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Tuesday, December 9, 2014

The "Redemption Option Premium" in the ABI Chapter 11 Reform Proposals

The propositions diminishing secured creditors' protections deserve careful attention as I think that, while not as bad as was being advocated, they remain unsound policy. 


These changes fall under two main headings, first, diminished protection of the secured claim during the case and second, a prospective "haircut" in "senior" recoveries (the word "senior" is sometimes used specifically to mean secured claims, and sometimes ambiguously as possibly operating between levels of unsecured claims and sometimes even between the unsecured class vs equity).  For this post I am going to just focus on the second for now, because it is the more complicated and thus the one I have spent more time trying to understand. 

The crux of the proposed changes to distributions of value to secured creditors under plans and in 363 sales is to create a "redemption option premium" ("ROP" for shorthand), the definition of which has been carefully labored over and resembles ideas that have kicked around outside of the commission for a few years.  In broad summary, because it really is a very, very long definition, the immediately junior class to the class or classes receiving the "residual value" of the reorganized debtor would be entitled to receive value (form undefined) equal to the price (to be determined using the Black-Scholes option pricing method which I will discuss a little bit below) of a 3-year option with a strike price equal to the payoff amount for the entire senior debt plus interest at the non-default contract rate for the full three years. A couple of simple examples involving just one level each of secured and unsecured debt are sketched out in the report and it is asserted that where the senior creditors are recovering, say, 50% of their claim under the plan or sale, the impingement on their recovery would be quite small, and where they were recovering 90% of their claim, it would be larger. 

The concept of some kind of upside participation entitlement is not crazy -- as noted, others, including me, have suggested something like it (not this form, specifically).  It is appealing to have a "safe harbor" in the fair and equitable analysis, where the plan proponent can put a proposed recovery into the plan for a junior class and know it's going to be enough, as opposed to having the unsecureds take what's offered and litigate up from there.  The use of an option premium as a measure of the safe harbor amount  is logical and even elegant, if a bit challenging at first for the less financially sophisticated decision-makers.  The report indicates that the delivery of the ROP is linked to the class not objecting in certain ways, which I find very confusing on first read, but at least that somewhat creates the potential of reducing valuation litigation, which might be a good thing, although, as I explain below, I don't think, net-net, it would do so because you can't figure out the ROP until you have settled on the valuation - that is one of the essential inputs for figuring out the value of the option.

However, the size of the proposed option - an option to buy "the entire firm" is a radical change from present practice where the norm might be to offer the obviously out of the money class a sub-10%  equity stake or a warrant to buy a slightly larger stake, or at best a combination of both.  So that is a several-fold increase that would certainly affect plan bargaining.  True, the workings of the option pricing model will cause the value of the option premium itself to be a similarly small percentage of the total enterprise value, as I will demonstrate below, and the senior stakeholders may choose to dole out the value in another form.  But, as I will show below, the opportunity for an out of the money class to come out of a bankruptcy with of an option to buy the entire reorganized debtor could lead to overly levered capital structures and also to otherwise irrational claims trading in the case itself.
  
The Commission also creates a host of problems with its determination to impose the haircut on senior creditors non-consensually and in widespread fashion.  Many of these are reflected in a long paragraph on p. 211 and developed further in footnotes.  For example, at fn 764, it is argued that the secured creditors' deficiency claims must be excluded from the distribution of the value -- effectively mandating a subordination of those claims. Nor could the secured creditor make an 1111(b) election to get around that truncation. 


So too, in order to force the transfer of value on the parties, the commission has to propose to eliminate the requirement of section 1129(a)(10) that at least one impaired class accept the plan for it to be confirmed.  If that requirement remained, the plan would fail, as none of the other requirements of fair and equitable would necessarily be fulfilled.  That then poses a question the plan leaves largely unaddressed - why bother with disclosure and voting in such an environment, if everyone can be crammed down?  What is the benefit of disclosure and voting that requires time and money to be spent on it?

In my own experience, I have found 1129(a)(10) to be a hugely useful provision for tailoring plan negotiations because it empowers the plan proponent to say no to the less realistic fringe constituencies in the case. In my last big engagement before I retired, the Barneys restructuring, we were able to conclude the entire restructuring out of court in part because the one potential objector to the restructuring knew it could never succeed in confirming an alternative plan because it could never get one impaired accepting class - it had only a blocking position in a junior class, whereas the investor preferred by the debtor controlled the senior class and could deliver that class for the 1129(a)(10) requirement.   Pulling that requirement out of the Code would have deprived the debtor of its most impersonal argument for preferring the senior investor.  The debtor either would have had to make it a personal matter - we like them better than you, leading in all likelihood to the spurned investor launching all kinds of spiteful litigation, or more likely have forced the debtor into a long, public chapter 11 proceeding in which they went through the drill of making a record about due consideration of the spurned investor's ideas, which would not have had any benefit for the business as a whole.

Further, at fn. 763, the report observes that the requirement would "in theory" (whatever that means in this context) have to take precedence  over contractual subordination.   No policy justification is offered for these demands, they are merely logical implications of the concept of a forced transfer of value down the priority chain.  They seem almost petulant, in all honesty,  The whole purpose of contracts is to allocate risk.  Subordination is just a form of insurance - why eliminate insurance held by senior secured creditors but not insurance held by other kinds of creditors?  Yes, bankruptcy law authorizes breaking contracts - but those are the debtor's contracts; they're to be broken only to the extent they impede the debtor's reorganization, which insurance doesn't do; and in any case, the non-debtor counterparty is supposed to get a claim for damages from the breach and its allocable share of reorganization value to compensate it for the federal government destroying the contract.  This aspect of the recommendations is especially radical and indefensible. The ideas of (a) wiping out deficiency claims that would be in the money if separately documented, and (b) wiping out contract claims against a non-bankrupt also raise a host of Constitutional questions.  

Indicating how weakly developed and potentially confusing this idea is, fn 762 of the report states that the ROP would not apply to senior classes in a plan that were repaid in full in cash, or received only debt securities, because the give-up is only meant to apply to residual value of the firm.  They fail to recognize how that would affect plan bargaining: why would anyone want to pay the seniors off if they could haircut them -- the trick is obvious: give the seniors just enough equity to take away and redistribute!  No one's going to think of that?   A similar quirk arises because they advocate that,  in a sale context, the opposite of the plan rules would apply and the give-up would apply to cash proceeds or take-back paper. Obviously that has dramatic impact on plan vs sale negotiations and, as a second order effect, creates litigation over why the debtor chose one course vs the other.  The same footnote further admits the commission has no idea how the proposal would work where equity was distributed among multiple classes -- who gives up what and to whom? 


To explore that question, I applied these proposal to a representative capital structure for a mid -2000s LBO. to see how they might play out.  

Scenario: Debtor has first lien debt of 300 million at 5%, 2d lien debt of 100 @ 7%, and equity of 300.   This is a very   Imagine the value in reorganization is 350 (1/2 the LBO valuation).  This would mean the first lien lenders have gauged their risk correctly and lent prudently, exactly as society should want them to do -- until the ROP raises its ugly head  - while the 2d liens have misjudged their risk materially, but for the rescue embedded in the ROP, and the equity would be wiped out.
 
Under current law we would distribute the 350 of reorg value 300 to the first lien debt and 50 to the second.  The first lien would take some of its recovery in new first lien debt, e.g., 150 million, and the rest in equity, in this case worth 150, implying the second lien would hold its 50 million of value as a 25% stake in the reorganized debtor.  Equity would get nothing but a release for cooperating.

So we'd wind up with this capital structure at emergence:

First lien :            150 new debt
                            150  common
Second lien           50  common
Equity                      0

According to the Commission, the ROP would be calculated as the value of a hypothetical 3-year option to purchase the entire firm with an exercise price "equal to the entire face amount of the claims of the senior class, including its deficiency claim if any."  But according to fn 767, in cases where that class is not receiving all the equity of the reorganized debtor, "the redemption price would have to be adjusted to include the claims of all such senior classes whether or not they are receiving residual interest in the firm or are among the classes required to share reorganization option value with immediately junior class." 

So what is the ROP here?  Who gets it?  Is it based on the first lien debt (300 principal plus 3 years interest, or 345 total) or just their equity stake (150 plus 3 years interest at 5% or 22.5 million?  Or is it held by the equity and based on the total debt (400 principal or 466 with interest on both tranches)?  The report punts on this question.  So I will run through the various permutations.

Let's assume, not withstanding what the report says, you don't include the first lien debt because the option holder wouldn't really be "buying" that; it would just be refinanced.  That seems irrelevant to the focus on residual value.  If it's just the first lien equity stake of $150 million that has to be bought out at $172.5 million 9to include three years of interest), using the suggestion in the report that the default measure of volatility be the S&P 500's trailing four year volatility of approximately  15, and a risk-free rate (1.1% at this writing), that equates to an option premium of approximately $9.3 million, according to this website.  

Do note, however, that in all likelihood, using the S&P 500's volatility over a long period likely under-represents the actual post-emergence volatility of a single stock, which will have less trading liquidity, less market makers and will not reflect the partially contrary movements of 499 other stocks in an index.   For example, the stock of  American Airlines, which emerged less than a year ago, has been over 30 for the last three months. If the volatility of a stock is under-measured, then the corresponding call option is under-priced (an option is more valuable, the more volatile the underlying asset (because the option price is fixed)).  If the option is under-priced, it is more valuable as an option than as cash. That in turn implies stakeholder battles in the confirmation context over the form of the ROP.  I don't see how this is a systemic improvement.   

Another form of potential mispricing occurs because the commission recommends using the pre-petition loan documents' non-default contract rate in building up the exercise price of the option, instead of market rates at the time of confirmation.  If interest rates have risen, the option is underpriced.  If they've fallen, it's overpriced. 

Look also at the implications an actual option would have for the post-reorganization period.  The first lien debt really wouldn't really have the upside economics associated with a 75% equity stake in the reorganized debtor.  If the value goes up, the 2d lien would exercise its option and take them out and appropriate the upside all for themselves.  Yet the first lien would bear 75% of the downside economics of the stock position - it has no offsetting "put" option to transfer losses to the 2ds, post-emergence.  This "heads the 2ds win, tails the 1st lose" is hardly equitable.  They would likely demand that the equity be doled out in the form of preferred and common and take at least a portion of their equity in preferred.  

Such a capital structure might look like this:

First lien recovery:            150 new debt
                                             75 new preferred
                                             75 new common
Second lien recovery           50 new common
Equity                                    0

But that raises many new issues - does the preferred require cash dividends and can the enterprise pay them?  Does it count toward the exercise price? If not, then the ROP gets cut in half, down to $4.5 million (confirm this at the website used earlier).  So maybe the solution is to give the 2ds that lower ROP in the form of additional common, taking their recovery from 50 to 54.5, and be done with it.  But if the 2ds disagree, how does the plan proponent decide? And how does the judge decide?  There is no guidance at all in the report or in prior case law since this is an exception to all the law that has built up over the last century on the absolute priority rule.

And we haven't even looked at whether the 2ds are sufficiently in the money that the "immediately junior class" to receive the ROP  is the equity.  Equity's option to buy out the 200 in equity, which I calculate to have a strike price of $293.5 million (the sum of the foregoing 172.5 to buy out the the first lien's equity, and 121 to repay in full the second lien at the 3-year mark) million has a much smaller value, $2.5 million.  That is because it is more out-of-the-money than the 2d lien would have.  But do think about the implications of giving old equity a free three-year option to regain control of the company after a bankruptcy.  How would that influence the design of the initial capital structure?  I suggest it would lead to high-risk, over-levered companies. 

These scenarios show, among other things, that embodying the value of the ROP in an actual option would rarely be a good idea from a policy perspective. It would distort financing decisions ab initio, reorganization bargaining and post-emergence capital structures.

They also show there would be disputes over how to value the ROP, in what form to disburse it and  over who gets it - the second liens or the equity.  The Commission punt  on all those questions.

A fourth kind of dispute would arise over who bears the cost of the ROP  Especially if the proposal to emasculate contractual allocation of the risk by contractual subordination at the time financing is raised.  The intent of the proposals definitely points toward having the first bear the cost.  But which cost?  If the firsts transfer an ROP of $9.3 million to the seconds, they reduce their recovery by roughly 3%.  The seconds' recovery jumps by 20% though (from 50 to 59.3).  If it's $4.5 million, they reduce their recovery by 1.5% and the 2ds recovery goes up 9%.  If  they transfer an ROP of $2.5 million to the equity, they reduce their recovery only by 1%.  So they would tend to align with the equity on that distribution in the absence of a clear rule.  But will the 2ds go along with that? 

And, more broadly, is all this gamesmanship and bargaining over 1-3% of the total enterprise value an improvement over the current law and practice?  Because the redemption option is always out of the money, the ROP is going to be rather small fraction of reorganization value, unless radically different volatility numbers get used.  These issues certainly contribute nothing to the actual viability of the reorganized debtor.  And, in a representative situation such as I just outlined, the ROP does not even appear to accomplish the purpose of avoiding valuation litigation at confirmation.  To some extent, my hypothetical dodged the valuation question that would be litigated at confirmation, by assuming one before trying to determine the ROP.  But the Commission does not propose a mechanism whereby the valuation is determined anytime before confirmation.  So it seems false advertising to argue this approach would forestall valuation litigation -- there is no way to do so in advance of knowing the valuation and the parties' take on it..  Do you think the offer of $4.5 million to the seconds would be enough for them to consent if they think the enterprise value is 10% ($35 million) higher?  Remember they get all of any increase. It might buy off equity, but if that doesn't change the 2ds' argument, nothing has really been gained. The bottom line is, if you're going to reach agreement on a valuation to begin with, you don't need the ROP to achieve consensus; and, if you're not going to reach agreement on a valuation, the ROP is not going to spare you litigation.  It just seems a fallacious argument.

The commission's report portrays it as a shortcoming of current law and practice that the absolute priority law wipes out junior classes in a "random" way depending on the vagaries of the timing of their filing in the economic cycle.  Even assuming arguendo that is true (why is it anymore random than any other event in relation to the business cycle? And is it all that random, because debt contracts are a big factor in bankruptcies and there is nothing random about their terms - maybe they were just badly designed in relation to the business cycle.), if what's being lost is an out-of-the-money option worth less than 3% of the enterprise value  -- on one investment in what is likely a very diversified portfolio  held predominantly by institutional investors  -- that's just not a big enough loss to overhaul a century of well-defined law and decades of familiar practice. 

The report itself, at p. 211, acknowledges that the ROP "requires further development", i.e., it's not ready for prime time and should not be considered ready to go into effect.  And I think this post illustrates the accuracy of that recognition.  To me, overall, the gain is not worth the candle, But, I could imagine that the ROP might -- if (a) it were simply a measure of value that you can pay a junior class to deem it to accept, and not an actual option to buy the firm, (b) it required the consent of the senior class making the give-up, and (c) were very clearly defined and allocated by statute -- be a useful option for plan proponents to get cases over faster.  It would turn into a sanctioned form of "gifting" -- which ironically elsewhere the Commission rejects (which is a whole other angle for criticism of the ROP -- if voluntary gifting is bad, why is mandatory gifting good?).  All these other radical changes would then be unnecessary, as it would be a voluntary give-up of the package of ROP value, deficiency claims, contractual subordination, and, since it would be voluntary, you would not need to remove 1129(a)(10) from the Code and it could keep on doing its useful job of streamlining the plan formulation process.