Distressed Debt Investing: Trade Claims Primer

10/29/11 8:38 PM

This blog will try to dissect distressed debt investing, up and down the capital structure. We will look at current distressed debt situations, try to explain the ins and outs of how decisions are made in the distressed debt world, probably rant a few times about positions that are working against me, and hopefully enlighten some readers.

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Trade Claims Primer
It gives me great pleasure to introduce a new contributor to Distressed Debt Investing, Joshua Nahas, principal of Wolf Capital Advisors. Wolf Capital is a Philadelphia based advisory firm focused on distressed debt, corporate restructuring, corporate finance advisory and capital raising services. Wolf provides advisory services to hedge funds and private equity funds on distressed investing and provides restructuring services to debtors as well as creditor committees. In his first post, Josh provides a primer on the sometimes esoteric field of trade claims trading and investing. This is a must read for all distressed debt investors. Enjoy!

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Trade Claims Primer
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 nonguarantor 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

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include the amount of the claim. Some examples of cases where large contingent claims were involved include the asbestos cases such as Owens Corning.. Priority Claims: Generally include back taxes and unpaid employee wages and benefits. contingent. Notes from the Ira Sohn West Research Conference Distressed Debt Investing Interviews Simon Davies European Distressed Debt Conference Special Offer Post Reorg Equity . When a company files for bankruptcy it likely to be in arrears on its accounts payable. based on the outcome of litigation). ► Feb (11) ► Jan (10) ► 2009 (114) MOST POPULAR POSTS Distressed Debt Reading List Distressed Debt Investors Club in Institutional Investor Distressed Debt Investors Club CURRENTLY READING Abnormal Returns Barel Karsan Controlled Greed Greenbackd How to Get a Hedge Fund Job Market Folly Merger Arbitrage Value Investing Blog Proof of Claim In order for the Creditor’s claim to be paid he must file a Proof of Claim (“POC”) with the court. liquidated. thereby increasing the tradeable instruments in the debtor’s obligations. Pension/OPEB Claims: Collective Bargaining Agreements (“CBAs”). All trade debts incurred in the period between the filing of the Involuntary Bankruptcy Petition and potential Entry of the Order for Relief by the Bankruptcy Court will be deemed to have a priority status. can also include lease deposits up to $2.. §546(c) of the Bankruptcy Code preserves a creditor’s state law reclamation rights. Once the Debtor files for bankruptcy protection. These include: Contract Rejection Damage Claims: Damages resulting from the termination of contracts under Section 365 of the Bankruptcy Code. unsecured.Distressed Debt Investing: Trade Claims Primer 10/29/11 8:38 PM in Institutional In. The date past which a claim can no longer be filed is known as the Claims Bar Date. environmental damages or other contingent events. The POC will have a Docket Stamp on it denoting the date of its filing.html Page 2 of 7 . there several other types of claims that arise from a bankruptcy filing which provide potential investment opportunities. These claims arise under state law. 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. purchase orders or contracts.452 and “Gap Claims” which arise when the Debtor is targeted in an Involuntary Bankruptcy Petition filed by one of its Creditors. Deficiency Claims: Secured claims that are under collateralized result in a deficiency claim under Section 506 of the Bankruptcy Code for the portion of the claim where there is insufficient collateral securing the claim. These claims arise due to the fact that a company’s suppliers ship goods on credit ranging anywhere from 30-90 days. although it is possible to appeal. whether there is a perfected security interest and have attached to the POC documentation evidencing the claim such as invoices. he must bid an appropriate discount to compensate for the risk. those rights are enhanced by the code and create additional requirements and defenses. Contingent Claims: Claims that may result from pending lawsuits. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) expanded the reclamation period from 10 days to 45 days prior to a bankruptcy and to 20 days postpetition from 10 days previously. While trade claims are the most common.com/2010/10/trade-claims-primer_26. Sample of Proof of Claim Form 10 http://www. Unlike other trade claims. whether that right is fixed. this increases the amount of debt on its balance sheet (AP). potential or contingent (i.. Types of Claims A “Claim” is a right to payment. these claims are accorded administrative status and are paid in full as long as the estate is administratively solvent. There are a number of requirements that must be met for these claims as well as potential defenses against such claims. 503(b)9 Claims: These are claims for goods shipped within 20 days of a company filing for bankruptcy. and claims past this date generally will not be paid. The POC must be signed by the creditor.Visteon Revisited (VSTOV) ► Sep (13) ► Aug (14) ► Jul (12) ► Jun (12) ► May (6) ► Apr (12) ► Mar (14) distressed debt analysis (14) distressed debt book reviews (2) distressed debt case study (7) distressed debt conference (9) distressed debt exchange (1) distressed debt ideas (7) distressed debt interview (6) distressed debt investing (21) distressed debt investing concepts (7) distressed debt investing reading list (1) Distressed Debt Investors Club (15) distressed debt news (4) distressed debt notes (2) distressed debt portfolio management (3) distressed debt research (5) Distressed Debt: Tembec (1) distressed investing (1) distressed investing news (1) double dip bankruptcy claim (1) due diligence (1) emerging manager hedge fund series (3) emerging manager series (1) equitable subordination (1) European Distressed Debt (2) European Distressed Debt Conference (1) examples (2) fairpoint (1) fraudulent conveyance (1) be attributed amongst various entities. Claims can fall into different categories: priority.e. liquidated. Reclamation Claims: Reclamation claims allow for the Creditor to reclaim the goods shipped to the Debtor. secured. The most common claim to arise out of a bankruptcy filing is a vendor claim or trade claim as they are more commonly known.distressed-debt-investing. §2-702(2) of the Uniform Commercial Code (“UCC”). however. Grace and Armstrong and environmental claims include cases such as Asarco and Tronox. disputed or matured. Defined Benefit Pension Plans and other employee benefits that are terminated pursuant to Sections 1113 and 1114 of the Bankruptcy Code give rise to unsecured claims.

the Debtor is required to file its Schedule of Assets and Liabilties and its Statement of Financial Affairs (“SOFA”).com/2010/10/trade-claims-primer_26. This generally occurs later in the case in the form of an Omnibus Objection made by the debtor. amount of claim and whether that claim is.g. For a sophisticated trade claims investor it is possible to begin negotiations to purchase a claim utilizing this information. 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. Disputed claims are claims where the Debtor is disputing the validity of the claim and intends to file an objection to the claim. A Liquidated Claim is a claim where the dollar amount is known. in which case the http://www. Contingent.distressed-debt-investing. Under Section 502(a). A tort case where the Debtor has been found guilty. upon petition the Debtor must file a list containing the name. The Schedules also contain the name. Liquidated/Unliquidated or Disputed. Purchasing a Trade Claim In examining the schedules it best to bid on an Allowed Claim. excluding insiders. but where the amount of the liability has yet to be established would fall into this category. a claim for which a proof of claim has been filed is deemed “Allowed” unless a party of interest (e. or the Debtor) objects to the claim. address. Nevertheless. An Unliquidated Claim is one where the debtor has liability. such as an adverse judgment in an ongoing lawsuit or claims related to remediation for environmental damages that are not fully know.html Page 3 of 7 . or within 14 days of filing. 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. Contingent claims are claims that may arise contingent upon an event taking place in the future. The Schedules are the primary source used to locate claim holders. Below is an example of a Debtor’s Schedule of Assets and Liabilities filed by Tronox Inc.Distressed Debt Investing: Trade Claims Primer g (1) gap bankruptcy (2) general motors (1) ggp (7) gm exchange (1) Greenstone (1) hedge fund jobs (1) hedge fund letter (10) high yield (5) high yield bubble (2) high yield returns (1) howard marks (2) idearc (1) insight health bankruptcy (1) ira sohn conference (5) ira sohn notes (1) Japan investing (1) kelly formula (1) Lehman (1) leveraged loans (1) Linked In (1) liquidations (1) list of distressed debt hedge funds (2) mark sellers (1) Marty Whitman (1) Michael Burry (3) michael milken (1) money manager interview (1) Nebraska Book (1) NewPage (1) non-agency rmbs (1) oaktree capital (1) Paulson (1) Perry Capital (2) Pershing Square (1) post reorg equities (5) q/a (1) Randy Smith (1) realogy (1) 10/29/11 8:38 PM Sourcing Trade Claims Upon filing of its petition for bankruptcy. address and claim of the creditors that hold the 20 largest unsecured claims. but the exact monetary measure of that liability is unknown. Bankruptcy Trustee.

When the counter party is a publicly traded company. should the claim be impaired or disallowed . There are instances where the Debtor marks every claim on the schedule as disputed or contingent. Representations and Warranties and Indemnification provisions. bank statements. then there is risk that he will not be able to perform his duties under the PSA. In addition. then counter party risk assessment becomes TWITTER UPDATES more difficult. 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. At this stage in the process the buyer will begin examining the documentation supporting the claim. Since the seller is not a capital markets participant. Equitable Subordination. the purchaser must reconcile these discrepancies before funding. However. It is also necessary to reconcile the amounts on the invoices with what is filed on the POC and the Schedules. the purchaser must be able to rely on the counter party to indemnify him for his losses. 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. the claim should be allowed. summary of tax returns and other information as needed to gain comfort with the counter party’s credit worthiness. the negotiation process for purchasing the claim begins.html Page 4 of 7 . the PSA should contain provisions for settling the disputes. In addition. 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. or is itself at SUBSCRIBERS risk of bankruptcy. 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. subject to final due diligence. validity and lack of any encumbrances on the claim. purchase orders. private business. has. insider trading or breach of fiduciary duty his claim may be equitably subordinated causing the priority http://www. This phase again can take a few days to a few weeks depending on the issues involved. the parties enter into a trade confirmation. courts which routinely handle complex commercial litigation. the purchaser can and should ask for financial statements. . If the seller of the claim aided and abetted fraud. Moreover. It is common for the PSA to require disputes to be litigated under New York or Delaware law. not a well established enterprise. 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. Once a claim holder willing to sell has been located.Distressed Debt Investing: Trade Claims Primer restructuring (2) restructuring conference (1) revolvers (1) rouse bonds (1) sahm adrangi (5) Scion Capital (2) Seth Klarman (14) shipping (1) short ideas (1) six flags (3) Spansion (1) special situation stocks (1) spreads (1) superinvestor (1) systematic risks (1) terms (1) Third Avenue Credit (3) Third Point (2) tousa (1) trade claims (1) tronox (1) value investing (1) value investing concepts (1) Visteon (2) Warren Buffett (2) 10/29/11 8:38 PM Bankruptcy Court will conduct a hearing to determine whether. This increases the risk and will required extra due diligence as well as the willingness to litigate if need be.com/2010/10/trade-claims-primer_26. This process can take anywhere from a few days to several weeks depending on the complexity of the issues involved. The claims purchase will be executed via a custom tailored contract known as a Purchase Sale Agreement (“PSA”). factors may come into play in the due diligence phase that require a re-pricing or cancellation of the trade altogether. In addition. This includes reviewing invoices. publicly issued debt or has a credit rating. the PSA will contain Indemnification provisions. This also avoids being in the home town court of the seller of the claim. Should legal disputes arise the between the buyer and seller. 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 PSA will required the seller to provide Reps and Warranties on the ownership. 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. If the counter party is financially unstable.distressed-debt-investing. he may change his mind several times throughout the negotiation process and also increase his offer based on competing bids. or to what extent. 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. The PSA will contain provisions governing the transfer of the claim. Due Diligence Once an initial bid is agreed upon. it is fairly easy to do counter party due diligence. One source of information is Dun & Bradstreet which compiles credit and other financial information on private businesses. if the counter party is a small. or have the buyer agree to indemnification provisions should the claim be allowed at a lower amount. or other contracts in order to determine the validity of the claim. 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.

Section 547(c) of the Bankruptcy Code contains exceptions for payments made in the ordinary course of business.distressed-debt-investing. The transfer was made within 90 days before the date of the filing of the bankruptcy petition or was made between 90 days and one year before the date of the filing of the petition to an insider who had reasonable cause to believe that the debtor was insolvent at the time of the transfer. a debt owed prior to the time of the transfer.co/ZIODHaWE 11 days ago What type of value investor are you? http://t.C.S. 11 U. DVP occurs when. 3001(e)2 http://www.com/2010/10/trade-claims-primer_26. should be analyzed. payment occurs.S. In order to minimize this risk seek to avoid purchasing claims of company.C. in this case they are not securities but the format is the same. It can be several months post closing of a trade that these issues are discovered and even longer until they are adjudicated. for cash that ensures that delivery occurs if. § 701 et seq. There are several criteria that are used to evaluate whether a payment was a Preference: 1. ).co/AbgHTphU 8 days ago Randy Smith of Alden Global http://t. 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.co/f43nuQkE 4 days ago of the claim to be moved to the end of the priority chain. not debt.. If there has been any unusual pressure or collection activity by the creditor resulting in the payment." 2.). often by making a payment to a favored creditor just before filing a petition to be declared bankrupt. The transfer was "to or for the benefit of a creditor. (Fraudulent Conveyance which has 2year look-back pursuant to 11 U. there must be an element of finality in the process. The transfer was made for or on account of an "antecedent debt"—that is. there is a simultaneous exchange of securities.. whether the payments were designed to give the transferee an advantage over other creditors in bankruptcy. the PSA is finalized and the trade is executed via Delivery vs Payment (“DVP”) format. § 548) 4. 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). § 547 CSFB's Special Situation Conference http://t. 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. To be true DVP. The transfer has the effect of increasing the amount that the transferee would receive in a liquidation proceeding under chapter 7 of the bankruptcy law (11 U. and circumstances surrounding the payments. whereby neither side of the trade can unwind the transaction after settlement.A. although “evidence of transfer” is not required it recommend. The transfer at issue is not required to be the type that occurs in every transaction between the parties. Rule 3001(e) reads as follows: Transferees trading on the “scheduled amount” prior to the filing of a POC must file a POC with court.S. 5. 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 . to complete a trade. 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. This has the effect of the claim being treated as equity.C. Avoidance Actions. http://t. The debtor was insolvent at the time of the transfer. including the amount and timing of payments. 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 purchaser must also have indemnification provisions covering such breaches. Rule 3001(e) 1 Assignment of a claim after a POC has been filed requires both a Notice of Transfer and an Evidence of Transfer to be filed with court. Additionally. Closing can occur anywhere from 10-30 days post initial confirmation of the trade.A. The standard practice is that once the trade has closed. The prior course of dealings between the parties. or whether there was any change in the status of the transferee such as the ability to obtain security in the event of nonpayment. inquiries may be made into the collection activities or practices between the parties.co/RKA3xKNr 8 days ago Longacre's Vladimir Jelisavcic's Presentation on Dryships http://t. and only if. The funds are then wired within one day of execution. insiders or those where the relationship could be potentially deemed as “insider”. the payment would not be ordinary course of business.Distressed Debt Investing: Trade Claims Primer 10/29/11 8:38 PM On Sell Side Research.html Page 5 of 7 . 3.co/8BoMtLNe 18 days ago Follow me on Twitter However.

distressed-debt-investing. are familiar with analyzing complicated capital structures and understand inter-creditor issues. The Transferor has 20 days to object to the transfer. how interesting are lease claims in such procedures? Sorry for the laundry list of questions but I tried to be as specific as I could. why? 3) How do you put a nominal value on operating leases (esp before filing of the SOFA)? Do you have a rule of thumb for estimating their value. THANK YOU VERY MUCH.com/2010/10/trade-claims-primer_26. 11/08/2010 Thanks for an excellent breakdown on trade claims. 11/08/2010 And sorry. to wait for the exit from bankruptcy for payment.. like say. they are also highly uncorrelated to the stock and equity markets making them attractive to distressed and special situation funds. or are unable. one more question: 6) In my limited experience with post petitions (LandAmerica Financial). so do you due diligence and invest wisely. While trade claims are an illiquid market. Frank Frank. one that is not rejected? 5) Do you consider leases to be roughly the same as trade claims in distressed debt investing or. Furthermore. My question is in regard to the treatment of LEASES: 1) In determining (A) the priority and (B) the amount of claims. like any other piece of financial debt (loan. Within 15-30 days post closing buyer follows up with claims agent to ensure claims register properly reflects the new owner of the claims... Is that typical? (I was kinda surprised that there weren't more leases imputed to the Opcos.Distressed Debt Investing: Trade Claims Primer 10/29/11 8:38 PM The clerk of the court or claims agent has the duty to notify the Transferor. Conclusion Investing in trade claims provides a unique opportunity set for distressed investors who already understand the bankruptcy process. Posted by Hunter Labels: trade claims 2 COMMENTS: Frank.. are capital leases "valued" differently than other financial debt? That is. With that said the market has grown more competitive and sophisticated in the last several years.. the trade claims were at the OpCo(s) while the leases were at the HoldCo.. bond) or is it different and if so. multiplying the next three years’ operating lease commitments (in the notes) by 3 or something? What's a good way of doing it? 4) What’s the rule of thumb for the nominal value of an operating lease that is rejected vs. 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.html Page 6 of 7 . is the nominal amount of a capital lease 100 cents on the dollar. is treatment of operating leases different than the treatment of capital leases? 2) On a claims basis.) Post a Comment Newer Post Subscribe to: Post Comments (Atom) Home Older Post http://www.

and/or speculations made in light of the ideas. opinions.Distressed Debt Investing: Trade Claims Primer 10/29/11 8:38 PM EMAIL ABOUT ME DONATE TO DISTRESSED DEBT INVESTING hunter [at] distressed-debt-investing [dot] com I have spent the majority of my career as a value investor.html Page 7 of 7 .distressed-debt-investing. For the past 7 years. I have worked on the buy side as a distressed debt and high yield investor. Under no circumstances is this an offer to sell or a solicitation to buy securities discussed on this site. All data. information and opinions are subject to change without notice. its editor and/or related parties may have positions in companies discussed. are committed at your own risk.com. http://www. financial or otherwise. Disclaimer This website is about distressed debt investing.com/2010/10/trade-claims-primer_26. Distressed-Debt-Investing. and/or forecasts. Any investments. trades. expressed or implied herein.