St. Louis, Here We Come: Implications of Patriot Coal Venue Change Decision

Today, Judge Shelley Chapman ordered that the Patriot Coal bankruptcy case be transferred to the United States Bankruptcy Court for the Eastern District of Missouri. We first wrote about a venue change here: Patriot Coal Venue Change proceedings.

For those interested in following along, I've embedded the order below (a must read in my opinion):

Patriot Coal Venue Change Order

The 8.25% Notes started the day 50-52 and closed 47.5-49.5. The converts were also quoted lower but I'm not sure how much actually traded.

Why were the bonds down? One desk analyst noted: "There isn't much case law in St. Louis, so the judge has more latitude to do what he pleases." The remainder of this post will try to drill down on the implications of a venue change to St Louis. As an aside, I have not heard yet if the Debtors will appeal this decision, but given how narrowly Judge Chapman wrote her opinion, it is hard to imagine it getting overturned.

As first discussed here on the blog (Patriot's hidden value for the guaranteed notes), there was a case to be made that if you separated the corporate structure of Patriot Coal into "clean" and "burdened" (clean being no legacy liabilities, burdened meaning many legacy liabilities), one could make the case that significant value would flow directly from operating assets to the guaranteed bonds without a rejected opeb claims getting a piece of that particular box. The bonds subsequently rallied as the "box theory" began to take hold.

Unfortunately, there is something that could put a bullet between the eyes of the box theory: substantial consolidation ("sub-con"). And unfortunately, the 8th circuit has a very small sample set (one to be exact) in sub-con decisions. Conversely, SDNY and the 2nd circuit have voluminous amounts of case law and definitive litmus test for sub-con.

There is currently a bankruptcy case being held in the District of Minnesota (also the 8th circuit) that discusses the 8th circuit's history with sub-con (Petters Company, Inc. - Case No. 08-45257). You can find the discussion here: Substantial consolidation in the 8th circuit. Some salient take-aways:

• The 8th Circuit applies a three-prong test for sub-con
• The 8th Circuit has addressed sub-con only once. A case in 1992 (First Nat’l Bank of El Dorado v. Giller)
• From the docket: "In determining the propriety of substantive consolidation, the Eighth Circuit identified several factors for review, including “(1) the necessity of consolidation due to the interrelationship among the debtors; (2) whether the benefits of consolidation outweigh the harm to creditors; and (3) prejudice resulting from not consolidating the debtors.”

The decision in Petters will ultimately have a major effect on the outcome of Patriot Coal and bond recoveries as I expect retirees and other creditors (converts?) to argue for sub-con to increase their recoveries (spread the clean assets over all the burdened liabilities). In Petters, those opposed to sub con have argued that given the limited history of sub con decisions in the 8th circuit, the court should rely on tests from other districts. For instance in the 2nd circuit, sub-con may be ordered if:

• creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or
• the affairs of the debtors are so entangled that consolidation will benefit all creditors.

Applying this test to Patriot Coal, from a third party observer's standpoint I would venture a guess that those suppliers that extended credit to Patriot didn't look at individual LLC's financials to determine credit worthiness - instead they probably looked at the corporation as a whole. We know the debtors are not so entangled given the frank reading of SOFAs that came out a few months ago (assets and liabilities were clearly defined). But again, this is using the 2nd (and 9th) circuit test which means little in this decision until we have more clarity on Petters

Before I move on from sub-con, I want to hit on one remaining point: partial sub-con is an established practice in other bankruptcy cases (and circuits). One could argue that if Patriot Coal was substantially consolidated, everything would collapse to one box which would, in effect, disenfranchise the guaranteed notes relative to the holdco converts (that are not guaranteed and at the bottom of the heap). I doubt that happens and instead believe, if a sub-con were to occur, it would be all the operating entities of PCX being consolidated, leaving hold-co in its own box and therefore structurally subordinated to everything.

Of course, sub-con is not the only thing that matters in this case. It is incredibly important but there are other value drivers here. In fact, one issue very much stuck out for me from Judge Chapman's ruling: The comments on issued related to Peabody's spin of Patriot. There were a number of comments in particular I thought relevant:

• "The agreements relating to Patriot’s October 31, 2007 spin-off from Peabody included a Delaware choice of law provision."
• "Counsel for the Debtors remarked at the Hearing that the 'circumstances surrounding Patriot’s spinoff from Peabody will most assuredly be looked at with extraordinary seriousness by both the Debtors and the Creditors’ Committee.'”
• "Moreover, the corporate headquarters of Peabody are also in St. Louis; this fact is significant in light of the issues that have been raised by the UMWA with respect to its spin-off of Patriot and its responsibility to provide promised cradle-to-grave health care benefits to Patriot employees and retirees who worked for Peabody prior to the spin-off."

 Causes of action (or at least discovery) against Peabody for the Patriot spin will probably be pursued (similarly discovery and actions against Arch Coal for the sale of Magnum will probably also be pursued). While bankruptcy venue itself does not have ramifications on the look back period for fraudulent transfers. Instead its based on a myriad of sometimes impossible factors to surmise. I, frankly, do not have a 100% clear picture on what statute would be used in the Peabody spin of Patriot. Would it be St. Louis? Would it be Delaware? Would it be New York? Each of these locations have different look back periods and that 2 year difference (4 vs 6) is enormous in this particular case. In fact, if readers have a strong opinion here, please reach out to me to discuss.

My bias on the 8.25% bonds is currently negative for some of the reasons mentioned above but also because I do not want to be long super high cost thermal coal along with being long high vol met coal (of, on average, lower quality B coals). I think this case's timeline will play out a lot longer than people anticipate which, in the face of difficult structural and regulatory trends (and negative cash flow), could erode the value of the debtor's estates. I think there are better ways to play met coal (one particular low cost met producer comes to mind) in the coming years.

We will continue to follow the case and update readers on the Patriot Coal bankruptcy.

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19th Annual Distressed Investing Conference

In past years, Distressed Debt Investing has attended and providers readers notes and commentary from the Beard Group's 19th Annual Distressed Investing Conference. Last year was a fantastic event (and prescient with a panel on shipping that was covered last year) and this year the panels and speaker again look top notch. Of particular interest to me are the panels on municipal debt restructurings, claim valuation, and "family office distressed investing", a topic I am hearing more and more about as family offices look to add new asset class and strategies to the mix.

What I've always loved about this conference is the healthy mix of stakeholders from the restructuring community that contribute and add value to the panels: buysiders, advisers, private equity, claims agent, consultants, and law firms. Each with their own perspective that will be of value to any investor navigating the ever difficult market we find ourselves in. For those interested in buy side commentary, the conference is featuring panelists from Schultze Asset Management (George Schultze himself), MatlinPatterson, Virtus Capital, and Elliot just to name a few.

Distressed Debt Investing will be in attendance and we hope to see you all there. For more information on the conference you can view the brochure here:

19th Annual Distressed Investing Conference Brochure

You can also find more information here at the conference website: 19th Annual Distressed Investing Conference

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Some Takeaways from Citi's Distressed Desk

Last week, Citi held their annual credit conference, an event I have attended for many years and always have thoroughly enjoyed. I would love to spend time writing a post on keynote speaker Michael Milken's fantastic keynote speech at lunch but thought it would make sense to spend time on some takeaways from commentary by Citi's distressed desk.

Scott Balkan, the head of the desk, kicked off with some insightful comments about the current positioning and state of the market. He noted that distressed funds across the board had a specific predisposition to safer trades. He used the analogy of two distinct trades (I'm paraphrasing the numbers below):

• Trade A: Security trades at 10. Three outcomes: 12, 15, 18
• Trade B: Security trades at 10. Three outcomes: 5, 12, 100

Scott noted that funds are reluctant to consider trade B and risk loss of capital despite the enormous upside in the tail scenario. I've touched on this topic before when discussing convex versus concave investing strategies.  Because of this dynamic, Scott noted that options (tail events to the upside), are more than likely mis-priced in the market and therefore present opportunities for the diligent investor.

Citi conducted a survey with their clients earlier in the year regarding positioning, cash balances, etc. On of the more interesting takeaways from the survey was very fund funds think their cash position is below average. But at the same time very fund funds think the current opportunity set is above average. No respondent said the opportunity set was very high. For me this is somewhat hard to reconcile.

One of Scott's final points was that most investors are fine being late. This corresponds with investors being predisposed to safer trades. The hardest investment to put on in any market is the falling knife. And because, across the board, funds are ultra focused on short term performance, funds are avoiding that falling knife. Another opportunity for diligent investors.

Citi's desk analysts then presented a number of ideas in the current market place. I will say the presentations across the board were fantastic. While I will not relay what securities the analysts discussed or which way they were positioned (ask your Citi sales coverage), the situations discussed included (but not limited to):

• Ambac
• AMR
• Sharp
• OSG (OSG had filed that morning! Everyone perked up started talking notes when they analyst began speaking)
• TXU

Overall, as usual Citi put together great ideas for distressed investors to chew on in a very difficult investing environment. Scott Balkan did note the desk is doing simply enormous volume and as I know a number of the distressed analysts personally, they deserve the volume given their quality of research, market color, and commentary. Great stuff.

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Very Quick Commentary on OSG

As all readers are aware, OSG filed for bankruptcy protection in the District of Delaware yesterday. First day motions and affidavit were filed yesterday. I am still going through most of the documents. During the day, the OSG bonds were quoted much lower but rallied hard and finished the day actually higher on the day before bankruptcy (bonds trading in the low 30s flat) with many dealers putting out quotes bid without. The revolver also finished the day quoted higher.

Driving some of this optimism (on bonds side at least) are things that were first publicly disclosed in the first day filings as the apparent lack of concern in the filings for the ultimate IRS liability that swings recoveries every which way (how much? are they priority claims per 507(a)8?, etc). To me by far the most important disclosure was on page 39 of the First Day Affidavit:

"In order to ensure uninterrupted business operations during the initial stages of restructuring and to formalize the intercompany transactions and transfers, OSG, OSM-UK, OIN, and OBS have recently entered into several revolving loan agreements. These revolvers are secured by pledges of equity, cash, accounts, general intangibles, and intercompany receivables. Under the Intercompany Revolvers, OSM-UK may borrow up to $150 million at any time from OIN (approximately $75 million was outstanding as of the Petition Date); OIN may borrow up to $150 million at any time from OSG (approximately $75 million was outstanding as of the Petition Date); and OBS may borrow up to $150 million at any time from OSG (approximately $50 million was outstanding as of the Petition Date)."

Two things are important here:

1. OSG, the holding company, will now have a secured claim against OIN and OBS to the extent the revolvers are drawn down. While this doesn't "prime" the unsecured revolvers as the unsecured revolvers also benefit from any value at OSG, it does layer in additional claims to which OSG bonds benefit
2. A big question is where the revolver was drawn down on prior to bankruptcy. Because cash doesn't just come from thin air, and OSG has down streamed capital in forms of loans, that capital had to come from somewhere. It probably came from the drawing down of the unsecured revolver at holdco. This is important because if the cash had resided at an intermediate holding company, the bonds would have been structurally subordinated in terms of recovery

To me Docket #16 (and the myriad of exhibits) is a fantastic read that gives a better understanding of the corporate structure and flow of monies (for example the disclosure that OSG owned money market funds had $320M on the petition date). 

I will be continuing to work through the first day filings and plan to post something further today or tomorrow as more information comes out of the hearing (3:00PM today in Delaware).

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Distressed Debt Analysis: OSG - A lot of Questions.

The "topic du jour" in many distressed circles is Overseas Shipping Group ("OSG"). I wrote about shipping a little over a year ago when I discussed value traps. Since that time, the shipping industry (specifically tanker market) has gotten considerably worst. Which brings us to OSG.

Before I begin this post, I would like to make a fairly significant disclaimer. Frankly, I do not know if OSG will file even file for bankruptcy. We will know soon though the fate of the company as its unsecured $1.5b revolving credit facility matures in February of 2013 and will be replaced by a $900M "forward start" facility with "more restrictive" covenants. Given the price of the bonds, the IO value is substantial and the longer the bonds stay the current the better the investment.

With that said, at this juncture, using public information, the OSG bonds are uninvestable with any reasonable margin of safety. The bank debt could be compelling but at lower prices and with a few things going your way (and technicals not ripping your face off).

The second caveat I have is that I am probably one of the more bullish people on tanker market in the long term. The supply / demand equation reeks of overcapacity in the market and with the U.S. producing an enormous about of crude domestically, one would think that the prospects for tankers will not be robust. While these are legitimate concerns, I believe that as the influx of new ships as a percentage of existing fleets decreases combined with global economic growth, tanker rates across the board will move up to reasonable levels versus today's rates where ships may be losing money on a week to week basis depending on bunker prices.

I am looking at OSG in a number of ways. From talking to a number of buy siders a general consensus has emerged:

1. A diligent investor can get comfortable with the asset value of OSG
2. It is incredibly difficult to forecast with any certain the claims pool at various boxes in the corporate structure

From here the asset side of the balance sheet is being built up through a sum of parts analysis:

1. What EBITDA and what multiple to apply to US flag business? Comps include KEX, MATX, HRZL
2. What is the market value of the unencumbered fleet?
3. What is the equtiy value of the FPSO JVs?
4. How much cash will be on the balance sheet the day the company files? Probably more important, where does that cash sit and what entity drew down on the revolver?

Given the leverage through the bonds, very small assumption changes can dramatically alter recoveries hence my comment above about the bonds being uninvestable. There is ~$510M notional value of bonds outstanding trading at a blended price of the high 20s. For rounding purposes, let's say 30% or ~$150M of market value of bonds. The US flag business is doing $100-125M of EBITDA. If you assume 1x turn less for the U.S. flag, you could wipe out nearly your entire bond recovery if it hinged on the multiple. For the bulls in you, if you assume 1x more turns for U.S. flag you just doubled your investment.

As noted above the problem with valuing OSG's capital structure is that the claims pool in various boxes is uncertain. The tax issue (foreign earnings being taxable in the U.S) that has notoriously put OSG in the cross hairs of many distressed investors drives this uncertainty. Some investors and research shops believe the ultimate liability will be low at ~$100M. Others I have talked to the number as high at $700M. Some funds have gone out and engaged tax specialists to better drill down on the liability. And as noted above, small changes in recovery tremendously moves ultimate returns of the bonds and hence this issue contributes to the difficulty in investing in OSG bonds.

The actual among of the tax liability is just one of the questions revolving around the tax liability:

• I have assumed the tax claim will be administrative in nature. But is there way based on where that claim is located (ultimate holdco) for it to get adverse treatment relative to the bank facilities?
• What interest rate will the IRS charge on tax in arrears?
• Will OSG try to negotiate with the IRS to lower the actual amount of put together a schedule whereas it will be drain on cash flow in the emergence years?

The next question many distressed investors are struggling with are the amount and location of charter rejection claims. OSG is party to a number of uneconomic arrangements where they are paying significantly more for vessels than current spot rates (or the current market for long term charters). OSG should and will reject these arrangements in bankruptcy and hence (like a typical rejection of executoruy contracts) create a claim in bankruptcy for their counterparties. Nuanced aspects of maritime law come into play here (does a rejection constitute a maritime lien and hence higher priority provisions may accrue?). I have plugged a number of $250M for rejection claims here and I believe they will definitely be senior to the bonds and at best (for the bank debt), pari with the unsecured revolver. But where were those charters executed? Are they closer to the assets and hence receive better status? 

Luckily with two extremely large unknowns, the capital structure of OSG is fairly simple. The bonds are issued at the holding company without any subsidiary guarantees. The unsecured revolver is structurally senior to the bonds as two intermediate holding companies (OSG Bulk Ships, Inc. and OSG International, Inc.) are also borrowers. There are two senior secured team loans backed by 15 ships that probably, at worst, simply be rolled. 

Some other aspects of the OSG case make it particularly interesting to me. The CEO of the company used to run a maritime restructuring firm. He knows the drill. And as all economic players do, he probably will act in his best interests which means siding with whichever party gives him the best management incentive plan. I foresee a valuation fight here (akin to Six Flags) where different creditor groups emerge and try to "team up" with management here to become the fulcrum.

Finally, the bifurcation of different "types" of holders in the unsecured credit facilities is simply fascinating. Is there a scenario where hedge funds step up to do a rights offering combined with a take-back facility to placate unsecured European lenders that do not want to hold equity, cram down the bonds, and emerge owning most of the de-levered company (with 10% to management) right before the cycle is about to turn? 

I think if you are buying this bank debt in the 60s, you will come out happy. Its still trading in the low 80s apparently driven by European banks unwilling to sell at prices below 80. At prices in the 70s, it becomes a bit more difficult to get comfortable with a 20+% just given the process risk. I am not sure if it will get there but a filing may force some weaker lenders hands.

If you want to discuss OSG shoot me an email as I've spent way too much time on it and as I do more and more questions emerge. Shipping bankruptcies have been interesting to follow this year (ONAVQ's hilarity comes to mind) and I am sure OSG, if they do file, will be a fascinating case to analyze.

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My Favorite Quote from the Most Recent Baupost Letter

This week, in the wake of Sandy and the intermittent power outages, loss of internet, and general feeling of "can't get anywhere" due to subway restrictions, I've had time to catch up on a lot of reading. Luckily one of the items I had printed out before the storm was Baupost's most recent letter to its investors. While I will not post the entire letter I did want to pull out my favorite paragraph from the letter (I also wanted to point out that Klarman notes that 3rd quarter gains were led by the Lehman securities in the ongoing liquidation and that cash balances were at 33.5%)

 Many in the press have already commented and cited Seth Klarman's abhorrence for QE3 laid out in the letter.  The paragraph preceding the QE3 annihilation is what I find most interesting (my emphasis added):

"The overall market environment seems increasingly risky to us, as securities prices are rising despite weak and generally deteriorating global fundamentals. U.S corporate earnings are expected to be lower this quarter. Higher markets in the face of eroding fundamentals can be a toxic combination. A market rising for non-fundamental reasons (i.e., QE and ECB bond repurchases) is always one that demands a healthy dose of skepticism"

As noted in many posts in the past I am deeply involved in the primary markets in all US credit products: Investment grade, high yield, and bank debt. And as appetite for primary paper picks up, pricing (yields) tightens, terms get weaker, and the risk/return scales falls to where investors are not getting compensated for the risk they are taking. As primary markets strengthen, so do secondary markets as a rising tide lifts all boats (though one could argue secondary market strength could really be the driver of primary market strength. Either way, all boats are rising). With both primary and secondary markets strengthen, a prudent investor would reduce his or her exposure to the asset classes in question. Instead, we've seen more investors pile into the asset class as retail fund flows and a general "can't be left behind" feeling has pervaded the market.

I am definitely not a "perma-bear." But when I look out into the marketplace and see quite a few hold-co PIK toggle dividend deals getting done in drive-by fashion with 8 and 9 handles, it stands to reason that risk isn't being priced correctly in the market place. Non fundamental reasons whether it be fund flows or as Klarman points out a "Central Bank" put seem to be the reason.

Another reason I think is the general shortening of professional investor's time frames. In the most recent Graham and Doddsville, Joel Greenblatt goes on to say, on shortening of investor's time horizons: 

"I think the reason for this is that your investors – your clients – generally just don’t know what the investment manager’s logic was for each investment. What they can view is performance. It’s pretty clear that for mutual funds, for instance, the performance of a given fund over the last 1, 3, 5, and 10 years has very little correlation with the future performance for the next 1, 3, 5, and 10 years. So institutional investors are left with predicting who’s going to do well in the future, which they attempt to do by looking at the manager’s process. For most clients, the manager’s process is not transparent and the rationale behind investment decisions is not clear. Clients tend to make decisions over much shorter time horizons than are necessary to judge skill and judgment and other things of that nature. So I think time horizons are getting shorter, not longer. We’re not in danger of people expanding their time horizons when they’re judging managers. I think time arbitrage will be the “last man standing,” pretty clearly. "

If the short term opinion is that QE will be forever with us, and central banks across the world will provide endless levels of liquidity, then the next move, all else being equal is higher. Investors inherently will believe themselves to be smarter than the crowd and will tell themselves "We will know when to get out FIRST." or "We are the best TRADERS out there. We will know when the time has come to cash in OUR chips."

The "chase" factor, especially for under performing funds is starting to take hold. I often ask friends and colleagues: "Is the pain trade up or down?". A few months ago everyone would have said up. Now I am getting more and more mixed answers. Investors are much longer than they were a few months ago for all the same reasons. Many stocks can go much higher in one year, but then collapse in three years. And I think that's one of my biggest problems with the world today: The only margin of safety is continuous Fed and central government stimulus.

A margin of safety means you buy a stock that you think is worth $10/share, using conservative assumptions, for substantially less than that. You don't get the $10/share valuation using aggressive growth projections or valuation multiples. Conservative assumptions is the opposite of 'hope' and I tend to think this market has priced in a lot of hope.

All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.

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