Corporate Restructure Conference

Earlier in the week, we had note from Wharton's Restructuring Conference. We continue with Part 2 of the restructuring conference with more notes and commentary:

One of the two morning sessions was a case study panel that discussed the Charter Communications restructuring. The panel included most of the key parties involved in this historic case, which was the largest pre-arranged bankruptcy filing ever.

Panelists:

Cyrus Pardiwala of PricewaterhouseCoopers as moderator (no role in Charter)

Richard Cieri of Kirkland Ellis – Debtors’ counsel

Gregory Doody – Executive Vice President and General Counsel, Charter Communications

Alan Kornberg of Paul, Weiss, Rifkind, Wharton and Garrison LLP – Bondholder Committee Counsel

James Millstein – Senior Restructuring Advisor, U.S. Department of Treasury (Formerly Lazard financial advisor to Charter)

Eric Zinterhofer – Senior Partner, Apollo Management

Mr. Millstein walked the audience through how Charter’s “Byzantine” cap structure came into existence through a multitude of bond issues. For those unfamiliar to Charter, the company had one of the most convoluted corporate structures known to man. Although the Charter operations were generating cash, the company’s highly leveraged balance sheet required access to the high yield bond market to refinance maturities. With the complete shutdown of the new issue market in 4Q08, Charter’s auditors refused to issue a going concern opinion. This is what precipitated the restructuring.

At this point (December 12, 2008) the restructuring advisors began approaching bondholders regarding a debt restructuring. Most bondholders were shocked by the announcement because the company had the cash to continue making interest payments and assumed the runway was much longer. Once bondholders got past the initial shock, they (mostly) agreed that avoiding a freefall bankruptcy was a must. Both the company and creditors feared an “Adelphia-like bankruptcy” that would destroy a lot of value via a protracted valuation fight.

On January 15, 2009 the company announced that two of its subsidiaries did not make their scheduled interest payments. Mr. Millstein referred to this as “the hammer” to get more bondholders to the table during the 30-day grace period. It was around this time that the “cram up” idea was hatched. For those unfamiliar, the cram up was a new twist on reorganizations last year whereby senior debt is reinstated if all events of default can be cured prior to emergence. In fact, Mr. Cieri noted that the original idea came from a consumer bankruptcy case where an individual reinstated his car loan.

The bank debt reinstatement was the crucial part of the Charter case because the firm had several billion dollars of senior secured bank debt with a LIBOR+250 interest rate, which they guessed was anywhere from 500 to 700 bps cheap to where a new loan could get done. Obviously, JP Morgan—the agent bank—opposed being reinstated, although Mr. Millstein had a funny anecdote about how they at first didn’t even understand what the company was attempting to do. Were Charter unable to reinstate the bank debt, there would have been a much longer bankruptcy case that would have destroyed value and “killed” many of the junior creditors. This fight eventually resulted in a 19-day hearing where JP Morgan’s attorneys argued that Charter was violating a covenant in the credit agreement that prevented any group from owning more than Paul Allen. The attorneys argued that the bondholders committee amounted to a “13-d group” and thus violated the covenant. Backing up a bit, a huge part of the plan was Apollo putting up $1.6 billion for an equity investment. The company’s lawyers argued that the ad hoc committee did not constitute a group under rule 13-d because they purchased their bonds at different times, different prices and for different reasons.

Ultimately, Judge Peck sided with the company in an 82-page opinion that the panel agreed would be the lasting legacy of the case. { Judge Peck’s opinion } Mr. Kornberg made some interesting observations about how the JP attorneys essentially shot themselves in the collective foot by stating from the outset of the case that they were out to get their clients higher interest payments. He believes that judges have little sympathy for unimpaired creditors when junior creditors are a) taking a haircut and b) putting in new money.

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Bankruptcy Investing and Restructuring

Grant, a member of the Distressed Debt Investors Club and guest contributor at Distressed Debt Investing writes an interesting piece on tax considerations in restructuring. Enjoy.

Some Key Tax Issues in Restructuring

Tax considerations can have a material impact on the value of a distressed business. The following contains a brief introduction to three important issues that investors in distressed securities might consider when estimating the impact of tax consequences on returns.

Modifications and Exchanges of Debt

While generally modifications of debt do not have tax consequences and exchanges can, the IRS may determine a modification to be effectively an exchange. Even altering an instrument’s interest rate by as little as 25 basis points, or by over 5% of the original yield, can trigger the IRS to treat a modification as an exchange. Internal Revenue Code (“IRC”) §108(e)(11) states cancellation of debt (“COD”) income on an exchange equals the difference between (a) the adjusted issue price of the old debt minus (b) the adjusted issue price of the new debt. Market price is the relevant metric for public debt instruments. For private debt instruments, the stated principal amount is used, unless the instrument does not yield adequate stated interest. In that case, the IRS discounts by the applicable federal rate as per IRC §1274.

Debt Discharge and COD Income

While debt discharge normally creates a taxable gain under IRC §61, IRC §108 allows exclusion of COD income from gross income under any of the following four conditions:

Occurs in a Bankruptcy Code (“BRC”) case

Occurs when taxpayer is insolvent

Is qualified farm indebtedness

Is qualified real property indebtedness1

The amount of excludable COD income is capped at the amount of the debtor’s insolvency, determined by the value of assets and liabilities immediately before discharge. Consider an out-of-court restructuring for a debtor with the following characteristics:

Debt outstanding: $20M

Market value of assets: $10M

Debt discharged: $12M

This debtor meets condition (2) and is insolvent by $10M: accordingly, $10M of the discharge is excludable. However, $12M of debt has been discharged, so the debtor will owe tax on $2M of COD income ($12M - $10M).

For debt discharged that is excluded (the $10M in the above example):

The debtor may make a IRC §108(b)(5) election, which allows the debtor to reduce its basis in depreciable assets by the amount of the excluded debt discharge. This reduction cannot exceed the debtor’s basis in depreciable property during the first tax year after the discharge (no negative basis).

If the debtor does not make the IRC §108(b)(5) election, there is a “waterfall” of tax attributes that must be reduced in the following order:

Net Operating Losses (“NOL”s)

General Business Credits

Alternative Minimum Tax (“AMT”) Credits

Capital Loss Carryovers

Basis of Assets

Passive Activity Loss and Credits

Foreign Tax Credits

(2), (3), (6) and (7) above are reduced by 33⅓ cents per dollar of debt discharged, while (1), (4) and (5) are reduced dollar-for-dollar.

NOLs and Section 382

Under IRC §172(b), NOL can be carried back two prior taxable years and carried forward twenty. IRC §382 limits NOL utilization by a company that has undergone an ownership change: the maximum deduction is the value of the loss corporation's equity times the IRS “long term tax exempt rate”. Consider the following example:

Value of loss corporation’s equity: $100M

Value of loss corporation’s NOL: $10M

Long term tax exempt rate: 5%

The use of the NOL by an acquirer is limited to $5M per annum (5% * $100M). Additional time-based limitations apply if the loss corporation’s NOL is greater than 25% of the loss corporation’s equity. NOL treatment is particularly pertinent in bankruptcy, as the debtor may have made significant prior losses, and may undergo a change of control as a result of restructuring.

There is a “bankruptcy exception” under IRC §382(l)(5): if historical shareholders and creditors2 of a loss corporation in bankruptcy own more than 50% of the loss corporation’s equity after the reorganization, the loss limitation on NOL usage does not apply. However:

Per IRC §382(l)(5)(B), NOLs will be reduced by any interest deducted by the debtor over the three past taxable years plus interest deducted in the current year on any debt converted into equity. However, if the debtor makes an election under IRC §382(l)(6), the IRC §382 limitation on NOL usage is calculated using the equity value of the debtor after the conversion of debt to equity. Making this election can make sense for a debtor which has converted a large amount of debt to equity, as more NOLs may be preserved after making this election than under the bankruptcy exception.

IRC §382(l)(5)(B) mandates that a second ownership change within two years of the ownership change resulting from bankruptcy will trigger the elimination of any NOL carryforwards that arose before the ownership change that resulted from bankruptcy.

Tax issues can have a major present and future cash flow impact on a company undergoing restructuring, with attendant value implications that a distressed investor ought to consider. Fortunately, most disclosure statements now include detailed explanations of a plan’s expected tax consequences. The CIT Group, Inc. bankruptcy provides one recent example of the management of tax concerns during a particularly complicated proceeding.

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