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Thursday, June 13, 2013

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 6: Miscellaneous Questionable Methodological Decisions)

This is the 6th and last in a series of blog posts that analyze an argument, being presented to an American Bankruptcy Institute commission on reform of the Bankruptcy Code, that the recoveries of unsecured creditors are somehow declining due to the purported imbalance in favor of secured creditors. The argument relies heavily on a law journal article published two years ago by a law student named Andrew A. Wood working under the tutelage of Professor Lynn LoPucki at UCLA. So far, I have shown how the article contains, and thus the argument is based on, incredibly unreliable and error-riddled data; that the sample sets being contrasted are not properly comparable because they cover different lengths of time and different economic conditions; that the purported increase in the use of second lien debt in capital structures cannot be shown to have had any adverse effect on unsecured recoveries; that valuation and intrinsic business merit have much more to do with any decline in any constituency's recoveries; that the author's failures, when tabulating unsecured recoveries, to comprehend structural subordination and to take into account payments outside of the chapter 11 plan, results in a misleading depiction of lower recoveries than actually occurred.  In this post, I will list three more methodological choices embedded in Wood's article that cause his tabulation of unsecured creditor recoveries to be understated.

Failure to Record Post-Petition Interest Recoveries

Neither LoPucki’s nor Wood’s study reports a recovery for unsecured creditors higher than 100%.  But occasionally creditors receive post-petition interest; depending on the length of the case, it can be significant.  Among the cases in Wood’s sample, several cases involved substantial post-petition interest.  I have already mentioned Six Flags, where the debt holders at the operating subsidiaries received payments in satisfaction of a post-petition interest claim that boosted their recovery to 110% of par by my estimation. Pilgrim’s Pride and Cooper-Standard both paid post-petition interest that increased noteholders’ recoveries, by my estimation to 108 and 106 of par.   Chemtura not only allowed unsecured noteholders’ claims for about 18 months of post-petition interest but also satisfied a make-whole claim that appears to have raised recoveries by the noteholders asserting it to over 120% of par. Recording those unsecured creditors’ recoveries correctly would, of course, boost the average recovery for senior unsecured noteholders in Wood’s table.

Calculating Averages Based on the Number of Cases

It seems odd that Wood calculates bottom-line recovery percentages by taking a simple average, assigning equal weight to every case, even though some cases are much larger than others. Here, large companies like Lear, Visteon, Idearc, Smurfit and Six Flags are mixed with much smaller ones that have one-tenth or less as much debt or enterprise value.  And full recovery cases Wood ignored, like GGP, are so large relative to the rest of the sample, that were recoveries to be weighted, they would likewise significantly increase the average recovery across the sample. In general, Wood’s approach appears to bias the average recovery downward, as larger businesses tend to do better in chapter 11 than smaller ones.  If an unbiased analyst were trying to assess real world impact of laws, he or she would be inclined to give more weight to the cases with the biggest impact on the constituency in question. 

How Much Weight Should be Accorded Valuation Estimates In Disclosure Statements? 

Many of the  recovery estimates used by LoPucki and Wood come from recovery estimate tables in disclosure statements, which in turn are frequently based on an investment banker’s valuation of a reorganized debtor’s projected equity value, a valuation that is often prepared several months before emergence.  We know those are not always perfect predictors of the actual value of that equity in the future.  For example, the equity issued in the Six Flags case has performed extremely well post-emergence and a real-world assessment of recoveries in that case ought to take that real-world performance into account.  For another example, the stock of Charter Communications traded immediately after emergence at nearly twice the price paid for it in the rights offering under the plan, resulting in substantially higher returns for those creditors who subscribed to the offering than the “13%” estimate contained in the disclosure statement – prepared 6 months earlier.[1]  For a third, the stock in Lear Corporation received by the one impaired class of unsecured creditors under its plan was also much more valuable than the disclosure statement anticipated; Lear’s February 14, 2013 press release says it has “[d]elivered superior returns to stockholders relative to both the S&P 500 and the Automotive Peer Group since November 2009 when Lear resumed trading on the New York Stock Exchange following its emergence from bankruptcy.  In addition, since November 2009 the Company's equity market valuation has more than doubled.”

At its February 21 hearing, the ABI commission heard Professor David Smith reference research that, in recent years, post-emergence equity tends to carry a higher value than estimated in the related disclosure statement, contrary to trends  in the 1980’s and 1990’s.  A recent article, “The Bankruptcy Discount: Profiting at the Expense of Others in Chapter 11 ” by Mark T. Roberts, in the Summer 2013 ABI Law Review, likewise argues, from a sample of 48 large cases in the 2005-2011 period, that disclosure statements contain enterprise valuations that are 12% - 20% lower than implied by public market valuations of comparable companies.[2]  The Wood article does not make any attempt to investigate or correct for that error. To be fair to the student-author, he was probably not aware of these views at the time he wrote his article, but one would expect any future discussion of reform to incorporate all the information available to it.

[1]           See Petition for Certiorari, Law Debenture Trust Co. v. Charter Communications, Inc., Dkt 12-847 (Jan 10, 2013) at 5 n.2 (citing CCI 2009 Form 10-K Annual Report F-13 (Feb. 26, 2010), CCI S-1 Registration Statement, at item 15 (Dec. 31, 2009), with CCI 2010 Form 10-K Annual Report 31).
[2]           Roberts’ article does not show the full detail of his calculations so is difficult to critique. But even without access to all his work, one can note that (1) his definition of “comparable companies” is mechanistic and even na├»ve; (2) a valuation prepared in accordance with accepted valuation practice inherently goes beyond a mechanistic derivation from mechanically determined comps; (3)  newly reorganized companies may systematically have higher costs of debt than those whose solvency is unquestioned, driving a DCF valuation down versus comps; (4) a newly reorganized company may have different banking relationships than the rest of its industry; and (5) he does not explore  to what extent the valuations of his control group are driven up by technical factors present in the public equity markets but not much found in chapter 11 (retail interest; issuer buybacks; index fund buying; margin-fueled demand) .  Finally, in his case study of the Chemtura settlement, which he characterizes as taking $280 million from equity, he completely overlooks the consensual reduction in claims that were part of the settlement that created solvency, and fails to consider whether those  reductions would have been smaller if the estate had been valued higher.