital infusions” take place within the applicable statute of limitations, they may be avoidable as a fraudulent conveyance giving rise to an intercompany claim, thereby creating a double-dip. In fact, a claim against the debtor recipient of the debt proceeds by virtue of a fraudulent conveyance may be superior to a claim arising under an intercompany loan where the fraudulent conveyance is treated as a general unsecured claim but the intercompany claim might have been deemed subordinated or recharacterized.
Moreover, even if the intercompany transfers appear as a “loan” on the intercompany ledger, its terms should be ascertained to understand any risk that the bankruptcy court might recharacter ize the intercompany transaction. (13) In particular, the rights and obligations of the counterparties to the intercompany transaction should be analyzed. In the Smurfit-Stone cross-border proceeding, the Canadian court held that although the intercompany claim upon which bondholders relied for a portion of their “double” recovery was clearly a “loan” in the general sense, it was nonetheless not a basis for a double-dip recovery because the terms of the intercompany loan stated that upon an insolvency proceeding, the “loan” would be repaid in valueless equity. (14)
Leakage could also result if the finance subsidiary/principal obligor has additional third-party creditors (such creditors will dilute recovery on account of the principal claim against the financing subsidiary). Note that even if there are no creditors on the subsidiary balance sheet, and even if the subsidiary’s documents preclude the incurrence of additional debt, the entire capital structure needs to be understood. For example, is there a large underfunded pension, and is the pension likely to be the subject of a distress termination in bankruptcy? If so, the Pension Benefit Guaranty Corp. may attempt to assert a claim against the subsidiary.
In any insolvency situation, nonborrower credit support carries with it the promise of additional recoveries against different obligors. Creditors with the benefit of guarantees (and investors determining what securities to buy) should carefully examine the applicable facts and law to determine whether any variety of double-dip exists it will enhance recoveries.
*Reprinted with permission from author