A PRIMER ON DISTRESSED DEBT INVESTING Intro Distressed debt investing is the practice of purchasing the debt of troubled companies

Distressed has two meanings o The issuer of the debt is troubled o Also refers to the price of the bonds; distressed debt often trades for pennies on the dollar The Growth of the Distressed Debt Market y The distressed market has nearly doubled between 1998 and 1999 y Several factor influenced this growth o Many more types of commercial loans are available for resale  There are many new types of charge-off loan portfolios o Many more banks and other lenders are managing their assets from a global portfolio perspective as opposed to an account-level basis  Banks are selling non-performing and sub-performing loans in the market at attractive discounts to get them off their books o Debt loads continue to grow Vulture Investors and Hedge Fund Managers y They buy the debt of troubled companies including subordinated debt, junk bonds, bank loans, and obligations to suppliers y Subordinated debt: a loan or security that ranks below other loans or securities with regard to claims on assets or earnings; in the case of default, creditors with subordinated debt wouldnt get paid out until after the senior debtholders were paid in full subordinated debt is more risky than unsubordinated debt y Junk bonds: a bond rated BB or lower because of its high default risk; these are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four % pts higher than safer government issues y The PLAN is to buy the distressed debt at a cheap price and then seek improvement of the company y Sometimes this debt is used as a way to gain an equity investment stake in the company as the vultures agree to forgive the debt they own in return for an equity stake in the company y Distressed debt investing is mostly about company selection y The returns for distressed debt investing can be very rewarding y The GROWTH of the distressed market has attracted the hedge fund manager into the game y Hedge funds: aggressively managed portfolio of investments that uses investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns o Hedge funds are most often set up as private investment partnerships that are open to a limited number of investors who usually have to buy in at a HIGH y y

price. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year o Hedge funds cater to sophisticated investors. Hedge funds are simply mutual funds for the super rich. They are similar to mutual funds in that the investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. o Hedging is the practice of attempting to reduce risk but the goal is to maximize return on investment. Distressed Debt and Bankruptcy y they are intertwined y many distressed investors purchase the debt while the borrowing company is currently in the throes of bankruptcy y Overview of Chapter 11 Bankruptcy o US Bankruptcy Code, Ch 11 o Recognizes the corporation as a GOING CONCERN o This chapter affords a troubled company protection from its creditors while the company attempts to work through its operational problems. Only the debtor company can file for Ch 11 protection o Classification of Claims  All issues of subordinated debt by a company would constitute ONE CLASS of creditors under a bankruptcy plan.  All secured bank loans (usually the most senior of creditor claims) are usually grouped together as one class of creditors  The bottom pile is common equity o Plan of Reorganization  The D has an exclusive right to file a plan of reorganization within 120 days of seeking Ch 11 bankruptcy protection.  If the company files a plan during this 120-day window, it has another 60 days to lobby its creditors to accept the plan  During this time (120 + 60 days) no other party in interest may file a competing reorganization plan  After the exclusive period ends, any claimant may file a reorganization plan with the bankruptcy court At this point, the gloves come off and senior and subordinated creditors can petition the bankruptcy court to have their plan accepted  A plan is ACCEPTED when all classes of claimants vote in favor of the plan o Prepackaged Filing  Debtor company agrees in advance with its creditors on a plan of reorganization before it formally files for protection under Ch 11. Creditors usually agree to make concessions up front in return for equity in the reorganized company. The company then files with the 2

bankruptcy court, submits its already-negotiated plan of reorganization, and quickly emerges with a new structure o Voting within a class  To constitute an acceptance of a plan of reorganization, either: 1) the class must be completely unimpaired by the plan, ie the class will be paid in full, or 2) in number and 2/3 in dollar amount of claims in the class must vote in favor of the reorganization plan  if the members of a class vote in favor of a reorganization less than unanimously, and any dissenting claimants in the class receive at least what they would have obtained in a Ch 7 Liquidation Plan, the dissenters are bound to receive the same treatment under the reorganization plan  *** SEE p10 of Anson for CH 11 FLOWCHART *** o Blocking Position  a single creditor can block a plan of reorganization if it holds 1/3 of the dollar amount of any class of claimants  therefore, a single investor can obtain a blocking position by purchasing 1/3 of the debt in any class o The Cramdown  under 1129(b) of the BC, a reorganization plan may be confirmed over the objection of any impaired class that votes against it so long as the plan (1) does not unfairly discriminate against the member of that class, and (2) is fair and equitable with respect to the members of that class o Absolute Priority  Senior secured debtholders, typically bank loans, must be satisfied first  Companys bondholders come next  Companys shareholders get whatever is left  It is usually the case that the senior secured debt is made whole and that subordinated debt receives some payment less than its face value with the remainder of its obligations transformed into equity in the reorganized company  It may seem unfair that the original equityholders are wiped out but this is the residual risk that is borne by every shareholder in every US company  The debtors outstanding debt may be freely bought and sold Using Distressed Debt to Recycle Private Equity o LBO firms are a great source for distressed debt o Leveraged Buyout: the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of 3

LBOs is to allow companies to make large acquisitions without having to commit a lot of capital  In the LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ration, the bonds usually are not investment grade and are referred to as junk bonds. Leveraged buyouts have had a notorious history, leading to many bankruptcies of acquired companies. This is because the leverage ratios were so high and the interest payments were so large that companys operating cash flows were unable to meet the obligations Distressed Debt Arbitrage o Arbitrage: the simultaneous purchase and sale of an asset in order to profit from the difference in the price it is a trade that profits by exploiting price difference of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies. Provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time  Getting harder to do this nowadays as pricing inefficiencies are quickly monitored by advanced computing systems The Return Distribution for Distressed Debt o Skewness and kurtosis o Skewness: an asymmetry from the normal distribution in a set of statistical data.. it can come in the negative or positive form, depending on whether data points are skewed to the left (negative skew) or to the right (positive skew) of the data average  By knowing which way data is skewed, one can better estimate whether a given or future data point will be more or less than the mean  Skewness risk is the risk that a model assumes a normal distribution of data when in fact data is skewed to the left or right of the mean o Kurtosis: measured relative to a normal bell shaped distribution. A POSITIVE kurtosis indicates a distribution with fatter than normal tails (leptokurtosis), while a negative value shows a distribution with thinner than normal tails (platykurtosis). Fatter tails show an exposure to large outlier events that occur more frequently than predicted by a normal distribution. A distribution of returns with thin tails indicates less exposure to outlier events o Sharpe Ratio Analysis: describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset you always need to be properly compensated for the additional risk you take for not holding a risk-free asset o Investors in distressed debt should experience the same type of risk as those risks of credit event risk Risks of Distressed Debt Investing o Two main risks  Business risk still applies 4

 Lack of liquidity o Conclusion  Distressed debt investors are rarely concerned with the timely payment of interest and principal Instead, they are concerned with the viability of the company as a going concern  If the company is already in bankruptcy, they will review the companys plan of reorganization INVESTING IN DISTRESSED SITUATIONS Intro Supply of distressed debt is highly cyclical Spinoff: the creation of an independent company through the sale or distribution of new shares of an existing business/division of a parent company. A spinoff is a type of divestiture Basic Restructuring Options y Firms can liquidate by Chapter 7 bankruptcy y Most firms more than nine out of ten first try to restructure their debt out of court and only when this fails do they file for bankruptcy y An out of court restructuring can be accomplished at much lower cost than a courtsupervised reorganization y Firms that successfully restructure their debt out of court experience increases in their common stock price from the time they become distressed to when they complete restructuring y While in Ch 11, the firm does NOT have to pay or accrue interest on its unsecured debt (and it only accrues on its secured debt) y Ch 11 also allows the firm to reject unfavorable lease contracts and to borrow new money on favorable terms by granting lenders superpriority over existing lenders (debtor in possession financing) o Debtor in Possession Financing: financing arranged by a company while under Ch 11 bankruptcy DIP financing is unique from other financing methods in that is usually has priority over existing debt, equity and other claims y a reorganization plan in Ch 11 can be passed with the approval of fewer creditors than a restructuring plan negotiated out of court (requires unanimous) y from an investors view, Ch 11 can also be attractive because the firm is required to file more financial information with the court than is generally available in an out of court restructuring y about one in four bankruptcy filings by public firms have been prepackaged o takes much less time and money o prepacks work best for firms whose problems are more financial than operational in nature y y 5

Strategies for Creating Value o Investor who purchases a distressed claim enjoys the same rights and disabilities as the original claimholder o A firms immediate objective is to reduce the total amount of debt in the capital structure the D has the exclusive right to propose the first reorganization plan for 120 days following the bankruptcy filing. This period is routinely extended in many bankruptcy jurisdictions o Rule of absolute priority: there is a hierarchy of claims and who takes what o This rule MUST be followed in a Ch7 liquidation o In Ch11, certain claims are given a higher priority to receive payment than others but absolute priority does not have to be followed exactly  Senior claimholders may leave crumbs for the lower claimholders to ensure passage of a reorganization plan by vote o Vulture investors follow three main strategies to earn a positive return on investment:  Make the entire pie larger by taking an active management role in the firm and deploying its assets more efficiently  Make someone elses slice smaller, thereby increasing the size of the investors slice  DO NOTHING, but undervalued inefficiently priced claims and wait for them to appreciate in value o The first two strategies are PROACTIVE o The last one is PASSIVE Proactive Investment Strategies y Taking Control of the Business o Several ways an investor can influence how the firms assets are deployed, he or she can:  Submit a reorganization plan which specifies what financial consideration will be delivered to the outstanding claims and to propose a business plan for the firm once it leaves Ch11 any person who holds any of the firms claims is entitled to submit a reorganization plan. The judge in the case can permit more than one plan to be voted upon at the same time  Purchase currently outstanding debt claims with the expectation that these eventually will be converted into voting common stock under the firms reorganization plan, this enables the investor to exercise control over the firms assets after it reorganizes  Purchase new voting stock and other securities that are to be issued under the firms reorganization plan (funding the plan) o the investors goal is to assume a management and control position in the company and directly influence its investment and operating policies. The investor earns a return by causing the company to be run more profitably y

o assets can be acquired by purchasing a large block of the firms equity and waging a proxy contest or a special stockholders meeting which is to force management to propose a more stock-friendly reorganization plan o purchasing equity is an ineffective way to acquire or exercise control in a financially troubled company o BC already includes a procedure for replacing management with a trustee if management is shown to be poor or corrupt o Prebankruptcy stockholders interests are diluted by new claims being issued as a part of a reorganization o The trick if the goal is to emerge from reorg as a major equity holder is to concentrate on buying relatively junior claims but not so junior that one ends up receiving nothing Bondmail y Investor can increase return by acquiring a large % of an outstanding debt issue to block the firms reorg plan y A class is deemed to have accepted a plan if at least 2/3 in value and in number of the claimholders in that close vote in the affirmative y An investor can threaten to hold up a firms reorg unless he is given a high recovery this is known as bondmail y An investor who holds a blocking position in a class cannot demand more favorable treatment under a plan that other members of the class Section 1123(a)(4) of the BC requires that all in a class must be treated identically under a reorg plan y Courts treat a holder of multiple claims within a class as a single holder if the claims are identical y With nonidentical claims, the holder is entitled to one vote for each claim y As long as one other holder is represented in the class, the investor CANNOT account for more than half of all holders only by controlling 100% of the claims can he have complete control over how the class votes y Blocking strategies are riskier if the investor purchases his or her claims before the firm files for Ch11 y Investors ability to coerce a higher payment is limited by cram-down y Cramdown: a plan can be confirmed over the objections of dissenters if the present value of the consideration class members are to receive under the plan equals the allowed value of their claims or if no more-junior class receives any consideration o the threat of a cramdown can be enough to reduce investors recovery drastically Passive Investment Strategies y Buy and hold strategy y After publicly traded bonds go into default, they typically trade at about 30% of their face value, the average discount for more junior bonds is even larger Risks of Distressed Investing y Firm specific y The J Factor 7

Judges are influential Judge uses discretion Judges influence the investment decisions Judges must approve major actions that lie outside the ordinary course of business o Interventionist judges have been known to permit a firm to take actions that are potentially harmful to creditors interests o SDNY judges favor management and have been known to extend the exclusivity period in which the D has the right to submit a reorg plan o Some firms go forum shopping Title Risk and the Mechanics of Transferring Claims y Number of steps must be taken to recognize the investor as the new owner of claims y Transfers of claims in Ch11 are regulated by Federal Bankruptcy Rule 3001(e) y Within 10 days of filing for Ch11, the D is required to file a schedule of Assets and Liabilities with the court clerk y Debtor sets a bar date and creditors with disputed or contingent claims must file a proof of claim by this date or forfeit their rights to participate in the reorg plan (other claimholders are assumed to have filed a proof of claim) y Under 3001(e), an investor who purchases a claim after a proof of claim has been filed by the selling creditor is required to prove the court with evidence of the transaction y Investor does not have to reveal number of claims or price of claims y Prior to August 1991, whcn new 3001(e) was adopted, more-rigorous disclosure requirements had to be satisfied o Investor had to reveal terms of the transaction to the court including the number of claims purchased, and sometimes the price. o Transfer of claims also had to be approved by a court order. In a number of widely cited cases, judges refused to approve claims transfers on the grounds that sellers were not informed about the value of the claims they were selling o Removing the Judge from this process has helped investors y Investors may still have problems: seller may have sold a given claim more than once; redundant sales like this may be fraudulent or the result of oversight on the part of larger lenders who assigned responsibility for selling the loan to more than one person y An investor can take several measures to reduce the risk of buying a redundant claim y Risk of Buying Defective Merchandising o Inherent certain legal baggage or liabilities from the original lenders that the investor had no role in creating o Fraudulent Conveyance  Fraudulent conveyance occurs when: 1) property is transferred from a firm in exchange for less than reasonably equivalent value o o o o

2) as a result, the firm is left insolvent or it was insolvent when the transfer took place the first criterion is almost always satisfied by the LBO under section 548 of the Bankruptcy Code, a fraudulent conveyance action can be brought within one year of an LBO Avoidable Preferences  Ch11 allows a debtor to recover certain payments known as avoidable preferences that it made within 90 days prior to filing for bankruptcy  the point of this provision is to discourage insolvent firms from cutting side deals with key creditors  payments to creditors made in the normal course of business and on normal business terms are not recoverable  if the investor purchases debt in a firm that subsequently files for bankruptcy, he or she may have to return payments that were received on the debt within the 90 day prefiling period. If the debt is purchased after the firm files for bankruptcy, the investor is not directly on the hook Equitable Subordination  Debt can be made LESS SENIOR if the selling creditor engaged in inequitable conduct that resulted in harm to other creditors or gave the selling creditors claim an unfair advantage in the case  Equitable subordination can hurt returns on investment because junior claims receive much less money  Bank creditor may be guilty of inequitable conduct if it uses too much control over a firms operations by lending more money or refusing to advance funds under a credit line, thus impairing the firms ability to pay other creditors Environmental Liabilities  Comprehensive Environmental Response Compensation and Liability Act (CERCLA), lenders can be held liable for the costs of cleaning up hazardous substances found on the borrowers property  A lender who has a security interest in certain contaminated property may be considered an OWNER or an OPERATOR of the property Protecting Against These Risks  Obtaining appropriate representations, warranties, and indemnities from the seller  This can be difficult because creditors usually want to rid themselves of all ties to the firm Disputed and Contingent Claims  Claims can be disputed or contingent for many reasons  The date that a claim comes into existence is important because under the BC all prepetition claims are discharged when the firm leaves bankruptcy 9

Counting Votes y For the buyer of a bank, trade or other nonpublic claim to be considered a holder of record and eligible to vote on a reorg plan, a statement of transfer of claim must be received by the claims processing agent no later than the official voting record date y The purchase agreement could include a provision that requires the seller to transmit his ballot to the buyer, although the seller may fail to perform its obligation in a timely enough manner the buyer could try to obtain from the seller a power of attorney that gives the buyer the right to vote the claim on behalf of the seller y Voting rights issues are complicated! y Another risk is the potential for abuse of the voting process y Bond churning: final counting of votes doesnt occur until 60 days after the voting record date during this time, a person could purchase some amount of bonds, keep the ballots (by agreement with the sellers), and immediately resell the bonds without the ballots, the buyer thus gets a shitload of votes without having to hold as many bonds y Disqualification of Votes o To profit from a proactive investment strategy, an investor must have some control over the outcome of the bankrupt firms financial reorganization o Allegheny International  Under its competing plan, Japonica proposed to acquire control of Allegheny, settling the creditors claims with mostly cash  After balloting had commenced on Alleghenys plan, Japonica started to acquire senior bank debt and acquired eventually just over 33% before the close of balloting  Japonica was thereby able to block the debtors plan  The judge in this case granted the motion of the D to disqualify Japonica because Section 1126(e) of the BC says that the court can disqualify the votes of any entity whose acceptance or rejection of a plan was not in good faith or was not solicited or procured in good faith Japonica acted in bad faith to acquire control of the debtor  Lessons from Japonica case: investor is more likely to be shut down by a judge if he or she openly proposes to acquire control of the debtor and proposes an alternative plan to the Ds and or acquires a blocking position in one or more classes for the sole purpose of defeating the debtors plan one cannot be TOO aggressive in their strategy Holding Period Risk y Annual rate of return that one realizes buying distressed claims depends on two unknowns: o The $ recovery eventually realized by the claims o The amount of time it takes to be paid this recovery y It is NOT uncommon for investors in distressed claims to seek annualized returns in the range of 25 to 30% 10

Legal and administrative costs increase over time o These costs MUST be paid before any other claims are settled in Ch11 and therefore they directly reduce the recoveries available for the firms claimholders y Delay destroys value because management continues to be distracted from running the business and key customers and suppliers are more likely to defect! y Ch11 cases usually run 2 to 3 years Strategic Role of Valuation y Investors return depends on two key values: o The true value of the firms assets (TV) o The value of the firms assets used in determining payouts to claimholders under the firms reorg or restructuring plan (PV); they are almost always different y Junior claimholders benefit from a HIGHER PV because they are last in line to be paid y Senior claimholders prefer a lower PV because they then receive a larger fraction of the total consideration distributed under the plan y Suppose that senior creditors are owed 200 and junior creditors are owed 100 (total of 300). Suppose further that the TV of the firms assets is 260 if this amount is also the PV, then senior creditors are made whole and only 60 goes for junior creditors and nothing for stockholders y Stockholders and junior creditors would clearly want the PV to exceed 300 y If the PV was 180, the senior creditors receive consideration worth 180 in the form of new debt and equity securities and possibily some case, and junior creditors and stockholders get NOTHING if the firm is still worth 260, the new claims must eventually appreciate in value by 80, a pure windfall for senior creditors y Any claimholder is free to vote against a reorg plan that uses an unfavorable PV y Investors should understand which particular claimholder class controls the reorg proposal process Lack of Info About Purchases and Purchasers y Investors generally operative in secret and do not have to disclose much about their purchases y This info does have to be reported if an investor files a Schedule 13D or 14D-1 with the SEC y The lack of disclosure can be a double-edged sword y The lack of info makes it difficult for an investor to know how many claims in a given class he or she should acquire y Knowing who owns a firms claims clearly provides a huge advantage in this market Liquidation Risk y In Ch7 liquidation, the firms assets are sold for cash by a trustee and the proceeds are paid to the firms claimholders according to the absolute priority rule y Liquidation is a much more frequent outcome for small firms than for large ones Insider Trading Issues y 11

y y

Concept of insider trading is not explicitly addressed in the BC Investors who trade on the basis of inside information face sanctions under Section 10(b) of the Securities Exchange Act, this is the same for investors in nondistressed securities An investor will also be considered a fiduciary if he sits on the Unsecured Creditors Committee which is appointed by a judge in every Ch11 case and it consists of the seven largest unsecured creditors who are willing to serve

Tax Issues y Tax penalty increases with the % of equity that an investor either purchases directly or acquires indirectly through the exchange of stock for debt y Preservation of NOLs o If an investor purchases a block of claims in a distressed firm for the purpose of acquiring control, the firm may lose significant tax benefits arising from its NOL carryforwards o NOLs are often a distressed firms largest single asset y Under 382 of the IRC, a firms ability to use its NOLs can be severely restricted when it experiences an ownership change y An ownership change takes place when any group of stockholders collectively increases its total % ownership of the firms common stock by more than 50% points during any three-year period y If an ownership change does take place, the restrictions on NOL use are generally less severe if the firm is in Ch11 Cancellation of Indebtedness Income y If an investor purchases a financially distressed firms debt at less than face value and later within two years becomes related to the firm by acquiring more than 50% of its equity, the discount may be taxable to the firm as cancellation of indebtedness (COD) income. Normally, such income is created whenever a firm repurchases its debt for less than full face value Exit Strategies and Liquidity Risk y Less liquid than most organized securities markets y Exit normally occurs in one of three ways o First, and most common, investors can simply trade out of their positions o Second, they can sell their claims at an IPO o Third, investors can swap their claims for cash and/or other consideration in a merger y Liquidity risk can arise in several ways o first, too many new types of claims may be created under the firms reorg plan, resulting in an overly complex and fragmented capital structure y an investors ability to trade out of his or her position may also be impaired if he or she signed a confidentiality agreement when the claims were purchased y analysis and investors may lose interest in a firm once it becomes financially distressed Do Vultures Add or Subtract Value in a Reorganization? 12

Bank lenders may be able to book a profit on a distressed loan sale if Some banks prefer to sell off their loans as soon as they become troubled, rather than actively manage them through a workout department y By buying up and consolidating distressed claims, vultures can also facilitate a reorg by reducing the so-called holdout problem y The presence of vulture investors therefore facilitates restructuring by giving the firm greater flexibility to choose an optimal capital structure Conclusion y Certain key qualities. o First is a superior ability to value a firms assets o Second defining quality of successful vulture investors is superior negotiating and bargaining skill o Finally, successful vultures understand the risks of investing in distressed situations, these risks cannot be eliminated, but they can be controlled y Consensual Plans o Under a consensual plan, every impaired class of claims must vote o Acceptance of the plan by a particular class requires the approval of at least 2/3 of the face value of the outstanding claims in that class, representing at least of the claimholders in the class o Plan must also satisfy the best interests of creditors test:  Each dissenting member of every impaired class must received consideration worth at least what he or she would receive in a liquidation y Nonconsensual Plans o For such a plan to be confirmed, two additional tests must be satisfied:  the plan must not discriminate unfairly, and it must be fair and equitable  if the plan meets these two conditions, then it can be crammed down on the dissenting classes  a plan is fair and equitable with respect to a dissenting class if the present value of the cash and securities to be distributed to the class equals the allowed value of the class members claims or if no more junior class receives any consideration y Feasibility Test o Every plan must also be deemed feasible by the judge in order to be confirmed o This means the company will be able to generate sufficient cash flow in the future to avoid another trip to b-court y y THE CURRENT MARKET ENVIRONMENT: Nations In Distress Decline in the Housing Market y The housing market has declined a lot y It grew until 2005, then it crashed in like 2006-07 13

Mortgage default rates started rising in 2006, but they spiked high hard in 2009 this is when the bubble burst and then defaults dropped off y Housing prices raised up very high until 2006, and then they dropped off Unemployment y The unemployment rate went haywire and then it started raises HUGE in like 20072008 y Job growth spiked DOWN negatively in about 2008 y Labor market conditions deteriorated dramatically during the recent recession, and despite a modest recovery in job growth beginning in early 2010, employment remains well below its prerecession level y Jobless claims spiked up SUPER HARD in 2009 Market Volatility y month of August showed volatility in the Dow Jones, with the average index fluctuating up and down a whole point y S&P had the same type of volatility State Debt Crisis y There are a ton of states who are experiences fiscal responsibility issues and there are states whose budgets are fucked because of their outstanding pension and spending liabilities y In 2009, 31 states were below the 80% funded threshold for a well-funded pension system. These are very high numbers y 20 states pensions to run out by 2025 o New York is not on the list Federal Debt Crisis y US Debt Crisis & Related Issues o US reaches debt ceiling in May 2011 o Legislation passed in August 2011, raising the debt ceiling $400 billion; additional incremental increases are subject to a congressional disapproval o Deficit to be reduced by $1.5 trillion over the next 10 years o Bi-partisan debt reduction committee created o US credit rating downgraded from AAA to AA+ International Debt Crisis y Greek debt is fucked y Their debt % is up to about 142.8% and the Eurozone average is about 85.3% y HISTORY KEY PLAYERS AND STRATEGIES What is Distressed Investing? y Evolution of Ch11 and the Origin of Distressed Investing o Distressed investing has its roots in the US Constitution o When congress initially enacted the BC, the debtors stakeholder were its lond-standing relationship bankers, bondholders, trade creditors and shareholders 14

o The Debtor was the KING of this process o Relationship banks were focused on minimizing losses rather than maximizing profits, and worked with the debtor to assure that the value of its business was maintained and it would emerge from bankruptcy o Bondholders and trade creditors that wanted to take an active part in the process would seek membership on the creditors committee in an attempt to gain influence or control  A creditors committee is a statutorily appointed group of the debtors largest unsecured creditors, whose duty is to represent the interests of all general unsecured creditors o Shareholders were shut out of the process y Creation of the Mini-Trading Exchange o Distressed investing came about o This was a new asset class and a sophisticated liquid efficient and mature trading market for bankruptcy loans, claims, and securities Who are the Key Players? y Fathers of Distressed Investing o Certain investors saw an opportunity to reap rewards by investing in the capital structure of distressed or bankrupt companies o Legendary and sophisticated investors investing in an unsophisticated and uncrowded market and realized HUGE returns o These investors acted as a check on certain Ch11 debtors o Some of the first big players:  Carl Icahn  Sam Zell  Leon Black  Marty Whitman y Young Guns of Distressed Investing o The next generation of distressed debt investors got their start trading junk bonds and completing LBOs o The increased use of junk bonds eventually caused too much leverage to be placed on companies and the early 1990s saw an increase in Ch11 filings o The junk bond market crashed and the next generation of distressed debt investors turned their attention to distressed junk bonds and other distressed securities y Platforms for Distressed Investing o Started with junk bonds and performing LBOs o Today distressed investors operate from different platforms o Three big ones are  Private equity funds  Hedge funds  Banks with proprietary trading desks

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Effect of the Volcker Rule: trading restrictions placed on financial institutions. Separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms y The rule minimizes conflicts of interest between banks and their clients through separating the various types of business practices y The rule basically stops banks from doing their normal business as well as trading on their own behalf y Separates commercial lending from investment trading Private Equity Funds y Characteristics o Private funds with institutional investors o Long-term equity interest in portfolio companies o Capacity to take over day to day management of companies o High value placed on secrecy and stealth purchases y Typical Investment Strategies o LBO: cheaply purchase non-performing bank loans and subordinated debt, eliminate the prior owners, assert private equity ownership o Asset Purchase: after company files for bankruptcy, offer cash bid for all assets, cash used to payoff creditors, PE firm acquires company free of all debt and with total ownership y Impact on the Market o PE funds often contribute to distressed situations by providing needed capital with a long term horizon and a willingness to take equity instead of debt o Certain traditional PE funds are beginning to enter the distressed investing world y Notable PE Funds o Sun Capital Partners o Bain Capital o Madison Dearborn Partners Hedge Funds y Characteristics o Private, unregulated, limited partnerships or LLCs o Sophisticated, focused, aggressive traders o High degree of flexibility o More willing to accept equity or subordinated securities than traditional bank lenders y Typical Investment Strategies o Activist investing: purchase debt in distressed company with the intent of acquiring ownership of the company when it enters bankruptcy, then forcing strategic changes upon management

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o Passive investing: buy up low-value debt from impatient investors and wait for the company to get better o Distressed debt arbitrage: purchase undervalued debt while simultaneously shorting stock, take home difference in stock price if company declines in value or loan interest if company turns around y Impact on the market o In the recent credit crunch, hedge funds could supply debtors capital that typically came from commercial banks o Some detractors blame hedge funds for insisting on quick returns without regard for long term equity value y Notable Hedge Funds o Solus Alternative Asset Management o Avenue Capital o Fortress Investment Group Traditional Bank Proprietary Trading Desks y These are where banks actively trade stocks, bonds, options, commodities with its own money as opposed to a customers these are popular mechanisms for distressed investing y Dodd-Frank Act requires proprietary trading to be completely phased out by July 2012, thus limiting their importance y Characteristics o Highly leveraged o Appetite for risk: credit, market, interest rate, operational o Fiduciary responsibilities to public shareholders o More liquidity and the ability to move positions and cross markets o Traders often leave to start their own hedge funds y Typical Investment Strategies o Arbitrage: buying a security in a market where it is undervalued and selling it in a market where it is overvalued y Impact on the Market and the VOLCKER RULE o Prop desk traders contributed to billions of write downs experienced by banks because of large exposure to mortgage-backed securities o VR under the DFA has largely eliminated prop trading desks from the investing world by forcing banks to spin them off by July 2012 o Enforcing the VR has been hard, as it is often unclear whether a trade is proprietary or part of a banks routine activity, which includes buying securities and selling them to clients Examples of Different Types of Distressed Investments y Examples o Asset Purchases (Section 363 Sales)  BC requires court approval for the use, sale or lease of property outside of the ordinary course of business

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Section 363 sales allow an investor to buy the assets of a distressed company, free and clear of all liens, claims and encumbrances o Sponsoring a Plan of Reorganization  Allows an investor to take control of a target company when it emerges from Ch11  Plan sponsor invests new money, distributes it to certain creditors, in exchange for release of their claim and an affirmative vote on the plan o Claims Purchasing  Claims purchasers enjoy the same rights and liabilities as the transferor Trade Claims a distressed investor may purchase claims at a discount from vendors unwilling or unable to wait months or years to receive money on account of their claims. A distressed investor may also purchase trade claims as a way to obtain a strategic advantage in a restructuring by gaining control of a larger share of a companys general unsecured claims Funded Debt Claims distressed investor may purchase undervalued, inefficiently priced debt claims and either wait for them to appreciate or use them to gain control of the restructuring process PURCHASING DISTRESSED ASSETS Three Distressed Asset Acquisition Approaches y Three ways investors can purchase assets of a distressed target company (T) o Purchase Ts assets out of court o Purchase Ts assets through a reorg plan in Ts bankruptcy o Purchase Ts assets through a section 363 sale in Ts bankruptcy Purchase Ts assets outside of Bankruptcy y Purchaser risks involuntarily inheriting Ts liabilities through: o Bulk Sales Act  In some states, a buyer of assets in bulk is automatically liable for all the liabilities if a creditor sues the buyer within six months after the purchase. The Act is designed to prevent business owners from secretly transferring their business assets to another company to avoid paying creditors o De facto merger doctrine  Focuses on whether this was a merger in fact o Successor liability doctrine  Product liability, environmental liability, employee-related liability y Purchase Ts assets or stock through Ch 11 Reorg Plan o Company is SOLD as asset purchase or equity investment through a plan of reorg 18

o Plan is court-sanctioned conduct between the company and its creditors that governs the companys obligations upon its exit from bankruptcy o To be approved, a plan must be:  Voted and accepted by certain types/classes of creditors; and  Approved by the bankruptcy court y Plan Can Bind All Creditors o A court can cram down a plan in spite of a rejection by a particular class o Court must determine that the plan  Does not discriminate unfairly  Is fair and equitable with respect to each impaired non-consenting class o Debtor must also demonstrate that the non-consenting class is receiving an amount equal to, or better than, the class would receive in a liquidation y Adv and Disadv of Purchasing Assets in a Plan o Flexibility in structuring the purchase o Can accomplish without an auction o Can provide sale free and clear of liens, claims, and encumbrances o Purchaser may be able to obtain Ts NOL carryforwards o Disadvantages:  Longer involvement and negotiation  Strict confirmation process requirements and 14 day stay of the confirmation order  More variables and lack of certainty Purchase Ts Assets in a 363 Sale y 363 Sale: A 363 sale is an emergency sale of the company, proposed by management and approved by the judge, before any plan has been proposed, let alone passed. A 363 sale can be an end run around the entire Chapter 11 procedure. Once the company is sold, the Chapter 11 turns into an Chapter 7 -- the proceeds of the deal are the only thing left to do for the court. y Ch 11 debtor may also sell certain assets or its entire business under 363 of the BC y 363(b) allows a debtor to sell property of the estate outside of its ordinary course of business o 363 sales may be free and clear of all liens, claims, and encumbrances o D can only sell whatever interest the estate has in the asset o Court must conduct hearing to show if the D has used reasonable business judgment in its decision to sell the assets o Ds usually show they have used sound judgment by conducting an auction to maximize sale price y Advantages of 363 Sale o No successor liability  Sales are free and clear o Greater certainty regarding process and legal uniformity o Greater flexibility with contracts and novation 19

Section 365 allows buyer to pick contracts and leases it wants D must assign contracts without modification and the party assuming must cure outstanding defaults Potential Disadvantages of 363 Sale o Must be open and transparent generally not private o Interested parties can still object and disrupt sale process o High transaction costs of conducting auction o Creditors may argue that a 363 sale will short circuit Ch 11 process and should be done through the plan, ie, that the 363 sale is a sub-rosa plan How a 363 Sale Goes Down o Prospective buyers negotiate purchase agreement with T o Seek support from Ts key constituencies (secured creditors, unsecured creditors, employees) o Obtain court approval  1st Stage establish bidding and auction procedures, including: break up fee expense reimbursement tight time deadlines all bids must use Newcos contract overbid protection Newcos right to match highest bid nd  2 Stage auction and court approval hearing 363 Sale SPECIFICS o usually involves a stalking horse with the following steps o stalking horse: an initial bid on a bankrupt companys assets from an interested buyer chosen by the bankrupt company. From a pool of bidders, the bankrupt company chooses the stalking horse to make the first bid. This method allows the distressed company to avoid low bids on its assets. The stalking horse sets the bar essentially  D and stalking horse execute asset purchase agreement  D files motion to approve bidding procedures Motion includes approval of breakup fee, expense reimbursement, qualifications of alternate bidders, overbid protection, procedures for alternative bidders to make bids, the timing and other details of auction, and contract assumption procedures  Court conducts hearing to approve bidding procedures for auction  Contract counterparties are notified about assumption/assignment and cure amounts  Competitors can conduct due diligence and submit competing bids Auction and Court Approval o D conducts the auction  D can change rules to maximize price 20

 

While price is important, the highest or best offer, as determined by the D and approved by the B court, will prevail  Court conducts hearing to approve sale based on highest or best offer, combined with hearing on assumption/assignment of contracts taken by buyer  Hearing is usually shortly after auction  Competing bidders normally lack standing to contest sale o Sample timeline:  Execute NDA; Commence due diligence  Complete due diligence, reach out to major players  Execute APA  1-5 days pass  file motion for bid procedure and sale  7-10 days pass  deadline to object to bid procedures  4-7 days pass  bid procedure hearing  5-25 days pass  deadline to object to sale/bid deadling  4-7 days  auction  1-5 days  sale approval hearing Whether to Act as a Stalking Horse o Advantages of being stalking horse  Head start over others, particularly with due diligence  SH negotiates the APA which is a template for the deal Normally other bidders must mark up the SHs APA  SH can negotiate bidding procedures and gain inside track  Better chance to negotiate with key stakeholders o Disadvantages  Resources used on due diligence and negotiation usually higher (mitigated by expense reimbursement)  SHs bid is transparent and known by other bidders (mitigated by overbid protections and breakup fee)  SH must make sure to save some powder for the auction Major Negotiated Bidding Procedures Terms o Timeline, including deadline for competing bids, timing of auction and sale hearing, and closing date  SH normally seeks procedures that maximize its chances for success  Difficult to get more than a limited exclusive/non-solicitation period o SH usually gets access to competing bid info o Process for the assumption and assignment of contracts and leases 21

o Break-up fee if stalking horse is outbid at auction is typically provided, but price is negotiated (normally 2 to 4% of purchase price)  Break up fee: A common fee used in takeover agreements if the seller backs out of a deal to sell to the purchaser. A breakup fee, or termination fee, is required to compensate the prospective purchaser for the time and resources used to facilitate the deal. o Expense reimbursement if SH is outbid at auction is customary although there are usually low caps on the dollar amount o Initial and incremental overbid protection (minimum amount of qualified bid and minimum amount of bid increases at auction) is typical but amount is negotiated (usually 2 to 5% or purchase price) o SHs ability to credit bid the breakup fee and expense reimbursement o Seller often requires a good faith deposit that is credited against the purchase price or returned if the APA is terminated other than for buyers breach Negotiation Considerations o Assurances of payment if SH loses at the auction  Distributions in a B case are made in the following waterfall order: secured, super-priority administrative, administrative, priority, unsecured, and equity  Breakup fees, expense reimbursements and other post closing true up payments are normal accorded administrative treatment, meaning they are supposed to be paid in full as a post-petition obligation of the bankruptcy estate (these administrative claims must be made first!)  Most conduct due diligence to ensure the estate is solvent to make these payments; otherwise should negotiate for super-priority administrative status, credit enhancements, holdbacks, or direct payment of fees from sale proceeds Substantive Considerations o Contracts and leases: who pays cure amounts, and is there a purchase price adjustment for cure payments? o Purchased vs. excluded assets o Assumed vs. excluded liabilities  Ie, environmental liabilieis o Purchase price adjustment provisions  Should there be a purchase price holdback to cover adjustments or other seller obligations?  Disparity of treatment of excess/deficit working capital adjustments o Government regulatory issues o Double materiality provision for buyers termination Relevant Case Law o Florida Dept of Revenue v. Piccadilly Cafeterias, Inc.  Whether a stamp tax exemption under 1146(a) applies to a D whose Ch11 plan has not yet been approved by a B court 22

Piccadilly filed for Ch11 protection and was awaiting confirmation SCOTUS held that preconfirmation transfers do not qualify for a stamp tax exemption under 1146(a) of the BC o De Facto Sub Rosa Plan Cases  When a D attempts to sell most of its assets in a 363 sale, the right to do so is sometimes contested on the basis that such a sale short-circuits the more elaborate safeguards of the plan confirmation process, in particular the duty to provide adequate information to parties in interest in the form of a disclosure statement  Majority view is that the sale of most all of the assets of a D can be approved without a plan, provided that the sale proponent demonstrates a good, sound business justification for conducting a sale prior to confirmation Second Circuits Chrysler Decision o Reaffirmed the majority view regarding whether the sale of mostly all of the Ds assets under 363 of the B Code constitutes a sub rosa plan of reorg in In Re Chrysler LLC o Chrysler court held that a disgruntled creditors argument that a 363 sale is a sub rosa plan is a red herring and that the real inquiry is whether the D exercised its business judgment o If the court finds the D passes the multifactor sound business justification test set forth in Lionel, then the D has presented an adequate rebuttal to the sub rosa plan argument  Lionel factors include Consideration of the proportionate value of the asset to the estate as a whole The amount of elapsed time since the filing Likelihood that a plan of reorganization will be proposed and confirmed in the near future Effect of the proposed disposition on future plans of reorganization Proceeds to be obtained from the disposition by any appraisals of the property And whether the asset is increasing or decreasing in value

 

OVERVIEW OF CHAPTER 11 Lifecycle of a Typical Ch 11 Case y See appendix Ch 11 Overview y Court supervised restructuring y Ch 11 is not a liquidation y The company is still considered a going concern 23

Plan of Reorganization y What is it: essentially a contract between the D and its Cs that modifies and supersedes the companys pre-bankruptcy obligations upon its exit from ch 11 o Address the form of currency Cs will receive and whether old equity holders will obtain recovery o Address the new capital structure o Governs how modified obligations are to be satisfied post-emergence o Provides for discharge of prepetition debts, injunction against pursuit of claims, etc Advantages and Disadvantages of Ch 11 y Advantages: o Automatic stay o Force other parties to negotiate o Binding on dissenting parties o Deadline for filing prepetition claims o Injunction discharging prepetition claims after exit o Avoidance powers y Disadvantages: o Restrict ability to pay debts that arose before the filing date o Strict disclosure obligations and oversight by multiple constituencies o Certain business transactions require court approval Disclosure Obligations y Schedules and Statements of Affairs o Each filing entity must file schedule of assets, liabilities, contracts and leases o Statement of financial affairs y Monthly Operating Reports o Cash receipts, disbursements, receivables and payables, intercompany activity, bank accounts, income and B/S statements, required each month, from petition date to exit y Section 341 Meeting o Opportunity for US Trustee and Cs to question the Ds representative regarding assets and reasons for filing Ch11 y Cs Committee Inquiries o Ds must be responsive Phases y Prep y Filing y Stabilization y Formulate business plan and execute restructuring transactions y Restructuring y Negotiate plan y Disclosure statement approved y Creditors approve plan 24

y Court confirms plan y Exit Alternatives to Traditional Ch 11 Case y Out of Court Workout: composition - Ds promise of partial payment in exchange for full settlement of claims; or extension an extension of payment period in which the D may satisfy obligations y Prepackaged Plan: plan is fully negotiated and drafted, and necessary votes have been obtained, prior to filing; can be competed in about 45 to 60 days from date of filing y Prearranged Plan: negotiated prior to the filing and major constituents may be contractually committed through a plan support agreement; votes are solicited after the Ch 11 filing; can be completed within 4 months from the date of filing Phases of Prepackaged Ch 11 Case y Formulate business plan and negotiate Ch 11 plan y Solicitation of votes y Creditors approve plan y Filing y Court confirms plan and disclosure statement y Exit Phases of Prearranged Ch 11 Case y Formulate business plan and negotiate Ch 11 plan y Obtain lock-up agreements with key constituents y Filing (company also files disclosure statement and plan) y Disclosure statement approved y Creditors approve plan y Court confirms plan Comparisons of Advantages and Disadvantages y Prepackaged Ch 11 o Advantages: avoids protracted case, administrative expenses, business disruption; allows for positive message to key constituents that process is an implementation tool for an agreement to create sustainable capital structure; quick, cheap, most certain process o Disadvantages: lengthy prepetition process precludes this option for many companies where liquidity is constrained; benefits limited to restructuring of funded debt; trade debt is untouched y Prearranged Ch 11 o Advantages: similar but not as potent as prepackaged case; shorter prepetition process makes this more available to more companies o Disadvantages: timeframe less certain, costs are higher; process risk is greater than in prepackaged given that solicitation has yet to occur y Traditional Ch11 o Advantages: company can employ full array of operational restructuring tools while protected by the automatic stay 25

o Disadvantages: difficult to send positive message to constituents as plan conformation and exit timeframe are uncertain; high administration costs; risk that management could lose control over case y Out of Court Workout o Advantages: avoids long case with expenses and business disruption; management remains in complete control of business o Disadvantages: does not enable D to realize any of the benefits of Ch11, and holdouts can leverage process Key Players in Ch11 Case y Bankruptcy judge y UCC y Ad Hoc Committee y Trade vendors y Customers y Unions y Employees y Postpetition DIP lenders y Prepetition secured lenders y LLs / executor contract counterparties y US Trustee y Fed and State Reg Authorities y Equity Holders Venue: Where to File y A D can file in any district where it is incorporated, maintains its principal place of business, or holds its primary assets o Only one entity files, all affiliated entities may file in same district y Choice of venue may be affected by: o Differences is law o Predictability o Convenience o Likelihood that venue may be challenged o Whether a district offers a home court advantage or the prospect of damaging press coverage Ds Automatic Stay y Commencement of the case triggers the stay o Stops pending lawsuits and other actions to collect prepetition debts or take control of companys assets o Limited exceptions:  Certain government actions  Postpetition lawsuits on postpetition claims o Worldwide application of the stay is subject to foreign courts willingness to grant comity, deference to US law Obtaining First Day Relief 26

D cannot pay prepetition claims without court approval Filing Ch 11 petition brings the Ds business to a halt if the D did not get immediate authority from the court to continue performing essential normal business operations y As soon as it can, court holds first day hearing where the D requests the relief it needs to effect smooth transition into Ch11 First Day Hearing y First and best chance to tell the court what it wants y Testimony of company witnesses may be heard y Court enters first day orders which are necessary to allow the D to continue to operate normally y Many first day orders are entered on an interim basis and are subject to input from interested parties Key First Day Motions y Cash Collateral: approving Ds use of prepetition lenders cash collateral to fund operations under Ch11 y DIP Financing: approving proposed postpetition financing to fund operations during Ch11 y Cash management: allowing company to keep using bank accounts and cash y Wages: authorize Ds to pay prepetition claims for wages and employee benefits y Critical vendors: authorizing immediate payments of certain prepetition critical vendor claims from available funds y Utilities: continuing providing service to the Ds y Customer Programs: continue to honor prepetition customer programs Use of Cash Collateral y B Code allows a D to fund its operations through use of cash collateral y Cash or cash equivalents that are the collateral of an existing secured creditor and the cash proceeds of other collateral y A D can only use cash collateral if: o The entity holding an interest in the cash collateral consents o The creditors cash collateral is adequately protected Adequate Protection y Not defined in the B code, common examples: o Paying periodic cash payments, interest on the debt o Providing additional or replacement liens o Demonstrating an equity cushion, proving that collateral is worth more than debt securing prepetition liens so that prepetition debt is not at risk of diminution in collateral value DIP Financing y B Code permits a company operating in Ch 11 to obtain postpetition (DIP) financing and provides incentives for lenders to extend credit y DIP financing is used even if a D can fund its operations through use of existing cash o DIP financing sends a positive message to the market and stakeholders; gives them comfort that the D has the means to operate and a liquidity cushion y y 27

DIP facilities are similar to out of court facilities, with respect to reps, warranties, covenants, defaults, credit y B court will need to approve any incurrence of debt or granting of liens o Interim approval usually sought on first day of case o D must show it has obtained the best financing available, meaning the most favorable pricing and least restrictive terms under circumstances Ordinary v. Non-ordinary Course Transactions y The B Code permits a D to operate its business in the ordinary course, subject to rules, without court involvement y Transactions NOT Limited by case: day to day transactions not affected by B case; o Examples: new sales, procurement, customer relations, performance of postpetition contracts, payment of postpetition payroll, taxes, permits, licenses, hiring, compensation y Transactions that ARE limited by case: D must seek court approval of these matters o Examples: pledging assets to borrow, using cash collateral that was pledged prepetition, engaged in certain transactions, sale of assets outside the ordinary course of business, assuming or rejecting executory contracts and leases Section 363 Sales y Raise cash through the sale of non-core assets that will not be part of the reorganized business y Section 363 allows Ds to sell assets free and clear of liens, claims, and encumbrances y 363 sales thus offer a purchaser the opportunity to acquire assets with exceptionally clean title Trade Vendor Issues Generally y Trade vendors will try to extract better terms or demand payment of prepetition invoices o Vendor making such a demand is subject to a contract, however, the vendor must continue to perform or risk violation of automatic stay y First day critical trade order allows Ds to pay some prepetition claims of vendors without contracts o Payment conditioned on vendor agreeing to continue to provide favorable terms y Bankruptcy clauses in contracts triggering defaults are generally unenforceable y Vendors that deliver prepetition goods to Ds on credit are protected by section 503(b)(9), which provides vendors that deliver goods in the ordinary course of business within 20 days prior to petition date with an administrative expense claim Executory Contracts and Unexpired Leases y Ds generally have the right to assume or reject executor contracts and unexpired leases o Executory contracts are generally contracts with material obligations remaining unperformed on both sides y

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o D typically has until plan confirmation to decide whether to assume or reject executor contracts o Unexpired commercial real property leases must be assumed within 120 days or they will be deemed rejected; a D can obtain a single 90 day extension to assume unexpired leases for cause o Counterparties try to make the D make an early decision whether to assume or reject contracts or leases y Section 356 allows D to assume, assume and assign, or reject all unexpired leases and unexecutory contracts with court approval, subject to limitations o Executor contracts are Ks where material obligations remain to be performed on both sides y D has flexibility to choose which executor Ks and unexpired leases would be beneficial to assume or reject o B court applies business judgment test to assumption/rejection motions y Until D assumes or rejects, the counterparty must perform postpetition contractual obligations, even if the D was in default prepetition y D must also continue to perform postpetition, including obligations under real property invoiced on a postpetition basis y If the D rejects the exec contracts or lease: o D is no longer bound o Counterparty has prepetition general unsecured rejection damages claim y If D assumes exec contract or lease, the D: o Is ound by the K and subject to admin claim for breach o Must cure any outstanding defaults (pre or post) o Must provide assurance of future performance if defaults exist y D has limited time to determine treatment of unexpired leases for nonresidential real prop, but until exit to determine treatment of all other exec contracts o D has 120 days to assume or reject an unexpired lease of real prop o D may obtain additional 90 day extension for cause but longer extensions requires lessors consent y Counterparties try to force D to make decisions early but the courts usually favor Ds y A D may include K and lease assumptions and rejections it its ch11 plan Assumption v. Rejection Decision Tree y the contract is profitable or difficult to replace? o YES Assume  D is bound by K and must continue to perform  D must cure any outstanding pre and post defaults o NO D is no longer bound o Counterparty has general unsecured rejection damages claim Avoidance of Transfers y Sometimes, assets transferred prepetition may be recouped in order to enlarge the bankruptcy estate for creditors benefits y Prepetition transfer may be avoidable as a preferential transfer if it is: 29

Of an INSOLVENT Ds property or interest in prop To or for the benefit of a C In connection with debt existing prior to transfer Occurs within 90 days prior to the filing date or within 1 year of the filing date if the C was an insider; and o Resulting in the creditor receiving a larger share than likely obtained under a Ch7 liquidation had the transfer not occurred y Prepetition prop transfer may be avoidable as a fraudulent transfer if it is: o Of a Ds property or interest in prop o Occurring within two years of the filing date; and o Made with actual intent to hinder, delay, or defraud a creditor or if constructive fraud exists y Constructive fraud occurred if there was no fair exchange of value and the D was insolvent, undercapitalized, or intended to incur debts it would be unable to repay y Look back period extends between four and six years prior to the filing date Role of Negotiation y Build rapport with key constituents y Get a compensation consultant involved from the outset of the plan to advise the board and to help create plan Chapter 11 Plan Confirmation y Exclusivity y Classification of claims y Relevant plan provisions y Disclosure statement y Voting requirements y Confirmation/cramdown y Discharge/releases y Exclusivity o 1121 says the D has the exclusive right to file a proposed plan during the first 120 days and can get extensions, and 180 days to exclusively solicit o exclusivity affords the D great leverage to control the process o pressure exists to complete restructuring at a brisk pace o exclusivity period can be extended, especially in certain jurisdictions, but there is a hard cap of 18 months!!! That is the absolute max y Extension or Termination of Exclusivity o cause for extension  case is large or complex  time to negotiate  D making progress toward reorg  D paying its bills as they become due  Amount of time elapsed in the case  Unresolved contingency exists o Can be terminated for cause o o o o 30

o 1121(d)(2) 120 day exclusive filing period capped at 18 months and solicitation period capped at 20 months Classification of Claims and Interests o 1122 substantially similar claims and interests o separate classification allowed if a rational basis or business justification exists  trade vs. bond debt  subordinated debt o cannot gerrymander classes to obtain an impaired accepting class Convenience Class o Convenience claims  Below specified amount cashed out  Administrative convenience avoids distribution of de minimis amounts  Sensitivity analysis to determine cost and cap on claims Undersecured Creditor o Classification  Secured claim = value of collateral  Unsecured claim for deficiency  C that holds both secured claim and unsecured deficiency claim may vote separately in respect of each claim Relevant Provisions of Plan o Treatment of old debt and equity o Establish terms of new debt and equity o Manner of selection of officers/directors/trustees o Treatment of Ds property Disclosure Statement o Bankruptcy equivalent of registration statement o 1125 of the BC states that a D must provide voting Cs and interest holders with adequate information including:  history of business  reason for filing  description of reorg plan  liquidation analysis  balance sheets and income statements  valuation of reorganized business o 25 day notice Voting requirements o 1126(c) a plan is accepted by a class of Cs if:  2/3 in value amount and more than in number of allowed claims of such class that have voted on plan vote in favor of the plan o 1126(d) a plan is accepted by a class of equity interests if  2/3 in amount of allowed equity interests of such class have voted in favor of the plan 31

o who votes?  Classes receiving some recovery but not a full recovery are IMPAIRED and entitled to vote o Who does not vote?  Classes that receive 100% recovery are unimpaired and are deemed to accept the plan  Classes that do not receive ANYTHING are deemed to automatically reject the plan  Administrative and priority creditors do not vote Plan Confirmation o Court holds a hearing to confirm o Contested confirmation may require  Depositions  Document production  Expert valuation testimony  Feasibility testimony Confirmation Requirements o 1129(a) after voting the court will confirm IF:  plan complies with BC  plan is proposed in good faith  voting classes have accepted the plan or have been crammed down  identities of post-emergence directors and officers are disclosed  plan is feasible (wont be back in Bcourt again soon)  plan is in the best interests in the Cs Cramdown o 1129(b) even if all classes do not vote in favor, plan can still be crammed down on dissenting classes if:  one impaired class votes in favor  plan does not discriminate unfairly and  the plan is fair and follows the absolute priority rule Discharge and Releases o Debtors Goal: all obligation through confirmation date are discharged except obligations expressly set forth in the plan o Releases:  Release of Ds claims  Release of third party claims (pre and post) o Permanent injunction Exiting Ch 11 o D emerges from ch11 on the effective date  Typically 20-3 days after confirmation because exit lenders will not close until the 14 day appeal period has expired o On the effective date:  Ds assets vest in the reorganized company free and clear of all claims 32

    

The reorganized D is discharged from all prepetition debts Equity is usually cancelled or diluted Automatic stay is terminated Exit financing replaces DIP financing D makes distributions as provided in plan

HENES: ECONOMIC LESSONS LEARNED FROM IRENE Five Lessons Learned from the Hurricane 1. Prepare for the Worst, Hope for the Best i. Upcoming economic forecast includes a potential double dip recession, an unsustainable entitlement system, a European banking crisis, a persistent housing depression, and a highly volatile stock market 2. We Need Political Leadership i. We need strong fiscal policy 3. You Cant Stop a Hurricane i. Increased borrowing or stimulus gimmicks will not stop it 4. Dont Mistake the Eye of a Hurricane for a Sunny Day i. We must be prepared for the back end 5. Must Rebuild i. Rebuilding our economic foundation HENES: CAN THE EUROZONE SURVIVE? y What is going on? o Debt crisis o Banking crisis o Growth crisis What should they do? o Consummate a comprehensive debt restructuring and bank recapitalization plan How did they get there? o They set maximums and status quos but have failed to meet these numbers, miserably o Current policies stunt growth and paradoxically increase deficits Henes Suggestions o Debt of member nations would be reduced to manageable levels through pay downs and voluntary write-downs by banks o Eurobonds, akin to US T-Bonds, would be issued by the Eurozone o funds received by the Eurozone would be used to pay down debt and recapitalize the European banks

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o the investment in these European banks would be in return for preferred stock, which would be issued to those Eurozone members that experiences and increase in borrowing costs as a result of the creation and issuance of Eurobonds Four Major Obstacles: i. the numbers in this restructuring are huge and a lot of capital will be needed, and a significant amount of which will be provided by strong Eurozone members, kinda like Germany ii. the creation of the Eurobond will increase rates for stronger members of the Eurozone while reducing rates for weaker members. Increased rates will mean higher interest payments for countries like France and Germany, who are already experiencing slower growth. Germany is AGAINST the creation of the Eurobond iii. Eurozone members must relinquish MORE sovereignty than they already have and this places the democracy of some member nations at risk iv. Huge political issues at hand, such as relinquishing sovereignty, and footing the bill for other countries In Re Oneida Facts and Background: this case addressed whether a premium payment created by the Deficit Reduction Act of 2005 for pension plans terminated as part of a Ch 11 restructuring is a prepetition claim or a postpetition administrative expense. Court ended up holding that the statutorily mandated premium payment was a contingent prepetition claim and was discharged upon confirmation of the debtors plan. DRA of 2005: o Enacted in 2006 to help reduce the deficit in the budget of the Pension Benefit Guaranty Corporation o PBGC is a federal agency established by the Employee Retirement Income Security Act of 1974 (ERISA) that pays participants of terminated pension plans, when the terminated plans lack sufficient assets to make their required payments to participants o DRA legislation required plan sponsors to pay additional premiums to the PBGC when pension plans are terminated in connection with an in-court or out-of-court restructuring o This DRA is calculated as of the termination date o When the termination takes place in a Ch 11 proceeding or an analogous proceeding under state law, the obligation to pay the DRA premium is deemed to arise upon the date of discharge (the reorganization date) o For out of court termination, the premium is due the month after pension plan termination o For in court termination the premium is due the month after discharge 34

Oneidas Bankruptcy and Procedural Posture o Oneida had a retirement pension plan for its employees o On 03/19/2006, they filed a petition of relief for Ch 11 o Ds pension plans were under-funded and the court approved the Ds request to terminate the pension plans under the distress termination provisions of ERISA o D then was subject to pay the DRA premiums and the DRA premium was the Ds only unsecured debt o Prior to confirmation, D and PBGC negotiated a settlement agreement that provided PBGC with a promissory note in the amount of $3M for its secured claim, based on liens obtained prepetition for Oneidas failure to make contributions and for any unsecured claims arising out of the distress termination of the Ds pension plans o Following confirmation, D and PBGC entered into a stip which preserved the rights of both parties to challenge or enforce the Ds responsibility to pay for the DRA premiums o Oneida commenced a proceeding seeking declaration that the DRA Premium was a prepetition claim that had been satisfied by the $3M note and that any remaining liability be discharged under the Ds reorganization plan A DRA Premium payment is a prepetition contingent claim under the BC o Court addressed whether it is even a claim  Under subsection (B) of the DRA, when a D is in Ch 11, the obligation to pay a DRA Premium arises at the date of discharge.  D argued that the payment obligation under the DRA was a contingent claim under 101(5)(A) of the BC, which defines a claim as a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured  PBGC argued that it was NOT a claim because the obligation to pay is not enforceable until AFTER the case was over (the date of discharge)  Court DID find that it WAS a contingent claim  Generally, pension liabilities are contingent claims o Next, court analyzed whether the contingent claim for the DRA Premium arose prepetition or postpetition  D argued that this was a prepetition claim because the right to payment was contingent and arose prior to the D filing for CH 11and that therefore the claim should be discharged upon plan confirmation  PBGC disagreed and argued that because the plans were terminated postpetition, the termination created a postpetition obligation to pay the DRA premium

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Thus, PGBC argued that this was an administrative expense claim which the D was required to pay in full upon plan confirmation Court determined that the obligation for payment arises when the future event is within the actual or presumed contemplation of the parties at the time the original relationship between the parties was created Court held that this was a contingent prepetition claim

Takeaway: When the parties have had a relationship prior to the commencement of the Ch 11 case that could give rise to a claim, if the claim arises postpetition, it will be a prepetition claim; this includes situations in which the relationship is an applicable statute, not merely a contract or other voluntary interaction Bank of America v. LaSalle Facts: BoA issued a $93M loan to LaSalle. Loan was secured by a mortgage on the Ds principal asset, part of a Chicago office building. When the D defaulted on the loan, the bank began foreclosure. LaSalle filed a petition for relieved under Ch 11. Ds proposed plan called for only previous equity holders to contribute new capital in exchange for the Ds entire ownership of the reorganized entity. BoA objected. Banks objection, as a major secured creditor, prevented confirmation of the plan. LaSalle resorted to a judicial cramdown on the Bank. A cramdown requires a reorg plan to be fair and equitable with respect to the creditors in order for a judge to authorize it. BoA argued that this plan violated the absolute priority rule, which prevents Ds equity holders from receiving ownership when claims will not be paid in full and thus the plan should have been denied. Nevertheless, the B court approves the plan Goes ALL THE WAY UP TO SCOTUS Issue: May a Ds prebankruptcy equity holders contribute new capital and receive ownership in a reorganized entity when the C objected to the reorganization plan? Holding: NO, the Court ruled a Ds prebankruptcy equity holders may NOT, over the objections of creditors, contribute new capital and receive ownership in the Ds reorganized entity if no one else has been given a chance to come up with an alternative reorganization plan TRONOX REORGANIZATION Background y Tronox manufactures titanium dioxide pigment and electrolytic and specialty chemicals y Formed in 2006 through a spin off from Kerr-McGee o Spin off: creation of an independent company through the sale or distribution of new shares of an existing business/division of a parent company; it is a type

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of divestiture; the spun off companies are expected to be worth more as independent entities than as parts of larger businesses y KM was involved in all sorts of businesses like uranium and wood treatement y Most of KMs historical businesses were discontinued, KM remained responsible for massive legacy environmental tort and retiree liabilities related to the discontinued businesses y KM put its oil and gas assets in a clean NEWCO and put its legacy liabilities in an OLDCO together with the businesses that comprise Tronox y Tronox spun off in two steps: o An IPO in November 2005 o A dividend of KMs remaining interest in Tronox to existing shareholders in March of 2006 y Free of legacy liabilities, KM was bought by Anadarko Petroleum Corp in August of 2006 for $18B Events Leading to Chapter 11 y Issues o KM kept the nearly $800M in proceeds from the IPO and debt issuance  Most of Tronoxs free cash was used to service legacy liabilities o Tronox inherited the pension plan for all discontinued KM businesses o 2008 negatively impacted Tronox business y mid 2008 preparing for Ch 11 filing y during negotiations with existing secured lenders about DIP financing, Lehman Brothers (agent for Tronoxs secured lenders) filed for Ch 11 o Credit Suisse replaces LB as the agent under the credit facility, and Tronox eventually secured a $125M revolving DIP credit facility from the Credit Suisse-led syndicate, and filed for B on 1/12/09  DIP loan required Tronox to commence a sale process for substantially all of its assets within 6 months of petition date y What is a DIP LOAN? o Debtor in Possession Financing arranged by a company while under Ch 11 bankruptcy process. DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity, and other claims  Gives the D a fresh start, which is subject to the Ds fulfillment of its obligations under its reorg plan Ch 11 Cases 2009 Developments y Once in Ch 11, Tronox sued Anadarko and KM for fraudulent transfer and other claims in connection with the spinoff o The litigation was one of the biggest assets of Tronoxs estates y 2 months into the cases, Tronoxs German operations commenced insolvency proceedings in German, triggering a default under the DIP financing agreement o Tronox entered into an amendment to the DIP loan to ensure that Tronox could borrow under the DIP loan o The amendment required that Tronox sign a stalking horse APA by 08/31//09 37

Signed an APA with Hunstman Corporation, a large chemical company and competitor of Tronox o Bidding procedures and 3% breakup fee were approved in 09/09 y Tronox negotiated with HC for a three month window in between bidding and the sale hearing so that they could pursue a standalone reorganization rather than a sale o They negotiated with the US regarding a plan of reorg as well as with lenders for maybe another DIP loan y On the eve of the auction, Tronox announced it had reached an agreement with stakeholders on a term sheet for a plan of reorg and that it also secured replacement DIP financing y Under the term sheet, Tronox would: o Repay existing prepetition secured debt and DIP financing with proceeds of the replacement DIP financing which would convert to exit financing o Contribute its interest in the Anadarko litigation and about $120M cash to litigation torts trusts which would settle their responsibility for tort and environmental liabilities o Hold a #105M rights offering, open to investors within Tronoxs creditor base, to fund the trusts under the plan and to be backstopped by a group of holders of the unsecured notes Ch 11 Cases 2010 Developments y Performance improved and capital markets opened up o More value was on the table so the government environmental creditors indicated that they need more consideration under the plan to settle the claims  Back at the negotiating table y Extensive negotiations and a new deal based on the new structure o Environmental and tort creditors now get $285M and the interest in the Anadarko litigation to settle the tort and environmental claims  Increased payments funded but a $170M rights offering plus a sale of $15M preferred stock to noteholders y Another group snuck in at the hearing to approve the backstop agreement and offered more money, and then Tronoxs existing backstop parties agreed to match these terms y Negotiations with the Equity Committee: o Equity committee was thought to have little power because the equity was questionable on account of the tort claim liabilities o EC wanted more of the proceeds rather than these unsecured creditors being paid MORE than in full o Mediation ensued and a B judge acted as mediator, and Tronox and EC reached a settlement  Existing shareholders received an improved package of warrants to purchase new stock in reorganized Tronox at enterprise value levels where unsecured creditors were recovering in full on account of their claims y Now with the EC satisfied, Tronox proceeded to confirm the largely consensual plan y 38

They emerged from B in 2011

Rights Offering y Generally: o An offering of securities to existing creditors (sometimes to shareholders), the proceeds of which can be used to fund obligations under a plan of reorg o Offered securities can be debt or equity and generally are exempt from registration under the securities laws pursuant to section 1145 of the B Code o Most rights offerings are backstopped  Backstopped: an investor or group of investors (stakeholder of D or a third party) agress to purchase securities that go unsubscribed (not purchased by other stakeholders) in the rights offering May be for all or up to a certain amount Backstop parties receive fees, payable in additional securities or cash, on account of their commitment to backstop a rights offering o Entry into a backstop agreement and the payment of related fees is subject to court approval under section 363(b) of the B Code Tronoxs Rights Offering y Need for Rights Offering o To fund its payments to settle tort liability creditors, Tronox determined that a sale of common equity was in the best interest o Couldnt borrow more, and did not have enough cash in hand y Terms of the Rights Offering o The $170M rights offering would be for approximately 78% of the equity in Reorganized Tronox, at an implied total enterprise value of $700M. New Convertible Preferred Stock would be convertible into 3.9% of the equity in Reorganized Tronox, at an implied TEV of $850M y A third party offered to backstop a greater rights offering but the existing backstop group met that offer Tronoxs Replacement DIP Financing y Replacement DIP Financing o In 12/2009, they entered into a $425M replacement DIP term loan with two tranches: (1) a $325M tranche B-1 that would be used to repay the existing DIP and prepetition secured debt, and which would convert into exit financing on the effective date of Tronoxs plan of reorg; and (2) a $90M tranche B-2 that would be used to fund obligations under the plan but which would be repaid in full on the effective date of the plan Equity Committees y Under 1102(a)(1) of the B Code, the US Trustee is required to appoint an official committee of unsecured creditors and MAY appoint additional committees of creditors or equity security holders if the US Trustee deems this appropriate y D pays the fees and expenses of the EC 39

Appointment of the EC o Under case law, the decision to appoint an EC turns on whether (1) the D appears to be hopelessly insolvent and (2) whether the Ds equity holders are adequately represented. o In other words, equity holders must show that (1) there is substantial likelihood that they will receive a meaningful distribution in the case and (2) they are unable to represent their interests without an official committee

CALIFORNIA MUNICIPALITY BILL y What is it? o Municipalities in the state will have to submit to a neutral review of their finances or must demonstrate a fiscal emergency before seeking Ch 9 B protection in federal court o It helps Municipal Labor Unions o In order to declare fiscal emergency, city or county councils can give a majority vote to bypass the evaluation process

In Re Washington Mutual Delaware B Court Facts: WaMus regulator, the Office of Thrift Supervision, seized WaMu and appointed the FDIC receiver. FDIC then sold most of WaMu Bank;s assets to JPMC where JPMC paid about $1.88B and also assumed more than $145B in deposits and other liabilities o The Global Settlement was deemed fair and just and was such approved Denial of the Reorganization Plan o Judge used a multifactor Master Mortgage Investment Fund TEST  Five factors that B courts should consider when evaluating the release of claims against a non debtor third party without the consent or agreement of the party deemed to be bound by such release: 1. An identity of interest between the D and the third party, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete assets of the estate 2. Substantial contribution by the nondebtor of assets to the reorganization 3. The essential nature of the injunction to the reorganization to the extent that, without the injunction, there is little likelihood of success 4. An agreement by a substantial majority of creditors to support the injunction, specifically if the impacted class or classes overwhelmingly vote to accept the plan 5. Provision in the plan for payment of all or substantially all of the claims of the class or classes affected by the injunction 40

In this case, Judge applied the Master Mortgage test and approved the Ds releases of plan supporters JPMC, the FDIC, and WaMu bank, but found that the releases granted by the D to settling noteholders, the unsecured creditors committee, certain indenture trustees and others, were not reasonable because none of these parties contributed significantly to the reorganization Impact: y A committee or other creditors can be granted a release from a debtor if they endorse and support a plan of reorganization The Master Mortgage test applied to all releases granted by the Ds would suggest substantially stricter scrutiny of such releases in the Ch 11 plan context

Bankruptcy Venue Reform Act of 2011 HR 2533, Amending 28 USC 1408 What is it? o Seeks to end B Court forum shopping, whereby Ds can file in a district to which they have very little connection, far away from their headquarters or principal place of business o The bill HELPS unsecured creditors who cannot afford to go to far away courts What does it require? o Requires Ds to file in the jurisdiction where they have their principal place of business, or principal assets, and eliminates this issue and enhances unsecured trade creditors chances of having their voices heard and their needs met Valuation of a Business and its Assets Value Creation y Firm creates value by earning a return on invested capital greater than opportunity cost of capital y the more you invest at returns above the cost of capital, the more value that is created y the firms strategy should be based on maximizing the PV of the expected cash flows y what drives value in the future: GROWTH y Takeaway: the firms value depends on the (i) the return on invested capital, and (ii) its ability to grow Common Valuation Methodologies y Discounted Cash Flow Analysis (most fundamentally sound method for valuing projects, divisions, and companies) o DCF valuation is forward looking o Relates the value of an asset or business to the PV of expected future cash flows to be generated by that asset or business o Investors require higher rates of return for riskier assets and lower rates for assets with less expected risk 41

Comparable Company Analysis o Generally a forward looking technique o Premised on the idea that the price that an investor is willing to pay in the public markets for securities of reasonably similar publicly traded companies is a relevant measure to determine what an investor is willing to pay today for the target company and its operating subsidiaries Precedent Transaction Analysis o Examines public M&A transactions o Compares to transactions of businesses reasonably similar o Unlike the CCA, this valuation includes a control premium and thus generally produces higher valuations than the CCA o There are other industry or market dynamics that may have a different effect on value vis a vis the CCA If the DCF method is the most fundamentally sound method, why do investors use other approaches? o Analysis is only as accurate as the forecasts on which it relies, so multiples analysis is useful in making such forecasts and the DCF values more accurate

Note y

Discounted Cash Flow Analysis DCF DCF analysis values a company on its future cash flows which are discounted at an appropriate discount rate given the companys unique characteristics y DCF is comprise of TWO PARTS: o NPV of a stream of Unlevered Free Cash Flows (Cash flow generated without regard to capital structure and financing, and thus available to all providers of capital o NPV of a Terminal Value (value of a business as a going concern, generally estimated using a perpetuity growth rate or exit multiple) y Enterprise Value = NPV of Cash flow + NPV of terminal value Approach and Methodology o Forward looking which discounts expected future cash flows by an appropriate discount rate, reflecting both the time value of money and additional discounts to account for market risks in general and company risks specifically, and is based upon a companys projected future cash flows  three components: PV of the projected unlevered free cash flows for a determined period The PV of the terminal value of cash flows The discount rate

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o Free Cash Flow: is the difference between cash inflows and cash outflows from operating activities reduced by taxes paid, net working capital investments, and capital expenditures o A common risk adjusted cost of capital is the weighted average cost of capital WACC DCF Step 1: NPV of a stream of unlevered free cash flows o DCF analysis starts at unlevered net income plus any non-cash items less ny cash charges that are necessary for the normal operation of the firm and that do not run through the income statement o DCF represents the value available to the sources of capital o The further out the UFCF is projected, the more subject to error the analysis becomes, as small errors are compounded over tiem  TV is used to capture the value of all future cash flow beyond the projection period DCF Step 2: NPV of a TV o TV is a projected value for the total company at the end of the periods for which UFCFNow is projected o Two main ways of deriving a TV:  Exit Multiple approach Assumes that the company will be valued or sold on a market multiple basis at the last year of your forecasts Value is typically determined as an EBITDA, EBIT, or free cash flow multiple  Perpetuity Value Approach Assumes companys cash flows grow at a certain rate in perpetuity Terminal year cash flow should be normalized to exclude items that would not recur into perpetuity  NOTE: both of the above methods need to be discounted to TODAYs dollars (PV)  Caveat always check the implied value of the other method in order to make sure they are realistic DCF Recap: o Uses  Intrinsic valuation of the business as a going concern  What a potential buyer should pay for a business  Theoretical benchmark, independent of market bias o Advantages  Most sound valuation method  Forward looking, based on cash flow, incorporates expected operating strategy into model  Less influenced by volatile public market conditions 43

o Disadvantages  Highly sensitive to underlying assumptions for cash flows (validity of projections), terminal value calculations, and discount rate  TV often represents significant portion of total value  Impervious to market dynamics and associates control premia, theoretical valuation may misrepresent what actually paid for the business Comparable Public Company Analysis Approach and Methodology o Determining the value of comparable companies, using a valuation metric such as EBITDA, cash flow, revenue, or other variable o EBITDA: earnings before interest, taxes, depreciation, and amortization  Essentially it is Net Income with interest, taxes, depreciation, and amortization added back to it; it eliminates the effects of financing and accounting decisions o this analysis is limited to public companies because a lot of the info needed is not available from private companies o subject to interpretation o analysis of selected companies includes detailed multi-year financial comparison of each companys income statement, BS, and cash flow statement; also look at each companys performance, profitability, leverage, and business trends Precedent Transaction Analysis Approach and Methodology o Uses details of precedent M&A transactions of companies in similar lines of business o Multiples are calculated based on the purchase price paid to acquire companies that are comparable o Precedent transaction analysis also explains certain other aspects of value  there is a control premium which represents the purchase of a majority or controlling position in a companys assets  this methodology generally produces higher valuations that the CPCA o Note: valuation conclusions under this methodology should not be based solely on quantitative measures; the results for and the circumstances surrounding these precedent M&A transactions are specific to such transaction and there are inherent differences between the businesses, operations, and prospects of each Weighted Average Cost of Capital (WACC) 44

o Cost of Equity  Capital Asset Pricing Model (CAPM) defines the cost of equity of a particular company as follows: Cost of Equity = Risk Free Rate + (Beta x market risk premium) y Risk Free Rate: 10 year US Treasury is often used as an approximation of risk-free investment return y Beta: represents the financial and systematic business risk of the particular company vs. the overall market portfolio (eg, 1 = risk equivalent to market portfolio) y Market Risk Premium: expected long-term premium of the overall market portfolio over a risk-free investment  Beta reflects: Systematic business risk of the company Financial risk (due to leverage)  Individual company Betas are estimated by several public o Calculating the Cost of Equity  Start with the predicated equity beta of comparable companies  These betas reflect the systematic business and financial risk of the various companies, in order to adjust for leverage, betas of the comparable companies have to be unlevered Unlevered Beta = Levered Beta / 1+Levered Beta x Rp  WACC = CoE x (Equity/Cap) + Cost of Debt x (Debt/Cap) x (1-t) Associates Commercial Corp v. Rash Facts: Rash filed a repayment plan under Ch 13 of B Code. ACC was listed as a creditor holding a secured claim because it held a valid loan and lien on Rashs tractor truck. Ultimately to gain confirmation of his Ch 13 plan and retain the truck, Rash invoked the cramdown provision of the Code. The cramdown allows a D to keep collateral over the objection of the creditor and requires the D to provide the creditor with payments that will total the present value of the collateral. At an evidentiary hearing, ACC argued, under the replacement-value standard, Rash would have to pay approximately $41,000 for a similar truck. Under the foreclosure-value standard, Rash maintained that the proper valuation was the net amount ACC would realize upon foreclosure and sale of the collateral, or about $31,875. B Court adopted Rashs valuation figure and approved the plan. Goes all the way up to SCOTUS Issue: is the value of collateral, under the cramdown provision of the B-Code, section 1325(a)(5)(B), determined by the foreclosure value standard, or what a secured creditor could obtain through a foreclosure sale of the property? Holding: NO. Under section 506(a) of the B Code, which governs the value of a secured claim, directs the application of the replacement-value standard when D, in a 45

repayment plan under Ch 13, has exercised the cramdown provision. Under 506(a) the value of property retained because the D has exercised the section 1325(a)(5)(B) cramdown option is the cost the D would incur to obtain a like asset for the same proposed use? o Dissent: Stevens thinks that 506(a) pointed to foreclosure as the proper method of valuation in the case at hand EISENBERG WHEN HEDGE FUNDS INVEST IN DISTRESSED DEBT y Generally o Hedge funds play a positive role in B proceedings providing desperately needed capital resources, fresh perspectives, and strategies and competent operational and financial expertise, all of which are vital to a debtors successful rehabilitation o In short, hedge funds are interested in profits rather than the debtors viability o loan to own strategies instances where loans are made or purchased by hedge funds with the intent to force the D into bankruptcy for the sole purpose of acquiring ownership of the company There is a Positive Role o Beneficial to the reorg process contributing, among other things, substantial resources in the form of capital, financial acumen and expertise o Because hedge funds are expected to generate greater returns for their investors, they are more likely to make loans that conventional risk averse lenders, such as banks, would shy away from. A list of top DIP lenders demonstrates that hedge funds now occupy close to a dozen of the top one hundred spots o Hedge funds and distressed debt investors may be the only lenders ready to provide funding necessary to reorganize Ds o Complementing the financing that distressed debt investors and hedge funds provide to Ds is the liquidity that these alternative investors provide to the Ds creditors o More often than not HFs that hold substantial bankruptcy positions collaborate with existing management to remedy deficiencies in the Ds business model o HFs may be able to work better with existing management because they do not have the bitter taste that pre-petition lenders can have from watching their loans go sour o In re Granite Broadcasting Corp: the B Court confirmed a reorg plan that granted ownership to a HF that swapped its debt for nearly all the equity in the reorganized D despite objections from preferred shareholders. The court found no evidence to suggest any bad faith or inappropriate behavior on the part of the HF and noted that the preferred shareholders failed to back their arguments with their purses

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o HF flexibility also enhances the prospects for reorganization by presenting more options to the D Conclusion o Trade creditors experiencing liquidity issues may choose to relieve this pressure by selling their unsecured claims to HFs

CHRYSLER DECISION Facts: in 2009, Chrysler was on the verge of bankruptcy. The US Treasury Dept gave the company a $4B loan using money from the Troubled Asset Relief Program. C proposed an out of court reorg plan that would have paid all of their secured debt. TD rejected this proposal and instead wanted a plan that would wipe out Cs secured debt, predicating billions of dollars in more TARP funding on Cs approval. When Cs first lien lenders refused to waive their right to full repayment, the TD devised a scheme by which C, instead of reorg under a Ch 11 plan, would simply sell its assets free of all secured interests to a shell company, the New Chrysler. C was able to avoid Ch 11s absolute priority rule, which provides that court should not approve a B plan unless it is fair and equitable to all classes of creditors. The forced reorg amounted to the TD redistributing value from senior, secured lenders to junior, unsecured lenders. But the government should not have been allowed, through its own self dealing as a junior creditor, to hand pick certain creditors for favorable treatment at the expense of others who would otherwise enjoy first-lien priority. Takeaway: the US TD essentially caused a sale and the secured creditors, the pension fund holders, received less than the unsecured creditors involved BATTLE OF WESTPOINT y Has to do with a group of senior lenders who have blocked an Icahn-led group holding the majority second lien position from receiving stock valued at $95M in WestPoint Stevens, they make bedding and bath towels If the ruling holds up as precedent, senior lenders may have more latitude to demand case, rather than securities, in bankruptcies that end with auctions When there is not enough cash to cover their claims, senior lenders could argue that their claims have not been satisfied Set them up to receive more stock or new debt from their restructured borrowers, leaving little or nothing for second lienholders B Court ruled that second lienholders, including Icahn, were entitled to the remaining $95M in stock A mandatory prepayment provision of the intercreditor agreement, which the lower court had interpreted to authorize payments of stock to the second lienholders, was actually overridden by a separate credit agreement between the senior lender and WestPoint

y y y y y

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y y y

This agreement, the higher court decided, allowed the senior lenders to accept nothing less than cash to satisfy their claim The intercreditor agreement also ran counter to the adequate protection clauses of the federal B Code, the district court found The clauses gave the senior lenders the right to receive cash, even though the intercreditor agreement was interpreted by the B Court to indicate that they could be paid in stock District Court warned that this would be a dangerous precedent if it was allowed to stand o taken to its logical extreme, the B Courts notion of adequate protection would allow a powerful creditor and a D anxious to achieve some value for its favored constituencies to run roughshod over disfavored creditors rights the case is significant in that it speaks to how courts may rule when terms of intercreditor agreements contradict the terms of creditor agreements that senior lenders draft with borrowers: you cannot have intercreditor provisions inconsistent with any priorities contained in the credit agreement

AUCTION SALES: CONNOLLY I. INTRODUCTION y B must be in the best interests of the creditors y Try to get the greatest return for the estate y Four B Corp v. Food Barn Stores, Inc: the court confronted the argument that the B judge improperly considered an alternative bid from a bidder that, allegedly, could not be an assignee of the lease that was the subject of the sale y Corporate Assets v. Paloian: held that the B Court did not abuse its discretion in deciding to permit a second auction and to confirm the sale of the property based on the results of that second auction o In this case, the appellant was the winner of the first auction, then another party came in and bid at the confirmation hearing, and another auction was held in which the winner at the first was the winner at the second, only his second winning bid was 15% higher than the first o Essentially, a B Court has discretion to grant a second auction under this case if the price can be maximized y Courts have vested unsuccessful bidders with STANDING to challenge the B sale o In Re BCD Corp: a sale was vacated because the terms of the sale said that certain amount of liabilities would be taken on once a party wins. One party wins and it is found out that the D doesnt give the winner all the liabilities that they were supposed to give and the losing parties are all upset. They sue to challenge the sale and they are said to HAVE STANDING! a. Victory Corrugated Container: the local custom and practice may have a significant impact on the sale and a bidder must be in a position to adduce some evidence of the local custom and practice in the auction process 48

II. ASSET SALES OUTSIDE THE ORDINARY COURSE OF BUSINESS a. Authorization for Asset Sales Outside of the Ordinary Course of Business o Can a D sell all of its assets outside the ordinary course of business under 363(b)? o In re White Motor Credit: B Court held that under 363(b), in the absence of an emergency, the B Code did not authorize the sale of substantially all the assets of the D o HOWEVER, second circuit, and many cases after, held that in In Re Lionel Corp: the court adopted the good business reason standard, rather than the emergency standard  The court must find a good business reason to grant a request to sell substantially all of the assets out of the ordinary course of business.. the factors to be considered by the B Court should include: 1. The proportionate value of the asset to be sold as a whole 2. The amount of time elapsed since the filing 3. The likelihood that the plan of reorg will be proposed and confirmed in the near future 4. The effect on the proposed distributions in a future plan of reorg 5. The proceeds to be attained from the disposition vis a vis and the appraisals of the property 6. The proposed alternatives for the use, sale, or lease of the assets 7. Whether the asset is increasing or decreasing in value  Braniff: courts will look very skeptically at an asset sale, especially a sale of all of the assets of the D, outside of a plan where the sale structure also addresses distribution to creditors (other than perhaps a secured creditor) b. Notice Procedures for Sales outside the Ordinary Course of Business 6004 of the B Code governs the notice procedures for sales outside the ordinary course of business and how notice is to be given y Takeaways: o Participation in an auction without appropriate due diligence may well lead to serious misstep o The consideration of local practice and custom is critical, not only for participation at the actual auction but also to avoid challenges to the sale or subsequent appeals o Due diligence should be conducted with respect to all aspects of the property including all claimed liens or encumbrances o Notice is required to be given to these creditors to avoid any issue of liability thereafter o Sales as is and where is may be subject to covenants and other matters that are ascertainable either from the record or from a physical inspection of the property 49

o Due diligence relative to the legal standard for the proposal of an auction and for the approval of an auction in that particular district should also be considered o A bidder must be prepared to address issues arising out of postauction sales or out of the courts predilection to open up the bidding yet again in the context of confirmation of the auction result o The successful auction bidder should try to preserve flexibility for the courtroom, especially where the court is likely to consider late bids or to consider that no party won the auction o The bidder may want to structure the bid in such a way that other bidders cannot better that bid o Special care should be given to the drafting of the APA and the sale order o These documents should be consistent and should specifically delineate which document controls in the event of a dispute o The bidder must be prepared to present an evidentiary basis for its good faith in connection with the auction process and for the proposition that it paid fair value for the property o The bidder should be in a position to present evidence, if necessary, as to the local custom and practice with respect to auction sales o The bidder should also be prepared to establish before the B Court, in the first instance, and on appeal that the auction either was or was not consistent with the reasonable expectations of the parties to the auction o Case law indicates that the likely standard on appeal will be whether the auction was consistent with the parties reasonably objective expectations GILSON: VALUING DISTRESSED FIRMS Intro y y y y y Valuation plays a central role in Ch 11 B negotiations There is an obvious absence of market forces and thus it makes valuation more complex and less precise Creditors can lobby for an alternative value, join an official committee, or align themselves with management to develop a plan that better suits their interests Creditors can petition the court to remove exclusivity and file a competing plan or can request a formal valuation hearing Why is there a lack of precision in the cash flows valuations? o the administrative B process may limit the amount and quality of available information o strategic distortion of the cash flows o related to four factors:  the relative bargaining strength of competing claimholders  managements equity ownership  the existence of outside bids to acquire or invest in the D 50

and senior management turnover

Sample y Firms have significant unused net operating losses when they leave bankruptcy Valuation Techniques y Calculating Market Value o Market value equals the total market value of the firm when is reorg plan becomes effective and the stock is first traded o Market value is the sum of the market value of equity and warrants distributed under the plan, plus the pro forma face amount of debt and preferred stock y Valuation Using Discounted Cash Flows o Capital Cash Flows model o Measures the cash available to all holders of capital and include the benefit of interest and other tax shields o Its the same as discounting the firms free cash flows by the WACC o Capital Cash Flows  NI + cash flow adjustments + cash and noncash interest = CCF o Terminal Value  TV is estimated in two parts  First part extends the financial projections and simulates a firms use of NOLs until the NOLs are used up or expire  EBIT estimated corporate tax + cash flow adjustments + tax shield due to NOLS = CCF  NOL ownership rule: the use of NOLs by a reorganized company is limited when the firm experiences an ownership change which occurs when any group of 5% shareholders collectively increases its total ownership % by more than 50%; the amount of the NOL that can be used per year after the change of ownership equals the FMV of the reorg companys equity multiplied by the long term tax exempt rate published by the IRS however, if the firm experiences a subsequent ownership change within 2 years after leaving Ch 11, all of the remaining NOLs are lost o Discount Rates  Beta is used by using the firms historical stock returns o Valuation using Comparable Company Multiples o Fresh Start Accounting Estimates  Fresh start accounting must be adopted when: the going concern value of the Ds assets at reorganization is less than the value of all allowed prepetition liabilities and postpetition claims; and prepetition stockholder retain less than 50% of the reorganized firms voting common shares

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it is the substitution of the administrative process for the market process that is responsible for the lower correspondence between the cash flow forecasts and market values Summary y They found that the DCF and CCM valuation methods generally yield unbiased estimates of value but that the valuation errors range is very wide y Valuation errors can be associated with the lack of information about the firms y The main interpretation is that valuing firms emerging from bankruptcy is more complex and less precise because of the substitution of the administrative B process for a market process PIPER AIRCRAFT CASE Facts: Epstein, legal representative of future claimants against Piper, contended that based on statistical assumptions about how many persons would have post confirmation claims against Piper arising from its preconfirmation manufacture of airplanes and airplane parts, the Future Claimants had a claim, as defined by Sec 101(5) of the B Code, of around $100M o Epstein filed a proof of claim on behalf of the future claimants o Piper and the UCC objected to the claim on the ground that the future claimants did not hold 101(5) claims against Piper o Under 101(10), only parties that hold preconfirmation claims may participate in a Ch 11 case and share in payments pursuant to a Ch 11 plan o 101(5) defines claim as either a right to payment or a right to an equitable remedy for breach of performance if such breach gives rise to a right to payment. The B Court ruled that the future claimants did not hold 101(5) claims against Piper and the district court affirmed Holding: congress intended to define the term claim very broadly under 101(5) so that all legal obligations of the D, no matter how remote or contingent, will be able to be dealt with in the B case o there are several tests used to determine whether certain parties hold claims pursuant to this section:  the accrued state law claim test  the conduct test  the prepetition relationship test o the lower courts adopted the prepetition relationship test in determining the future claimants did not hold claims pursuant to 101(5) o Epstein argues for the conduct test, which says that a right to payment arises when the conduct giving rise to the alleged liability occurred o Under the conduct test, Pipers conduct was its prepetition manufacture, design, sale and distribution of allegedly defective aircraft, and that because Piper did this all prepetition, future claimants should have claims o The proper test IS the prepetition relationship test 52

o Establishes the Piper Test: an individual has a 101(5) claim against a D manufacturer if (i) events occurring before confirmation create a relationship, such as contact, exposure, impact, or privity, between the claimant and the Ds product; and (ii) the basis for liability is the Ds prepetition conduct in designing, manufacturing and selling the allegedly defective or dangerous product. Here the future claimants failed the minimum requirements of the Piper Test RULE and Takeaway: A contingent claim is included in the definition of claim. The person contingently affected must have at least contemplated the possibility of the liability occurring at the time the event giving rise to the claim occurred. o A person does not have a claim under 101(5) against a D manufacturer where the person has had no preconfirmation exposure to a specific identiable product of the D or any other preconfirmaion relationship with the D CORPORATE GOVERNANCE Fiduciary Duty Overview Background y Environment in corporate world is hostile and difficult o Courts, agencies, lenders, bondholders and other parties are aggressive and willing to second guess director decisions y Directors of a financially challenged company may be asked to approve certain transactions, payments (dividends, stock repurchases) or restructuring strategies that could be attacked if the company was to falter y Approval of a transaction or payment or restructuring strategy could serve as foundation for the breach of fiduciary duty claims y Each of those claims would be made with benefit of 20/20 hindsight and would be premised in some measure upon allegations that: o company was insolvent at the time of the challenged transaction, payment or restructuring or was rendered insolvent by such challenged transaction o the company did not receive fair consideration in connection with the challenged event o the challenged event preferred certain stakeholders over others or did not maximize the value of the enterprise Directors; and Officers Fiduciary Duties y The actions of the board of a company are governed by the laws of the state in which it is organized y Most are incorporated in Delaware y State law imposes fiduciary duties on both directors and officers y Primary fiduciary duties are: o Duty of care o Duty of loyalty 53

Fiduciary Duty of Care o Requires that actions and conduct of directors and officers be informed and considered, and that decisions must be made with requisite care o In satisfying its duty of care, the Board should  Inform itself of all material information reasonably available to it  Carefully consider that information and all reasonable alternatives and;  Act with requisite care in discharging its duties o In discharging the duty of care, directors may reasonably rely on the advice of counsel, accountants, investment bankers and others whom they reasonably believe are acting in areas of their own professional expertise and have been selected with reasonable care o Nonetheless, directors should not merely be passive recipients of advice, rather they should ask questions of the advisors and satisfy themselves as to all issues o Directors should independently evaluate assumptions and information provided by advisors o Important to establish and follow a decision making process and maintain good records to demonstrate compliance with the duty of care Fiduciary Duty of Loyalty o Directors and officers must act in food faith and in a manner they reasonably believe to be in the best interests of the corp o Directors and officers must not act solely or primarily for their personal or non-corporate purpose, such as to preserve their positions or wages The Business Judgment Rule o Protects directors and officers in their decision-making process o Creates a presumption that the directors and officers acted on an informed basis, in good faith and with the honest belief that the action was in the best interests of the company and its shareholders o They must fulfill their duties of care and loyalty to receive the protection of this presumption Loss of Business Judgment Protections o Protection may be lost in the following circumstances  Improper director interest  Director self-dealing  Lack of good faith  Fraud  Recklessness  Failure to act reasonably or exercise judgment; and  Abdication of responsibilities o If the protection of the BJR is lost, the entire fairness standard applies

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The burden shifts and the directors and officers must prove that the challenged decision or transaction was both procedurally and substantively fair o A B Court recently reiterated that, for breach of duty of loyalty claims, the P need only prove that the D was on both sides of the transaction and the burden then shifts to the D to prove that the transaction was entirely fair which burden is greater than meeting the BJR inherent in duty of care cases In Re Brown Schools  Consider how this problem may arise between a portfolio company of a private equity sponsor and the sponsor: the sponsor controls the board and owns the equity Summary of Business Judgment Rule o Whether a corp is solvent or insolvent, courts have found that directors and officers will be entitled to the benefits of the BJR if they comply with their fiduciary duties of care and loyalty o Heightened level of security based on hindsight may be applied to directors and officers of an insolvent or near-insolvent corp o Because of concerns about future second-guessing, directors and officers of a financially challenged company should assume heightened level of security o Directors and officers of a financially challenged company should be prepared to defend their actions under the entire fairness standard To WHOM Fiduciary Duties are Owed y Solvent Corp: o Directors and officers of a solvent corp owe their primary (if not sole) fiduciary duties to the corp and the corps SHAREHOLDERS o Generally owe no fiduciary duties to the corps creditors y Insolvent Corp: o Directors and officers of a clearly insolvent corp owe their primary duty (if not sole) to the corp and the corps CREDITORS o This is true for an insolvent corp even if it has not commenced a B case y Zone of Insolvency o The analysis above is more complex when a corp is not YET insolvent but is nearing insolvency  Known as the zone of insolvency o Under DELAWARE law, directors and officers of a corp within the ZOI should assume they have a duty to exercise judgment in an informed good faith effort to maximize the corps long-term wealth creating capacity o In other words, directors and officers of such a corp have a duty to maximize the value of the corp for the benefit of all stakeholders o In the ZOI, directors and officers must continually strike a balance among:  Allowing distressed or threatened businesses the freedom to develop and pursue strategic options (none of which will be risk free)

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Accountability to creditors when business decisions prove to be unsuccessful and the value of a Cs claim is reduced or lost; and  The obligation to maximize shareholder value o A DE Supreme Court has eliminated the fiduciary duties directors and officers might owe to creditors in the zone of insolvency N. Amer. Catholic Educ. V. Gheewalla (Gheewalla)  Based on subsequent court precedent interpreting Gheewalla, creditors may not be entirely without recourse  Specifically, at least one B Court has noted that Gheewalla reaffirmed the principle that Cs may have derivative standing to bring and action for breach of fiduciary duties where the company is in the zone of insolvency In Re VarTec Telecom Derivative Claims o When a corp is solvent, only shareholders may bring derivative lawsuits against the corp o When a corp is insolvent, only Cs may bring derivative lawsuits against the corp o When a corp is in the zone of insolvency, the board is protected from shareholder derivative suits if the board takes into account creditor interests in their decisions  Courts have been inconsistent in addressing whether Cs can bring a derivative claim for breach of fiduciary duties  Directors must balance maximizing shareholder value with accountability to Cs by maximizing the value of the corp as a whole Standards for Determining Solvency o Solvency analysis is needed to determine to whom directors and officers duties are owed o Generally, courts employ two tests  Cash flow test: a corp cannot meet its debts as they come due  Balance sheet test: corp has liabilities in excess of its assets o A corp IS INSOLVENT if it is found to be insolvent under either the cash flow test or the balance sheet test Cash Flow Test: corp is considered insolvent under the equity or cash flow test if it is unable to pay its obligations as and when they come due o Key consideration is whether the corp has the ability to produce sufficient cash to pay its debts as they mature o The source of cash may be from continuing operations, the disposition of assets, or other capital-raising activities o Case law is unclear as to how far out a corporations ability to pay its debts must be assessed o A corp should take a conservative approach to value its contingent or offbalance sheet liabilities and assess other liquidity or solvency issues

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Balance Sheet Test; corp is considered insolvent under the BSTest if the sum of its debts exceeds the aggregate value of its assets o Neither book value nor GAAP are controlling for purposes of the BSTest o Valuation of assets must be included at FMV o In addition, the cost of disposing of an asset needs to be considered in valuing an asset o All liabilities must be included in this analysis, regardless of whether they are matured, including estimates of contingent or unliquidated debts or other claims o Recent case law places weight on the markets perception of value, by reference to the trading price of a corps securities and ability to raise debt or equity financing, in determining whether a corporation is solvent in Re Iridium Operating  depends in part on whether the market is fully informed regarding the corporations financial situation. Moreover, many bond issuances and leveraged loans are trading substantially below par in the current economic climate, which may detract from the probative value of trading prices o no clear rules have been established for the valuation of contingent liabilities  majority of courts discount contingent liabilities by their probability of success or probability of becoming liquidated liabilities  some courts value contingent liabilities at their full face value Strategies to Minimize D&O Liability y Analyze solvency throughout the restructuring process y Comply with fiduciary duties of loyalty and care y Carefully assess insider issues y Obtain professional advice as various alternatives are analyzed, including the achievability of a potential course of action y Document the basis or reasoning underlying D and O decision making, including the burdens and benefits of a B filing y Distinguish between decisions made as a stockholder and decisions made as a board member y Take actions to maximize the value of the enterprise, rather than the interests of a particular stakeholder Final Key D&O Considerations y Ds and Os should evaluate and consider a financially challenged companys alternatives with the following questions in mind: o Assuming the company is now in the ZOI, what is the best course of action that will maximize value? o Caution: A HOME RUN or HAIL MARY strategy that would benefit stockholders if successful, but which imposes significant risk of loss to other stakeholders if not successful, is likely to be the subject of future scrutiny if it fails to come to fruition y 57

Ds and Os should be prepared in the future to demonstrate by reference to a thorough process and a well established contemporaneous record that the best course was chosen to maximize value Incentive, Retention, and Severence Payments in Ch 11 KERPs and Severance o Before Oct 2005, B Courts routinely approved key employee retention plans (KERPs) and severance plans for senior executives and other employees under sections 105(a) and 363(b) of the B Code. These plans were approved where the court found that the proposed plan was a reasonable exercise of the Ds business judgment o To curb abuses of KERP and severance plans, including allegedly excessive executive compensation, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) which added sections 503(c)(1), (2), and (3) of the B Code o These 2005 amendments dramatically changed the standard for implementing KERP and severance plans for senior executives and other insiders y Who is an INSIDER? o 101(31) of the B Code defines an insider of a corp as a director, officer or person in control of of the D, or a relative of a director, officer or person in control of the D o no bright-line test exists to determine insider status B courts have identified various indicia of insider status, including BOD appointment, and an executives ability to exercise control over business operations or to set corporate policy  a persons title alone, such as VP is not necessarily determinative of insider status --- see Office of the US Trustee v. Fieldstone (a VP was not an insider based merely on his title, but election to his position by the BOD rendered him an insider) y Retention Programs Under 503(c)(1) o 503(c)(1) of the B Code severely limits a Ds ability to implement retentiondriven bonus programs for insiders  retention and severance payments to non-insiders are not affection by 503(c)(1) of the B Code o to make a retention payment to an insider, the D MUST SHOW THAT: (all three) 1. the insider has a bona fide offer from another company at the same or greater rate of compensation 2. the insiders services are essential to the survival of the business; AND 3. the proposed retention bonus is capped at ten times the mean award for non-management employees during the year or, if there is no program for non-management employees, 25% of any retention award granted to the insider in the prior year y Post-BAPCA Incentive Programs y 58

o Ds now seek to implement incentive plans as a means to compensate insiders o A proposed incentive plan is not doomed simply because it has the effect of causing employees to stay with the D o The plan is subject to 503(c)(1) of the B Code only if the primary purpose of the plan is retention In Re Nellson Nutraceutical Severance Programs under 503(c)(2) o 503(c)(2) of the B Code allows severance payments for insiders ONLY if the payments are:  part of a generally applicable program; and  less than ten times the mean severance pay given to non-management employees during the calendar year in which the payment is made o 503(c)(2) of the B Code does not apply to post-petition severance plans adopted for the benefit of non-insiders Catch-All Section 503(c)(3) o Assuming a proposed incentive or severance plan does not run afoul of 503(c)(1) and (2) of the B Code, to secure court approval, ,the D must still show that the proposed plan is:  Within the Ds ordinary course of business; OR  Justified by the facts and circumstances of the Ch 11 cases o Factors a court will consider in approving an incentive plan include whether:  The plan is calculated to achieve the desired performance  The cost of the plan is reasonable in the context of the Ds assets, liabilities and earnings potential  The plan is consistent with industry standards  The D performed reasonable due diligence; and  The D received independent advice and counsel in creating and authorizing the plan Considerations for Incentive Plan Development o Ensure plan for insiders is truly incentivizing o Consult with independent advisors throughout the plan development process o Consider plans used at comparable companies within the industry o Develop a plan structure that meets the companys current and anticipated needs o Endeavor to obtain consensus with relevant stakeholders (lenders, official committees and the Office of the US Trustee), but be prepared for litigation

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DIP FINANCING Statutory Requirements for DIP Financing y B court must approve of Ds incurrence of debt and granting of liens in accordance with 364 of the B Code y D may obtain secured debt if unsecured credit cannot be obtaining by offering administrative priority y D may incur secured debt o With priority over all administrative expenses o Secured by unencumbered property; or o Secured by a junior lien on encumbered property y If credit is STILL unavailable, the D may obtain secured credit under 364(d) that o Is pari passu with existing liens (less common); or o That primes existing loans (more common) y To secure financing, the D must provide adequate protection to any C with an existing lien on the collateral being pledged Standards for Approving DIP Financing y Looking at a Ds postpetition financing, courts consider whether the postpetition financing o Is needcd to preserve the assets of the estate and is necessary, essential for continued operation of the Ds business; o Is in the best interests of the Ds Cs and estates; o Is an exercise of Ds sound and reasonable business judgment o Was negotiated in good faith and at arms length between the D on the one hand, and the agents and the lenders on the other; and o Contains terms that are fair, reasonable and adequate given the circumstances of the D and the proposed prepetition lender o Courts will generally defer to Ds own business judgment Adequate Protection y Intended to compensate a C for the diminution in the value of its collateral because of: o Automatic stay and limitation on the Cs ability to foreclose on its collateral o Ds postpetition use of the property; and o The grant of a pari passu or priming lien under a DIP facility y 361 of the B Code provides a non-exclusive list of what may constitute adequate protection o periodic cash payments; o additional or replacement liens; and o indubitable equivalent of the Cs interest in the collateral o primed lender may also obtain a superpriority administrative claim under 597(b) of he B Code if adequate protection is insufficient to cover diminution 60

administrative claims must be paid in full in cash upon confirmation of a Ch 11 case

Common DIP Provisions y found in terms of the credit agreement itself or in the court order approving the DIP facility y commonly-requested DIP provisions include: o rollups; o covenants tied to a reorg plan or 363 sale o waivers of rights to challenge validity, priority, or perfection of prepetition liens o waivers of the Ds right under 506 of the B Code to charge the collateral for the costs and expenses associated with preserving such collateral o caps on fees that may be incurred with respect to the investigation of such liens; and o priority liens on the proceeds from avoidance and preference actions y provisions often requested by not commonly approved: o provisions operating to divest the D of discretion in the formulation of a plan of reorg o blanket releases of, or limitations on, liability arising from the lenders prepetition conduct o waivers of avoidance actions o cross-collateralization of prepetition and postpetition loans; and o time limits on the investigation of the validity, perfection or priority of prepetition claims Terms Unique to DIP FINANCING y Generally, DIP lenders will require the debtor to provide a budget (including a detailed 13-week cash forecast). o Budget will limit use of both new liquidity and working capital. o Debtor will be required to perform subject to that budget. y Lenders often require heightened, ongoing reporting obligations, such as: o weekly business performance update calls; o comparisons of performance versus budget; and o ongoing access to key financial personnel and financial advisors. y A DIP financing package may also include covenants tied to the debtors financial performance and the progress of a chapter 11 case, such as: o revenue and EBITDA targets; o store or facility closing milestones; and o plan of reorganization implementation milestones. y Fees payable to DIP lenders in the event of a default are usually significant. Common Objections 61

y y y y y y y y y

Interest is too high. Fees are too high. Payment of postpetition interest to prepetition lenders exceeds the value of the lenders collateral; rate of interest as contract rate vs. default rate. Insufficient time to investigate liens and claims of secured lenders and/or insufficient reservation of rights to clawback refinancing if prepetition liens are invalidated. Unnecessary rollup of prepetition debt into superpriority postpetition debt. Covenants are too onerous/may make a default too likely. DIP lenders should not have liens on avoidance actions. Liens granted to a DIP lender may violate the terms of existing leases. Extent of priming (self priming vs. all junior liens).

Practical Considerations y When asked to approve a DIP facility, the court will also consider, among other things: o if the proposed terms are consistent with market terms; o if the debtor has provided reliable projections to support its proposed financing package; and o the viability of other alternatives. y Hence, the debtors ability to satisfy the requirements provided by section 364 may turn on the marketing process utilized by the debtor when obtaining the proposed financing package. o How many other lenders were solicited? o Was credit available from alternative lenders? o On what terms? o At what cost? y Witness testimony will typically be required to support these propositions. Three Approaches to DIP Financing y What are the various approaches to providing investing using DIP financing? o Provide DIP as a Preexisting Secured Lender  Roll-up prepetition debt  Convert prepetition debt to equity  Convert DIP to equity o Purchase Debt Securities and Provide DIP  Influence plan formulation o Provide DIP as a Third Party Financier  Obtain priming liens and favorable interest rates Provide DIP Financing as a Preexisting Lender y Roll-Up o A roll up allows lenders that have existing loans predating the bankruptcy petition to transform their prepetition debt into the funds lent under the DIP facility. 62

o The rolled up loans then receive super-priority administrative status, along with the new money provided by the DIP loan to finance the debtor's operating needs, that primes the liens of the preexisting lenders. o Mechanism used to encourage creditors to lend to distressed companies.  Allows a secured lender to advance its position in the debtor's bankruptcy case.  Assures immediate repayment of the prepetition claim. y Converting Debt to an Exit Facility or Equity Stake o Upon confirmation of a plan, DIP lenders may provide the debtors with the option to pay the DIP in full or convert the DIP into an exit facility. o Rather than seek repayment, a DIP lender may contribute new capital through a DIP facility in exchange for new equity in the company. o DIP lenders may provide debtors with the option of repayment or converting their DIP facility into an equity stake in the company. For example:  ION Media Networks, Inc.: At the companys option, the DIP facility may be converted into 62.5% of the common stock of the reorganized debtor.  Hayes Lemmerz Inc.: The companys DIP lenders may convert their $100 million DIP facility into 84.5% of the common stock of the reorganized debtor. o A DIP for equity swap may be combined with a prepetition debt for equity swap.  e.g., General Motors: the U.S. Treasury converted its $24.2B DIP loan plus $19.4B in pre-petition financing into a 60.8% equity stake in the reorganized company. y Traditional Loan to Own Strategy o What is it?  Rescue financing from an outside source that serves as a lifeline/bridge to a sale of substantially all of the companys assets to the third party financier. o How does it work?  As a condition to executing the DIP agreement, the debtor simultaneously executes a stalking horse asset purchase agreement with the third party financier.  As a condition to funding, the court approves sale procedures (including break-up fee and expense reimbursement).  The DIP agreement and related sale/DIP orders will contain other conditions and case milestones requiring a short sale process.  If the stalking horse bidder is outbid, the winning bidder must pay the break-up fee and expense reimbursement, and repay the dip loan; if the stalking horse bidder wins, the loan balance is credited against the purchase price. Purchase Debt Securities and Provide DIP Financing 63

A party interested in providing a DIP loan may buy into a debtors capital structure to have a seat at the table. o In addition to providing a DIP facility, a DIP lender may purchase a controlling or blocking position in a companys existing debt securities. y The debt security that converts to equity is often referred to as the fulcrum security. o To identify the fulcrum security, investors must evaluate the debtors debt capacity and enterprise valuation and the dynamics of the bankruptcy case. y Additionally, some cases stay in chapter 11 for prolonged periods. As such, the fulcrum security may change over time. y Absent an agreement concerning overall enterprise valuation, a valuation hearing/battle, which can have a substantial impact on recoveries, will be necessary y Investors in debt securities should be cognizant of insider-trading restrictions o Bonds are securities and trading is subject to insider-trading laws. o Bank loans are generally not viewed as securities, but a court could conclude that bank loans should be treated as securities. y To avoid being restricted for extended periods, investors generally have their advisers review the information before receiving it and then require the company to disclose the information after a certain period. o Investors have also used IntraLinks to disseminate confidential information to the holders of a distressed companys leveraged loans so that the investor can buy the leveraged loans after obtaining confidential information. y If there is a concern about possession of material non-public information then consider the use of "big boy" letters informing the counter-party to a trade that the investor may have such information. Provide DIP as a Third Party Financier y Priming Lien o A third party financier may seek a priming lien to provide the DIP loan. o To obtain this type of loan, the debtor must be otherwise unable to obtain credit. o Section 364(d)(1) allows the bankruptcy court to authorize the debtor to obtain a priming lien, which effectively subordinates any current liens to the lien securing the new debt.  To obtain approval of a priming lien the debtor must prove that the preexisting lenders will have adequate protection of their liens. This requires a showing that the other lender's interest in the collateral will not be reduced or impaired as a result of the loan. y Favorable Interest Rates o A DIP lender may be able to negotiate a highly favorable interest rate. o DIP loans usually also come with a short maturity, which may allow for additional fees in the event of an extension or amendment.  e.g., Delphi: the DIP loan interest rate increased by 2% following an accommodation agreement to extend the length of the DIP facility y

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Flowchart for Chapter 11 Bankruptcy

Hierarchy of Creditor Claims

Timeline of Chapter 11 Filing

Lifecycle of a Typical Chapter 11 Case

TRONOX Key Players

TERMINAL VALUE OF A BUSINESS

DISCOUNTED CASH FLOW TERMS

TERMINAL VALUE FORMULAS

RELATIVE CONTRIBUTION OF THE NPV OF THE CASH FLOWS vs. TV

EQUITY VALUATION vs. FIRM VALUATION

Joes Crab Shack Valuation Projected Income

JOEs CNTD

JOES WITH COMPARABLE PUBLIC COMPANY ANALYSIS

JOES WITH PRECEDENT TRANSACTION ANALYSIS

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SUMMARY VALUATION ANALYSIS, TOTAL ENTERPRISE VALUE SUMMARY

11

WEIGHTED AVERAGE COST OF CAPITAL

12

RISK FREE RATE SELECTION

13

WEIGHTED AVERAGE COST OF CAPITAL CALCULATION

DISCOUNT RATES

UNLEVERED INDUSTRY BETA

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DUTY TO MAXIMIZE VALUE

OVERVIEW OF DIP FINANCING

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DIP FINANCING STRUCTURES

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