Distressed debt experts see busier market, big ground-rule changes

By Paul Deckelman

New York, June 11 - The Chinese have a familiar saying which is also a not-so-subtle curse: may you live in interesting times. For distressed debt market participants, they are getting more and more interesting, seemingly every day.

A panel of experts in the field told attendees at this week's 19th Annual High Yield Bond Conference presented by the New York Society of Security Analysts that with default rates expected to continue rising to near-record, or even record levels, things will certainly get busier in a market that has been a sleepy backwater of late. Current efforts by troubled companies to cut debt and otherwise right the ship may have the effect of only delaying the inevitable, setting the stage for even more blow-ups two, three or more years down the line.

At the same time, however, many of the traditional rules used to value bonds, bank debt and other distressed obligations are being thrown out the window, with judges and other officials involved in high profile-bankruptcy cases, starting with last year's collapse of several large financial houses and now including, but certainly not limited to Chrysler LLC and General Motors Corp., making crucial decisions that will set new legal paradigms for how such cases are handled in the future.

The experts also caution that investor recoveries are bad - and are only expected to get worse.

Default rates continuing upward

Default rates, over the next 12 months "have nowhere to go but up," declared Anders J. Maxwell, the managing director focusing on corporate restructuring and strategic sales for the Peter J. Solomon Co. investment bank, a frequent participant in corporate workouts.

He said that the current surge of defaults had really been building up for the better part of a decade, with defaults kept to "artificially low" levels in that time, largely by the easy availability of credit which allowed troubled companies to borrow what they needed to avert disaster - or to at least postpone it. Now, with a changed credit and economic environment having forced many such borrowers into default or even bankruptcy, "there's no question in our mind where default rates should go."

"I think there's going to be a spike" in defaults, agreed John J. Monaghan, the National Practice Group Leader of Boston-based law firm Holland & Knight LLP's Corporate Restructuring, Insolvency and Creditors' Rights Practice Group.

"There's a wholesale lack of liquidity available to the highly distressed companies to do what the traditional restructuring has always done in the past."

Another factor, he said, was that "in every past [negative credit] cycles, you've had the 'big boys' filing Chapter 11, the 'medium boys' following soon thereafter." In turn, those "medium Chapter 11s beget small Chapter 11s."

Over the last few "extraordinary" months, "the big boys have filed" - names like Chrysler, GM, shopping mall giant General Growth Properties Inc. and Lehman Brothers Inc. "That has a trickle-down effect," he advised. "The suppliers to those folks have lost some business. The lenders to those folks, they've lost some money." While such companies "can hang on," he said, a lot of them are "hanging on by their fingernails."

On the other hand, Adam B. Cohen, an attorney and former investment banker who founded Covenant Review LLC, an investment advisory service which specializes in legal analysis of bond indentures and debt instrument covenants, took a more cautious view, saying there were many "unknowable factors" that work against being able to accurately make such predictions, including unusual circumstances not present in past situations.

He noted that "we were waiting for '07, which was going to be the year when defaults [rose] and '08, when defaults were supposed to go up tremendously," although neither year ultimately showed a sharp upturn.

He said that over the last 60 days, "I've watched the demeanor and the thought processes [of institutional investors whom his firm advises] completely change" to a more positive view, although he also acknowledged that these could easily change back to a more negative feeling "in the next 60 days."

Changing the rules

One potential minefield for investors, the panelists agreed upon, was what Monaghan called "the hugely different paradigm" established in the current Chrysler reorganization - and seen in other big bankruptcies over the past year where government has gotten involved and the traditional rules regulating who gets what, how and when, have fallen by the wayside. The recent GM bankruptcy is another such situation, with some criticism from the financial community of the allegedly favorable treatment said to have been given to one politically favored class of creditors, the auto workers union retirees, at the expense of another group, the bondholders.

Monaghan noted the way the Chrysler reorganization, which will leave Fiat SpA, the U.S. government and the union in possession of the company, has been pushed via a rapid-fire series of decisions over the span of just two-and-a-half weeks, start to finish. In contrast, he said, the usual procedure is that all parties get at least 20 days' notice before anything happens, "and that [short timeframe ] is only in emergency situations. Most of the time, there's a market check that goes on for 60 to 90 days, so you know that the consideration is adequate."

The veteran bankruptcy lawyer said that "if it were just these two cases," he'd reluctantly accept it as "an exception to the general rules," motivated by a need to act to save the economy - but he noted other whirlwind cases that seemed to run roughshod over established procedures as well.

He said "it started with Lehman," where virtually all of its broker-dealer assets were sold to Barclays Capital on just three days' notice and with parties not really having adequate valuation information "because we knew the whole economy was going to crash if they didn't. We all went 'that's the Lehman Brothers Exception'."

He said there followed in quick succession the General Growth Properties bankruptcy, which "smashed through" other traditional procedures, coining another "exception;" GM, with the projected sale of virtually all of its good assets on short notice - yet another "exception;" and Chrysler, cleared for a quick closing in which, to boot, senior secured debtholders will get a 33% recovery while trade creditors will be made money-good - a reversal of the usual order, he said, which "is turning my universe on its head."

Monaghan said that "maybe five years from now, we'll go back and say 'okay, those were the five or six huge-company 'exceptions' - but it could be that this is precedent for a whole new world."

Cohen said that in the Supreme Court ruling quashing an attempt to stop or delay the fast-moving sale brought by endangered dealers and pension-fund Chrysler creditors feeling the sale agreement gives them short shrift, the high court "said the right things," about this being a unique case and not a ruling on the case's merits - but he asked whether "all these exceptions are adding up?"

Maxwell added that traditionally, a bankruptcy process is "banging heads until you get consents" from the involved parties. Looking at the government's efforts to speed the big auto reorganizations through despite established procedures, he said "we all knew this was coming - because [president Barack] Obama got elected by the unions. He was not going to just let these companies fail. That was sort of understood last fall." With the government moving vigorously to implement its preferred solution over traditional creditor objections, "consents [of the parties] is not required anymore. What gets dictated gets done."

Reduced recoveries ahead

Turning to the kind of recoveries that debtholders can expect in the new market environment, Cohen said that "some of the worst securities in [companies'] capital structures are turning out to have better returns than expected - but then when the music stops, it's going to be the senior guys that are going to have smaller recoveries."

He said that "a lot of these credits that seem to be most in trouble may hang on a lot longer than expected, but what the recovery is in the end for the senior lenders is pretty, pretty poor."

Cohen noted that distressed companies, fighting to stay alive, have indulged in various strategies, including selling off assets, doing debt exchanges, issuing new debt and the like, "all sorts of ways to play around."

For instance, he said, Clear Channel Communications Inc. - currently trying to line up debt holder support for an exchange offer scheme that also involves its outdoor advertising unit -- "could hang on for another year or 18 months" - and "considering where some of its most structurally subordinated debt has traded, anyone who took a bold view on Clear Channel a couple of months ago is doing pretty well - actually terrifically. But what's going to be left if Clear Channel files for bankruptcy?"

He said that troubled computer chip makers like NXP BV and Freescale Semiconductor Inc., which have resorted to outright cash sales of assets, "are prolonging their lives, which is terrific, but if they go bust, I don't know what is going to be left for senior lenders." He also said that in some cases, even when there are assets there, covenants and indentures may have been carefully initially structured or later amended, so "there's a lot less securing bank loans than one might expect."

Monaghan pointed to some changes in the bankruptcy laws "that I think, net-net, are going to reduce recoveries, and "some unfortunate decisions from various courts around the country" that are also going to reduce recoveries, citing the controversies which have arisen in the Chrysler case as well as in the reorganization earlier in the decade of flatware maker Oneida Ltd.

"I think recoveries are going to be lower," he projected. "It's hard to predict now exactly how much lower. I think that it's going to be sector specific." He said that problematic sectors "which I have my eye on" include retail, "mega-cases" and those involving defined-benefit plan participants.

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