Happy Holidays from Distressed Debt Investing

2013 was an eventful year. One that I'll remember for the rest of my life...

As I've said in years past, I am humbled to have one of the greatest readerships out there. The blog will be coming up on its 5th year in 2014 - something I could never have fathomed back in 2009. In addition, Reorg Research has grown to a sizable staff and there is no way I could have accomplished what we've done without surrounding myself with an amazing group of talented individuals. I could not be more grateful for each of their contributions.

I want to wish everyone a happy and healthy holiday season. And a happy and profitable 2014!



iGlobal Forum's 5th Global Distressed Debt Investing Summit

I'm happy to announce and alert readers to iGlobal Forum's 5th Global Distressed Debt Investing Summit which will be held February 19th here in New York. As usual, iGlobal is going to put on a fantastic conference with some fantastic panels and speakers. The keynote this year will be given by Thomas Wagner, Co-Founding Partners and Co-Managing Member of Knighthead.

The panels this year again rely on a heavy focus on distressed debt investing with panels dedicated to very topical municipal processes and opportunities in Europe. Panelists come from a wide assortment of backgrounds and include professionals from firms including Halcyon, Canaccord Genuity, Fortress, Apex, KKR, Barclays, Bowery, Magnolia Road, Blackstone, CQS and Third Avenue.

I am also happy to announce I'll be speaking at the event as well.

For more information about the conference please visit here: http://www.iglobalforum.com/event.php?id=97

And for the agenda, you can find it here: http://www.iglobalforum.com/event.php?id=97&page=agenda

Looking forward to seeing you there!



Reorg Research Analysis: Judge Gropper Rules Anadarko's Kerr-McGee Owes Billions in Damages for Tronox Spinoff ($APC, $TROX)

We do this only rarely, but given the relevance to so many parties and case laws, I wanted to reproduce Reorg Research's analysis on the Anadarko / Tronox opinion that hit the docket yesterday afternoon.

I believe Reorg Research is currently the best provider of analysis, commentary, research and news on the distressed space in the market today and its pieces like this that we are putting out everyday that differentiates us from the competition.

Please reach out if you have questions. Enjoy!

Judge Gropper Rules Anadarko's Kerr-McGee Owes Billions in Damages for Tronox Spinoff

Relevant Document:
Judge Gropper Opinion

In a 166-page decision, Judge Allan Gropper ruled that the Anadarko owned Kerr-McGee E&P business is liable for its actions during the spinoff of the chemical business later named Tronox Worldwide. The amount of the damages is uncertain but could swing widely between $5.15 billion and $14.46 billion depending on certain factors.  Remarkably, the opinion also includes a discussion of consent to jurisdiction in the context of Stern v. Marshall, an issue that will be heard by the United States Supreme Court next month.

The opinion largely addresses the "basic issue" identified by Judge Gropper - "under what circumstances can an enterprise rid itself of its legacy environmental and tort liabilities by spinning off substantially all of its assets and leaving behind property incapable of supporting the liabilities."

It is highly expected that defendants will appeal. If the decision is allowed to stand it could have a chilling effect for companies with substantial environmental liabilities that are attempting to restructure outside of the bankruptcy process. Such companies may face narrowed out-of-court options and be forced to file for bankruptcy where they otherwise might have attempted spin-offs analogous to Tronox.

A striking feature of the opinion, when compared with other successful fraudulent conveyance suits, is Judge Gropper's finding of an "actual" (i.e. intended) fraudulent conveyance based on effort to free assets from environmental and tort liability. Notably, based on the structure of the spinoff in question, Gropper, supported by the Southern District of Texas case ASARCO LLC v. Americas Mining Corp., found actual fraud due to "the clear and intended consequence of the act, substantially certain to result from it."  Moreover, according to Judge Gropper, "the case raises issues of first impression regarding the application of the fraudulent conveyance laws in the face of substantial environmental and tort liability."

The extremely complicated case revolves around a spinoff and separation of Kerr-McGee's oil and gas business from its old holding company. The holding company faced billions of dollars in environmental cleanup liability. Judge Gropper found that the Kerr-McGee defendants "acted with intent to 'hinder and delay' the Debtors' creditors when they transferred out and then spun off the oil and gas assets, and that the transaction, which left the Debtors insolvent and undercapitalized, was not made for reasonably equivalent value." According to the opinion, because the profitable oil and gas business "was no longer owned by Old Kerr-McGee, which was responsible for the legacy liabilities, New Kerr-McGee, which owned the billions of dollars of equity in the E&P assets, was in a position to disclaim liability for the legacy liabilities."

Damningly, Judge Gropper concluded from the facts that it was "clear that Kerr-McGee management intended from the outset to free the valuable [oil and gas] assets from the legacy liabilities, especially as this burden precluded Kerr-McGee from being an attractive merger candidate." Further "the written record is also absolutely clear that freedom from Old Kerr-McGee's legacy liabilities was a central consideration in the decision to split the two businesses and in the structure that was devised."

The split of "old" and "new" Kerr-McGee was completed in 2005 when a chemical business was transferred out of "old" Kerr-McGee and the separations was formally documented. Old Kerr-McGee became Tronox pursuant to these agreements. Judge Gropper found that Tronox was left with insufficient cash and an "illusory" indemnity from New Kerr-McGee. Tronox was also left with hundreds of millions of dollars of pension and OPEB liabilities. Anadarko purchased the oil and gas business after it was split off.          


Judge Gropper did not decide, on a final basis, the measure of damages on the fraudulent conveyance counts. While the opinion noted that the "net value of the property transferred out was $14.459 billion, or stated differently, that Tronox on a consolidated basis suffered a diminution in value of $14.459 billion," there remains outstanding issues on whether damages can be limited.

Before a final determination is made, the defendants will be able to file a §502(h) claim in the debtors' bankruptcy case and all parties will brief the issue of the dilutive effect of such claim. The issue is limited but the difference in damages is large depending on the claims effect. For example, if the defendants § 502(h) claim is valued at 89% (GUC recovery under the DS) of the legacy liabilities of $10.459 billion, defendants would be entitled to offset $9.3 billion from plaintiffs' recovery of $14.459 billion, resulting in a damages award, not including attorneys' fees or costs, of $5.15 billion. But, if all If all general unsecured claims, including the section 502(h) claim, shared in this value, the recovery of a general unsecured creditor would be only 2.8 cents on the dollar, and defendants' section 502(h) claim would be worth only $292.852 million Offsetting this against plaintiffs' recovery would result in a damages award, not including attorneys' fees or costs, of $14.166 billion.

Fraudulent Transfer Considerations

The original complaint, filed in May 2009, set forth eleven claims for relief. Three of these claims revolved around fraudulent transfers: "(1) actual fraudulent transfers under the Oklahoma Uniform Fraudulent Transfer Act...; (2) constructive fraudulent transfers under the Oklahoma UFTA; (3) fraudulent transfers under §§ 548 and 550(a) of the Bankruptcy Code"

An issue distressed investors face in fraudulent transfer/fraudulent conveyance cases revolve around what applicable law is being used and the resulting statute of limitation. For example, Delaware state law has a 4 year look back window whereas New York has a 6 year window. In his opinion Judge Gropper notes, "There is no dispute that the "applicable law" in this case includes the law of Oklahoma. There is a dispute as to whether that law also includes Federal law under the FDCPA, the act under which the United States has filed its complaint-in-intervention"

Importantly though, Kerr McGee/Anadarko sought dismissal on the group that the claims in the complaint are "time-barred" under Oklahoma law. The plaintiffs therefore, Gropper, writes "must rely on either the Oklahoma UFTA or the FDCPA to survive a limitations defense, as the limitations period under the Bankruptcy Code is only two years from the challenged transfer to the petition date, and only minor transfers took place during the two years preceding the Debtors' filing under chapter 11 on January 12, 2009." Oklahoma provides a four year limitation period for claims of actual fraudulent conveyance and constructive fraudulent conveyance.

Critically, Judge Gropper determined that a contrary Fifth Circuit case, Mirant, was not applicable to Tronox and the FDCPA could be used in conjunction with section 544(b) of the bankruptcy code to extend the lookback period.

As noted above, even without reference to the oft-cited "badges of fraud," Judge Gropper found an "actual" fraudulent conveyance because "[i]n the present case, there can be no dispute that Kerr-McGee acted to free substantially all its assets - certainly its most valuable assets -- from 85 years of environmental and tort liabilities. The obvious consequence of this act was that the legacy creditors would not be able to claim against "substantially all of the Kerr-McGee assets," and with a minimal asset base against which to recover in the future, would accordingly be "hindered or delayed" as the direct consequence of the scheme. This was the clear and intended consequence of the act, substantially certain to result from it."

Nevertheless, Gropper found that several badges of fraud were present and none of defendants' purported "supervening purposes" - a belief that Tronox had upside potential, the unlocking of value via the spinoff and a general attempt to limit overall liability - were sufficient to defeat a finding of actual fraudulent conveyance.

Even so, Judge Glenn concluded that under the analysis of "constructive" fraudulent conveyance, neither side seriously disputed that "billions more" was transferred out than was transferred in as part of the transaction. The opinion rejects a number of reasonably equivalent value defenses, most notably defendants' contention that reasonably equivalent value should be tested on a strict entity-by-entity basis. On the critical issue of insolvency at the time of the transfer, Gropper applied a "balance sheet test" based on both a "market" and "ex post" analysis.

Recent cases such as Campbell's Soup and Iridium, generally speaking, relied on a debtor's ability to raise capital in public offerings as contemporaneous market evidence of solvency. Tronox had an IPO and issued hundreds of millions of dollars of debt. Critically, Judge Gropper concluded that this market evidence had to be discounted by a number of factors, including that the issuances were at the "height of a market of irrational exuberance" and that IPO prices were set using "inflated, sell-side projections." Moreover, "[t]he record is also clear that the financial statements omitted certain critical contingencies and potential liabilities." Further, "[a] principal reason why financial statements are of little use in a solvency analysis is that generally accepted accounting principles (GAAP) require reserves only for claims that are 'probable and reasonably estimable'...The record is replete with evidence that Kerr-McGee misapplied this standard and thereby understated its liabilities for GAAP purposes," according to the opinion.
On the issue of an "ex-post," academic valuation of Tronox at the time of the IPO, Judge Gropper frames the substance of the dispute as centered on the environmental and tort liabilities "which, again, is what this case is all about." As laid out in the decision, the plaintiffs' expert witness on the subject of environmental liability was Neil Ram of Roux Associates. Ram concluded that the present value of the future response costs of environmental remediation at the sites, as of November 2005, was between $1.499 billion and $1.684 billion. According to Judge Gropper,  "Kerr-McGee never performed such an analysis, either in connection with the IPO or otherwise, and there is no dispute that accounting reserves for environmental costs do not purport to be useful in a UFTA solvency analysis." The opinion continues by noting defendants also called their own expert witnesses on environmental costs, Neil Shifrin and Richard Lane White of Gnarus Advisors LLC, but "the only conclusion on this record is that it is Defendants' position that the net present value of the remediation costs of Tronox as of November 2005 was $278.1 million or, at most, $376.2 million." Judge Gropper took exception with this valuation, concluding that "Shifrin and White that Ram should have valued Tronox's future environmental liabilities as approximately the amount that Kerr-McGee had recently paid over a two-year period does not pass the common sense test."

The decision further goes into related detail about the sales process undertaken at Tronox prior to the spinoff. Judge Gropper describes the litany of private equity firms that simply passed on a bid for the business due to the legacy liabilities, as well as the failed bid by Apollo that eventually left the company with only one option - the spinoff and IPO. "the 'market,' except for Apollo, refused to bid on Tronox with all of the legacy liabilities included in the deal. As noted above, Lehman identified 60 potential bidders, and contacted 16, and 13 signed confidentiality agreements. The field was narrowed to four final bidders, who were given access to a virtual data room to perform due diligence. Only Apollo was willing to accept the legacy liabilities. Bain Capital, JP Morgan Partners and Madison Dearborn Partners eventually dropped out. Bain Capital chose not to make a final bid in part because of the cost to diligence the legacy liabilities, JP Morgan made a bid only for the assets of the chemical business, and the bid submitted by Madison Dearborn Partners excluded the assumption of any legacy liabilities."

Tronox began to struggle almost immediately after the March 30, 2006 spinoff, according to the complaint.

Issue of Consent

The opinion also includes a discussion of Stern v. Marshall and recent divergent case law discussing consent and whether or not a court can enter a final order in a case where a defendant does not consent to the court's jurisdiction. In this case, Kerr-McGee originally consented to the court's jurisdiction before withdrawing its consent eight months after filing an answer to the complaint. While Judge Gropper's opinion states that "it should be stressed that the issue of consent with regard to this Court's resolution of the fraudulent conveyance claims is not a real issue in this case," the court nevertheless concluded that "it has final authority to enter a final judgment" in the proceeding, but that "[i]f an appellate court should disagree, it is respectfully requested that this decision be deemed proposed findings of fact and conclusions of law for final entry by the District Court."

This decision was predicated on the fact that Kerr-McGee filed proofs of claims against the debtors for, among other things, damages for failure to abide by the terms of the spinoff and for failure to assume the defense of environmental litigation allocated to Tronox. Moreover, the relied on Second Circuit precedent to find that that Kerr-McGee's answer constituted "unconditional consent" to the entry of a final order.

On the issue of consent when a creditor files a proof of claim, Judge Gropper's ruling diverges from recent cases in the Seventh and Fifth circuits, but coincides with an older decision in the Seventh Circuit and also the Ninth Circuit. Case law in this area has become fragmented recently in advance of Executive Benefits Insurance Agency v. Arkison, a case that will be argued before the United States Supreme Court in Jan. 2014. The main issue presented in Executive Benefits is whether a bankruptcy judge can issue a final order on the basis of litigant consent, and if so, whether "implied consent" based on a litigant's conduct is sufficient. The court's decision will have significant ramifications in preference and fraudulent transfer litigation, as illustrated by Tronox.

Calls to the attorneys for the litigation trust were not returned prior to press time, and attorneys for the defendant either declined to comment or were not available by press time.



Reorg Research is Hiring: Senior High Yield Reporter

As some of you know Reorg Research has rapidly expanded its coverage of the distressed space over the course of 2013. We have many plans for 2014 and beyond and with that we are looking to add to our growing staff. We are currently looking to add reporters with a specific emphasis on high yield but are also looking for reporters from the distressed and muni space.

Many of our current employees have come from referrals and introductions from the blog readership. Oftentimes analysts and bankers have worked with certain reporters in the past and have recommended them directly to us. If any readers know of talented financial journalists looking to make a move to a fast-growing platform, please let me know (hunter [at] distressed-debt-investing.com).

I've included the job description below. Have a wonderful Thanksgiving!

Reorg Research is looking for an experienced reporter to help cover the high-yield bond market. The role involves breaking news on a variety of issuers in the below investment grade space and stressed. The position will require working with analysts, lawyers, and other reporters regarding important developments in specific companies and involving leading industry professionals.

Reorg Research is a fast-growing news and research platform for professionals and investors specializing in distressed debt, bankruptcy, and the leveraged finance markets. We cover key market transactions and provide data, analysis and commentary on every major bankruptcy and multiple pre-bankruptcy, stressed and distressed situation. Our coverage is regarded in the marketplace as best-in-class and many of the key decision makers in the credit markets have come to rely on our intelligence on a daily basis.

Key Responsibilities:

  • The reporter will be expected to cover spot news, as well as longer, in-depth pieces on specific scenarios and companies.
  • Develop and maintain rapport with key contacts in hedge fund, investment banking and capital markets professionals.
  • Identify new trends and developments in high-yield investment.
  • Collaborate with financial and legal analysts and other reporters across multiple sectors and geographical areas.


  • This position will be require technical knowledge of high-yield bond and syndicated loan markets.
  • Proven experience in financial journalism.
  • Strong writing ability.
  • Proven ability to network.
  • Ability to represent the company in public/at industry events.

This is a full-time position based in New York City. Includes competitive compensation and benefits, as well as additional incentive equity options, and professional development programs. Please submit a short explanation of why your background makes you a good fit for this position, along with a resume and recent example of your work to reporterjobs [at] reorg-research.com.



Emerging Manager Interview Series: Tålamod Asset Management

Over the past few years, I've been fortunate enough to compare notes on situations with a number of brilliant managers managing sub $250 million. I met Andersen Fisher of Tålamod Asset Management when I was working on a distressed equity that turned out to be a monster win as well as a number of names in the coals / materials space. Andersen has always provided a great sounding board on names and is very thoughtful in thinking about value and distressed investing with a more holistic view which can be seen from the interview below. He was gracious enough to take some time out for us and I'm sure readers will be fascinated with the conversation. For more information on Tålamod, you can visit their website at www.talamod.com

Can you give a quick overview / history of your background? What made you step out on your own from Watershed?

I was exposed to the principles of value investing from an early age, as my father ran a value-focused hedge fund before he got into public policy, back when hedge funds were still a novelty, not an asset class.  Both he and my mother’s father, whom I was very close to growing up, always stressed the opportunity of being able to see value by taking a contrarian view and to respect markets while maintaining a healthy skepticism of market prices.  When as a child you repeatedly get the “price and value are very different things” lecture over baseball cards, you end up better prepared to deal with the internet or housing bubble.    It didn't seem so at the time, but now I realize what an advantage it was to have bedtime reading include John Train and Charles Kindleberger.  In retrospect, I was raised in a way that made it natural for me to gravitate towards distressed and value investing. 

I started my own career as a professional investor in private equity, working in London for Hicks Muse’s European fund and then in San Francisco for Golden Gate Capital shortly after David Dominik and Jesse Rogers left Bain Capital and Bain & Co. to form that firm.  At both firms, I was trained to think about what determined and created the enterprise value of a business.   This was a great foundation for distressed investing as it focused not on the relative value of various equities or figuring out the right relative spread level for a certain bond, but instead on determining the absolute value of a business. 

Historically, a good portion of the excess return in distressed debt investing has come from being able to look beyond the constraints that limit other investors to certain asset classes and to see value in busted loans and bonds that have claim on a business’ value.  When people ask if we are only credit investors, I often joke that we own a lot of equity “dressed in drag” in a credit CUSIP. 

After business school, I went to work for Meridee Moore at Watershed, looking to find the best risk-adjusted claim on a company’s enterprise value based on the prices where various parts of its capital structure were trading in the secondary market.   One of the things I love about the distressed investing niche of the market is that, unlike equities and the world of High Frequency Trading, our world is still highly intermediated by human beings.   Relationships with peers, rivals, lawyers, traders, financial advisors and other market participants matter.   Given her long career in the market beginning with her time at Farallon, Meridee has an incredible network of relationships and working with her at Watershed was a great way to learn not just how our market works but, as importantly, who makes it work. 

My family has deep roots in Texas, and in 2008 my wife and I were expecting our first child.   I've been blessed to live in many interesting places throughout the world, but Dallas has always been home and I always knew I wanted to raise my children in Texas.  At the time, it was clear that an incredible distressed opportunity was on the horizon, and while I knew it would be hard to raise capital in a financial panic, I was excited about the chance to compound capital and start building a firm. 

I remain incredibly grateful that Ray Hunt and Chris Kleinert at Hunt Investment Group shared my view that it was the right time to start building Tålamod and provided our initial capital.   Our business model was old fashioned compared to many of the mega startups of hedge funds pre-crisis, in that we started with a relatively small amount of capital and sought to grow organically via compounding and take in new assets at a measured pace.   They've been great partners for the past five years.

In some of your materials you often speak about the sweet spot as combining the key elements of distressed investing and event-driven investing. Can you expand on this point as we've seen significant crossover of styles in the past few years?

One of the cardinal sins of finance is to mismatch the duration of your liabilities with the duration of your assets.   As I mentioned above, by training and upbringing, I've always gravitated towards value investing.  While numerous studies have shown the advantages of investing with Graham-and-Dodd- like-discipline over the long run, cheap stocks can stay cheap for a very long time.  Unfortunately most hedge funds have monthly or quarterly liquidity terms. 

As such, event-driven investing pulls forward the catalyst that unlocks or realizes value, and by reducing the effective duration of one’s assets, it is a much better fit for the demands the liability structure of a hedge fund place on any investment strategy.   Of course, one of the challenges some event or catalyst laden strategies have is that they lack a margin of safety.   Take a standard merger-arbitrage trade – to over-simplify, your payouts are typically 1pt of upside if the deal closes, 5pts or more if it falls through.  Sure, that is a good trade if you are 90% sure the deal will close, and diversification can further reduce risk in a merger arbitrage portfolio, but we try to avoid situations with that much downside per unit of upside.

Instead, we look for situations where we think we can get our principal back in a downside scenario and which have numerous catalysts to potentially unlock value to the upside.  Distressed situations tend to offer this type of set up, as the troubles that drive a company into bankruptcy are well known and discounted, and forced selling from certain market participants who can’t or won’t hold defaulted securities further reduces prices.  

The cadence and nature of the restructuring process offers numerous catalysts that can unlock value.  Outside of distressed situations, spin-offs, re-financings, litigations and other types of catalysts can offer the same type of value: underpinned by a low downside with an event to trigger upside.  But I think the reason you’ve seen crossover is that the style and strategy fit very well with the mandate of running a low correlation, absolute return vehicle that offers reasonable liquidity to its LPs.

You talk often about the competitive advantages of being a smaller distressed debt fund. In the past we've heard the opposite: Can't participate in rights offerings / get blocked out of allocations / etc. What response would you have to those complaints?

There is no doubt that much larger funds can monetize their balance sheet in certain ways that are not currently available to us, and one example would be getting paid a fee to “backstop” a coercive rights offering that nearly all other creditors will participate in.  But, given our smaller balance sheet, we also have numerous competitive advantages available to us that larger firms don’t have.

One obvious example comes from the fact that I can invest $5 million in Lehman and get almost identical returns to a $500 million investment.  Ideas that can accommodate a billion dollars of investment don’t discriminate between big and small funds.   However, ideas that can only accommodate $20 million of capital by definition exclude many of our larger competitors.   In a wonderful paradox, our universe of opportunity is larger because our balance sheet is smaller.

Interestingly, while we like off-the-run opportunities and smaller names as a result, we have also had tremendous success in mega bankruptcies where we originally were invested or evaluated the on-the-run opportunity but end up finding an obscure niche in the capital structure that offered much better risk/return trade-offs.   One example was in the Abitibi Bowater restructuring.   We became involved in the situation when the old Abitibi bonds were trading around 8 cents.   Lots of good investors at larger funds owned these and they were a great trade as they doubled in price by the time the company exited bankruptcy. 

But there was one bond in the cap structure that had guarantees from 23 additional subsidiaries.   It took hundreds of hours to try and comb through the various dockets, past filings, tax records, etc., to piece together an approximation of the value in those guarantees, but we thought it was significant and rotated into these “double-dip” –really 23x dip – bonds when they traded about 10% or 1pt higher than the on-the-runs.  The issue was small: half was held by a bank that got hung with a position via a busted syndication and it was trading around 10c.  The idea only really had $10 million of capacity, and required tons of work to evaluate, but those bonds got roughly 5x the distribution of shares in the new company than the “on-the-runs.”    It was a nearly identical risk, but obviously had a much better return.

We’ve seen this phenomenon frequently enough that I often tell investors that one benefit of our size is that while we may be in the same names as many of our peer funds, we often own very different risk than they do.  Small size also makes some risk easier to hedge, which can be a benefit in normal markets.   But big or small, you still have to get the fundamentals of the investment right. 

Given the small investment team at Tålamod how do ideas get in the book? What is the filtering mechanism?

Bonds and loans do distressed investors the great favor of pricing relative to par, which makes the wide end of the filter easier to use.  If a stock is trading at $30, it may or may not be interesting but the price tells you nothing.  If a bank loan is at .30, clearly the company is distressed.   The loan may be worth .10 or .50, but you know at least to take a look.   For equities, it is a bit harder, and while we can run standard valuation screens like anyone else, they are not as useful in identifying situations that have defined catalysts.

When we do our first cut of work, we try to identify the following: What is our downside valuation? What are potential upside cases? What are the catalysts to drive the upside cases? What are the key unknowns or uncertainties that determine how we are deriving our valuations? This last point is crucial.  Often, after a first cut, the takeaway is: “I think our downside recovery is 50-60 points, if x goes your way, we should recover 60-70 points, and if x,y&z all go your way it could recover as much as 80-90 points.”  There are always unknowns, so those levels are always ranges, but in general, you can usually do much more work to tighten the range.  

If a bond with those types of outcomes is trading at 60, it is worth doing that additional work to tighten your estimates and try to reduce the unknowns.   If it is at 85, we put our pencils down and watch.   I’d say nine times out of ten, if not more, we end up putting our pencils down.  So while size of the team matters in terms of sourcing, I think size of “institutional memory” matters much more.   You can move much more quickly to re-underwrite when a situation you’ve passed on cracks six months later and gets much closer to a risk profile with diminished downside.  

Institutional memory also matters in idea sourcing when it comes to following new issues.  We rarely participate in new issues, which in times like these can be frustrating, but you have to know the business you’re in and be able to make a separate peace with watching Twitter double on the break or PIK-toggle holdco notes trade up a point from the sidelines as a spectator.  

Still, we follow new issues because markets are cyclical and some of these new issues today will be tomorrow’s distressed supply.  It is much easier to evaluate a distressed situation when you can recall what everyone liked about a business three years ago, have a decent sense of what went wrong and, as importantly, what went right since then.  We’re lucky that Kyle, Jay and I have all been working together at Tålamod for five years, as we gain increasing leverage on the firm’s continuously compounding institutional memory.   

How much "macro" goes into play in your decision making process?

You have to be aware of how macroeconomic trends are going to impact the businesses you are investing in.  Given the distressed focus here, the macro trends in many sectors we invest often are challenging: take Appalachian coal for example.   We try to price in continued macroeconomic pressure and get the benefit of cyclical turn “for free” but that is not always possible and sometimes you have to underwrite to some type of turn cyclically based on historical information.  

The event-driven nature of our portfolio reduces its effective duration which dampens overall market risk, and thus macro risk, but obviously it is important to make sure your catalysts are not very correlated with overall market conditions or macro trends for this to be true.  We hedge some portfolio risk on a top-down basis, but prefer to reduce risk via position level hedges or shorts.  In general, the strategy is less sensitive than many others to general macro risk due to lower duration and non-correlated catalysts, but the lesson of 2008 is that no strategy is immune to market breakdowns.  

That is what made the fall of 2011 so difficult to risk manage: there was a real chance of a collapse of the European banking system.  Incredibly, the best month for the S&P 500 since our inception was October of 2011, as the key lesson many took from 2008 was “risk-on” or “buy” when policymakers show they “get it” by putting forward plans, no matter how half baked or unworkable they are, like the EFSF.  Others, ourselves included, took away a different lesson, remembering the “Super-SIV” or MLEC proposed by Treasury in 2007 and concluded that inoperable “solutions” and policy marker hand-waving are not enough to solve real liquidity crises. 

In the years since, a lot of documentation has come out that shows real conditions had only become worse in the European banking system that October, including documentation of the Deputy Governor of the Bank of England, in which they warned the three largest banks in Britain that there was a serious chance they would “all be out business by Christmas.”  It wasn’t until LTRO was announced by the ECB on December 8th that the problem was really addressed, but if you waited until then to lift macro hedges you got killed by the 15% move up in October. 

That experience makes it a real challenge to think about how to use macro hedges going forward.  We knew at the time nothing was fixed in early October, and with hindsight from subsequent public disclosures, one would have been even more concerned if they were privy to the private conversations of Bank CEOs with their key European regulators.   But you got killed if you were short equity or credit indices as a macro hedge in October of 2011.  I’m not sure I have a good answer to this dilemma. 

Over time your cash position at the fund has moved around precipitously. Currently your cash is the lowest it’s been in some time. Are you seeing significant opportunities in the market place today?

We are seeing interesting opportunities, and believe firmly in the motto of the great Canadian investor Peter Cundill: “There’s always something to do.”  As we noted above, while all distressed investors would love another 2009-size opportunity set, they are few and far between.   Still, there are always good opportunities and in this type of market, we are fortunate that we have more opportunities available to us than some of our much larger competitors.  

Our cash balances are not always a function of our opportunity set.   Yes, many distressed investments are by design long-biased as they are very difficult to hedge.  Unlike the classic “long Ford, short GM,” equity pair trade example, if you own a Madoff claim, you can’t reduce the overall risk of buying a claim in a ponzi by shorting a Stanford claim.   First, the trade doesn't work like that and second, you can’t get a borrow to deliver the short even if it did.  

So, often you have to underwrite risk vs. reward at a price and are either long or in cash.   In a portfolio built from the bottom up with that type of underwriting discipline, you will end up with cash balances from time to time.   Further, the event-driven nature of distressed investing usually means there is always a bit of a frictional cash balance as catalysts occur and the trade manifests itself and converts to cash.  While it would be wonderful to be able to buy continuous compounding equities and hold them for decades like Warren Buffet, that doesn't tend to happen very much in distressed or event-driven investing.  

You can’t escape risk. You have to choose the risks you’re willing to run.  The upside to the short duration of a distressed, event-driven portfolio is low correlation and dampened beta.   The downside is you run reinvestment risk and, over the cycle, any type of disciplined underwriting means there will be times when cash build ups occur.  There is a reason Seth Klarman has been willing to give back capital from time to time, and his incredible success in the past complicates this issue as Baupost is of such a large scale.  At times it is nice to be a bit more nimble than the firms we aspire to model ourselves after and have a wider opportunity set with smaller investments available to us. 

Pulling from your 3Q letter, I found myself enthralled by the discussion of the credit cycle. This quote in particular: "After several years, the pain of the last default wave is forgotten, years of outsized returns have attracted capital flows to the space and very speculative loans are made freely. Eventually, a limit factor is reached where underwriting standards remain weak but decline no further. Either a shock to the system or just the law of gravity results in some defaults occurring when weak borrowers can’t refinance even under the lax standards of the day. These defaults chasten some lenders, which makes it slightly harder to roll maturing debt, which causes more defaults which can quickly spread to panic and complete the cycle at new peak spreads." Can you summarize for readers where you think we are in terms of the credit cycle?

I think we are near or at the point where underwriting standards are weak but don’t have much more room to weaken.  Rates are somewhat limited in terms of how much lower they can go, and while spreads could compress further and are not near historically low levels, it is coupon, not spread that compensates for default.  As such, with “risk free” benchmark rates so low, spreads really can’t get to the tights we’ve seen in past cycles as all-in coupon would not cover any practical level of expected defaults.

Indenture and credit agreement terms could still weaken further, but they are already surprisingly weak and additional deterioration of creditor protection will require further “innovation” from the geniuses that man desks of leveraged finance.   To paraphrase Sir Isaac Newton: “If I am able to extend further, it is because I stand on the shoulders of PIK-toggle.”

So, I think we are at a point where underwriting is weak, but is unlikely to materially weaken.  Given GDP growth for the past few years, defaults should have been higher based off of what was observed in past cycles.  Further, as corporate executives have been pressured by shareholders to deliver EPS growth despite minimal revenue growth, leverage levels have significantly increased recently.   In the past, spreads follow leverage levels, but typically with a bit of a lag.  You saw this lag most recently in 2007.  

Finally, while it seems counter-intuitive, after a crisis sometimes you need growth or stabilization to “allow” defaults.  Matt King at Citi recently highlighted this phenomenon by noting that in Japan, it took several years for the banks to retain enough earnings before they could allow defaults to tick up, less their solvency issues become clear.   This is more of an issue in Europe than in the US, but in the middle market where bank lending still matters, it is relevant.

You noted in the same letter that you believe the next default cycle will be ripe for "the good company with a bad balance sheet,” a holy grail for distressed debt investors. One could argue that the growth of the high yield and leverage loan market and loosening credit standards (i.e. PIK toggle dividends) portends the exact opposite scenario – for example, a company that should never have raised debt with a bad balance sheet. Can you discuss why you are bullish on the next distressed cycle?

What I was highlighting was that there is a chance that the next distressed opportunity is a result of an upside surprise to growth and corresponding higher rates, more like a 1994 or 1998 than a repeat of the 2008 crisis.  The point was that interest coverage or fixed charge coverage, not leverage ratios, tend to be the limit function for how much a determined corporation can borrow.  At a 6% cost of debt, I can leverage myself 8.3x and still have acceptable interest coverage ratios if I am an average company, while at 8%, I can only leverage 6.3x.

If the economy starts growing again at 4-5%, my revenues will be growing and my cash flow will increase, but EBITDA needs to increase by over 30% such that I can de-lever fast enough to roll my debt at that higher rate.   If EBITDA has only grown by 10%, I am a healthy, growing company that still has too much debt.  Either I need to raise equity or I default and deleverage my balance sheet by equitizing a tranche of bonds.  This will create interesting opportunities for distressed investors, including the legendary white whale of “good company with a bad balance sheet.”

Obviously, another growth scare could also create interesting distressed opportunities.  If we have an earnings recession despite QE-infinity, it will get messy exactly because of the low quality credit being extended that you note above.  I think most people understand the impact of another recession, given how traumatic and recent the experience of 2008/09 was.   In my letter I was trying to note that there were also risks from growth, as ’94 is not as fresh of a memory.

One final reason to think there will be incredible values to be had in the next distressed cycle: capital devoted to performing credit has increased significantly in the past five years.   Capital devoted to distressed, while a decent size, is only about 2.7% the size of the high yield and investment grade market.  Finally, the historical buffer between distressed investors and performing credit has typically been the dealer desks that provide liquidity.  The financial reforms of the past few years have greatly reduced this buffer.  Going into the crisis of 2008, dealer inventory was equal to about 50% of the inventory held by IG and HY mutual funds and ETFs.  Today, it’s closer to 10%.

In the next distressed cycle, supply will dwarf natural demand, and retail investors may likely play the role of the key determinate marginal seller given the impact of credit ETFs and other fund flow dependent actors.  All this will occur with a greatly reduced ability for the banks to intermediate.  There are bound to be great opportunities.

Can you talk about one of your more compelling investment opportunities today that fits into Tålamod's strategy?

Sure.  We think one of the more compelling themes in the market today is the massive disconnect between the valuations pure-play growth companies are able to demand compared to the similar assets held by companies with legacy businesses that are not market darlings.  Look at Tesla vs. any automotive company or Shutterstock vs. Getty Images.  The growth and success of the challenger businesses are impressive, but it often seems like the market places negative or no value on the distribution systems, intellectual property, systems, customer relationships and cash flow of the legacy businesses.

As distressed investors, we have spent a lot of time the past decade looking at the Yellow Pages industry.  Until recently, the key to success in investing in the busted debt of those once great quasi-monopolies was to correctly underwrite the decline curves of the legacy print businesses.  At times, markets priced in revenue declines of 50% a year, and if you could get confident that 20% declines were more likely, buying first lien bank debt with high coupons and amortization pay downs at massive discounts to par was a good way to make a return.  This didn’t require the businesses to perform well, it just required “really bad” declines in revenue to occur instead of “absolutely horrendous” declines.

Directories understood the challenges they faced long ago and tried to build their digital offering, but legacy capital structures depended on higher margin print businesses, thus transforming the business for the next decade took a back seat to meeting the next quarter’s covenant or interest payment.  However, after restructuring, some businesses deleveraged enough to properly invest in their digital business, while they still received very healthy, if declining, cash flows from their legacy print business.

Five years ago, digital was a tiny part of the business for most directories, but today it is a real business, and some have very attractive metrics.   We think the incumbent Canadian directory company, Yellow Media, is a great example.  Nearly one in three Canadians visit the company’s digital properties monthly, and nearly one in three smart phones have downloaded their app.   They provide real service to their customers, and their proprietary traffic and huge customer database give them a meaningful completive advantage over many other digital competitors.  The digital business is growing at 10% and soon will account for half of the company’s revenues.

Those types of user penetration metrics and growth profiles would garner a huge valuation if the digital business were a pure-play stand alone.   Just look at how Yelp, Web.com and other businesses going after the same niche are valued.   Now, I don’t know if any company is worth 20x revenue, like Yelp is currently priced, but I know 2.2x EBITDA is cheap for a Canadian business that has very similar characteristics, save for one key difference in that Yellow Media’s digital business is already quite profitable.  And that is to say nothing about the real cash flows still being generated by the legacy print business.  While the stock has had a great run this year, the surprising fact is that enterprise value is little changed, as the increase in the equity account is offset nearly entirely by the fact that the company has paid down debt early with free cash flow.  

The directory sector offers great opportunities for distressed investors right now for several reasons.  First, you have to be able to price a series of decreasing cash flows from a legacy print business in secular decline.   This should be a core competency of distressed investors.   Second, you have to be able to understand the risks and opportunities of the transition the industry is making to digital.  Frankly, this type of thing is not a core competency for distressed investors, but the great news is that several of these businesses in Europe have made the transition to majority digital businesses so there is a road map on process and valuation.  We are at a disadvantage to the fortune tellers in Silicon Valley when it comes to foreseeing how a division that accounts for 1% of revenue is the key to the business’ future fifteen years hence, but when that same division is 40% of revenue and growing, even distressed guys can begin to understand what 2016 might look like.  Third, you have to be able to look across capital structures and geography.  These directory businesses are very similar, and while there are nuances to why perhaps Canada and France are more defendable markets than the US or Sweden, they are all going through the same transitions, just at different stages.   They also all have different balance sheets.   We own a term loan in one directory which we think is a very attractive credit risk.  We own another term loan in a different company that we think is equity risk, despite it being senior secured.   And we own converts and equity in yet another, which is very likely the best risk/return tradeoff of all three. 

But you have to be able to think first what each business is worth, and then feel comfortable buying the right claim on that enterprise value in whatever form it takes: loans, bonds, common, etc.  Again, this is a core competency of distressed investors, who don’t suffer from being restricted to a single asset class.   We think there are plenty of catalysts still to come in the space: mergers, refinancing, management changes, and, most importantly, the pending transition to majority digital businesses.  It’s a great niche in the distressed market right now.

Tålamod recently celebrated its fifth anniversary.  After 5 years running your own shop, what advice would you have for investors currently at funds looking to go out on their own? Can you talk about some of the lessons you've learned in those five years?

Many people will tell you that you obviously have to love investing and have a passion for what you are doing, and I can only echo and reinforce that message to anyone looking to set out on their own.  What is not mentioned as often is one reason this passion is necessary is that the business is incredibly hard, and success does not come easy.   We compete against so many talented investors in what are often zero sum situations that a search for an edge always needs to be coupled with a healthy dose of humility. Inevitably times will arise where that humility proves warranted by your mistakes.

Passion and confidence are required not only to motivate you to find and execute the brilliant trade, but to risk manage and mitigate losses from the less-than-brilliant one.  We all admire the investors who get it right, but the ones I most admire are the guys who can also handle getting something wrong well, too.  There are going to be ups and downs, in your portfolio and in growing your firm. But you have to be able to handle the frustrations just as well, maybe even better, than the triumphs in order to remain balanced, focused, and keep things moving forward. So I would add resiliency to passion as key ingredients to traits that are necessary, but not sufficient, for success in starting a firm.

Another lesson I would add is that our industry is undergoing a significant secular change in and of itself.  In the twenty years from 1985-2005, hedge funds as an asset class underwent tremendous growth, in large part fueled by stealing share from simple “60/40” allocations as institutions rushed to replicate David Swensen’s success and Yale’s healthy allocation to alternatives.  This trend was waning prior to the financial crisis, but 2008/09 accelerated that shift.   As a result, AUM growth from new allocations will be much lower in the next 20 years.   Further, the marginal dollars being allocated are mostly going to established brand names and large scale funds.

The days of walking off the prop desk and being handed a $1 billion dollar fund on your way out the door are long gone; so it is even more important to be careful in choosing your initial capital partners, your team members and your early LPs as new funds need to plan on it taking years, if not decades, to ramp up to the scale of the large institution that someone may be thinking about leaving.  In a way, this is a bit of a “back to the future” model, as many of the legends in the industry also started at small scale in the ‘80s, not because they expected to be running $10 billion businesses in a few years, but because they were excited about the ability to compound $10 million of capital as an investor.

The great news for someone looking to start a fund is that as more capital goes to the mega-funds, more opportunity becomes available to the smaller guys if you can build a sustainable business.  Technology is providing some operating leverage to small firms that was unavailable ten years ago. 

I also know that many of the most sophisticated institutional allocators understand that as more of their competitors cluster to the big funds, the better they will do if they devote new capital to smaller funds.   There are people out there looking for intelligent investors willing to take the risk and open a new shop. 

But while people use the term “emerging manager” as a marking term, I don’t like that adjective.  We strive to be a “great,” “thoughtful,” “talented,” and/or a “first class” manager.  Emerging suggests a progression occurs on the path from small to big.  In reality, some things should never change no matter your size.  The fiduciary responsibility we have to our smallest investor is identical to the one we owe large institutional allocations.   Other things are always evolving or emerging.  I have become a better investor based on experience, but I’m sure Paul Singer and Seth Klarman are better investors today than they were a year ago, too.

So build a great team, find the right partners, bring passion and confidence, but don’t forget resiliency and patience if you are looking to build a firm that can last.  Our firm’s name, Tålamod, is taken from the Swedish word that translates to patience, or perseverance or level-headedness depending on context.   I chose this name partially in the hopes that my wife, who is a Swede, would be patient with me and the demands a new firm would have on our time  - a supportive spouse is another prerequisite for anyone looking to start a firm and I am very lucky to have one.   But the main reason I named our fund Tålamod is because each of these traits – patience, perseverance, equanimity - are so essential to success in the type of investing we do, and in building a firm.        

*Disclosure: Tålamod is a client of Reorg Research



Advanced Distressed Debt: Recharacterization

One of the the more fought over issues in contentious bankruptcy proceedings revolves around whether a loan is really a loan. Unsecured creditors often fight to "recharacterize" a loan as really equity. Why? Because that leaves a much larger piece of the pie for them, relative to diminished recoveries that would be absorbed by senior lenders. While the bankruptcy code doesn't specifically address the issue of recharacterization, jurisdictions across the country have developed their own ways and analyses to test whether an instrument can be recharacterized.

DDI contributor George Mesires has penned a fantastic piece below regarding a recent decision in the ninth circuit of appeals on this very issue. Enjoy!

Recharacterizing Debt as Equity

A recent decision issued by the Ninth Circuit Court of Appeals underscores a risk that a presumptive creditor faces when a bankruptcy court is authorized to review a loan transaction and recharacterize the purported debt as equity in a bankruptcy proceeding. See generally, In re Fitness Holdings International, Inc., 714 F.3d 1141 (9th Cir. 2013). Although not breaking new ground, the Ninth Circuit resolved a split within its circuit, and joined four other circuit courts of appeals in holding that a bankruptcy court has the authority to recharacterize a debt claim as equity.


Over the course of four years preceding its bankruptcy case, the Debtor, a home fitness company, borrowed over $24 million from its sole shareholder, Hancock Place. Thereafter, the Debtor borrowed $12 million on a secured basis, consisting of both term and revolving loans, from Pacific West Bank, guaranteed by Hancock Place. Subsequently, the loans were amended several times to accommodate the Debtor and its weakening financial position. In 2007, Pacific West Bank agreed to refinance Fitness Holdings’ growing debt burden. The loan proceeds were used to pay off Pacific West’s secured debt, which released Hancock Place from its guaranty, and to pay down, in part, Hancock Place’s unsecured debt. Notwithstanding these restructurings, Fitness Holdings filed a voluntary petition under chapter 11 of the Bankruptcy Code.

During the bankruptcy case, the unsecured creditors committee sued Fitness Holdings, the Bank, and two of the company’s directors to recover the payments made to the Debtor’s sole shareholder (Hancock Place) alleging, among other things, that the payments were fraudulent transfers. The committee alleged that the payments were not loan repayments, but rather, improper distributions by the Debtor to the equity holder for less than reasonable equivalent value.

The bankruptcy court dismissed the lawsuit for failure to state a claim. During the subsequent chapter 7 case, the liquidating trustee appealed the bankruptcy court’s decision. The district court affirmed the dismissal, citing the Ninth Circuit Bankruptcy Appellate Panel’s Pacific Express precedent, which held that bankruptcy courts are limited to the statutory remedy of equitable subordination under section 510 of the Bankruptcy Code, and accordingly that the chapter 7 trustee was barred from bringing a recharacterization action. By so holding, the payments made to the defendants were deemed to be debt, and by definition, the payments could not be fraudulent transfers.

The Ninth Circuit’s Decision

On appeal to the Ninth Circuit, the appellate court held that the district court was not bound by the BAP’s Pacific Express decision, and overruled that decision, holding that the remedy of equitable subordination is separate and distinct from the remedy of debt recharacterization. In the fraudulent conveyance context, the Ninth Circuit held that when a defendant asserts that the payments were debt payments, the court must determine under state law whether the purported debt is, in fact, debt. If the court determines that the payment is not a payment on account of an underlying debt, the court may recharacterize it as equity under state law principles.

The Ninth Circuit is the Fifth Court of Appeals to hold that a bankruptcy court has the authority to recharacterize claims in bankruptcy proceedings. However, this growing consensus has not resulted in unanimity over the analytical framework for recharacterization. For instance, the Fifth Circuit looks to state law to define claims. The influential Third Circuit, home to the Delaware courts, holds that a court may exercise its equitable authority to determine if a claim is more like debt or equity, and considers several factors, including (i) the name of the instrument; (ii) whether the instrument includes a right to enforce payment of principal and interest; (iii) whether the instrument includes a fixed maturity date; and (iv) whether the instrument affords the holder a right to share in profits or participate in management. The Sixth Circuit uses an 11-factor test derived from federal tax law to review a claim for recharacterization. Although the Second Circuit has not addressed the issue, bankruptcy courts in New York follow the Sixth Circuit and  consider factors such as those identified above by the Third Circuit, but also the following: (i) presence or absence of a fixed maturity date and schedule of payments; (ii) the source of repayments; (iii) the adequacy or inadequacy of capitalization; (iv) identity of interest between creditor and stockholder; (v) the security, if any, for the advances; (vi) the corporation’s ability to obtain financing from outside lending institutions; (vii) the extent to which the advances were subordinate to the claims of outside creditors; (viii) the extent to which the advance was used to acquire capital assets; and (ix) the presence or absence of a sinking fund to provide repayment.

Although the Seventh Circuit, which includes courts in Illinois, has not addressed the issue, a federal district court has expansively construed the scope of a bankruptcy court's equitable powers stating that other circuit courts have “correctly recognized recharacterization as a tool that may be used by bankruptcy courts.” In re Outboard Marine, 2003 WL 21697357 (N.D. Ill. 2003).  It accordingly remanded the case to the bankruptcy court to consider whether the loan should be recast as equity upon consideration of the factors identified by the Sixth Circuit.

The Ninth Circuit joined the Fifth Circuit in holding that a bankruptcy court shall look to the underlying state law to determine if a particular obligation owed by the debtor is debt or equity, which is consistent with U.S. Supreme Court precedent that holds that the determination of property rights is generally determined by state law.

Although this decision should be welcomed by third party creditors insofar as it allows estates to recharacterize debt and potentially increase the pool of funds available for unsecured creditors, it also underscores the importance of being familiar with the state law requirements of creating a debt obligation. If improperly structured, a presumptive secured creditor may be in the unenviable position of finding its debt recharacterized as an equity claim, commonly worth nothing in a bankruptcy proceeding.

George Mesires is Co-Chair of the Finance and Restructuring Practice at Ungaretti & Harris, LLP in Chicago, and concentrates his practice on finance, corporate restructuring, bankruptcy, distressed mergers and acquisitions, and general corporate matters. George can be reached at grmesires [at] uhlaw.com



Analyst Program at Reorg Research

As some of you know, I started a company: Reorg Research. We are doing some incredible things with both our technology and our intelligence product that is setting a new standard in the marketplace. I have a team of incredibly bright-minded analysts and lawyers in producing news and research on distressed and stressed situations across the board. And our customers, without a doubt, are some of the world's greatest buy side and sell side institutions.

Warren Buffett captured it best: I honestly do tap dance to work every day. I work with people I love, doing what I love.

As we expand our coverage, I am looking to hire a few more analysts join our growing team. Candidates should have 2+ years of experience in restructuring advisory and/ or financing investment banking, or in a distressed/ special situations desk analyst role. Excellent oral and written communication skills are needed. Analysts will publish research and topical news-oriented articles daily and will be in regular contact with subscribers, including buy-side investors, sell side desks, restructuring advisers and legal professionals. Ability to work independently and quickly is a must. Our team is highly collaborative and dedicated-- a congenial and adaptive personality is critical. This is a NY based position.

Proficiency/ working knowledge in the following areas:

  • Financial modeling, including valuation and recovery analysis
  • Analysis of legal documents, including bankruptcy filings, credit agreements, bond indentures etc.
  • Bankruptcy process
  • Covenant analysis

For those interested, please send your resume to: analystjobs [at] reorg-research [dot] com



Distressed Debt Investing: Puerto Rico

The topic on everyone's minds these past few weeks in distressed debt land has been Puerto Rico. While yields on traditional muni land paper have come in quite a bit over the past few weeks, I am going to go out on a limb and suggest, for the benefit of the doubt, PR will be a topic that we will be talking about for a LONG TIME. Frankly, the situation is bad (not to mention the forced selling aspects of when certain issuers lose their IG rating). The sheer amount of debt is staggering and we are not just talking about COFINA or PREPA or an off the run situation like the University of Puerto Rico but also all the PR based corps as well as the implications for the monolines.

We've started doing a lot of work at Reorg Research on Puerto Rico given these wide ranging implications and the sheer complexity and richness of its capital structure. Our first piece, one that we've been thinking about to introduce the legal ramifications of the case (we have a number of lawyers on staff now) I've reproduced below. Enjoy!

The 'Cracks' of the Bankruptcy Code? The Ambiguous Status of Government-Related Entities in U.S. Commonwealths

Recent attention on the precarious situation of Puerto Rico's economy has raised questions regarding the impact of Puerto Rico's status as a commonwealth territory on Puerto Rico's recourse to United States bankruptcy law.

Puerto Rico, like the United State's other commonwealth, the Northern Mariana Islands, is subject to the jurisdiction of the federal courts and are covered by the bankruptcy code. This is formalized in the code, which defines "United States," (when used in a geographical sense) to include "all locations where the judicial jurisdiction of the United States extends, including territories and possessions of the United States." As a result, "persons" domiciled in or with assets in Puerto Rico can be debtors under the code, just like persons in the fifty states.

Interestingly, the drafters of the code have not extended this equal treatment to chapter 9. Political subdivisions of "states" may file for chapter 9. The definition of "state" in the bankruptcy code "includes the District of Columbia and Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9 of this title." According to Collier's, this exception "has the effect of preventing political subdivisions, agencies and instrumentalities of the District of Columbia and Puerto Rico from being debtors in chapter 9 cases." Under section 109(c), only a municipality is an eligible debtor under chapter 9, and that term means a political subdivision, agency or instrumentality of a state. For this purpose, "state" is limited to one of the 50 states of the United States.

It is also worth noting that the states and commonwealths themselves are not eligible to file for chapter 9 because they are not "municipalities" and only "municipalities" are eligible for chapter 9. According to the federal courts' "bankruptcy basics" page the definition of municipality, "is broad enough to include cities, counties, townships, school districts and public improvement districts. It also includes revenue-producing bodies that provide services which are paid for by users rather than by general taxes, such as bridge authorities, highway authorities, and gas authorities." But, there is simply no procedure in the bankruptcy code to deal with the insolvency of a "state" itself.

Another important limitation on government-related entities' recourse to bankruptcy law stems from the code's definition of who is a "person." Only "persons" can file for chapter 7 and chapter 11 relief. The code defines the term "person" to include "individual, partnership and corporation" but not "governmental units." "Governmental units" means "United States; State; Commonwealth; District; Territory; municipality; foreign state" and also any "department, agency, or instrumentality of the United States . . . a State, a Commonwealth, a District, a Territory, a municipality, or a foreign state" (emphasis added).

As a result of the above, the United State's commonwealth territories - Puerto Rico and the Northern Mariana Islands - are in the odd position that both their municipalities and their "governmental units" cannot file as debtors under any chapter of the bankruptcy code. Adding further confusion, there is no bright-line test as to whether a government-related entity is or is not a "governmental unit" for purposes of the code.

All of these factors were on display in a recent case from the Northern Mariana Islands. The Northern Mariana Islands Retirement Fund filed for bankruptcy on April 17, 2012, describing itself as a "public corporation and autonomous agency of the Commonwealth established pursuant to Public Law 6-17 to provide retirement security and pensions to the employees of the Commonwealth government." At the time of its filing, the fund estimated it was only 32% funded due to a "perfect storm" of factors including "the failure of the Commonwealth's central government and autonomous agencies to remit full employer contributions; a difficult investing climate over the most recent three to  four years; and a benefit structure that has been continuously increased and made more generous by the Commonwealth government without a corresponding increase in funding to the Debtor to cover increased costs," combined with the Commonwealth Government "declaring payment holidays, diverting earmarked revenues from the Debtor and reducing contribution rates for the Commonwealth Government, its agencies and political subdivisions." The fund estimated that it would deplete its assets by July 2014 and thereafter would be "unable to provide any level of benefits to current and future Beneficiaries."

Despite the extreme financial predicament of the fund, a variety of parties - including the Commonwealth Government and the United States Trustee's office, as well as individual retirees - moved to dismiss the bankruptcy, asserting the fund is an instrumentality of the commonwealth government and therefore a "governmental unit" not eligible for relief under chapter 11.

The fund's omnibus response to the motions to dismiss included the following arguments: The fund lacks traditional government powers and does not conduct traditional government  functions; the commonwealth government does not actively control the fund; and congressional intent requires an "inclusive" approach to eligibility. Interestingly, the fund also argued there was no "satisfactory alternative" to bankruptcy because it is not eligible for chapter 9 relief as a municipality of a "State" due to the definition of "State" in the bankruptcy code. The only alternative for the fund, according to its response, is receivership and receivership is not an alternative to bankruptcy since receivership would "essentially constitute a liquidation" and lacks the protections of the bankruptcy code that help debtors achieve a "fresh start." A footnote in the fund's response states that, if denied bankruptcy eligibility, it would "fall between the cracks" of the bankruptcy code.

Judge Robert J. Faris sided with those seeking to dismiss the case and ruled that the fund was ineligible to be a debtor. Judge Faris rejected an "alternative relief" test which would have looked at the fund's non-bankruptcy alternatives. He called this approach, "completely unmoored from the statutory text." Faris concluded that the key question is whether the fund is an "instrumentality" of the commonwealth but found dictionary definitions of the term "instrumentality" lacking a plain meaning. Instead, Faris relied on legislative history and concluded that the intent of Congress was to define "instrumentality" broadly so long as the relationship between the entity and the government is "active...in which the department, agency, or instrumentality is actually carrying out some government function." Faris concluded that "providing compensation and benefits to government employees is a quintessential government function." The opinion also relies heavily on the fact that the fund's plan serves only government employees and retirees, and that the Commonwealth has "significant ongoing influence over the Fund." Judge Faris contrasts this with a Third Circuit decision in the Nortel case that ruled that a UK entity established by the government to guaranty obligations of failed private pensions plans was not a "governmental unit." Faris distinguished Nortel because in that case the fund "was funded entirely by private employers and benefitted only nongovernmental employees."

The Northern Mariana Islands Retirement Fund case is notable because it shows the precarious situation of government-related entities in the United States' territories. Judge Faris showed no inclination to look at the non-bankruptcy alternatives available to the fund, and instead relied on a the text and legislative history of the bankruptcy code to decide whether it was a "governmental unit." However, it is unclear if the drafters of the bankruptcy code truly intended to leave "governmental units" in the territories ineligible under both chapter 11 and chapter 9. The consequence for the Northern Mariana fund was drastic. Various retirees sued both the fund and the Northern Mariana Islands government and the result is a recent settlement agreement whereby the fund is being taken over by a receiver and retirees will face haircuts to their benefits.

For more information on Reorg Research, please visit our site here: Reorg Research or request a trial here: Reorg Research Trial Request



Off Topic: On Starting a Company

I was looking through the blog today for an old post, and I was surprised to realize that my last original blog post was March 14th, 2013. I've tried my damnedest to put some unique content ever few weeks and promise you I will do a better job in the future. I truly apologize for the lack of content.

March 14th, despite being a little over only 150 days ago seems like an absolute eternity. Since then, my wife has given birth to our second child (healthy baby boy), my mom has had brain surgery (battling breast cancer), and I've worked harder than I've ever worked starting a company. I've debated for some time in writing post below and decided to finally pull the trigger.

As many of you know, Reorg Research spawned from a problem that has plagued distressed debt investors, restructuring bankers, and lawyers for a long time. Principally, there was an incredible amount of time wasted navigating archaic tools to get information on bankruptcy proceedings. Whether it be claims agent sites or PACER, following multiple dockets was an inefficient process in which time could be better used actually analyzing information versus finding information. I believe, and our customers will attest, that Reorg Research is by far the easiest way to stay up on many cases at any one time on a near real time basis. I haven't logged in PACER in 7 months and couldn't imagine having to go back to the old fashioned way of tracking cases whether they be bankruptcy, adversary proceedings, patent litigation, anti-trust, etc.

Since then, Reorg Research has grown and matured our news, reporting, and research into something that I am EXTREMELY proud. We constantly hear how great our content is relative to our competitors and we strive to constantly improve our offering. I like to tell people one of my favorite things to do is read disclosure statements. When friends / family outside the distressed world ask me what our company does, I respond by saying "We are the world experts on corporate bankruptcies and distressed debt." I stand by that.

Reorg Research is not what this post is about. This post is about 3 lessons I've learned starting a company. I could probably expand this list into many many many more things I've learning via mistakes, failures, etc, but I think this list of three are paramount to building a successful organization.

Lesson #1: Hire well. Hire meticulous.

While this is really two lessons, I think it is amazingly important to starting a company. As an example, let's say you are a new organization with 5 employees. If just ONE of them is bad, productivity decreases by 20%. Further, the founder and the remaining 3 employees need to pick up the slack and therefore their core roles are compromised.

Hiring is by far my most important job. It's not even close. People argue raising capital is an important aspect of building a company. My retort is capital is plentiful while talented, excellent, tenacious, and loyal people are rare and seemingly impossible to find.

We interview LOTS of people for each job that we are hiring. The combination mentioned above (talented, excellent, tenacious, loyal) is hard to find but finding that person that can fit with your team takes a meticulous process that is rigorous but at the same time fulfilling.

My staff is EXCELLENT. I would put my team up against any out there.

Lesson #2: You have to be obsessed with what you do. 

I'm sure everyone has heard this one in the past. You have to like what you do to be successful at it. I take that a step further. You have to be obsessed with it.

Starting a company is hard. The amount of small things to do to get a company off the ground is comical. Did you know you need to keep I-9s in a different folder than other employee files? It never ends and only builds up as your company grows.

I love distressed. I love bankruptcy. As some of you have seen, my first slide whenever I teach a class on distressed starts with a slide that reads: In 20 years, what's most likely to be around? Google, Facebook, or bankruptcy.

I am the guy that gets jazzed up by marshaling issues in OSG, or deficiency claims in Cenage, or litigation value in TCEH. I'll read a filing and send off emails at ungodly hours and then people look at me strangely the next time they see me. "Are you ok?" they ask. Of course I am - Wasn't that filing I sent you AMAZING?

The days are long and to get through them you can't just love what you do. Not just that (adding a rider to Lesson #1), the people around you have to also love what they do. These are people you will bounce ideas off of and spend long long hours with and that rapport by relishing in a common topic / theme / subject / task makes the days go by easier.

Lesson #3: The reason why so many start ups fail is that they can't get to or don't know their customer

We are a B2B start up. Our customer are hedge funds, investment banks, asset managers, law firms, restructuring advisors etc. The blog, DDIC, and the network they provided and I built since 2009 was invaluable to getting momentum for Reorg Research's offering which in turn increases word of mouth effects which in turn gives you more momentum.

People often ask me if I started the blog knowing Reorg Research was an ultimate goal. The answer is no. I started the blog because I love bankruptcy and distressed debt and a friend sent one of my early stories to a WSJ editor who linked to the blog and the rest is history. But the network that was built by the connection with other like minded people that love what we all do on a daily basis was priceless.

If you are thinking about starting a company, do whatever you can right now to start getting in front of customers. Start a Twitter feed, start a blog, optimize your LinkedIn profile, go to networking events, etc. It doesn't matter.

The reason this is so important, outside of the revenue / growth aspects, is that if on Day 0 (not even Day 1), you can't get solid and critical feedback from a handful of potential users, you are going to have a heavy uphill battle. The alpha for Reorg Research was ready for testing in 4Q 2012 where 10-20 close friends and readers of the blog got to test drive the system and crush me with their feedback . The site looks and functions infinitely better because of that feedback.

If you are considering starting a company (or fund for that matter), I would suggest you read this book: http://www.amazon.com/The-Four-Steps-Epiphany-Successful/dp/0976470705/ref=pd_sim_b_9. It's one of the few books I can say really changed the way I view successes and failures of the business / start up world.


One of my employees has been tasked with yelling at me if I am not writing blog content on a more regular basis. While I can't promise I will be penning as many pieces I did in the past, I will do a better job of getting emerging manager interviews, legal pieces, and conference notes up on the site. Now back to that Cengage DS!



TMA NY NextGen Event: The Shipping Industry - Navigating Distressed Waters with Wilbur Ross

Next week, Wednesday July 24, the Turnaround Management Association's New York group of young professionals, NextGen, is hosting what I think is going to be a fantastic event: a networking and education breakfast on the shipping industry with an elite panel including Wilbur Ross.

The number of distressed situations we have seen in shipping is only increasing and given the richness of each situation's capital structures, distressed debt investors have spent significant time learning the dynamics of a very complicated industry. I personally think that certain parts and verticals in the shipping industry will produce amazing returns for patient investors over the coming years.

Moderated by David Hilty, MD at Houlihan, panelists include:

  • Wilbur Ross, WL Ross & Co
  • Paul Leand, AMA Capital Partners
  • Lisa Donahue, AlixPartners
  • Steve Hannan, Evercore
More details and registration for the event can be found here:

I'll be in attendance and hope to see you there!



Reorg Research Job Posting

As most of you are aware, Reorg Research was announced a little over three months ago. I have been extremely grateful for the blog's readership that has allowed us to tailor and grow a product that is meeting the needs of the buy side and sell side community in both making their lives easier in following bankruptcy dockets and alerting them of our proprietary news, intelligence, and research on distressed situations that is moving markets. Feedback has been overwhelming positive and we plan to continue to build out our product offerings and coverage. With that said, we are hiring a few more distressed debt research analysts to our team.

The ideal candidate will have 2 years working in restructuring at an investment bank or as a desk analysts at a broker-dealer covering distressed situations. He/she should be conversant and be able to analyze intricacies of legal documents including credit agreements, indentures, asset purchase agreements, etc. This person should have strong communication skills and be able to set up to the plate when we require more writing than just pumping out excel models.  And this person should  want to be part of a growing team that is building something great from the ground up.

Our material is read by the vast majority of distressed hedge funds and distressed trading desks across the Street in addition to many law firms, FAs, and other professionals in the restructuring community. This is an opportunity for a few enterprising candidates to get their name out there in the distressed community with the eventual goal to move to the buy side at an elite fund.

To apply, please send your resume and a 2-3 paragraph investment write-up to recruiting@reorg-research.com. If you have any questions on the role, you can reach out to me specifically (hunter [at] distressed-debt-investing [dot] com)



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.