Bankruptcy Round '09: Creditors Take The Gloves Off

No one ever called bankruptcy pretty, but when searching for an analogy for this cycle as compared to those of the past, Black Friday at the Macy's shoe department comes to mind.

Maybe that's a bit strong, as it hasn't come to actual blows-yet. However, this cycle of bankruptcies is not only shaping up to be especially large but also especially contentious, as senior secured and junior creditors battle for a piece of bankrupt companies' troubled pies.

While recovery disputes between creditors have been around as long as capital structures themselves, sources say lousy valuations and top-heavy capital structures have created an atmosphere more adversarial than in the past.

First, the severity of this recession has caused companies' values to decline substantially-both in reality and by way of perception-so when a valuation is done, the results come nowhere near what the company previously was worth. Imagine, again, the pie. A few years ago, the company was a nice, voluptuous apple pie. Now, because of a plunge in value, all that's left is half a pie, maybe even a cold, stiff half. Moreover, back in the day, companies divided their debt more equally, taking out secured revolvers and term loans, while issuing fairly equal amounts of bonds. But in more recent years, a shift has taken place, and term loans, in many cases, have become the majority chunk of the capital structure.

By definition, those senior-secured creditors have first dibs at recovering their money in the event of a bankruptcy. But companies heading into bankruptcy today have so much senior-secured debt, and given such low valuations, senior secured isn't so secure anymore. Maybe half a pie covers the top of the capital structure, maybe it doesn't. Either way, the junior creditors, the bondholders, may be left snatching at crumbs. Homebuilders and retailers are two sectors especially prone to this situation.

"If the senior secured debt is the only debt that's actually covered by the value of the company, then that class will probably take some of their securities in debt, the rest they'll take in equity, and everyone else below them will be wiped out," said Michael J. Reilly, a restructuring attorney with Bingham McCutchen. "When the value is low, there's less to go around. And therefore the junior classes are threatened even more today than they were before."

And they're not going away quietly, sources say. One option junior creditors have is to try and hold out for a higher valuation. They have their experts or their investment bank argue the company shouldn't be valued today under such pessimistic circumstances, that a valuation in, say, six months would produce a higher value. And a higher valuation could cover another tier of creditors.

"And there's some validity to say current valuations are impacted because of a lot of strange things that are unprecedented that are affecting the U.S. economy," said Jeffrey R. Manning, group head of special situations at Trenwith Securities. "They can argue, 'A normalized valuation in a normalized time would have meant we're still in the money. So, your honor, let's give this thing more time and valuations will improve and the estate will be better served because more people will gain something in the recovery.'"

However, waiting it out for a higher valuation isn't always in the best interests of the senior-secured lenders, or the company, and therein lies the conflict. As Reilly puts it, "Bankruptcy is a terrible place to be a competitor." The longer a bankruptcy drags out, in most cases, the harder it is on the company, so the question becomes: Can the company survive a protracted legal battle?

"Is the enterprise conserving cash or losing cash?" Manning said. "If the enterprise is able to conserve cash, then I think there's some stronger footing to go back to the judge and say, give us more time, we'll figure out a more equitable solution. If the enterprise is losing cash, and the senior lenders can say, 'Our DIP is at risk because the enterprise is losing cash,' then I think the junior creditors are in deep nougat."

In most cases, the parties tend to negotiate an agreement and settle, as this saves a lot of time, money and fighting, and most of these companies can't afford to live through a long battle. "In some places they're fighting it out, in some places they're trying to cut deals," Reilly said. "The tendency is usually to cut a deal, but the fights come if the expectations of the creditors are too far apart. Many times you have to fight for a while before they actually cut a deal. People have to see the reality."

In some cases, there may be no other option than a 363 sale transaction, a provision that allows a company to sell its assets, leaving the creditors to fight over the proceeds, said Rick Hyman, a bankruptcy and reorganization lawyer with Mayer Brown. "But more likely I think we'll see deals. Senior lenders will be required to make some concessions in order to get the consent of junior lien holders to do a transaction that arguably benefits everyone."

With more bankruptcies to come, however, we will likely see more conflicts.

"We maybe have our toe in the water at this point; it's going to get significantly worse before it gets better," Hyman said. "A lot of those LBO deals are coming due, they haven't triggered their covenants, but it's coming."

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