Introduction
While bank lenders and bondholders generally represent the largest portion of debtor’s pre- petition claims, upon filing there is a large constituency of other creditors who also possess claims against the debtor at various levels of priority within the capital structure. Because the sale, assignment and transfer of ownership of these claims are not considered securities, securities trading laws do not apply. The lack of uniformity and active market for these claims makes the instruments less liquid and transparent, thereby providing an opportunity for outsize returns for those willing to perform the necessary due diligence and shoulder the liquidity risk. Vendor claims generally trade at a 10-20% discount to other wise pari passu securities and therefore present a potential arbitrage opportunity for investors. The typical vendor does not wish, or may not be financially able, to wait months or possibly years to receive his money and is usually sufficiently motivated to sell his claim at a discount. A distressed investors may also purchase trade claims as a way to obtain strategic advantage in a restructuring. By gaining control of a larger share of a company’s General Unsecured Claims (“GUCs”), a sophisticated distressed investor can gain leverage to influence negotiations with the Debtor and other Creditors. By purchasing trade claims at a discount to the unsecured debt he already owns, the investor also lowers the effective cost basis of his investment (assuming trade and bonds will receive the same consideration in the reorganization). In addition, if the claims pool is large enough an investor can set up a capital structure arbitrage trade by going long a trade claim and short pari passu unsecured bonds of the same company. In structuring such a trade, one must ensure that the bond and the claim are at the same entity and that the bond does not have any guarantees or claims on subsidiaries that might make it more valuable. For instance in the case of Nortel Networks, their North American bonds issued at Nortel Networks Inc (“NNI”) had guarantees from their Canadian parent which the trade claims of NNI did not. Thus, one had to segregate the value of the North American and Canadian operations to determine the value of an NNI claim. Fortunately in this case there were bonds issued at the Canadian parent Nortel Networks Corp (“NNC”) that did not have recourse to NNI, so one could subtract the value of an NNC bond from an NNI bond to find the implied value of an NNI claim. Many times this is not the case and one needs to try and apportion the value using information available in the company’s financial statements. If the company has subsidiaries that are not guarantors of its debt then it will segregate the financials of the guarantor and non-guarantor subs. Also, one may look to segment reporting of revenue and EBITDA and attempt estimate how much value may be attributable to the various entities. In a scenario where the investor faces a great deal of uncertainty over valuation and how it will be attributed amongst various entities, he must bid an appropriate discount to compensate for the risk. Types of Claims A “Claim” is a right to payment, whether that right is fixed, liquidated, potential or contingent (i.e., based on the outcome of litigation). Claims can fall into different categories: priority, secured, unsecured, contingent, liquidated, disputed or matured. The most common claim to arise out of a bankruptcy filing is a vendor claim or trade claim as they are more commonly known. These claims arise due to the fact that a company’s suppliers ship goods on credit ranging anywhere from 30-90 days. When a company files for bankruptcy it likely to be in arrears on its accounts payable, this increases the amount of debt on its balance sheet (AP), thereby increasing the tradeable instruments in the debtor’s obligations. While trade claims are the most common, there several other types of claims that arise from a bankruptcy filing which provide potential investment opportunities. These include:
Proof of Claim In order for the Creditor’s claim to be paid he must file a Proof of Claim (“POC”) with the court. This is done by filling out Official Form 10 within 90 days from the Section 341 meeting of creditors and filing it with the Bankruptcy Court. The date past which a claim can no longer be filed is known as the Claims Bar Date, and claims past this date generally will not be paid, although it is possible to appeal. The POC will have a Docket Stamp on it denoting the date of its filing. The POC must be signed by the creditor, include the amount of the claim, whether there is a perfected security interest and have attached to the POC documentation evidencing the claim such as invoices, purchase orders or contracts. Sample of Proof of Claim Form 10 Sourcing Trade Claims Upon filing of its petition for bankruptcy, or within 14 days of filing, the Debtor is required to file its Schedule of Assets and Liabilties and its Statement of Financial Affairs (“SOFA”). The Schedules are the primary source used to locate claim holders. In practice the Debtor routinely is granted extensions to the filing of schedules and it can take some time before a potential investor has the requisite information in order to bid on a claim. Nevertheless, upon petition the Debtor must file a list containing the name, address and claim of the creditors that hold the 20 largest unsecured claims, excluding insiders. For a sophisticated trade claims investor it is possible to begin negotiations to purchase a claim utilizing this information, albeit without knowing whether the debtor is disputing the claim or if the amount of the claim at petition will be the same as what is listed on the Schedules. The Schedules also contain the name, address, amount of claim and whether that claim is, Contingent, Liquidated/Unliquidated or Disputed. Contingent claims are claims that may arise contingent upon an event taking place in the future, such as an adverse judgment in an ongoing lawsuit or claims related to remediation for environmental damages that are not fully know. A Liquidated Claim is a claim where the dollar amount is known. An Unliquidated Claim is one where the debtor has liability, but the exact monetary measure of that liability is unknown. A tort case where the Debtor has been found guilty, but where the amount of the liability has yet to be established would fall into this category. Disputed claims are claims where the Debtor is disputing the validity of the claim and intends to file an objection to the claim. This generally occurs later in the case in the form of an Omnibus Objection made by the debtor. Below is an example of a Debtor’s Schedule of Assets and Liabilities filed by Tronox Inc. Purchasing a Trade Claim In examining the schedules it best to bid on an Allowed Claim. Under Section 502(a), a claim for which a proof of claim has been filed is deemed “Allowed” unless a party of interest (e.g. Bankruptcy Trustee, or the Debtor) objects to the claim, in which case the Bankruptcy Court will conduct a hearing to determine whether, or to what extent, the claim should be allowed. There are instances where the Debtor marks every claim on the schedule as disputed or contingent. This increases the risk and will required extra due diligence as well as the willingness to litigate if need be. Once a claim holder willing to sell has been located, the negotiation process for purchasing the claim begins. This process can take anywhere from a few days to several weeks depending on the complexity of the issues involved. Since the seller is not a capital markets participant, he may change his mind several times throughout the negotiation process and also increase his offer based on competing bids. Moreover, factors may come into play in the due diligence phase that require a re-pricing or cancellation of the trade altogether. If an investor is bidding on a disputed claim he will need to factor the risk that the claim might ultimately be disallowed into his bid price. In addition, he may want to reduce price of his bid to allow him to negotiate with the debtor for a reduction in claim size in exchange for a stipulation that the debtor will treat the claim as an Allowed Claim. Due Diligence Once an initial bid is agreed upon, the parties enter into a trade confirmation, subject to final due diligence. This phase again can take a few days to a few weeks depending on the issues involved. At this stage in the process the buyer will begin examining the documentation supporting the claim. This includes reviewing invoices, purchase orders, or other contracts in order to determine the validity of the claim. It is also necessary to reconcile the amounts on the invoices with what is filed on the POC and the Schedules. If the invoice is for less than what is listed on the POC or what is listed on the POC is less than on the schedules, the purchaser must reconcile these discrepancies before funding, or have the buyer agree to indemnification provisions should the claim be allowed at a lower amount. The purchaser must also confirm that the entity at which the claim he is purchasing is filed corresponds to the entity listed on the supporting invoices as well as have been filed prior to the Claims Bar Date. The claims purchase will be executed via a custom tailored contract known as a Purchase Sale Agreement (“PSA”). The PSA will contain provisions governing the transfer of the claim, Representations and Warranties and Indemnification provisions. The PSA will required the seller to provide Reps and Warranties on the ownership, validity and lack of any encumbrances on the claim. In addition, the PSA will contain Indemnification provisions, should the claim be impaired or disallowed . This means that if for some reason the purchaser of the claim needs to seek recourse because the seller misrepresented his claim or it was disallowed as a result of actions taken by the seller, , the purchaser must be able to rely on the counter party to indemnify him for his losses. If the counter party is financially unstable, not a well established enterprise, or is itself at risk of bankruptcy, then there is risk that he will not be able to perform his duties under the PSA. When the counter party is a publicly traded company, has, publicly issued debt or has a credit rating, it is fairly easy to do counter party due diligence. However, if the counter party is a small, private business, then counter party risk assessment becomes more difficult. One source of information is Dun & Bradstreet which compiles credit and other financial information on private businesses. In addition, the purchaser can and should ask for financial statements, bank statements, summary of tax returns and other information as needed to gain comfort with the counter party’s credit worthiness. Should legal disputes arise the between the buyer and seller, the PSA should contain provisions for settling the disputes. It is common for the PSA to require disputes to be litigated under New York or Delaware law, courts which routinely handle complex commercial litigation. This also avoids being in the home town court of the seller of the claim. If the claim being purchased is from a foreign supplier whose country is a signatory to the NY Convention of the International Chamber of Commerce (“ICC”) arbitration, then the PSA should include provisions for disputes to be settled via arbitration as courts of signatory countries are required to enforce arbitration judgments conducted in accordance with ICC rules. Legal Issues Affecting Trade Claims There are several legal issues that can impact the value of a claim or cause the claim to be disallowed. The following is a brief summary of some of the major issues that need to be diligenced from a legal perspective before purchasing a claim. Equitable Subordination. If the seller of the claim aided and abetted fraud, insider trading or breach of fiduciary duty his claim may be equitably subordinated causing the priority of the claim to be moved to the end of the priority chain. This has the effect of the claim being treated as equity, not debt. This risk is heightened when a claim is purchased from an insider and one must have strong reps and warranties from an insider that he has not aided and or abetted any malfeasance. The purchaser must also have indemnification provisions covering such breaches. It can be several months post closing of a trade that these issues are discovered and even longer until they are adjudicated. In order to minimize this risk seek to avoid purchasing claims of company, insiders or those where the relationship could be potentially deemed as “insider”. Avoidance Actions. When a company files for bankruptcy all payments made in the 90 days prior to bankruptcy (1 year for payments to insiders) are investigated as potential Preference Payments. A Preference Payment is the payment of a debt to one creditor rather than dividing the assets equally among all those to whom he/she/it owes money, often by making a payment to a favored creditor just before filing a petition to be declared bankrupt. The Bankruptcy Trustee has the power to Avoid (unwind) any payments that are deemed to be a Preference This is known as an Avoidance Action and the money is reclaimed by the bankruptcy estate . There are several criteria that are used to evaluate whether a payment was a Preference:
However, Section 547© of the Bankruptcy Code contains exceptions for payments made in the ordinary course of business. The prior course of dealings between the parties, including the amount and timing of payments, and circumstances surrounding the payments, should be analyzed. Additionally, inquiries may be made into the collection activities or practices between the parties, whether the payments were designed to give the transferee an advantage over other creditors in bankruptcy, or whether there was any change in the status of the transferee such as the ability to obtain security in the event of nonpayment. If there has been any unusual pressure or collection activity by the creditor resulting in the payment, the payment would not be ordinary course of business. The transfer at issue is not required to be the type that occurs in every transaction between the parties. It is necessary only that the type of payment be somewhat consistent with prior dealings and transactions Closing the Trade Once the due diligence and legal review is complete, the PSA is finalized and the trade is executed via Delivery vs Payment (“DVP”) format. ). DVP occurs when, to complete a trade, there is a simultaneous exchange of securities, in this case they are not securities but the format is the same, for cash that ensures that delivery occurs if, and only if, payment occurs. To be true DVP, there must be an element of finality in the process, whereby neither side of the trade can unwind the transaction after settlement. The funds are then wired within one day of execution. Closing can occur anywhere from 10-30 days post initial confirmation of the trade. The standard practice is that once the trade has closed, the Transferee files a Notice of Transfer and Evidence of Transfer (supporting documentation to evidence the transfer of claim) with the Bankruptcy Court pursuant to Bankruptcy Rule 3001(e). Rule 3001(e) reads as follows:
Conclusion Investing in trade claims provides a unique opportunity set for distressed investors who already understand the bankruptcy process, are familiar with analyzing complicated capital structures and understand inter-creditor issues. While trade claims are an illiquid market, they are also highly uncorrelated to the stock and equity markets making them attractive to distressed and special situation funds. Furthermore, it is possible in many cases to bid on claims at a discount to an established plan recovery for the reasons: stated earlier: that many trade creditors do not wish, or are unable, to wait for the exit from bankruptcy for payment. With that said the market has grown more competitive and sophisticated in the last several years, so do you due diligence and invest wisely. Link to other articles by Joshua Nahas: http://joshuanahas.com/joshua-nahas-publications/ Comments are closed.
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AuthorJoshua Nahas Archives
May 2017
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