Hedge Funds Elbow Aside Creditors in Fast-Tracked Bankruptcies

(Bloomberg) -- Lenders to deeply distressed companies are calling the shots in big corporate bankruptcies so far in advance that some cases are practically over before they get started.

Investment firms and hedge funds are increasingly engineering bankruptcy loans and side deals to take control of Chapter 11 reorganizations from the outset. They’re putting up desperately needed funds to keep the targets in business -- but often only after crafting terms that lock in rich rewards for themselves while potentially locking out rivals and lower-ranking creditors. The trend is sure to speed up cases, but it also forces judges to make quick decisions that may shortchange some valid claims.

It’s a stark departure from older norms, when a troubled firm fell into Chapter 11 and huddled with creditors -- overseen by a federal judge -- on a plan to repay debts in a way that was relatively transparent. In recent cases like J. Crew Group Inc., key features of bankruptcy exit plans were designed well ahead of the filing itself, out of view of the court and swaths of creditors.

Similar tales are playing out in other large corporate bankruptcies. From 1995 to 2005, just 10% of bankruptcy loans given to publicly traded firms were linked to a specific Chapter 11 exit plan, according to a working paper from Kenneth Ayotte of UC Berkeley and Jared Ellias of UC Hastings. From 2015 to 2018, the number soared to 50%.

Take J.C. Penney Co., the U.S. retailer that went bankrupt early in the Covid-19 pandemic. It entered Chapter 11 with a deal in place for $900 million in bankruptcy loans, known in the industry parlance as a debtor-in-possession financing. The catch: the J.C. Penney debt holders funding it -- hedge funds included -- required tight deadlines for the restructuring, veto power over the process, a hefty interest rate and fresh legal protections for their existing holdings.

Complaints poured in. One creditor group called the financing “predatory” and another, its lowest-ranking creditors, likened it to a robbery. U.S. Bankruptcy Judge David Jones said the deal contained “an awful lot that you look at and you just don’t like.” But where else would J.C. Penney get the money needed to avoid liquidation? Jones approved the loan, and the department store chain’s stores emerged from bankruptcy about seven months after it sought court protection.

Those bankruptcy lenders -- a group that as of August 10 included H/2 Capital Partners, Silver Point Capital and Brigade Capital Management -- are now set to become the owners of most of J.C. Penney’s real estate holdings. Rebutting the attacks from other creditors, the lenders argued in court papers that their financing was the best deal available. Representatives for Silver Point and Brigade declined to comment further and a representative for H/2 didn’t respond to requests for comment.

Left Out

Such deals inject some certainty into an inherently risky process that can take months or even years to complete. The problem, according to the study’s authors, is that they may block better restructuring proposals, leaving low-ranking creditors with less than they might reasonably expect. This betrays a key bankruptcy goal -- to maximize the value of a firm for all creditors.

David Scheer is one of the creditors left in the dust. Scheer, who owns and manages a hotel in upstate New York, owns a chunk of J.C. Penney bonds that are unsecured, meaning they’re nearly last in line for repayment. Creditors like Scheer will likely recover just pennies on their holdings, according to court papers: more than $1.3 billion of unsecured J.C. Penney notes will share a cash pot of $750,000. They could get more if the re-born company hits certain performance goals in the coming years.

“It’s just like you don’t exist,” Scheer said in a November interview. He and his brother wrote letters to the court, and Scheer spoke up in hearings more than once, to no avail. He saw the process as unfair and wanted more time for J.C. Penney to examine its options. “The judge holds the keys and he just handed them over to the lenders,” he said.

Extra Edge

Existing secured lenders start with a built-in advantage when it comes to potential bankruptcy loans. They’re holding a lien on a company’s assets that puts them at the front of the line to get repaid. That’s a problem for other would-be lenders: Almost no one wants to provide a new loan to a shaky company that would be second in priority to anyone else, but they usually can’t leapfrog ahead without consent of the secured lenders.

This gives the secured lenders a big say in whether a company is able to reorganize -- saving sometimes tens of thousands of jobs -- or if it liquidates. What’s more, those existing lenders aren’t always conventional bankers. Sometimes they’re investment firms and hedge funds that bought up distressed loans dumped by banks, and they’re out to maximize profit for their portfolio clients.

Sophisticated investors can and often do use their position in the repayment line to their advantage. If they pony up a bankruptcy loan to keep the company afloat, they can stuff it with provisions that help steer a case to their desired outcome. So-called case milestones are one way of doing it -- they set deadlines which, if not met, can throw the borrower into default.

Playing Chicken

“The problem for the judge is he has to play chicken with the secured lenders, to protect the needs and concerns of junior classes, because he might not have another source of funding,” said Robert Gerber, a former bankruptcy judge who presided over the General Motors case of 2009. “The last thing he wants is for the case to die on his watch.”

Health and wellness company GNC Holdings Inc. got backlash for agreeing to “aggressive milestones which permit their senior creditors to take advantage of a temporary dip in value,” one creditor group alleged in an objection. But without the loan offered by those senior creditors -- and the milestones woven into the financing -- GNC would’ve run short of the cash needed to operate, according to its financial adviser.

J. Crew also came under fire for the milestones embedded in its bankruptcy loan. The preppy retailer’s unsecured creditors alleged the loan contained deadlines and restrictions that “would predetermine the outcome of these cases” and “deprive unsecured creditors of their day in court on key plan issues,” according to court papers.

Quick Turnaround

Still, the loan was approved -- no other funding was available -- and J. Crew exited bankruptcy in September, a little more than four months after filing for Chapter 11. Anchorage Capital Group is its new majority owner.

In one of the biggest active cases, unsecured creditors of Chesapeake Energy Corp. say the DIP loan was engineered by existing lenders to deprive the lower-ranking group of assets they were counting on. They also contended at a Thursday court hearing that the lenders blocked a competing plan that would have been cheaper, and that short deadlines were set to hustle the deal through.

On top of that, the $925 million loan has sat nearly unused, raising the possibility that Chesapeake granted existing lenders more protection for their old debt and handed over control of the bankruptcy process in return for providing a loan that wasn’t really needed. Jeff Jonas, a lawyer for the junior creditors, said in court Thursday this tied up “hundreds of millions of dollars” worth of assets that could have been used to pay unsecured creditors.

Support Agreements

Milestones are just one way investors can control a case. They may require a company to pursue a specific transaction -- often a sale of the company to the lenders themselves. That can be specified in the loan itself or embedded in a so-called restructuring support agreement, a side deal with a group of creditors who agree not to make a fuss in bankruptcy if certain conditions are met.

So far this year, at least 26 firms with more than $2 billion in assets have filed for Chapter 11 bankruptcy. Only seven of those firms entered court protection without a restructuring support agreement or bankruptcy loan containing milestones, according to a Bloomberg News review of court records.

“It used to be a that company filed for bankruptcy and reorganized,” said Ellias, the UC Hastings professor. “Now, companies have restructuring discussions outside of court and briefly step in to implement them.”

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