What do you do in your spare time? I read bankruptcy dockets.

On April 16th, 2012, a company based in Ronkonkoma, New York filed for bankruptcy. The company's name is Integratas Security Corporation. Integratas employs 366 people who provide day to day guard services across the tri-state area. Because of increased competition (including a competitor started by one of its former employees) in the face of weakening customer demand, Integratas is unable to pay its debt and has filed bankruptcy in the Eastern District of New York (Central Islip).

In its first day motions, Integratas notes that it has entered into an Asset Purchase Agreement (APA in the bankruptcy world) with one of its competitors. The terms of the APA are as follows:

• $750,000 consideration, with which $250,000 is due at the close of the sale, with the balance paid out based on a formula that could ratchet the price down.
• In exchange, purchaser will receive assumption and assigned of service contracts of Integratas, vehicles and equipment, and the trademark name
• The full purchase price is predicated on producing revenue of at least $6.9 million, one year subsequent to closing
• There is a customary break up fee and overbids

There will be an auction to determine if there will be a higher bid for the company. That auction is scheduled for June 6th, 2012 in Jericho, NY. Competing bids are due by the 1st of June.

For those interested, here is the docket: Integratas Pacer Link

When people ask me what I do for a living, I tell them I invest in junk bonds and bankrupt companies. Most people's knowledge of distressed investing ends with Richard Gere. 

Let's run a quick thought experiment: In 20 years, of the four items below, what is the most likely to be around?

1. Facebook
2. Google
3. Apple
4. bankruptcy

Since the dawn of lending, millions of individuals and institutions have mispriced their ability to repay their debts.  I am not quite sure if it is more hope or more greed, but, usually at the most inopportune times, lenders extend far too much credit, and debtors take on far too much of a burden, and the result is bankruptcy (I will use the term bankruptcy and restructuring interchangeably in this post). Bankruptcy is here to stay.

The problem of course is bankruptcy is ugly. Our representation in the press is this:

And bankruptcy is complex. It is oh, so complex. Seth Klarman has publicly stated that Baupost had one analyst that just looked at Enron, solely, for a number of years. Complex org charts, upstream vs downstream guarantees, rejection claims, pension negotiations, dual tracks, conflicting valuation assessments, Rule 2004 discovery, releases, etc is just the beginning.

And it is opaque. The most disgusting business out there are transcription services that charge $500-$1000 for a copy of a court transcript. Someone tell me how to disrupt that, and I may just invest in your company immediately. There is a service that arguably 1% of the investing world (CourtCall) knows about that one must register with, and then pay $50, to listen to court proceedings. PACER still charges you for access fees. The time information is posted to a docket to what happens in the court can take days. Club deals abound like no where else.

But all these create investment opportunities that I think are unparalleled in the public investment universe.

One of the anecdotes Warren Buffett, distressed investor himself, tells students is that long ago, he would pick up Moody's stock manuals and start with A. It is a good exercise. Via the media, the public is exposed to maybe 10% of the U.S. invest-able stock market. By relentlessly going through the alphabetized list of names, enterprising investors can catch bargains that are in boring businesses (ugly), with uncertain prospects (complex), that rarely disclose anything to investors (opaque). Sound familiar?

The reason I gave the above example about Integratas was not because I think its a particularly compelling investment. But I do think an investor would be better spent learning the securities industry in the tri-state area than spending time reading Microsoft's 10K where they will compete with legions of investors. I bet you no more than 10 people knew about the Integratas acquisition before this post. Let's say you can eek 5% margins on the $7M of revenue or 350k of EBITDA. Versus a purchase price of 750k (and only 250k due up front), that doesn't look like a terrible investment at all.

I could read bankruptcy cases all day long. That may be a sick sick thing to say but the stories of these companies are simply riveting. And because I have done this for some times, the opacity begins to melt away, and the trove of information is incredible. Some information released on dockets would scare public companies. But with that information, an astute investor can, in my opinion, get closer to the intrinsic value of an enterprise.

Sometimes its hard to invest in these enterprises. Trade claim shops probably do it best by sourcing their own claims by "dialing for dollars" (i.e. calling listed creditors and offering a % of par for their claim). Though that can be administratively expensive unless you are dolling out 5 figures a purchase and you do not have your ducks in a row.

Author Note: I do not know the distressed private equity industry as well as I should. Lynn Tilton's Patriarch Partners is one that you hear about most often. I'd be curious if readers had any other names I should get to know that participate in companies with EV's less than $50M that play across the capital structure in loan to own strategies. Please shoot me an email with suggestions.

With the markets currently in a bit of "shaky patch" and most distressed debt guys I know reading everything they can about CAPP coal and legacy liabilities (see: PCX), it is starting to get more fun and interesting out there.  New issue concessions are definitely high and the bull trade / thesis rests on an ECB or Bernake put. We are still no where close to time to drain the penny bank into the market, but it feels a lot more fairly valued to a whisper of cheap, out there. There still isn't a lot of pain though or really panic as the sell offs have seem orderly.

I am very very lucky to have been exposed to a part of the market that few experience early in my career. People ask me "How do I get involved in distressed?" Start with A. Find a case in a local district of yours and follow the proceedings closely. Call some of the creditors and see if they will part with their claims. Talk to the lawyers and get to know some of the players involved in the space. Head to the court and sit in on a proceeding. By doing this with one or two cases, you'll learn more than you ever sitting in a class. And maybe, just maybe, you'll find an opportunity that you can plow significant capital into and come out with out-sized gains because you were the only one in the world paying attention.

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U.S. Supreme Court Affirms Right of Secured Lender to Credit Bid Under a Chapter 11 Plan

As we first discussed a few weeks ago, the Supreme Court of the United States heard arguments related to the legitimacy of the practice known as credit bidding. The decision was important as credit bidding is a fundamental tenet of distressed debt investing under loan to own strategies. Contributor George Mesires weighs in on the issue:

On May 29, 2012, the Supreme Court decidedly put to rest an issue that has caused secured lenders angst since 2009 when the Fifth Circuit in the Pacific Lumber case first allowed a debtor to sell assets under a plan of reorganization free and clear of a creditor’s lien without providing that lender the right to credit bid its debt in the sale. Specifically, the Court settled the split among the judicial circuits (the Seventh Circuit on the one hand, and the Third Circuit (home to the Delaware bankruptcy court) and the Fifth Circuit, on the other) by holding that a debtor “may not obtain confirmation of a Chapter 11 cramdown plan that provides for the sale of collateral free and clear of [a secured lender’s] lien, but does not permit the [secured lender] to credit-bid at the sale.”  The decision provides needed guidance to secured lenders and practitioners as the previously unsettled state of the law added uncertainty, risk and a higher cost of capital in these credit bid situations.

Generally, a debtor in bankruptcy may sell its assets in two ways: (i) under § 363 of the Bankruptcy Code; or (ii) pursuant to a plan of reorganization under § 1123 of the Bankruptcy Code.

Under § 363, it is not disputed that a secured creditor may credit bid its debt (unless the court in very limited circumstances finds that “cause” exists to deny the secured lender the right to do so).

Alternatively, a debtor can sell its assets pursuant to a plan of reorganization. In certain circumstances, a debtor can “cramdown” a plan of reorganization over the objection of creditors, including a secured creditor. To cramdown a secured creditor, among other things, the reorganization plan must be “fair and equitable” to the secured creditor. The “fair and equitable” standard may be satisfied by showing that the plan provides: (1) that the holders of such claims retain the liens securing such claims and receive deferred cash payments having a present value equal to the value of their collateral; (2) for the sale of the collateral free and clear of liens (with such lien attaching to the sale proceeds of the sale) but subject to the secured creditor’s right to credit bid; or (3) for the realization of the secured creditor’s claim by some means which provides the secured creditor with the “indubitable equivalent” of its claim.

Thus, the plain language of clause (2) above states that a secured creditor shall have the right to credit bid in a sale of its collateral pursuant to a plan of reorganization.  Indeed, historically, there has been little dispute that a secured lender had the right to credit bid its debt in such cases.  Recently, however, several creative debtors (see e.g., debtors in the Pacific Lumber, Philadelphia Newspapers, and RadLAX cases) have attempted to sell a secured creditor’s collateral pursuant to a plan of reorganization without allowing the creditor to credit bid.  Such arrangements have been upheld by two federal circuit courts (the Third and Fifth Circuits), and disallowed by another (the Seventh Circuit).  

In the RadLAX case, the debtors proposed selling substantially all of their assets under a plan of reorganization and using the sale proceeds to repay the secured lender. As part of its plan, however, the debtors sought to deny the lender the ability to credit bid its debt.  Not surprisingly, the bank objected to such treatment, since the bank would be forced to come out of pocket with cash, which adds both administrative and financing costs to the transaction, instead of using the debt owed to it as currency.

It was fitting that Justice Scalia, one of the Court’s great textualists, delivered the 8-0 opinion for the Court.  Calling the debtors’ reading of § 1129 “hyperliteral and contrary to common sense,” Justice Scalia did away with a detailed analysis of the purposes of the Bankruptcy Code, pre-Code practices and the merits of credit-bidding that lower courts focused on, and instead focused on a well established canon of statutory interpretation – the general/specific canon.  That principle of statutory interpretation provides that “specific governs the general” and where a general authorization and a more limited, specific authorization exists side-by-side, the terms of the specific authorization must be complied with.  Thus, “clause [2] of the fair and equitable standard (above)] is a detailed provision that spells out the requirements for selling collateral free of liens, while clause [3] is a broadly worded provision that says nothing about such a sale.  The general/specific canon explains that the ‘general language’ of clause [3], ‘although broad enough to include it, will not be held to apply to a matter specifically dealt with’ in clause [2].”

Justice Scalia, in a nod to the United States Department of Justice, who filed an amicus curiae brief supporting the secured lender’s position, acknowledged in a footnote that the right to credit bid is “particularly important for the Federal Government, which is frequently a secured creditor in bankruptcy and which often lacks appropriations authority to throw good money after bad in a cash-only bankruptcy auction.”

The Supreme Court’s ruling is important for at least two reasons.  First, resolution of this issue will streamline the administration of future bankruptcy cases by providing secured lenders the assurance that they can credit bid in both 363 and plan sales under the Bankruptcy Code, which will result in greater efficiency and lower costs of capital.

Second, the Court’s decision upholds the long-standing principle that bankruptcy law has not permitted a secured creditor to lose its lien in bankruptcy without the lender’s consent, payment in full, or surrender of the collateral to the lender.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires@uhlaw.com.  

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My Favorite Ideas from Ira Sohn

Last week we attended the Ira Sohn Research Conference where some of the best hedge fund managers in the world pitched some amazing investment ideas. For those that were not following, I was updating readers in real time on Twitter (@DDInvesting) trying to get information out as fast as humanly possibly.

In that regard, our notes from this year our going to take a different feel. For more comprehensive notes you can visit Jay at Marketfolly or Jacob at ValueWalk or Josh at The Reformed Broker. In addition, a number of the presentations are being floated around specifically Bill Ackman's presentation on JCP.

In terms of distressed debt portfolio managers, the panel of speakers included notable player Jonathan Kolatch, founder of Redwood Capital, who was very impressive. In fact I believe, and I might be mistaken, Kolatch used to work with Dave Tepper at Goldman Sachs (forgive me if I have that fixed up). Larry Robbin's Glenview Capital and John Paulson are also active players in the distressed debt market. It was great to hear from each of them.

So for each manager, I have boiled down the ONE take-away I came away with from the conference. Some of these are investment ideas and some are more general investing wisdom.  Overall I encourage all of you who have never been to the conference to attend one soon - it is such a learning experience listening to best pitch their ideas. Enjoy!

Ken Rogoff - Harvard University


Professor Rogoff spoke about what he is known best for: severe finance crisis. His book "The Time is Different" talks about, in depth, many of the great financial calamities world economies have faced in the past. The most interesting or salient point he made: Looking at the charts, Greece has been in default for 50% of the years since the data was recorded. The situation in Greece (as well as other weaker European nations) is keeping a tight lid on the euro which is beneficial to German consumers and industry. If this dynamic wasn't the case, I think the fact that the country you are trying to save has been in default 50% of the time, you have to let it go.

Larry Robbins - Glenview Capital Management


I interviewed at Glenview many moons ago when their AUM was 1/5 of what it is today. I regret not closing that position because Robbins is simply a force of investment acumen. Robbins spent most of his time talking two trades: Long hospitals and life sciences (Tenet in particular) and short the "new high club" - treasuries, utilities (specifically ITC) and the defense sector. The takeaway from this presentation was simply the thoroughness of the ITC short. Glenview went as far as testifying in front of the regulators that ITC's capital structure allowed it to overcharge consumers. The short wasn't really valuation in nature (in my opinion the worst kind of shorts). It was based on technical information that required a lot of digging. And there is a catalyst here - a rate review / drop in rates so the shorts just don't have to sit around forever and wait for valuation to come down.

Jonathan Kolatch - Redwood

Kolatch spent his time discussing Argentina sovereign debt. He compared Argentina to other countries in Europe: Debt to GDP is half or less than most countries in Europe. There are less deficits. Rapid GDP growth. And bonds yield 15% - well higher that most countries.  It was a very compelling presentation. Kolatch noted that if Argentina traded 300 bps behind Brazil, the trade offered a 36.5% IRR (in 3 years) with a 13.7% current yield. The takeaway here is summarized by how Kolatch described Argentina's nationalization of YPF. He agrees that its a bad thing, but the motivations might be different from what the market is handicapping and that creates opportunities and mispricings.

Dwight Anderson - Ospraie Management


This is the first time I've heard Tutor and Tiger Alumni Dwight Anderson speak. Anderson's talk focused on two ideas: Long Westlake Chemical, and a pair trade of long palladium / short platinum. The takeaway here, and similar to other Tiger alumni, is the understanding or better yet anticipation on what's going to happen next. The second-derivative thinking on Westlake was a beautiful thing to watch: Low nat gas prices are a benefit to Westlake and the benefit is no where close to being fully realized. Similarly the platinum vs palladium trade was thinking two steps ahead: Platinum mine production is accelerating later this year into net year, whereas palladium will be in a deficit, combined with structural changes in the consumption of the two materials in auto products. Really compelling stuff.

Meryl Witmer - Eagle Capital 

Witmer learned the ropes with Michael Price and Max Heine of Mutual Series. She spent her time talking about two idea: Gildan and Viacom. In one of her opening slides, she discussed Eagle's general philosophy which focus on looking for strong management teams that are good capital allocators who buy back stock a "fire sale prices" running companies that generate good cash flow and maintain a healthy balance sheet. The emphasis on fire sale prices is interesting - so often the investment community pushes for companies to buy back stock irrespective of price. Yes, its probably better than making a dumb acquisition, but its far less important the value of cash in a downturn (whether buying own stock or someone elses). As investors we know this but we rarely put that to our management teams we cover.

Phillipe Laffont - Coatue


Lafont spoke about two stocks: Equinix and Virgin Media. Similar to other Tiger Cubs, Laffont looks for industry leaders. One of the most interesting things he said at the conference, which I had never really thought about: The market inappropriately values companies that will do a LARGE forward buyback. So a company like Virgin Media which in theory could buy back all its shares outstanding in the next five years is seriously undervalued. He didn't postulate why this is - it's probably because many market participants simply don't believe management.

John Wilder - BlueScape Resources

This was an amazing presentation on the dynamics going on in the natural gas market. One of the industries I have never covered is oil/gas, but I do look at the coal names (moreso now than a few weeks ago) which is relevant in so many ways.  Wilder was quite bearish on the near term forward curve for gas.  The one key point I took away from his presentation was a fantastic graph showing commodity prices versus GDP - natural gas demand has been relatively stable / flat and has not kept up with GDP growth. With little gas drilling economically viable at current pricing (outside the Marcellus) the demand side wildcard of LNG exports may not be all they are cooked up to be - the mystical "100 BCF/day won't happen in the near term.

Jeffery Gundlach - DoubleLine


The introduction to Gundlach noted that according to one study, DoubleLine is the fastest growing company in America. That is magical. I have covered Gundlach on the blog a number of times. If you haven't heard him speak, you are missing out. Gundlach talked about constructing portfolio that can handle all tail scenarios. To Gundlach, cooperation = bull market; contention = bear market - and we have a ton of contention right now. I listed his trades on Twitter, but for those not there: Long IBEX, 1 year Libor (10x levered), natural gas, cash; Short SPX, JWN, Apple, 2 year swaps. The portfolio he laid out makes a lot of sense and in a very bullish or very weak market, would probably do well.

David Einhorn - Greenlight Capital


This was a whirlwind presentation. You can see part of it here: Greenlight's Thoughts on Cash Heavy Companies. The amount of items covered here would be impossible to do any service to, on either the long or the short side. Probably one of the better ideas presented here was short Dicks Sporting goods on encroachment from Amazon. Again, 2nd order thinking here (which really was present throughout the presentation: US Steel short, Japan, Cairn Energy, etc).

Dan Ariely - Duke University


Dan Ariely is one of the leading experts in behavioral economics and self-control. His talk really centered on the latter. Ariely pointed out that self control, boiled down, is the dynamic between long term interests and short term interests: And the short term usually wins. As such, how do we overcome this? The take-away here is how loss aversion can affect us outside of investing. Studies show we have to win 2-3x what we equivalently lose to have the same emotional effect on ourselves. So instead of using "treats" to reward ourselves, instead use the loss of "treats." His example: When he told diabetic patients he'd give them $3 each day they took their meds, no one changed their habit. When he then told another group of patients that he deposited $100 in their bank and that each time they didn't take their meds, he'd take $3 out, there was an 80% increase in compliant patients. Amazing! The last point he made was really telling: Self control problems will only get worse in times; marketers will not make their products LESS tempting.

Steve Mandel - Lone Pine


Another Tiger Cub. And similarly he said: I believe leaders stay leaders and leaders win. His themes include being negative on fixed income, being long tech leaders, and being long share count shrinkers. The one name he mentioned was Kohl's which trades below 10x, has been affected by cotton prices (short term problem) and has a solid leadership team aggressively buying back stock at a discount to intrinsic value.

John Paulson - Paulson & Co

John Paulson likes to think big. And as I noted, his CVI trade was probably the best idea presented (despite the fact that you had to buy it at T+2 or T+1 to actually execute the trade). His thesis on CZR brought some interesting facts to life - i.e. the holding company owns assets (online gaming) outside of the levered enterprises and you're probably already covered there. He did note that CZR was an option play and placed a $138/price target on the name. He also spoke about AngloGold Ashanti, which in his opinion, is the cheapest way to play gold.

John Lykouretzos - Hoplite


Another Tiger Cub (Tiger Cub Cub - was a PM at Viking). This is the first time I have heard Lykouretzos speak. He presented on Starbucks and laid out a very very compelling thesis. Again Tiger Cubs like to play quality companies and really Starbucks is one of the best out there.  He laid out a number of tenets of value and pointed out that growth in the U.S. store base + moving to consumer packaged goods could create tremendous shareholder value.

Bill Ackman - Pershing Square


On a day JCP was getting absolutely murdered, Ackman, as usual presented a detailed case study on why he is long JCP (and the next day his slate of directors was elected at CP). I do not want to do the presentation any disservice, so I'll link to it for those that have not seen it. The title is Think Big - and at the end he notes JCP could be worth $300/share. Thing big we shall! Here's the presentation.

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Competing Plans in Bankruptcy

Over the last few years, we've seen a number of cases run parallel plans in bankruptcy - sometimes contentiously between creditors trying to argue they are the fulcrum and sometimes for legitimate business reasons. Distressed Debt Investing contributor George Mesires of Ungaretti & Harris LLP has written a piece talking about competing plans in bankruptcy. Enjoy!

Competing Plans in Bankruptcy
One of a debtor’s most powerful levers during a bankruptcy case is its exclusive right to file a plan of reorganization during the first 120 days of a bankruptcy case.  This period, commonly known as the exclusivity period, coupled with the automatic stay, provides a debtor breathing room to focus its efforts on, among other things, formulating a plan of reorganization to exit bankruptcy.  Exclusivity provides a debtor an opportunity to develop its plan of reorganization without the threat of its strategy immediately being derailed by competing constituents.  Certainly the careful debtor may work with other constituents to build consensus around its plan of reorganization, but exclusivity gives a debtor the initial leverage over its creditors and other constituents during the important early few months of a bankruptcy case.

Often times, however, particularly in complex bankruptcy cases, 120 days is simply not enough time for a debtor to formulate its plan of reorganization, and in such circumstances, debtors often request, and courts routinely grant, extensions of the exclusivity period.  Indeed, in many cases, debtors were granted seemingly indefinite extensions, a practice that led some critics to contend that exclusivity extensions unduly prolonged the time and increased the expense of chapter 11 reorganizations to the detriment of other constituencies.  Even though the Bankruptcy Code permitted a party in interest to petition the bankruptcy court for authority to file a competing plan, such requests were rarely granted.  Generally, if a bankruptcy case appeared to be on-track, courts deferred to the debtor so that the debtor could maintain control of the plan process.

To address the concern that debtors were hiding behind the cloak of exclusivity to the detriment of other constituents, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) amended the Bankruptcy Code provision relating to exclusivity by imposing an 18 month limit on a debtor’s exclusivity period.  The amendment was intended to motivate a debtor and other constituents to develop a consensual plan, thereby reducing the time and expense of a protracted chapter 11 proceeding.  Notwithstanding its laudable intent, the BAPCPA amendment relating to exclusivity may have, in fact, complicated the chapter 11 process by stripping bankruptcy courts of their discretion to extend exclusivity and automatically permitting other constituents to file competing plans after 18 months.

The Exclusivity Period
Pursuant to § 1121(b) of the Bankruptcy Code, a debtor has the exclusive right to file a plan of reorganization during the first 120 days after the commencement of a chapter 11 case.  If a debtor files a plan during this exclusive filing period, section 1121(c)(3) of the Bankruptcy Code grants an additional 60 days during which the debtor may solicit acceptances of that plan, and no other party in interest may file a competing plan.

Section 1121(d) of the Bankruptcy Code provides that the Court may, in its discretion, “for cause,” extend these periods: “[o]n request of a party in interest . . . and after notice and a hearing, the court may for cause reduce or increase the 120-day period or the 180-day period referred to in this section.”  11 U.S.C. § 1121(d)(1).

Although the Bankruptcy Code does not define “cause,” a number of courts have looked to the Bankruptcy Code’s underlying legislative history for assistance in construing this term in this context.  See, e.g., In re Ravenna Indus., Inc., 20 B.R. 886, 889 (Bankr. N.D. Ohio 1982); accord In re Amko Plastics, Inc., 197 B.R. 74, 77 (Bankr. S.D. Ohio 1996); Gaines v. Perkins (In re Perkins), 71 B.R. 294, 297-98 (W.D. Tenn. 1987); Teachers Ins. and Annuity Ass’n of Am. v. Lake in the Woods (In re Lake in the Woods), 10 B.R. 338, 342-45 (E.D. Mich. 1981).

Courts hold that the decision to extend the exclusivity period is left to the sound discretion of a bankruptcy court and should be based on the totality of circumstances in each case.  See, e.g., 203 North LaSalle Street P’ship v. Bank of Am. Nat’l Ass’n (In re 203 North LaSalle Street P’ship), Nos. 99 C 7110 and 99 C 7108, 1999 1206619 at *4 (N.D. Ill. Dec. 13, 1999) (“[T]he Code commits the decision on extending the exclusivity period to the discretion of the bankruptcy court.”); First Am. Bank of N.Y. v. Southwest Gloves & Safety Equip., Inc., 64 B.R. 963, 965 (D. Del. 1986); In re Dow Corning Corp., 208 B.R. 661, 664 (Bankr. E.D. Mich. 1997); In re McLean Indus., Inc., 87 B.R. 830, 834 (Bankr. S.D.N.Y. 1987).

In determining whether cause exists for an extension of a debtor’s exclusivity period, courts have relied on a variety of factors, each of which alone may constitute sufficient grounds for extending the exclusivity period.  Factors that courts have routinely considered to determine whether “cause” exists include: (a) the existence of good faith progress towards reorganization; (b) the size and complexity of the debtor’s case; (c) a finding that the debtor is not seeking to extend exclusivity to pressure creditors to accede to the debtor’s reorganization demands; (d) existence of an unresolved contingency; and (e) the fact that the debtor is paying its bills as they come due.  However, in no event shall the exclusivity period be “be extended beyond a date that is 18 months after the [petition] date,” and the 180-day period “may not be extended beyond a date that is 20 months after the [petition] date.” 11 U.S.C. § 1121(d)(2).

BAPCPA Amendment Concerning Exclusivity
Following the BAPCPA amendment to § 1121, regardless of how well the bankruptcy case is progressing, bankruptcy courts no longer have any discretion to consider requests for an extension of exclusivity beyond 18 months after the petition date.  Accordingly, after 18 months, any party in interest has the ability to file a competing plan of reorganization.  The sudden ability of other parties in interest to file a plan of reorganization can have a dramatic effect on the negotiating posture of the competing constituents and significantly alter their negotiating leverage.  Moreover, competing plans will likely add further complexity (both procedural and substantive) to the proceedings.

The Tribune bankruptcy case is probably the most prominent example of a post-BAPCPA case that became significantly more complex and protracted following the expiration of the debtors’ exclusivity period.  Following the automatic expiration of exclusivity in August 2010, and efforts by a mediator to garner support for a single plan, four plans of reorganization were filed by various creditor groups.  And nearly two years after the expiration of exclusivity, Tribune is still in bankruptcy.  (Yet to be fair, confirmation hearings are set for next month).  See also, Lehman Brothers (three competing plans); Tronox (two competing plans); Meruelo Maddux Properties (three competing plans).  All of these cases posed significant procedural challenges after the competing plans were filed, mainly because the Bankruptcy Code is silent as to how competing plans should be presented to the creditor body.  Should competing plans be presented to voters simultaneously or sequentially?  What processes should govern dissemination of the vast amounts of information associated with competing plans?

Regardless of the outcome of these cases, one question that will remain unanswered is whether such cases would have been more efficiently administered had the bankruptcy court retained the discretion to extend the debtor’s exclusivity period, or whether amended § 1121 compounded the cost and length of the bankruptcy proceedings.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires@uhlaw.com.

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TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

Before we get to the post: Ira Sohn thoughts/commentary will be posted over the weekend. In the meantime, Jay at MarketFolly has a comprehensive set of notes up. I wrote this on my Twitter feed: John Paulson's idea of the CVI contingent value securities was the most compelling - I'm still doing my research on it. Behind that was Bill Ackman's thesis on JCP: First time I've heard it and I get the premise of the pitch. I am long JCP stock as of yesterday.

To more relevant, distressed business. Contributor Josh Nahas, Principal of Wolf Capital Advisors, and I were speaking today. Earlier this week, the TOUSA decision was overturned by the appellate court. Aurelius, one of the best distressed funds around, benefited greatly on this ruling. This could be one of the more salient stories in distressed debt land this year and no one out there is as good in covering these situations like Josh. Enjoy!

TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

On May 15, 2012 The United States Court of Appeals for the Eleventh Circuit reversed the decision of Judge Alan S. Gold of the U.S. District Court for the Southern District of Florida in the Bankruptcy of homebuilder TOUSA Inc. The Circuit court upheld the previous ruling by the Bankruptcy Court that in fact the financing of the payment to Transeastern Lenders constituted a fraudulent conveyance. The issues in the case have has been closely followed by bankruptcy attorneys, secured lenders and distressed investors as the implications are far reaching, particularly as it relates to rescue financing for companies near insolvency. Link to ruling: http://react.bracewellgiuliani.com/reaction/documents/BasisPointsTousa11thCircuitOpinion.pdf

Not only did the Circuit court uphold the Bankruptcy Court’s finding that a fraudulent conveyance had occurred, but it also found that the Transeatern Lenders were repaid by the proceeds of that fraudulent conveyance and were subject to potential claw back litigation as “initial transferees”. In addition, the court found  that the Transeatern Lenders bore some responsibility for diligencing the source of funds that was being used to repay them, and therefore should have known that their repayment was likely the result of a fraudulent transfer.

The distressed community has been split on the issues in TOUSA with most willing to acknowledge that the 2007 financing was highly suspect, while uncomfortable with idea that lenders should be held responsible for diligencing the sources of their repayment.  Funds specializing in rescue financing and secured lending, as well as distressed funds who were in the Transeatern Loan, were the most disturbed by the ruling; while distressed investors, and certainly TOUSA’s unsecured bondholders, felt that a line was finally being drawn over perceived corporate maneuvering and asset shuffling prior to a Chapter 11 filing.

As a quick refresh for our readers (see earlier post for more details) TOUSA was a Florida based homebuilder focused on the construction of single-family residences as well as townhomes and condominiums.  TOUSA Inc and its subsidiary TOUSA Homes LP had also entered into a JV with Falcone/Ritchie LLC (Transeastern) that was funded by the group of creditors referred to by the court as the “Transeastern Lenders”.  However, when the housing market began to turn down, the JV failed.

As a result TOUSA wound up in litigation with lenders to the JV and ultimately agreed to a $420mm settlement.  In order to pay for the settlement TOUSA raised a new first and second lien term loan facility.  The loan was secured by essentially all of TOUSA’s unencumbered assets including its previously unencumbered subsidiaries, the “Conveying subsidiaries” (the subsidiaries were guarantors on the $700mm revolver).  In January 2008, approximately six months after the closing of the new loan, TOUSA and its subsidiaries filed for Chapter 11 Bankruptcy protection. (1)

The Unsecured Creditors Committee (“UCC”) sought to have the new loan avoided as a fraudulent conveyance on behalf of the debtors’ estate and the proceeds paid out to the Transeastern Lenders returned for the benefit of the unsecured creditors.  The UCC argued that the Conveying Subsidiaries had not received reasonably equivalent value in exchange for securing the new credit facilities.  The unsecured creditors filed litigation to recover the value of said liens from the Transeastern Lenders under section 550(a)(1) of the Bankruptcy Code on the ground that the Transeastern Lenders were the entities to whose benefit the liens had been granted. (2)

Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida agreed with the claims asserted by the unsecured creditors and found that a fraudulent conveyance had indeed occurred.  As part of his decision Judge Olson relied heavily on the evidence from the public domain regarding the condition of the housing market, TOUSA’s sagging stock price as well as the public comments of TOUSA executives regarding a potential restructuring that demonstrated the company’s precarious financial situation and called into question the solvency of the debtor prior to the 2007 refinancing.

On appeal Judge Gold heavily criticized the Bankruptcy Court’s reasoning and its reliance on anecdotal evidence and took the unusual step of quashing the bankruptcy courts ruling.  Judge Gold found that the Transeatern Lenders had no duty to conduct what he deemed “extraordinary due diligence” and that the Conveying Subsidiaries received reasonably equivalent value.  This value was almost entirely attributed to TOUSA avoiding bankruptcy as a result of the Transeatern Lenders being repaid and thus averting a a Chapter 11 filing..

The 11th Circuit disagreed with Judge Gold’s finding and held  that a fraudulent transfer had taken place and that lenders should have a duty to conduct some level of due diligence as to the source of their repayment, particularly when the entity is in financial difficulty.  While the Circuit court did not address specifically whether reasonably equivalent value was received by the Conveying Subsidiaries and affirmed that avoiding bankruptcy is a source of value, the court found in favor of the Bankruptcy Court’s ruling that the risk assumed by the Conveying Subsidiaries far outweighed the perceived benefits of avoiding bankruptcy.

The Circuit court also addressed the question of whether the Transeatern Lenders constituted initial transferees under section 550(a)(1)  of the Bankruptcy Code subject to a clawback of funds as a “subsequent transferee” under section 550(b)(1) which provides for good faith defense against litigation seeking the recovery of funds.  Ultimately the court ruled that the Transeastern Lenders met the definition of initial transferees which will likely make them subject to recovery actions by the UCC. The Court has now remanded the case back to the District court to determine what the appropriate remedies should be given that a fraudulent transfer has been ruled to have occurred.(3)

It appears that the Court is not looking to impose unrealistic expectations on all future lenders, nor is it questioning the value attributable to avoiding restructuring.  Rather, they seem to be focused on the facts in TOUSA which appear to be particularly egregious and therefore should not be considered standard. Indeed, the Court’s analogy to TOUSA’s demise being more akin to a “slow-moving category 5 hurricane than an unforeseen tsunami.” seems to indicate that debtors will still be able to exercise their best judgment and pre-petition rescue lenders will not routinely be found liable for fraudulent conveyance, despite what opponents to the Bankruptcy Court’s ruling feared it would imply.  However, debtors, lenders and their advisors will likely now be more cautious in situations where they are operating near the zone of insolvency.

Given that many distressed investors participate in rescue financing as well as in distressed loans that they believe may be refinanced, there are reasons to be concerned about a ruling that requires investors to diligence the source of funds being used to repay them.  Nevertheless, distressed investors routinely find themselves in situations where they feel the debtor is given far too much leeway to maneuver its assets and engage in rescue financing when an orderly restructuring is in the best interests of creditors and is likely inevitable.

The courts both in and out of bankruptcy already provide the debtor with broad latitude in their financial decisions as per the business judgment rule and efforts by distressed investors to negotiate a consensual restructuring are frequently stymied as a result.  Dynegy is a good analog for the TOUSA situation and most distressed investors (and the court appointed examiner) would agree that the kind of maneuvering that occurred in that case was disturbing and should be prevented from occurring in the future.

Finally, while potential fraudulent conveyance litigation is not usually the primary driver behind an investment thesis, it is a valuable chip in the negotiations with the debtor and the pre-petition lenders.  Had the district court’s ruling stood, distressed investors would have faced an almost insurmountable hurdle in proving a fraudulent conveyance had occurred, and would have lost a valuable leverage point in negotiating with the debtor.  Moreover, it would have likely emboldened debtors and their advisors to engage in even more pre-petition maneuvering rather than pursue a meaningful restructuring.  Too often creditor value is eroded while management of financially distressed companies pursue unrealistic plans to avoid the inevitable restructuring.

Net/Net while the ruling has some potential negative effects for distressed investors focused on rescue lending or when betting on a distressed piece of paper being refinanced, the ruling itself will likely be a positive for distressed investors. Hopefully it will encourage debtors to engage its creditors in meaningful dialog prior to filing a Chapter 11 and avoid some of the more questionable transactions such as TOUSA, Dynegy and Tribune.

Notes: 
(1) Judicial Backlash Adds to Challenges Faced by Lenders.  Edward Estrada, Reed Smith.  The Journal Of Corporate Renewal, July/August 2010
(2) Eleventh Circuit Upholds Bankruptcy Court’s Fraudulent Transfer Ruling in TOUSA  Debra Dandeneau. Weil Bankruptcy Blog, MAY 16, 2012 http://business-finance-restructuring.weil.com/fraudulent-transfers/eleventh-circuit-upholds-bankruptcy-courts-fraudulent-transfer-ruling-in-tousa/#axzz1vANZnoP5

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