Creditor's Kick The Can Down The Road...Then Kick It Some More
“Lenders don’t want to book losses, so they’re happy to extend and forbear rather than litigate and take the collateral,” CohnReznick’s Shandler said. “Bondholders and other secured creditors see an opportunity for improvement [in operational cash flow and the value of the collateral] over time. As long as revenues are covering operating costs and cash flow is neutral or positive, creditors are often willing to wait for a better market to achieve higher value.”
Easy money played a large role, according to Dombrowski of Alvarez & Marsal: “Money is available and virtually free, so banks are not pressed to [compel] restructurings. They’re not really pushed until there is a liquidity crisis. And, in this environment, we are extremely far from illiquidity.”
Kotler, of Duane Morris, added: “The resistance among lenders to foreclose on assets stems partially from the fact that, in their eyes, a semi-performing loan is better than a non-performing loan, even if the business is limping along.”
Absent Bidders, Silent Auctions
Bankruptcy auctions are fewer in number and are generating less interest than the economy would seem to dictate, confounding insolvency professionals. A number of companies that go to bankruptcy auction have barely neutral—and sometimes negative—cash flow, and some also have faulty business plans. These factors make them less attractive to would-be bidders, Dombrowski said, adding that prospective bidders are weighing carefully how much of an investment they will have to pump into any company they buy at auction. “Few companies are willing to spend real money to purchase bankrupt companies and then have to spend additional time and money to fix the underlying problems given the uncertainty of the result,” he said. “Auction prices have been disappointing.”
Interest in bankruptcy auctions has waned so dramatically that some potential bidders will not attend unless their expenses are reimbursed, Shandler said. “It’s gotten to where the cost of having a backup bidder is to pay their expenses. Otherwise, nobody shows up,” he added. Still, according to Shandler, auctions remain a good barometer of the value of any asset: “If you have a good feel for the actual business value, you can make sure you bid properly. When people are at least kicking tires, everything ends up selling for the right price.”
Catalanello, who represents bankrupt debtors as well as bidders, recalled two recent auctions that highlight not only that this is a buyers’ market, but also the zero-sum duality of bankruptcy. “In one, my client was looking for a strategic acquisition to help it expand its geographical footprint in the mattress retail industry and bid for a company with a strong brand and surprisingly solid balance sheet, but that was crippled by its parent’s chapter 11 filing. Surprisingly, only one other bidder materialized: a private equity firm looking to expand upon a portfolio company’s pillow business. On the flipside, I represented a digital music startup in a recent chapter 11 case into which sophisticated investors had pumped approximately $80 million, largely to build its intellectual property as the company never launched operations. Despite the uniqueness of the intellectual property and the level of interest shown by many in the music industry, it turned out to be only a two-dog race: one group led by senior management team and another group led by the debtor’s former investment banker.” (Read on for our discussion of the relative worth of intellectual property as collateral, as part of a larger look at what kinds of collateral are viewed as most—and least—valuable.)
Personal relationships among the professionals sometimes come into play. Lawrence Kotler represented a client looking to buy an ethanol plant in Syracuse. The client’s initial bid, he said, “was extremely modest. I got to talking with the debtor’s counsel, with whom I have a good relationship, and he let on that they were thrilled to get any bid. It’s definitely a buyers’ market.”
Effects of 2005 Code Change: Deep-Cleansing Action or Fruitless Fire Drill?
Eight years after a major change to the Bankruptcy Code, debtors, creditors, investors and attorneys are still feeling the effects. On one hand, the Code was revised to allow debtors to cleanse their companies of unwanted commercial real estate leases and some other contracts; favorable leases are assumed and unfavorable leases are rejected. On the other hand, changes to the Code sharply compressed the amount of time—to 210 days—that a chapter 11 debtor is given to assume, assume and assign, or reject its leases.
“The time framework means that, in many cases, unless the value exists as of the petition date, debtors have lost the ability to mine the value of their favorable leases for the benefit of creditors,” Kotler said, pointing to chapter 11 filings by Daffy’s and St. Vincent’s Hospital as prime examples. However, “in many cases, especially in retail, the leases are valueless at the time of the filing but would likely increase in value over time, if the debtor had that kind of time.” He cited Ames, Caldor and Kmart as three examples of that phenomenon.
According to Dombrowski: “With a large tenant that has a large space, it’s extremely difficult to relocate people in a short time frame. From debtors’ perspectives, this [aspect of the Code change] is not helpful. Since the Code change, a lot that was done in bankruptcy—cleansing the company, getting new owners, restructuring, consolidation of distribution centers and the sales force—is now mostly done outside of bankruptcy.”
Heuer said: “Debtors, especially in retail, need time for closing sales and to dispose of inventory. The Code changes compress matters into a matter of months.”
Kotler added: “The compressed time frame means that if a lease is on the cusp of being favorable but is not necessarily immediately favorable, the tendency is for the debtor to reject it.”
Shandler said: “You’re trying to do a lot in a little time, including getting rid of inventory. But retail customers know to wait for the 40-percent-off sale.”
Valuable - And Damaged - Collateral
It is well-settled that a ton of feathers weigh the same as a ton of steel. The equation does not hold when the value of collateral is being measured. Assets that were worth, say, $100 million to a healthy company are not necessarily worth as much when they are collateral, especially when the collateral is in the form of intellectual property, custom goods, technology, goods with expiration dates or the product of heavily regulated industries. Consider a pharmaceutical company that files for bankruptcy protection. Its inventory—medicines with expiration dates—can be sold only by companies properly licensed to do so. “The fact that the pharmaceutical industry, for instance, is heavily regulated leads to inaction while everyone is trying to measure the regulatory environment and its effect on the collateral,” Shandler said.
The ticking clock and regulatory restrictions on who may sell prescription drugs inherently reduce the value of collateral. “Any factor that restricts monetization of the collateral diminishes the value of the collateral,” Catalanello said. For example, while Catalanello generally extolled the virtues of 363 sales, noting there has been significant activity in that space, public health and safety concerns could trump the power and effectiveness of 363 sales if speed is the goal of the transaction.
Dombrowski equated the pitfalls of using medications as collateral with that of using support-driven technology as collateral: “Without the support, the value of the technology drops considerably.”
Meanwhile, Dombrowski said that the value of patent portfolios—and investors’ interest in them— is an open question and has been since 2011, when the Canadian telecom company Nortel Networks, two years after filing for chapter 11 protection, sold 6,000 patents for an astounding $4.5 billion. Relatively few patent portfolios have been offered for sale in bankruptcy since Nortel, making it challenging to infer laws of large numbers. The signs, however, are not overwhelmingly positive: One West Coast auction attracted no bids at all, and Kodak’s presumptive auction price of $2.5 billion for 1,100 digital patents turned into an actual selling price of one-fifth that amount. A consortium consisting of Apple, Google and Microsoft bought the patents for $2 billion less than pre-sale estimates.
“Nortel was a crazy auction that resulted in a purchase price well beyond anyone’s wildest expectations,” Dombrowski said. “People saw that and thought ‘Holy smokes. I’m going to make a fortune.’ Kodak believed its patent sale would eliminate most of its financial problems, but it didn’t play out that way. So now, with a small sample size and the possibility that Nortel was an outlier to the high side, the values of patent portfolios are an open question.”