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      Insolvency News and Analysis - Week Ending November 21, 2014
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    Posts Tagged ‘Reuters’

    “Equality is Equity”

    Sunday, December 19th, 2010

    The distribution scheme embodied in federal bankruptcy law serves several important functions.  In Chapter 7, the detailed statutory distribution scheme imposes order on the chaos that might otherwise attend the liquidation of business assets.  In Chapter 11, the fixed order of priority claims and the “absolute priority rule” – along with the requirement that similarly situated classes receive identical treatment – provide predictability within the confirmation process and a framework for out-of-court negotiations.

    But not all resolutions of business insolvency afford this level of predictability.  In particular, state and federal receiverships afford the prospect of considerably greater flexibility and discretion on the part of the appointed receiver and the appointing court.

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    The scope of a receiver’s discretion was illustrated early this month by the 7th Circuit Court of Appeals’ approval of a federal receiver’s proposed pro rata distribution of the assets of six insolvent hedge funds.

    SEC v. Wealth Management LLC, — F.3d — 2010 WL 4862623 (7th Cir., Dec. 1, 2010) involved an SEC enforcement action against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud.  At the SEC’s request, the Wisconsin District Court appointed a receiver for Wealth Management and its six unregistered pooled investment funds.

    The receiver’s plan, approved by the District Court, was relatively straightforward:  All investors would be treated as equity holders, and would receive pro rata distributions of the over $102 million invested in the funds.  Two investors who had sought redemption of their investments pre-petition disagreed and appealed the receiver’s plan.  The essence of their argument was that Wisconsin law (and Delaware law, which governed several of the funds), required that investors who sought to redeem their investments be treated not as equity holders, but as creditors of the failed funds.  As a result, their redemption claims were of a higher priority than investors who had not sought to withdraw their funds.  The investors also relied on 28 USC § 959(b), which provides that receivers and trustees must “manage and operate” property under their control in conformity with state law.

    The 7th Circuit rejected this argument, finding instead that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that “equality is equity,” the court found that to give unpaid redemption requests the same priority as any other equity interest “promotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less.”

    The Wealth Management decision highlights the flexibility and ambiguity of the receivership system – itself a critical distinction from the well-defined priorities of federal bankruptcy law.  Though the 7th Circuit’s reasoning – rooted in “similarly situated claims” – is consistent with the policy objectives of the Bankruptcy Code, the result is diametrically opposed to the scheme of priorities on which Wealth Management’s investors undoubtedly relied.

    Wealth Management – like many receivership cases – is a case based on federal securities fraud.  But federal and state receiverships are applicable in a variety of contexts – including business dissolutions, directorship disputes, marital dissolutions, and judgment enforcement.  Where a proposed distribution to creditors can be fairly characterized as “equitable” under the circumstances of the case and where it represents a fair exercise of the receiver’s fiduciary duty on behalf of the receivership estate, the flexibility of a receivership may justify its typically high cost.

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    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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    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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    Distressed M&A: The Party Rolls On

    Saturday, July 18th, 2009

    A couple of earlier posts on this blog (here and here) have periodically discussed the state of bankruptcy-related mergers and acquisitions during this Chapter 11 cycle.  A post dated July 10 by Reuters’ Alexander Smith suggests that M&A activity – which has been brisk – continues unabated.  Smith notes:

    There were five bankruptcy-related M&A deals announced during the week [of July 6], including the acquisition of venture-backed public company Nanogen by French investment holding company Financiere Elitech for $25.7 million. So far this year there have been 173 bankruptcy-related deals, the highest level since the same period of 2004 when there were 202. During 2009 the most bankruptcy-related M&A deals have occurred in the industrials sector with 23 percent, followed by the media and entertainment sector with 16 percent. In terms of geography, U.S. targets represent 83 deals or 48 percent of the total of bankruptcy M&A. This is hardly surprising given the speed with which some of the biggest bankruptcies have happened in the U.S. – with a little help from section 363 easing rapid asset sales at GM and Chrysler.

    As noted in prior posts, this remains an excellent environment for purchasers with the cash, business vision, and/or creativity to make strategic acquisitions.

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