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Basics of Financial Investing – Part 7

Bankruptcy Investing

While U.S. government-guaranteed bonds and high-quality uninsured corporate bonds offer a substantial degree of risk protection, the trade-off is in the form of lower promised yields. At the other end of the spectrum are the bonds of companies that have already declared bankruptcy. Clearly, such bonds contain high levels of risk. Both the timing and amount of any recoveries on defaulted bonds are typically very uncertain. Accordingly, defaulted bonds need to be priced at levels that will offer relatively high potential returns if they are to attract enough investor interest to absorb the available supply. Assembling and managing a portfolio of such bonds constitutes one of a number of specialized areas of investing.

One may invest in bankruptcies by purchasing claims on a firm that has failed and filed for bankruptcy under either Chapter 7 (liquidation) or 11 (reorganization). Most such investing is in the defaulted bonds (secured, senior, or subordinated) of the debtor (the firm that declares bankruptcy).

Trading does, however, take place in other instruments including defaulted bank loans, trade claims, and damage claims as well as the common and preferred stock of the debtor. Investors in such instruments are generally betting that the market is more pessimistic on the recovery prospects for the failed firm than is warranted by the facts.

The History of Bankruptcy Investing

Early in the 1980s a few savvy investors appeared to have found a surefire way to make money. As large public companies started to reorganize successfully in Chapter 11 (the current revised Bankruptcy Code had become effective in 1979), many bankruptcy investors realized that one could hardly lose by purchasing the stock of a newly reorganized company emerging from Chapter 11. Why was this?

First, as of 1979, Chapter 11 became much more ‘‘user friendly’’ and popular. The Bankruptcy Code completely reworked the way large corporations rebuilt their capital structures. The old Chapter XI and the old Chapter X each had serious legal failings that tended to prevent either one from being utilized as an effective tool to correct the capital structure of a publicly held firm that failed. Liquidations that tended to recover relatively little value for the claimants were the usual result. Often, greater value can be preserved by reorganizing the bankrupt firm and thereby retaining its value as a going concern. These early bankruptcy investors realized that, to become viable, many firms simply needed a more realistic capital structure. Creating this more realistic structure usually meant that much or perhaps all of the recognized firm’s old debt was converted into equity and that its old equity was largely or totally wiped out. Such a shift in the capital structure allowed control to be transferred to the true economic owners (old debt-holders). A fundamentally strong business with too much debt could equitize its liabilities. Along with favorable tax treatments concerning net operating loss carry forwards (now severely limited), a great investment opportunity usually existed in the new balance sheet of the reorganized firm.

Second, most of the creditors who received the new post-reorganization stock were not traditional equity-holders. They were either trade vendors who were receiving stock in lieu of their trade claims, or bondholders who were receiving stock in lieu of their debt holdings. Only rarely did such creditors have any interest in becoming stockholders in the company that had defaulted on their debt. As might be expected, these former creditors promptly dumped their new shares in the reorganized debtor on to an unreceptive market. This rush for the exit caused a downward pressure that the successful bankruptcy investors spotted, jumped on, and rode up as the fortunes of the newly reorganized firm became apparent. Unfortunately, bankruptcy investing is no longer so simple.

Bankruptcy investing is just the latest iteration in the history of distressed debt investing. The process started with Revolutionary War bonds in the 1780s and continued into the following century with railroad bonds; next came the 1929 Crash, followed by substantial investment opportunity, the REITs, LBO junk bonds, and the FDIC crises of the eighties and nineties. The late 1990s brought us Japan’s difficulties and problems in the emerging markets. All of these situations presented bankruptcy investing opportunities. Today a number of trading desks have sophistication in the area. Among them are Cargill, CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley.

Where Are We Now?

Competition among distressed investors has become more and more intense. Not infrequently too many bankruptcy investors are chasing too few bankrupt situations. Prices tend to be bid up to full value or even higher. The prices of defaulted bonds are, however, often lower in the early, uncertain stages of a bankruptcy. Accordingly, a trend toward earlier investments in bankrupt companies has developed. This early investment in ongoing bankruptcy cases (when values are much less certain) has increased the risk of losses. It has also substantially increased demands on the savvy bankruptcy investor. Such an investor needs quickly to ascertain the likelihood of success or failure for the bankrupt firm, and accurately, in order to predict the consideration that will be received by each of the different classes of debt-holders as part of the plan of reorganization.

Those who wish to invest in the early stages of a bankruptcy need rapidly to ascertain the following: (1) the chances of the bankrupt firm’s success with its underlying business model and a realistic capital structure; and (2) an assessment of what that capital structure will be and how new value will flow to each of the current classes of creditors.

The first assessment is relatively straightforward. Would the firm be profitable if it had little or no debt to service? The second assessment requires not only a firm grasp of economics, but also of the political and legal processes that pervade the Chapter 11 process. Having defined the topic, I shall now offer a series of rules designed to assist one who would like to participate in the bankruptcy investing market.

Avoid the stocks of bankrupt companies. If you want to bet on a turnaround, buy their bonds (not their stock).

A company declares or is forced into bankruptcy because it is unable to pay its bills as they come due and/or because the monetary value of its liabilities is greater than that of its assets. Under bankruptcy law, creditors’ claims have priority over claims of shareholders’. According to the absolute priority of claims principle, all valid creditor claims are to be paid in full before the equity-holders receive anything. This principle is applied absolutely in Chapter 7 bankruptcy cases where the firm is liquidated. It also guides allocation of value in Chapter 11 cases where the firm is reorganized.

While saying ‘‘equity comes out last’’ seems trite, this maxim guides the process in terms of who gets what. Distributions trickle up from there. Some nominal payout to pre-petition equity is not uncommon. Generally, however, these holders will receive only a di minimus (5% or less of the stock in the company coming out of bankruptcy) interest in the reorganized debtor. This modest allocation may be assigned to the old (pre-bankruptcy filing) shareholders primarily in order to speed the reorganization process along. This departure from the absolute priority principle is only one of many legal variances that exist in the Chapter 11 process. That process involves a great deal of give-and-take and consensus-building designed to move the process along speedily. A bankrupt company almost always finds itself with an unmanageable debt burden. The face values of its outstanding liabilities substantially exceed the market value of its remaining assets. A firm whose assets could be sold for a greater amount than it owes to its creditors could probably have avoided a bankruptcy filing in the first place. Such a firm should be able to liquidate some of its assets and use the proceeds to reduce its debts by enough to regain its financial health. Alternatively, the firm could be sold as a unit. The proceeds could then be used first to pay off the creditors, with any excess being distributed to the shareholders.

Thus, firms that are forced to declare bankruptcy are almost always unable to raise enough money from asset sales to pay their creditors in full. As a result, once the bankrupt firm’s remaining value is distributed to satisfy (usually only partially) the creditors’ claim, nothing is likely to be left for the old shareholders. True, the company itself often survives, but usually in a slimmed-down form with a new, less debt-heavy capital structure. When the reorganized firm does survive and emerge from bankruptcy, it does so with new shareholders composed largely or exclusively of those who had been its creditors. Bondholders and other creditors end up owning most or all of the stock of the recognized company. Usually the distribution does not even fully cover the creditor claims, to say nothing of having something left over for the shareholders.

Unsophisticated investors may sometimes take a look at a bankrupt company whose stock had traded at, say, $80 a share, and was now down to $0.25, and say to themselves, ‘‘How much lower can it go? If only it went up to fifty cents, I would double my money.’’ They reason that the company, although bankrupt, is likely to survive, and if it does, certainly the business will retain some value. These under-informed investors don’t realize that most if not all of that value will be distributed to the creditors. Unfortunately for these newly minted shareholders, the price of this bankrupt company’s stock is far more likely to go to zero than to double. For some research on this question, see "Penny Stocks of Bankrupt Firms, Are They Really a Bargain", by Ben Branch and Philip Russel in Business Quest, 2001. This Branch/Russel study found that the vast majority of bankrupt companies’ stocks either became worthless (93 out of 154) or declined in value (44 out of 154) over the course of the bankruptcy proceeding. Less than 10 percent (14 of 154) gained value. For every dollar invested in a bankrupt company’s stock, the investors recovered an average of 30¢ and lost 70¢. Even lottery tickets have a higher payout (around 50%).

While the stock of bankrupt companies is rarely an attractive investment, the bonds of such companies may be. Whatever value of the bankrupt company that remains tends to be awarded to the creditors (after the lawyers and the tax collectors get their pound of flesh). The question then becomes: How much value is left relative to the price that the market is putting on the debt? Any generalizations here are uncertain at best. This much, however, seems safe to say: The bonds of bankrupt companies are much more likely to emerge from the bankruptcy proceeding with some value than are the stocks. Indeed, most of the time, the bonds of a bankrupt firm will produce a higher percentage return (with a lot less risk) than does the stock. The bonds of bankrupt companies may or may not be an attractive investment, but they are almost always a better investment than the bankrupt company’s stock. If you want to bet on the turnaround of a company that has declared bankruptcy, you should buy its bonds, not its stock. Normally, high-risk investments tend to produce high returns. The performance of the stocks of bankrupt companies is an exception to this general tendency. By no means do all high-risk investments pay off, even on the average.

In this regard, many sophisticated vulture investors like to assemble a hedge position involving a combination short position in the stock of a troubled (but not yet bankrupt) company coupled with a long position in its bonds. If the company does continue downhill, the price of its stock is likely to drop by a much larger percentage than do its bonds. Indeed, the stock’s market price may decline to zero while the bonds retain substantial value. If the company somehow stays out of bankruptcy, the bonds will eventually pay off (pay all principal and interest as due) while the stock may or may not do as well. An investment based on a careful computation of the related values can, in some cases, produce what approaches a win/win investment when pricing anomalies appear. That is, on occasion the bonds’ price may rise while the bankrupt company’s stock price declines all the way to zero. Thus both parts of the hedged position show a profit.

Understand the absolute priority of claims principle and how it applies.

Under the so-called absolute priority rule in bankruptcy, the assets of the debtor are liquidated and the senior-most claims are to be paid in full (if possible). What is left after the senior creditors are paid goes to the next level of claimants under the inter-creditor pecking order. This process continues from the top of the capital structure down through the various levels of priority until the bankrupt estate’s funds are exhausted. The claimant class on the bubble is paid pro rata. Nothing is distributed to the lower classes of claimants unless the higher class is paid in full. This principle applies almost absolutely in Chapter 7 cases. Chapter 7 cases, one of two types of bankruptcy cases, are liquidations with an independent trustee selected to manage the liquidation. Once all the assets are sold, the proceeds are distributed to the claimants in the form of cash.

Order of Priority in Bankruptcy

  1. Priority and Administrative Claims: Taxes, legal and accounting fees, debtor in possession (DIP) financing, back wages, trustee fees (separate priorities attach to each of these categories, but in most cases they are all paid in full in cash)
  2. Secured Claims: Up to the value of the collateral, then the remainder if any, becomes a senior claim
  3. Senior Unsecured Claims: Relative to any subordinated claim
  4. General Claims: Such as those of trade creditors (on the same level as senior claims, but are not senior to subordinated claims)
  5. Subordinated Claims: Relative to any senior claim; may have several layers
  6. Preferred Shareholder Claims: Rarely does the distribution reach this level
  7. Common Shareholder Claims: Payout here is even rarer

In Chapter 11 cases, absolute priority, while the law, is only a guide in practice. Under the so-called best interest of creditors test, each creditor class must be allocated at least as much value as the class would receive in a liquidation. In a successful Chapter 11 reorganization, the firm’s assets are not sold off and thereby reduced to cash. The firm is considered to be worth more as a going concern than it would be through the sale of its assets. This failure to reduce the bankrupt firms’ value to cash opens a Pandora’s box in regard to who gets how much of a distribution. The value of a cash distribution is easy to evaluate: Cash is cash. But the value of a package of to-be-issued securities (especially equity securities) in a reorganized firm coming out of bankruptcy is not so easy to place a value on. When a bankrupt firm is reorganized, a set of securities (debt and equity) reflecting claims on the company emerging from bankruptcy are distributed to the claimants. These securities have not yet been priced by the market. Accordingly, estimating their value is an uncertain process. How much stock (or other securities) of undetermined market value needs to be distributed to a given class of creditors to satisfy their claims cannot be established until the new stock begins to trade. That trading usually does not begin until the securities are distributed and the reorganized firm emerges from bankruptcy.

Often the market value assumptions made in the court-approved plan of reorganization turn out to be very wide of the mark. A low estimate for the total value for the reorganized firm can create a substantial investment opportunity for the savvy bankruptcy investor. Such an investor will realize that the post-reorganization securities to be distributed to the claimants are based on an assumption that the reorganized debtor is valued at much less than it actually turns out to be worth. How could such a mis-valuation occur? Bankruptcy cases are, by their nature, a very political process, with lawyers representing several distinct groups of claimants. Each of these creditor groups has an agenda. In many reorganization cases, the more senior classes of debt-holders will seek to persuade the court to adopt a relatively low valuation for the bankrupt company. If the seniors’ efforts are successful, such an undervaluation is likely to result in little or no distribution to the junior classes of debt (e.g., subordinated bondholders). The senior bondholders will thereby capture a greater percentage of the reorganized firm’s value than they would be entitled to under a more realistic valuation. The junior bondholders will, on their part, seek to establish a higher valuation and, if successful, capture a larger share of the reorganized firm’s value than they would if the estimated value was lower.

How are these valuation estimates generated? The bankruptcy court must approve the plan of reorganization if it is to go forward. As part of its approval process, the court must make a factual determination regarding valuations. The goal of this process is supposed to be to establish a fair benchmark valuation estimate for the enterprise. If, for example, the reorganized firm is estimated to be worth $100,000,000 coming out of bankruptcy and it issues 10,000,000 shares (and has no debt), the plan can treat each share as being worth $10. Under these circumstances, a claim of $100,000 could be satisfied in full with an award of 10,000 shares. If, however, the enterprise was estimated to be worth only $50,000,000 and issued 10,000,000 shares, each share would be projected to have a value of $5. Twice as many $5 shares would be required to provide a full recovery on a $100,000 claim as would he needed if the share value was projected to be $10. Establishing an estimated valuation for the company is a fact question with dueling experts on valuation issues. By the time a case is set for reorganization, adequate data are generally available in the marketplace to make an intelligent determination. Sometimes, however, the results have been skewed during the reorganization process. All of these situations create investment opportunities.

Successful bankruptcy investing requires a better than average knowledge of valuation techniques and legal niceties. Valuation’s interaction with bankruptcy law is the often major driver in Chapter 11 cases. These subjects can be mastered by an individual investor, but the initial time and the cost in the form of investment losses that it takes to ‘‘spool up’’ helps explain why bankruptcy investing has historically been the province of institutional investors. Moreover, the creation of bankruptcy investing opportunities is a very uneven process. When the economy is strong, few firms fail. When it is weak, many do. As a result, expertise in bankruptcy investing is a skill in high demand in some market environments, but not so high in others.

Be mindful of the political nature of the Chapter 11 process. Invest accordingly.

Drafting a reorganization plan and obtaining approval from the creditors and court always requires some give-and-take by the parties. Whatever reorganization plan emerges from the Chapter 11 process reflects the interplay of a group of varied parties’ interests. The process is inherently political. The relevant players to this process include:

The Bankruptcy Judge: He or she alone among the various participants does not have a financial interest in the outcome. The judge does, however, play a very important role in deciding how much latitude to give to the debtor relative to the creditor, and how fast to push the process along.

The Debtor: The pre-bankruptcy managers of the now-bankrupt firm often remain in place through the bankruptcy/reorganization and, possibly, once it emerges from bankruptcy. In many cases, new management will eventually be brought in. Whether under new or old management, the debtor will have a lot to say about any reorganization plan as well as what is done with the firm’s assets during the period in bankruptcy. At least for the first 180 days (and this period of exclusivity may be, and often is, extended), only the debtor can propose a reorganization plan. That plan is, however, subject to creditor approval. Each class of creditors must vote by majority of number and two-thirds of dollar value to approve the plan. For a reorganization plan to be implemented, the senior creditors must give their approval. If junior creditors reject the plan, the bankruptcy court may, nonetheless, approve it over their objections (cramdown).

The debtor’s managers will be interested in preserving their jobs, protecting their reputations, and avoiding being targets of lawsuits from angry claimants. They will want to assist in the process of assembling a viable enterprise to emerge from bankruptcy, and they will want to pursue and/or create value for the claimants. The more selfish objective of protecting their own financial position is, however, likely to play an important role in their decisions. Often in an attempt to preserve some value for their own equity holdings (stock) and jobs, they have waited for too long to file Chapter 11. They may well have chosen to ignore advice and facts that clearly demonstrated their need to seek court protection. By the time they are forced to file, a great deal of the enterprise’s value is likely to have eroded away. At least some of that value might have been preserved by court protection, had the firm filed bankruptcy sooner.

The creditors, as a group, are focused almost exclusively on maximizing the recovery value of their investment. Creditors, however, are not a homogeneous group. They are often divided into several separate categories with differing priorities and interests. Specifically:

  • DIP (Debtor in Possession) financing lenders head up this group as secured claimants who are usually paid before any value goes to pre-bankruptcy filing claimants.
  • Tax claims filed by IRS, state, and local governments have high priority. These claims are usually paid off in cash even when the debtor reorganizes in a Chapter 11.
  • Administrative claims from lawyers and other professionals are also a priority and paid in cash.
  • The claims of the Pension Benefit Guaranty Corporation (PBGC) are also high-priority and usually satisfied with cash.
  • Bank lenders will generally have secured claims. As such, they are in a strong position to maximize their recovery.
  • Bondholders may have secured, but more typically, have either senior unsecured or subordinated claims. The larger bondholders, who may be either senior or subordinated claimants, generally pursue a reorganization plan structure that will enhance their recovery.
  • Trade creditors round out the list of major constituents in most cases. If represented by a union, the employee claimants may also have an important voice.

Each of the above-mentioned creditor groups has its own agenda and separate interests. A reorganization plan allocates differing amounts of value to different categories of creditors. Accordingly, the creditor classes act together to maximize the size of the pie but are often in conflict over how to divide it up.

Understanding how these creditor groups interrelate is an important key to any successful bankruptcy investing program. One useful way to grasp how these cases sort out is to study some of the reorganization plans for major Chapter 11s. Copies of these plans are available online at the websites of many of the bankruptcy courts around the country. You will need to obtain an ID number from the court in order to access the website, but this is free and easy to do.

After reading a few reorganization plans, take a look at several of the official disclosure statements that accompany the plans. Reading these plans and disclosure statements should provide you with a feel for how the process works.

Much of the conflict in the reorganization process involves estimating the value of the emerging firm.

Placing a fair and realistic value on the reorganized firm and its securities as it emerges from bankruptcy is an inherently uncertain and often contentious process. To estimate the enterprise’s value properly, you need to project the emerging firm’s income and growth potential as well as the risks attached thereto. Then you need to allocate the firm’s estimated value onto the securities (debt, equity) to be issued and distributed to the claimants. Only then will you be able to place a meaningful value on the package of securities scheduled to be distributed to the various claimants.

Estimated values can be derived from an analysis of cash flows, industry comparables, market multiples, and liquidation values. In addition, a quick assessment needs to be made concerning the secured creditors’ rights in bankruptcy. This assessment will require a horseback analysis of the off balance sheet liabilities, the collateral values, and the liquidation priorities as well as the practicalities of enforcing the rights of the secured creditors. For example, how would you foreclose on a satellite? An assessment also needs to be made of what guarantees might be outstanding. How strong are the guarantees? How creditworthy is the guarantor?

Different groups of claimants have differing interests in determining how large or small an estimated value is to be placed on the reorganized firm. By its very nature a bankruptcy filing results when an enterprise’s value is expected to be less than its creditors’ claims. Reorganizing a firm that has had to file for bankruptcy rarely changes the reality that creditor claims exceed the enterpriser’s value. In other words, in a bankruptcy the value available to satisfy the creditors’ claims is almost always too small to pay off those claims in full. Indeed, the cost of the bankruptcy process itself (legal and other professional fees, lost business due to disruptions, etc.) is likely to reduce the firm’s value further. At least some (and perhaps all) of the bankrupt firm’s creditors are very likely to suffer losses. Each group understands that the estimated value of the reorganized enterprise, whatever it may be, will be used for the purpose of determining how the reorganized firm’s value is to be distributed to the various categories of claimants. The percentage of value allocated to the more senior creditors varies inversely with the emerging firm’s projected value relative to the size of their claim.

Suppose, for example, that senior creditors have claims of $40 million, and the reorganized firm is estimated to be worth $50 million when it comes out of bankruptcy (assume that it has paid all its administrative and priority claims before coming out). The senior claims are satisfied first and then junior claimants are assigned what is left. With these numbers, the senior creditors might be awarded about 80 percent of the firm’s value ($40/$50 = 80%). A distribution of this amount to the seniors would leave 20 percent of the firm’s value for the more junior claimants. If, in contrast, the reorganized firm is estimated to be worth $60 million, the seniors’ share would fall to about 67 percent ($40/$60 =67%) and the juniors’ would rise to about 33 percent. Frequently the valuation process is sufficiently uncertain that one could reasonably estimate the value of an emerging company at $50 million or $60 million. At the point in time when the court is determining whether to accept an estimated value for the firm of $50 million, $60 million, or some other amount, the security market has not had an opportunity to establish a true market price through the interplay of supply and demand. The market-determined valuations will not emerge until after the reorganized firm comes out of bankruptcy and its securities start trading. By that time, however, the firm’s securities will already have been distributed to the claimants. Clearly, the value estimate that the court accepts and uses in the reorganization plan will play a large role in determining how much of the total pie goes to each class of claimants.

Sometimes these valuation issues are settled within the creditor’s committee. At other times the judge must sort things out. Frequently the junior and senior creditors will each hire their own separate experts to argue for their preferred valuation estimates. Because value estimates involve substantial subjectivity, different experts can come up with and seek to justify the accuracy of very different numbers.

Learn the identities and agendas of the players in a bankruptcy.

Event dynamics are an important part of assessing bankruptcy investment opportunities. Timing is crucial. An investment will normally require an evaluation of such matters as which creditors hold strategic blocking positions in terms of voting rights and what unresolved regulatory issues might be outstanding.

Successful bankruptcy investing often involves playing the angles for maximum advantage. Given the political nature of the process coupled with all the other uncertainties, the value to be distributed to any particular claimant class will depend greatly upon how things develop over time. Knowing who the players are and how they are motivated can be very helpful information to be used in analyzing how the reorganization plan will be constructed and how fast it will proceed. Pursuant to this issue, consider the following list of players and their agendas.

The Judge and Court

Does the bankruptcy court judge have a reputation for being debtor-friendly? Such an orientation would not be favorable to the creditors. A debtor-friendly judge is likely to allow the bankrupt firm’s managers a substantial amount of latitude. The use of that latitude may lead to the dissipation of a significant amount of the firm’s assets. Recall that the debtors’ and creditors’ interests are not necessarily aligned.

Does the court have a crowded docket and does the judge have a reputation for moving slowly? The time spent in bankruptcy is costly. The slower the process, the worse things are for the creditors. The expenses incurred in the form of professional fees tend to increase with the length of time the case takes. If more time is available, more tasks will be undertaken and more fees will be charged. Furthermore, the sooner creditors receive their recovery, the greater its value to them.

Are banks major participants? If so, their presence in this case could be either favorable or unfavorable for the other (e.g., bondholder) creditors. Banks are usually experienced and motivated to get the job done. They will push to recover as much of their money as they can, but they are usually realistic about what is possible. Most banks have a good sense of when to cut their losses and move on. If banks are creditors in the case, their presence will be felt by the other creditors. Usually, banks will hold senior secured claims, which gives them considerable leverage in the bankruptcy process.

Are institutional investors major players? Mutual funds, insurance companies, and other institutional investors are also experienced and motivated much like the banks. Having them on the creditors’ committee is usually a plus, particularly if your claims are para pasu (at the same priority level) with theirs.

Vulture investors are also usually well equipped to navigate the ins and outs of bankruptcy proceedings. They do, however, come in a variety of flavors. Often, the vultures represent themselves in the process. Some vultures (with their own money at stake) are not at all afraid to play a game of chicken, skunk at the picnic, or monkey with a gun (see below) in an attempt to improve their recovery for themselves. They may have purchased a position for pennies on the dollar. As such many believe that they have little to lose by being very aggressive. Accordingly, they may sometimes appear to act irrationally and hold out for unreasonable recoveries.

All of these games involve the risk that the game-playing can have an adverse impact on everyone involved in the case. The larger the positions of the ones playing the game, the greater the risk.

The bankrupt firm’s mid and lower-level employees (past and present) tend to have the court’s ear, especially when they are represented by a union. Their claims are frequently disputed as they may relate back to written or verbal contracts and understandings that can be subject to varying interpretations. The equities of the situation often incline the court to be sympathetic to the firm’s employees. Through no fault of their own, these current or former employees have already lost a great deal (perhaps their jobs, money in their 401Ks, etc.) as a result of the bankruptcy. Higher-level employees and former employees whose actions may have played a role in the firm’s failure are likely to appear less sympathetic to the judge.

Government agencies such as the PBGC, IRS, FDIC (Pension Benefit Guaranty Corporation, Internal Revenue Service, Federal Deposit Insurance Corporation) are often claimants in bankruptcy cases. Unless they appear too arrogant, the courts tend to give careful consideration and some degree of deference to these fellow government employees who represent such agencies.

Games Played by Aggressive Creditors

Chicken: Two groups of creditors threaten each other (e.g., banks versus bondholders) with legal action (e.g., convert a Chapter 11 case to Chapter 7, or oppose the proposed reorganization plan) unless it is structured in a way that is more favorable to their position. Each side threatens action until one side blinks or the threats are carried out by both sides.

Skunk at the Picnic: One particularly aggressive claimant refuses to go along with the deal worked out by all of the other creditor groups unless he or she is given some sort of special consideration.

Monkey with a Gun: One aggressive claimant convinces (or attempts to convince) the other parties to the negotiation that he or she is so irrational that unless they go along with his or her demands, the aggressive claimant is likely to do something that is destructive to everyone’s interest.

Companies find themselves forced into bankruptcy for a variety of reasons. Understanding the history and underlying causes of the company’s insolvency and descent into bankruptcy can be quite helpful in assessing the chances for a successful investment. For example, the asbestos liability cases and the Texaco situations are totally different from the excessive leverage situations like Federated Department Stores, Macy’s, and the like. Firms with deteriorating operations have fundamental problems that tend to be very difficult to address:

Boston Chicken and Fruit of the Loom are examples. Going through Chapter 11 bankruptcy and coming out as a reorganized enterprise cannot by itself cure a basic problem with the emerging company’s business plan.

The most straightforward bankruptcy cases to analyze are those in which a basically healthy company is leveraged to the point where it cannot service its debt. Such a situation is relatively easy to fix by simply reducing the over-leveraged firm’s debt level. Similarly, a company that has been hit with a raft of damage claims (e.g., asbestos) but is otherwise healthy can generally be repaired by isolating the claims and assigning a portion of the firm’s value to the claimants. Situations in which the firm itself has deep-seated fundamental difficulties (e.g., obsolete technology) are much more problematic. For example, some firms may be operating in declining industries (video rental) or facing serious foreign competition (steel, textiles). No amount of capital restructuring is likely to deal effectively with their long-term problems. In the middle are those firms that have a basically viable business, but have been poorly managed. New management may or may not succeed in overcoming the problems. Clearly, one needs to assess the underlying causes for the bankruptcy.

Some problems are relatively easy to deal with. Others are more difficult, and still others are essentially impossible to repair.

Obtain copies of and analyze the pre-bankruptcy filing financials and the schedules filed in the bankruptcy case. But do not accept these numbers at their face values.

Firms that file for bankruptcy have generally been fighting a losing battle for months (or in some cases years). During the course of that battle, they have almost always been trying to put a positive spin on a negative reality. Whatever financial numbers were released in their public reports (quarterly and annual) prior to the bankruptcy filing are almost certain to reflect much wishful thinking, if not outright fraud. Don’t ever make the mistake of relying on the values contained in those statements. The firm has been resisting recognizing and reporting realistic accounts of underlying values in an attempt to avoid, or at least to put off, the inevitable. Basic maintenance has been deferred to conserve cash. Some assets have been sold at fire sale prices in order to raise more cash. The company has continued to bleed profusely as it moved from the last pre-filing reporting date to the point of a bankruptcy filing. Thus, the company’s true financial picture is almost always worse than the numbers shown in the last financial report that it filed before the company went into bankruptcy.

Table 1.1 contains some examples of defaulted bonds and their Chapter 11 prices at inception, their prices on emergence, and the number of months that it took them to emerge.

TABLE 1.1. Selected Bond Recoveries in Chapter 11

Debtor Percent of Par Price on Filing Year Percent of Par Price on Reorganization Number of Months in Chapter 11
Carter Hawley Hale 17.9% 1991 39% 15
Federated Dept. Stores 51% 1990 98% 24
Flagstar Corp. (Denny’s) 98.5% 1997 110.7% 8
Public Service of New Hampshire 30.4% 1988 99.1% 28
Southland Corp (7-Eleven) 38% 1990 91.5% 3
USG Corp. 67% 1993 93% 27

These recoveries are not representative. Over half of the companies that file for bankruptcy yield lower recoveries than their market value levels just before (but not just after) they went into Chapter 11. These statistical data do, however, provide support for the theory that the flow of information is inefficient. Moreover, the bankruptcy process is itself almost certain to be quite costly. The lawyers and other professionals (accountants, actuaries, appraisers, auctioneers, brokers, investment bankers, etc.) all charge fees of hundreds of dollars an hour for their services. They can quickly rack up many billable hours. Furthermore, the ongoing businesses tend to lose value throughout the bankruptcy process as customers and key employees fall away. Thus any attempt to place a value on the business should place a high discount on the numbers in its pre-filing financials.

Intangible assets reported on the bankrupt firm’s balance sheet usually have little or no actual value.

In evaluating the potential to recover value from a bankrupt enterprise, one place to start is with the firm’s last pre-bankruptcy balance sheet. That balance sheet will contain a number of different categories. One category of assets that should generally be assigned very little value is the now bankrupt firm’s intangible assets. Assets on the balance sheet such as goodwill, franchise value, deferred tax credits, and so on may have some value to a healthy, going concern. They have little or no value in a liquidation and may have relatively little value in a reorganization.

The point is particularly relevant in the post-2000 era, when many of the more recent bankruptcies are of high-tech, dot-com, telecom-type enterprises. In a bankruptcy situation, ‘‘assets’’ such as software under development, fiber-optic cable rights, domain names, and the like tend to have much less value relative to their cost than do hard assets such as those made of bricks and mortar.

Notwithstanding all of the above, the market often undervalues distressed and default securities.

The securities market hates uncertainty. And yet the outcome from a bankruptcy proceeding is full of uncertainties. As a result, the bonds of bankrupt and near-bankrupt firms are usually very depressed and frequently even more depressed than the situation warrants.

Each bankruptcy situation is different. An uninformed, random investment in defaulted securities is likely to produce uneven results. On the other hand, one who carefully analyzes the available information for distressed and defaulted securities and then assembles a well-diversified portfolio of those securities that the investor’s analysis suggests are undervalued may thereby achieve an attractive return.

Do not overlook potential causes of action as possible sources of recovery.

Sometimes much of the potential recovery for the bankrupt firm’s creditors can be derived from its causes of action. Causes of action are fact patterns that may give rise to a claim for damages from the cause of action’s owner. The bankrupt firm may be able to pursue various types of claims against former officers and directors, auditors, and other professionals and related firms, those who did business with the debtor shortly before it failed. If the pursuit of these claims is successful, they may result in substantial recoveries for the bankrupt estate and its creditors.

One category of such claims involves what are called fraudulent conveyances. A fraudulent conveyance is a transaction that has the effect of ‘‘hindering, delaying or defrauding’’ the collection of the debts by the debtor’s creditors. Suppose the debtor and a third party entered into a transaction that was detrimental to the debtor at a time when the debtor was insolvent. If substantial value that would otherwise have been available to the debtor’s creditors was dissipated, the transaction would constitute a fraudulent conveyance. The debtor would be entitled to avoid (reverse) that transaction and thereby recover the amount of value that was lost. If, for example, a debtor sold a subsidiary to a third party at a price well below its true market value at a time when the debtor was already insolvent, the debtor would be entitled to recover the lost value from the buyer.

Preferences constitute a second category of claims that are frequently a source of recoveries for the bankrupt estate and its creditors. Preferences may arise when the debtor repays some of its debts shortly before it files for bankruptcy. Suppose that just prior to the bankruptcy filing, the debtors paid off one or a few of its debts to a favored creditor or group of creditors. Such a pre-filing payoff would be made at the expense of the other creditors’ interests. The favored creditor gets paid in full while the others are left to collect (usually only partially) from a depleted estate. Any creditor that was preferred in this way is said to have received a preference. If, for example, the manager of a firm that was about to declare bankruptcy paid off its debts to a few favored creditors just before the debtor filed for bankruptcy, these payments would be subject to a preference action. The recipient of the preference may be required to repay the payment money to the bankrupt estate. Once the preference money was repaid, the creditor would get in line for recovery with the other creditors. Usually, the bankrupt estate’s recoveries from preferences are modest. Various types of misbehavior by the former managers or directors, including gross negligence, fraud, or acting to the firm’s detriment because of a conflict of interest, give rise to a third category of claims. Similar issues can arise with professionals (e.g., auditors). Often the true defendant in those matters is the insurance company providing coverage. They are the ones who will pay the claim up to the limits of coverage.

A dollar in the form of a claim is almost always worth substantially less than a dollar of cash (a bird in the hand versus a bird in the bush). Recoveries on claims require success in a variety of areas, not the least of which is collectibility. Winning a judgment may be only the first step in the recovery process. Moreover, the cost of pursuing claims is often substantial. If the recovery effort is unsuccessful, the distribution pot will be further diluted by the costs of the effort. Still, these types of potential recoveries should not be overlooked. Sometimes such claims are the only potential upside value that remains in the bankrupt estate. Also, be aware that the anticipated litigation costs of pursuing certain claims may be so large as to prevent such claims from being pursued.

The market for distressed and defaulted securities is volatile. Don’t invest unless you can tolerate its fluctuations.

The supply of distressed and defaulted securities depends upon the misfortunes of the issuing companies. The more companies that fail, the more defaulted securities enter the market. Such calamities depend, to a large degree, upon the state of the economy. When the economy is strong and the securities market robust, relatively few companies get into trouble and rather little new product is created. At such times, those investors who specialize in distressed and defaulted debt instruments are all seeking to acquire similar resources. Too much money is chasing too little product. Such an imbalance can lead to inflated prices for distressed and defaulted securities.

At other times, the market is overwhelmed with supply. In the early 2000s, many companies found themselves in financial difficulty first because of an unsustainable boom that allowed half-baked ideas to raise money for ventures destined to fail and then because the unsustainable boom turned into a recession. Many of these companies had relied on the capital markets to provide them with an endless supply of cash. When the market turned off the spigot, they had nowhere else to turn. They failed in droves. The bond market was soon flooded with distressed and defaulted products. Such down cycles never last forever. Eventually the economy began to recover and the supply of problem debt securities started to decline.

The demand for distressed and defaulted debt instruments rarely keeps pace with the fluctuations in supply. A hardy band of vulture investors stays in the market through thick and thin. Others come and go as circumstances change. The variations in demand are, however, small compared to the volatility of supply. When new supply overwhelms the demand from those who like to participate in this market, the new product tends to remain in the hands of others, particularly its original owners. That is, the holders of investment-grade and high-yield debt instruments find that their portfolios are accumulating an unwanted percentage of downgraded-to-distressed-and-defaulted-level debt instruments. Banks experience a similar phenomenon with their distressed and defaulted loans. Some of these investors hold on to the downgraded paper and try to salvage what they can. Many others try to sell their holdings into an unreceptive market. A very depressed market for distressed and defaulted debt securities is the result. A large supply of such debt instruments may create an attractive opportunity to buy, but not such a great time for those who are already holding a portfolio full of such investments. If you can hold your positions long enough for a turnaround to occur, you may have found your market. If you need the cash, you may well be in serious trouble.

Many holders of bankrupt companies’ indebtedness become distressed and defaulted debt-holders by default. A number of these investors have no choice in the matter. They cannot hold for security. They must sell. For example, many banks and insurance companies are forced by pre-established loan ratios and capital reserves to unload any debt holdings that they have in a bankrupt firm. Likewise, certain pension funds and managed accounts are prohibited by their charter from holding any bankrupt indebtedness. Similarly, high-yield mutual funds simply can’t tolerate the elimination of the high-yield coupon and must unload. They need to redeploy their funds into earning assets. Non–investment grade bank lending quadrupled from $150 billion in 1993 to $626 billion in 1999. This growth continued into the 2000s. High-yield bond issues tripled to $650 billion in the seven years preceding 1999. By the end of 2004 the total had risen to $952 billion. The May 2005 downgrading of GM and Ford added $450 billion to the total. Starting in 1999, the default rates on high-yield bonds also tripled. Post-2000, telecom, energy, and airlines lead the list of distressed debt opportunities. As more and more bonds default, more and more bankruptcy-investing opportunities await. Rest assured that while the rate of bankruptcy filings will ebb and flow (indeed, default rates fell to a very low level in 2004–5), bankruptcies and bankrupt securities will always be with us.


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