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    Archive for December, 2009

    The “Empty Creditor Hypothesis” – Systemic Financial Risk? Or Worrisome Empty-Headedness?

    Sunday, December 27th, 2009

    A significant amount of ink has been spilled in recent months over the state of the financial derivatives markets and their role in 2008’s financial melt-down.

    Some of that ink has spilled into the area of corporate insolvency – and in particular, into an examination of whether or not credit default swaps (CDSs) – a type of derivative instrument designed to let a creditor hedge its risk with a debtor – have any impact on the dynamics of work-out negotiations when the debtor experiences difficulty repaying the debt.

    This blog has devoted two prior posts (here and here) to the role of CDSs and bankruptcy.  One of the troubling issues raised by researchers (and noted here) in connection with the distressed debt market has been whether or not high-risk investors (i.e., speculators) might be incentivized to buy CDSs on distressed debt, banking on the debtor’s default (akin to “naked short selling” of a company’s stock) on the anticipation that the debtor would fail – thereby triggering a payout on the CDS.  This issue is known more popularly as the “empty creditor problem” – so-called because speculators holding the CDSs issued with respct to a distressed company are not legitimate creditors, but merely risk-takers maneuvering to profit from (and thereby attempting to engineer) corporate failure.

    As 2009 draws to a close, the International Swaps and Derivatives Association (ISDA) has stepped into the debate with a recently published research paper on the matter.  Entitled “The Empty Creditor Hypothesis,” the ISDA’s research paper argues – convincingly – that this sort of speculation is far less a problem than some have suggested.  This is so primarily because the pricing on CDSs begins to rise dramatically as the CDS-backed debtor begins to falter.  Therefore, the profits to be made from purchasing such CDSs are, effectively, non-existent – and there is little reason to speculate in them.

    The ISDA’s point is that there simply isn’t enough of a profit to be made in purchasing CDSs typically issued on distressed firms – and therefore, insufficient potential payoff to attract the sort of “empty creditors” that have concerned distressed debt researchers.  As a result, the “empty creditor problem” really isn’t a “problem.”

    But speculation isn’t the only point of impact that CDSs may have on a distressed debtor’s efforts to negotiate with creditors.  Where the holder of a CDS is also the original lender or the holder of CDS-backed debt, the existence of such derivative securities – which effectively “back-stop” the underlying debt similar to the way in which a fire insurance policy “back-stops” the risk of loss on a building – may incentivize the company’s creditors to be far less flexibile in their discussions with the debtor.

    The ISDA attempts to address this potential effect by pointing to a small sample of data available for the research paper, which suggests that during the period that CDS hedging has been available, workouts (i.e., restructuring events) have grown as a percentage of the number of defaults recorded during the same period.  Therefore, “the . . . statistics presented . . . would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”  However, the ISDA admits that

    “[a] full analysis of the relationship between [the] likelihood of restructuring and availability of hedging with credit default swaps would require extensive data collection, . . . and is beyond the scope of this note.”

    The ISDA’s research paper has received attention – and succinct summaries – from the New York Times, London’s Financial Times, and Reuters.

    The ISDA’s suggestion that CDSs have essentially no impact on corporate restructuring smacks of whistling by the graveyard: In fact, the impact of CDSs has been noted, at least anecdotally, in several large corporate bankruptcy filings during 2008 and 2009.  Nevertheless, the precise nature and extent of the “CDS effect” remains to be seen – and is likely fodder for another research paper . . . or five.

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    Buyer’s Market? Or Seller’s Standoff? A Look At The Numbers

    Sunday, December 20th, 2009

    Several posts this year – the most recent one here – have noted the general buyers’ market prevalent for strategic buyers shopping for distressed M&A.

    A recent CFO.com article drives home the same point, but with more specificity . . . and an important caveat.  Kate O’Sullivan’s piece entitled “Strategic Buyers Still in the Catbird Seat” observes that though overall M&A activity has been off by as much as 1/3 from 2008 levels, strategic buyers closed 94% of this year’s deals.  Strategic buyers appear to have a continued advantage heading into 2010, and – as was the case this year – distressed assets are expected to comprise a significant portion of next year’s deal activity.

    However, the current buyers’ market is not necessarily a bargain-hunters’ bonanza.  Though a recent survey by the Association for Corporate Growth (ACG) and Thomson Reuters (summary available here, with statistical summary here) suggests a modest pick-up in transactional volume for 2010, O’Sullivan (citing the ACG data) notes continued constraints on credit and – perhaps more importantly – a fundamental disconnect over valuations buyers and sellers are willing to accept.

    Either or both factors may hamper any significant increase in deal volume over 2009, but the ACG survey suggests that pricing multiples may be the sticking point for many deals.  “[M]ultiples for middle-market transactions in general have fallen markedly, from a high of 10.1 times EBITDA (earnings before interest, taxes, depreciation, and amortization) in 2007 to 8.4 times EBITDA today, according to survey respondents. They may go still lower: 80% of respondents say they expect to pay no more than 5 times EBITDA for targets in the next six months.”

    Not surprisingly, most sellers will be reluctant to sell at prices reflecting just half the multiple they could have obtained only 36 months ago: “37% of survey respondents cite valuation problems as the biggest hurdle for deals right now.  ‘Sellers try to argue that you shouldn’t look at the current environment when valuing their company, that it’s just a bump in the road.  But buyers are reluctant to buy that argument,’ says [ACG Chairman Den] White.”

    What buyers will buy remains to be seen.  Stay tuned for a fascinating 2010.

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    The Stanford Saga – Chapter 13: Three Questions About Recognition

    Monday, December 14th, 2009

    An update regarding Peter Wastell and Nigel Hamilton-Smith’s dispute with federal Receiver Ralph Janvey over control of Stanford International Bank Ltd. (SIB)’s financial assets, and the 13th in a series on this blog covering the dissolution of Allen Stanford’s erstwhile financial empire and alleged international “Ponzi scheme” – a dissolution playing out in Montreal, London, and Dallas.

    Wastell and Hamilton-Smith, liquidators appointed by Antiguan regulators for the purpose of winding up SIB in Antigua, and Janvey – a federal Receiver appointed at the behest of the US Securities and Exchange Commission to oversee the dissolution of Stanford’s financial interests in connection with an enforcement proceeding in the US – have sought recognition of their respective efforts in courts outside their home jurisdictions.  Each has met with mixed results: Janvey’s request for recognition was denied in the UK, while Wastell and Hamilton-Smith, originally recognized in Canada, have been removed and replaced by a Canadian firm.  Each of these results has been appealed.

    Meanwhile, Wastell and Hamilton-Smith have sought recognition of the Antiguan wind-up in Janvey’s home court pursuant to Chapter 15 of the US Bankruptcy Code.  Initial briefing was submitted several months ago; supplemental filings (including copies of the decisions rendered in London and Montreal) have been trickling in.  US District Court Judge David Godbey has set an evidentiary hearing for mid-January 2010.

    Messr’s. Wastell and Hamilton-Smith’s supplemental brief, filed last week in Dallas, addresses three issues, apparently raised by Judge Godbey during a recent conference call with the parties:

    The Current State of Fifth Circuit Law on What Constitutes an Entity’s “Principal Place of Business,” Including Whether Stanford International Bank’s (“SIB”) Activities Were Active, Passive or “Far Flung.”

    The liquidators acknowledge that while Chapter 15 of the US Bankruptcy Code doesn’t refer to an entity’s “principal place of business” in dealing with a cross-border insolvency, many US courts nevertheless analogize an entity’s “principal place of business” to its “center of main interests” (COMI) for purposes of determining the forum that should host the “main case.”   The American approach is, according to the liquidators, similar to that followed by European courts.

    That said, what constitutes an entity’s “principal place of business” is not a settled question under US federal case law: The Fifth Circuit (where the Stanford matters are pending) applies a “total activity” test, which is also applied by the Sixth, Eighth, Tenth and Eleventh Circuits, whereas the Ninth Circuit applies a “place of operations” test, the Seventh Circuit applies a “nerve center” test, and the Third Circuit examines the corporation’s center of activity.  The liquidators suggest in a footnote that these “varying verbal formulas” are functional equivalents, and “generally amount to about the same thing” under nearly any given set of facts.

    A significant portion of the liquidators’ brief is devoted to applying the facts of SIB’s dissolution to the Fifth Circuit’s “verbal formula;” i.e., “(1) when considering a corporation whose operations are far-flung, the sole nerve center of that corporation is more significant in determining principal place of business, (2) when a corporation has its sole operation in one state and executive offices in another, the place of activity is regarded as more significant, but (3) when the activity of a corporation is passive and the ‘brain’ of that corporation is in another state, the situs of the corporation’s brain is given greater significance.”  See J.A. Olson Co. v. City of Winona, 818 F.2d 401, 411 (5th Cir. 1987).

    The liquidators argue:

    – SIB’s principal place of business was in Antigua;

    – SIB’s activities were neither “passive” nor “far flung” and thus the “nerve center” test should not predominate; but

    – even if SIB’s operations were passive or far flung (which they were not), its “nerve center” was in Antigua.

    The Relationship Between SIB and the Financial Advisors Who Marketed SIB’s CDs to Potential Investors.

    The liquidators are emphatic that financial advisors who marketed and sold SIB’s CD’s to potential investors were not, in fact, agents of SIB.  Rather, “they operated individually under management agreements with SIB, or were employed by other Stanford companies which had management agreements with SIB . . . .  These advisors worked for Stanford related entities all over the world, including Antigua, Aruba, Canada, Colombia, Ecuador, Mexico, Panama, Peru, Switzerland, and Venezuela, as well as in the United States . . . . All of the financial advisors marketed the CDs but none had authority to contract on behalf of SIB . . . . Further, Liquidators understand that the financial advisors sold other Stanford-related products besides SIB CDs.”  Those advisors who were located in the US ‘worked for an entity called the Stanford Group Companies (“SGC”), and though they marketed SIB CDs to potential depositors, they were not agents of SIB.'”

    Put succinctly, the liquidators’ argument is that an international network of independent sales agents does not create the sort of “agency” that would alter cross-border COMI analysis under US law: “[US] Courts analyzing similar circumstances have consistently held that a company’s COMI or its principal place of business is in the jurisdiction where its operations are conducted even if the company has sales representatives in other jurisdictions.”

    The “Single Business Enterprise” Concept as Part of the “Alter Ego” Theory of Imposing Liability.

     Finally, the liquidators argue that SIB is neither part of a “single business enterprise” nor an “alter ego” of other Stanford entities or of Stanford’s senior managers – and their respective “principal place[s] of business” in the US cannot be imputed to SIB for purposes of determining SIB’s COMI.  This is so, according to Messr’s. Wastell and Hamilton-Smith, because:

    – The doctrine of “single business enterprise” liability is a particular creature of Texas law – which, in addition to being inapplicable to an Antiguan-chartered international bank such as SIB, is itself no longer viable even in Texas.  See SSP Partners v. Gladstrong Invs. (USA) Corp., 275 S.W.3d 444, 456(Tex. 2008) (rejecting the theory because Texas law does not “support the imposition of one corporation’s obligations on another” as permitted by the theory); see also Acceptance Indemn. Ins. Co. v. Maltez, No. 08-20288, 2009 WL 2748201, at *5 (5th Cir. June 30, 2009) (unpublished) (recognizing the holding of Gladstrong).

    – The doctrine of “alter ego” does not apply because its primary use is to permit corporate creditors to “pierce the corporate veil” and seek recourse from the corporation’s parent or individual shareholders.  Here, the liquidators argue, Mr. Janvey is attempting to pierce the corporate veil in the opposite direction:  He is attempting to permit creditors of a corporate parent or individual principals to seek recourse from a distinct and separate foreign subsidiary.  Such “reverse veil piercing” is properly obtained (if at all) through the “extreme and unsual” remedy of substantive consolidation through bankruptcy.  However, liquidation of the Stanford entities through a federal bankruptcy proceeding is something Mr. Janvey has, to date, “studiously avoided.”

    – The equitable purposes of the “alter ego” doctrine would be frustrated in this case.  The “injustice” that “alter ego” relief is designed to reverse would, in fact, only be furthered where SIB investors would see their recoveries diluted by creditors of other Stanford entities.

    Mr. Janvey’s response is due December 17.

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    What’s It Worth?

    Monday, December 7th, 2009

    Prior to the economic downturn – when sales were rising and debt was cheap – many businesses found it convenient to spur further growth by taking on “second-tier” secured financing, or engaging in aggressive leveraged buy-outs (LBO’s).  With the recession and resulting steep drop-off in firm revenues worldwide, many of the same businesses (and LBO targets) found themselves over-leveraged and struggling to service their debt.  First priority lenders have responded to this distress by negotiating exclusively with their debtors for pre-arranged “restructuring” plans that, in effect, provide for the transfer of assets and repayment of the first-priority debt – but provide little, if anything, to “second-tier” lenders and other creditors.

    recent piece from Reuters discusses what junior creditors are doing about it.

    As illustrated in recent Chapter 11 cases such as Six Flags Inc., Pliant Corp., and Trump Entertainment Resorts, Inc., junior creditors are attempting to fight back with competing restructuring plans of their own – proposed plans that provide them with better returns, or with a meaningful equity stake in the reorganized debtor. 

    A review of the dockets in each of those cases indicates that these efforts have met with varying degrees of success.  The Reuters piece suggests three variables that can impact the success of this strategy:

    Valuation.   Arguably the most critical factor in supporting a plan that competes with one pre-negotiated with the first-priority creditors is evidence demonstrating that the debtor is, in fact, worth more than the first-priority creditors claim.  That demonstration can be challenging, particularly in light of today’s uncertain economy and pricier debt.  Even so, junior creditors are likely to argue credibly that a company whose revenues were historically strong should not be under-valued purely on the basis of weaker performance in a generally weaker economy.  Still other junior creditors seeking to preserve their original position may be willing to advance additional funds, thereby opening up a possible source of financing otherwise unavailable to the debtor.

    The Court.  Concerns such as docket management and the court’s philosophical disposition to maximize enterprise value or protect the position of junior creditors – or not – are factors that have real effect on the success of junior creditors’ bid to present a competing plan.

    Cost-Benefit.  Finally, the presence – or absence – of effective negotiation between the parties can impact the perceived benefit of a competing plan.  When everyone is talking and a plan can be effectively built, a successful outcome is more likely than a full-blown “plan fight” which weighs down the estate with administrative expense and can, if sufficiently large, even jeopardize the debtor’s successful post-confirmation operations.

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