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Thursday, June 13, 2013

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 2: Negligible Role of Second Lien Debt)

Negligible Role of Second Lien Debt. 

In the preceding blog post, I provided an overview of major problems with a law review article written by one Andrew A Wood, under the direction of Lynn LoPucki, a professor at UCLA, that is being offered to support an argument that the Bankruptcy Code needs reform.  Wood argued that unsecured creditors' recoveries had declined in  recent years, compared to a set of cases taken from the 1990's.  Wood argued that the decline was likely due to an increased use of second lien debt in capital structures.  This post will explain why he is wrong.

I will begin with an analysis of the second lien debt in his sample. 

Wood’s sample consists of 42 firms that confirmed chapter 11 plans in 2009 or 2010.  Of those, 15 had 100% recoveries for general unsecured creditors, and 2 had recoveries stated by Wood to be greater than 77% but less than 100%. Even though such high recoveries could not possibly support his thesis, I examined the cases anyway for the presence of second lien debt.  Among these 17 cases, there were only two cases involving second lien debt, Source Interlink and Primus Telecommunications.  However, neither one is a true “second lien” deal.

Source Interlink is what practitioners refer to as a “split-lien” deal (where one type of lender, typically a group of banks, takes a first lien on working capital assets, while a different group of lenders, typically non-banks who are not well-suited to process periodic borrowing requests against working capital assets, takes a lien on PP&E and sometimes IP; then they each take 2d liens on the others’ collateral as insurance against a deficiency in their primary collateral).  As no creditor takes a purely second-lien risk, these should not be considered “second-lien deals”; they are more accurately understood to be pure first-lien deals where the collateral has been split to fit the funding preferences of various lenders.  The amount advanced in a “split-lien” deal is not, as a function of EBITDA, materially greater than a pure “first lien” financing; thus it does not generally increase the amount of secured debt on the company compared to a standard “first lien” deal.  However, for the sake of conservativism, I choose to treat them all as “second lien deals” because, as the reader will see, the recoveries in these cases were generally not affected by the additional lien.[1] 

In Source Interlink, which was a prepack, the ABL was refinanced, getting a full recovery, while the term lenders received 66 cents on the dollar on their secured claim.  Most important for Wood’s erroneous thesis, general unsecureds received 100% of their claims, so clearly the second lien did not impact their recovery at all.  To figure out how much the term lenders recovered on account of their second lien on working capital, I examined the liquidation analysis, which gives a range of values for the working capital. Selecting the best case scenario is appropriate, given the prepack was confirmed, and is also the most favorable to Wood’s thesis, so it is the most conservative approach I could take in disputing it. The liquidation analysis places a high value on the working capital of about $267 million; the disclosure statement puts the ABL outstandings at $189 million.  With $872 million of other secured debt, the $78 million surplus on the working capital gives no more than a 10% recovery on the second lien  -- in a case with 100% recovery for general unsecureds.

Primus also is not a classic “second lien” structure, because (1) the first lien only secured an upstream guaranty, and there was no other debt at the “second lien” borrower; and (2) the so-called “second lien” was structurally senior as well as secured, such that the lien was irrelevant to its recovery. But in any case, the “second liens” in Primus – another case with a 100% recovery for “general unsecured creditors” -- were stated in the disclosure statement to receive a 92-100% recovery. 

Of course, cases with recoveries for general unsecured creditors above 77% cannot possibly support Wood’s and Gotbaum’s contention that unsecured recoveries have declined from the earlier era.  So I turned to the 25 cases where unsecureds’ recovery was worse than the purported 77%.

Among them,  I found only 8 that had some kind of second-lien debt.  Four (Aleris, Linens & Things, and two chip companies, MagnaChip and Spansion) were not true “second lien deals” but, like Source Interlink above, “split-lien” deals.  The other four had genuine second-lien structures.

Among those 8 cases, the 2d lien was classified as totally or virtually totally unsecured in 5 of the 8 cases –Linens, MagnaChip, Ion Media, Neff and Pliant). The 2d lien recoveries in those cases ranged from 0 to 17.5%.  In none of those cases did the 2d lien receive a distribution that was even 5% larger than the unsecureds received.

Of the remaining three cases, Aleris is best viewed as one where the second lien recovered nothing.  It too was a “split-lien” deal, and analysis is further complicated by a substantial amount of European debt on a separate branch of the corporate structure.  An ABL facility, which was only about 20% of the secured debt at filing, was refinanced by the DIP, leaving the term lenders as the only pre-petition secured parties in the case; in that posture, the case probably ought not be thought of as a “second-lien” case at all, but, for sake of conservatism again, I will do so.  In connection with the DIP, the term lenders rolled up roughly 20% of their claims and received a 28% recovery on the balance, for a total recovery of about 42%, but that recovery was significantly self-funded, by dint of a rights offering they put together at exit. It is not easy to allocate their recovery between the second lien on the ABL and the first lien on the fixed assets, but I followed the same approach as I took in relation to Source Interlink – what is the most that can be attributed to the second lien on working capital?  A look at the liquidation analysis shows that the working capital was valued at about $230 million, while the disclosure statement reported that the ABL had $244 million outstanding at filing. The term lenders’ second lien on the ABL collateral therefore contributed nothing to the term lenders’ recovery.

In Spansion, 2d lien creditors appear to have been paid in full (although keep in mind it was really a split-lien deal) and unsecureds were depicted in the disclosure statement and Wood’s article as receiving 31-45 cents on the dollar. 

In the only other case with a 2d lien, Finlay Enterprises, the 2d lien debt was a mere $22 million, less than 5% of the prepetition debt, and was paid in full.  In that case, there was also 3d lien debt, but the circumstances behind the creation of  Finlay Enterprises’ second and third lien debt do not support the author’s thesis.  Both debts came into existence a few months before the bankruptcy, when hedge funds holding approximately 80% of the company’s unsecured bonds swapped their bonds for third lien debt and lent the troubled company a fresh $22 million on a second lien basis.  The third lien only received a 44% recovery; had the exchange not occurred, its holders would have received slightly less, about 35%.

The following table presents the recoveries of all second liens in Wood’s sample:

  96 (midpoint between 92-100)
  17.5 (classified as unsecured)
Source Interlink
Magna Chip
Ion Media

So the 10 second liens in Wood’s set actually recovered substantially less on average than general unsecured creditors in his 42 case sample.  And the median recovery is likewise below the median recovery by general unsecureds reported by Wood, as one can see by comparing the above table to the one in his article. The few “pure” second-lien deals, like Ion Media, Neff and Pliant, had terrible recoveries for second lien lenders.  Although I did not research payments under first-day orders, I would imagine that, once those were taken into account, it would show that the second liens did worse than general unsecureds.

And just to complete the point, note that, out of a pool of 42 cases, Spansion and Finlay are the only 2 — less than 5% —  in which the presence of a second lien can even be argued to have altered unsecureds' recoveries and even then only by a small amount. But keep in mind that both cases actually differ materially from the second lien paradigm to which Wood refers.  Rather, the fact that the 2d lien was essentially worthless in at least 60% of the cases where one existed tells us that the driving factor in recoveries was not lien structure.

One might respond that Wood is not exclusively focused on 2d lien impacts, that he also argues the proportion of secured debt relative to assets has increased.  I don’t think the proportion of secured debt to assets is a meaningful ratio and I am suspicious of his decision to measure secured debt against “assets” as opposed to what seems more relevant, the rest of the capital structure.  When I looked at the 25 companies with purportedly low unsecured recoveries, I found in many cases that their secured debt was less than ½ of the funded debt, often less than 1/3 — and that, of course, is just the debt, and one needs to look at the equity that existed when the capital structure was put in place. Even a highly levered capital structure would have had at least 1/3 equity (larger companies like Lear probably had more) and that would bring the secured debt down consistently to 1/3 or less of the total capital structure. 

As well, one has to recognize that a meaningful portion of a debtor’s secured debt would not have been funded but for the assurance provided by collateral – for example, hardly any of those debtors would have been able to obtain a committed revolving credit facility on an unsecured basis, as such facilities are only available to high investment grade borrowers. In at least one case, Lear, a very substantial portion of its secured debt arose when it drew down on its committed, secured revolver only a few weeks before its bankruptcy filing, a time when it would not have been able to borrow on an unsecured basis at all. (And obviously, it used those funds to pay operating expenses, which were unsecured debts, even though, having been paid off pre-petition, they don’t show up in the disclosure statement).

In sum, I cannot find any evidence in Wood’s sample of heavy amounts of secured debt, first or second priority, meaningfully impacting recoveries by unsecured creditors.

[1]           The NTK case, which Wood lists as a 100% recovery for general unsecureds, may also be considered a “split-lien” deal.  In that case, one group of asset-based lenders had a first lien on working capital; another on PP&E.  The ABL group also took a 2nd on the PPE, but the fixed asset lenders did not get a 2d on working capital.  It is clear from the record in that case that the ABL was over-secured by itself and thus the 2nd lien was irrelevant to the ABL (or anyone else’s) recovery. Such a structure has also been around a very long time and does not represent a change from an earlier era. Thus, I choose not to include it as a “second-lien” case.