Trade Alert: United States

UNITED STATES OF AMERICA

On 25 January 2019, an agreement was reached to end the 35 day shutdown of the US government - the longest shutdown in history. This shutdown is reported to have shaved USD 8bn  off US economic activity in the first quarter of 2019 with USD 3bn estimated lost in the last quarter of 2018. Amidst this backdrop, volatilities were noted in the USD 1.1bn US leveraged loan market at the end of 2018. Despite this, defaults have remained low, partly due to an estimated 73 per cent of leveraged loans being covenant-lite meaning that fewer defaults are triggered. Moody's ratings agency, however, advised that there are more low-rated credits today than during the height of the financial crisis, with an estimated 44 per cent of first time issuances in 2018 having a corporate rating of B3 (the lowest rating you can get and still access the market). Optimism for 2019 though is strong with Barclays anticipating USD 400-420bn of loan issuance connected with merger, acquisition and buyout financing whilst also predicting that the credit cycle will not end in 2019 or even at the start of 2020. BNP Paribas is slightly less optimistic with its analysis suggesting that defaults will pick up at the end of 2019 and start of 2020. This is, however, likely to lead to a reduced volume of distressed trading in the US in 2019 (as was the case in 2018).

However, in 2018, many high profile US companies, particularly retailers, entered into bankruptcy proceedings or liquidations. These included:

• Toys "R" Us Inc. which filed for Chapter 11 bankruptcy on 18 September 2017 to enable it to restructure USD 5bn of its long-term debt. This restructuring was not successful, with approval being received from the Bankruptcy Court to liquidate its assets on 15 March 2018 and the last store in the US shutting down on 29 June 2018.
• Mattress Firm Inc. (part of the Steinhoff conglomerate) entered Chapter 11 bankruptcy proceedings in October 2018. On 22 November 2018, it was reported that the company had emerged from bankruptcy with USD 525m in funding with plans to keep around 2,600 stores open (with 660 closing).
• American Tire filed for Chapter 11 bankruptcy on 4 October 2018 following a year of financial upheaval. It emerged from bankruptcy on 19 December 2018 following a USD 1.1bn debt-for-equity swap.
• Sears, the large American department store, filed for Chapter 11 bankruptcy on 15 October 2018. It looks like Sears will avoid liquidation following the announcement on 16 January 2019 of a USD 5.2bn offer by its chairman in a Bankruptcy Court auction (which remains subject to approval by the court). 

This trend looks set to continue in 2019. PG&E, one of the largest providers of utilities in California, filed for Chapter 11 bankruptcy protection on 29 January 2019 at least in part due to significant asserted liabilities arising from Californian wildfires. Other companies, especially those in the energy, retail, and healthcare industries, are expected to follow suit. The anticipated uplift in Chapter 11 bankruptcy filings will likely result in an increase in trading of Chapter 11 claims.

KEY POINTS FOR TRADERS - CHAPTER 11 CLAIMS

Issues that creditors should consider when trading Chapter 11 claims include: (1) the secured status of the claim and the value of the underlying collateral; (2) whether the claim is subject to attack, subordination or disallowance; and (3) the priority of the claim and the potential waterfall allocations (including what these claims may receive – cash, take-back debt, equity interests, and/or interests in a litigation trust).

The Bankruptcy Code does not allow for unmatured post-petition interest to be claimed for unless: (1) the creditor is claiming the interest as a secured creditor and the value of its security exceeds its claims; or (2) the estate of the debtor-in-possession is solvent and it is able to pay its unsecured debts in full. Thus, unless a claim is "over-secured" or the debtor-in-possession is solvent, no claim will accrue post-petition interest. For this reason, in the vast majority of cases involving the purchase of claims, the transferee should understand that it will likely not be entitled to post-petition interest on the claim.

There are a variety of ways that the debtor-in-possession or, more usually other creditors, may seek to attack, subordinate, or disallow claims in order to increase their own entitlements. Transferees must be cognisant of whether the debtor-in-possession’s case may be substantively consolidated (i.e., the debtor-in-possession’s entire corporate structure is combined such that claims of every debtor entity receive distributions at the same "structural" priority level). This could negatively (or positively) impact the distribution a transferee receives on account of the purchased claim depending on the priority and which debtor the claim originally stood against. Other creditors may seek to recharacterise the claim in question from a debt claim to an equity interest (equity interests are subordinate to all claims for distribution purposes) based on the true character of the monies advanced in support of the claim. Moreover, other parties in interest may seek to subordinate claims based on the inequitable conduct vis-a-vis other creditors conducted by the original claim holder (or transferee). In these instances, the subordinated claim will not receive distributions unless senior claims are paid in full. Some courts have held that even innocent transferees of claims that are to be subordinated are not insulated from subordination. Finally, claims may be disallowed if the underlying debt is proved not to be owed after an objection to the claim is filed.

To best protect against these risks the transferee should ensure that it receives all of the relevant information from the transferor including the proof of claim and associated documentation relating to the underlying asset. The transferee should familiarise itself with the history of the claim and the transferor as well as arguments in the Chapter 11 case to understand if the claim may be subject to attack. The claims trade contract should also be drafted in a way that shifts the risk of any subordination, disallowance, recharacterisation or the like back on to the transferor.

Furthermore, the transferee should determine if a bar date has been set in a Chapter 11 case and ensure that the claim has been properly filed before the bar date and is correctly identified by the debtor-in-possession on the case’s publicly available claims register.

OVERVIEW OF CHAPTER 11 BANKRUPTCY

Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code") governs reorganisations in the US with Chapter 11 bankruptcy cases usually the most complex and costly forms of US bankruptcy proceedings. During Chapter 11 proceedings, the courts will assist the debtor (known during this process as the "debtor-in-possession") to restructure its debts and obligations with the business generally continuing to operate. The court is required to provide permission for certain actions including asset sales (other than in the ordinary course of business), payment of pre-petition claims (i.e., claims that arose prior to the filing date), termination or assumption of executory contracts and unexpired leases, or obtaining post-petition credit to run or expand business operations. When a company files for Chapter 11 proceedings, it immediately triggers an automatic stay which is broad in scope and applies to almost all types of creditor action against the debtor-in-possession and the assets in its estate.

The debtor-in-possession initially has the exclusive right to propose a Chapter 11 plan. If it is determined at a hearing that, among other things, this plan is feasible and fair, treats similar creditors equally and is deemed to be in the best interest of the debtor-in-possession’s estate, then the Bankruptcy Court will approve the plan. The confirmation of the Chapter 11 reorganisation plan will generally discharge a business debtor-in-possession of all of its pre-petition debts to creditors.

WHAT ARE CHAPTER 11 CLAIMS?

Shortly after a debtor’s Chapter 11 petition, the debtor-in-possession will list all known claims in its schedule of assets and liabilities. Generally, for creditors with claims that are not listed in these schedules (or which are listed as "disputed", "unliquidated" or "contingent"), such creditors must file a proof of claim by a bar date set by the Bankruptcy Court. Creditors with listed claims may object to the debtor-in-possession's description of their claim. The Bankruptcy Court will set a deadline by which the debtor-in-possession and other interested parties may object to the creditors' proofs of claim.

TRADING CHAPTER 11 CLAIMS

Unlike the Loan Market Association (the "LMA"), the Loan Syndications and Trading Association (the "LSTA") does not have a prescribed form of transaction documents for claims trading. As seen with MF Global, Madoff and Lehman claims, bespoke documentation is produced for each claim depending on the basis of the claim (be it debt, bonds or of a derivative nature).

There is an active and well-developed market for trading Chapter 11 claims and, in the absence of a court order, parties may freely transfer bankruptcy claims. Partial claims can be transferred, though the documentation (both the underlying contract and notice filed with the bankruptcy docket) for such claims must be meticulously constructed to ensure ultimate enforcement. Claims involving publicly traded securities may often be traded through customary market channels without the need to provide any notice to the Bankruptcy Court. However, claims traders should be wary of court orders such as those: (1) limiting the transfer of significant percentages of equity interests or controlling interests; or (2) imposing additional notice and information requirements in respect of those trades. The Bankruptcy Court will generally set a record date for claims trades prior to distributions, and trades that occur after such date may not be recognised for distribution purposes. If a proof of claim in respect of a claim that is not based on publicly traded securities has already been filed, then the buyer of the claim must file evidence (in the form of a standardised claim form available on the applicable court's website) of the transfer of the claim with the Bankruptcy Court. Any objection to the transfer must be filed with the Bankruptcy Court within 21 days of the mailing of the notice (meaning the form filed with the Bankruptcy Court) to the seller. In the absence of any objection, the transfer is deemed valid.

Claims that are acquired for an amount lower than face value are enforced at their full face value if the claim is otherwise valid. One exception to this general rule is for claims based on bonds issued with original issue discount. In this instance, it is (again) the general rule that original issued discount is treated by the courts as if it is unmatured post-petition interest.

Unless the acquired claim is secured, and the value of the collateral exceeds the value of the claim, interest will not accrue on the claim.

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LEGAL UPDATE: GERMANY

This month we were reminded of the importance in considering the permitted transferee provisions in Credit Agreements which are not governed by English law. As reinforced in case law, the English courts will interpret the term "financial institution" broadly to encapsulate non-trading special purpose vehicles with minimal capitalisation.[1][1] This counters the position taken in the US where the courts have found that certain hedge funds which acquire distressed loans in the secondary market are not necessarily deemed a "financial institution" pursuant to the transfer provisions of certain Credit Agreements.[2][2] Care should also be taken with this provision in European jurisdictions, particularly Germany where the German courts are likely to look to the definition of "Financial Institution" in the Capital Requirements Regulation (the "CRR") if they were to be asked to make a ruling. Pursuant to the CRR, an entity will qualify as a financial institution if its principal activity is to: (1) acquire holdings; or (2) trade for its own account in transferable securities, money market instruments, foreign exchanges or derivatives. It is arguable that an entity which purchases debt does not fall within this definition.

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BREXIT UPDATE

Banks relying on a UK authorised passport under the Capital Requirements Directive to lend into the EU continue to prepare for the impact of Brexit. This is of particular relevance to lending activities in France, Italy and Germany (where banking licences are required for certain lending activities). The impact of Brexit remains unknown, with it not yet agreed if a withdrawal agreement will be entered into or if the UK will leave the EU with no deal in place.

These preparations include inserting provisions that enable these banks to allocate the trade allocations to another party (be it a branch of the same entity located in a jurisdiction with a valid passport or to another entity within their corporate structure). These provisions have been included in various documents including Trade Confirmations and Funded Participation Agreements. It is important for counterparties to these banks to review this language carefully and consider, amongst other things:

• who the proposed new counterparty is (if it is a different branch then the entity itself that is being faced does not change however, if the entity is changing then the new KYC requirements and credit risk should be considered);
• who is the transacting party at each time and who is the relevant party for recourse purposes;
• what is the mechanism for the transfer (i.e., if the bank is a Grantor under a Funded Participation, are there notice requirements if the branch changes or, if the entity changes, what are the transfer provisions pursuant to the Credit Agreement and are there any perfection requirements for the security package); and

if the bank is a Grantor under a Funded Participation, is the Participant required to provide consent? 

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NOTABLE TRANSACTIONS

SEARS HOLDING CORP. ("SEARS")

On 16 January 2019 Sears announced that Eddie Lampert, chairman of Sears whose hedge fund ESL Investments is also the largest shareholder and creditor of Sears, won a bankruptcy court auction to purchase Sears for USD 5.2bn. This was an improvement on his earlier offer of USD 5bn. Reports suggest that this deal could still be scuttled by creditors unhappy with the "going-concern" sale and who would prefer liquidation. A hearing to consider approval of the "going-concern" sale is scheduled for 4 February 2019. If Sears is liquidated, it could result in the loss of around up to 68,000 jobs following the closure of 425 Sears and Kmart stores. Transform Holdco’s bid (Eddie Lampert’s special purpose entity) is backed by USD 1.3bn in financing from three financial institutions rumoured to be Bank of America Corp. and Citigroup Inc. (existing lenders of Sears) as well as Royal Bank of Canada, who have together agreed to provide a USD 950m asset-backed loan as well as a USD 350m revolving credit line. On 28 December 2018, Sears also announced the closing of an additional 80 stores by March 2019.

AMERICAN TIRE DISTRIBUTORS INC. ("AMERICAN TIRE")

On 19 December 2018, American Tire emerged from Chapter 11 bankruptcy following approval from Judge Kevin Carey of the balance-sheet restructuring plan giving control of the company to bondholders in exchange for USD 1.1bn of bondholder debt. It was announced by the company on 27 December 2018 that the financial recapitalisation was successfully completed and that payments would be issued for all pre-petition obligations currently due. The recapitalisation was on a consensual basis with USD 1.005bn of committed exit financing arranged to support operations and future growth initiatives. American Tire filed for Chapter 11 bankruptcy on 4 October 2018 following a tumultuous financial period in 2018. Goodyear Tire & Rubber Co.'s and Bridgestone Americas Inc.'s decisions in April and June 2018 respectively to deal directly with customers and repair shops (as opposed to through tire distributors like American Tire), as well as the announcement in August 2018 that Sears Holding Corp's auto centers would install tires purchased on Amazon.com, contributed to the drying up of American Tire's cash reserves. It was announced in Court on 5 October 2018 that American Tire had reached an agreement in principle with the majority of its senior lenders which, together with the agreement already in place with 75 per cent of its bondholders, would enable it to exit bankruptcy. This deal would allow bondholders to receive a 95 per cent equity stake in the reorganised company with the existing shareholders. This reorganisation agreement cuts around USD 1.1bn of its debts, previously detailed at totalling over USD 2.3bn.

NEW LOOK GROUP LIMITED ("NEW LOOK")

An announcement was made on 14 January 2019 regarding the proposed debt-for-equity swap on New Look's bonds which is proposed to complete between April and June 2019. Under these proposals, the face value of New Look's existing GBP 1.03bn of senior secured notes will fall 77 per cent and will be converted to GBP 250m of new secured notes in the restructuring. The secured notes were one of the best performing high-yield bonds in Europe last year, with prices topping 60p but have now fallen to 30p following one of the worst Christmas periods on record for the UK high street. The restructuring will see an immediate GBP 80m injection of capital which will be refinanced by an issue of GBP 150m PIK notes (which will also be offered to the holders of the existing senior secured notes). Following the restructuring, the equity will be held as follows: 72 per cent by PIK noteholders, 20 per cent by senior noteholders, 5 per cent by New Look management and 2 per cent by unsecured noteholders who saw the value of their GBP 176m fall to just 3p on 14 January 2019 with their value effectively wiped out. 

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