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In the eleven months leading up to Dec. 1, 2001, three of the largest bankruptcies since 1980 had occurred. Then, on Dec. 2, the largest filing in U. S. history occurred when Enron Corp. filed for protection under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Southern District of New York. It is worthwhile to note, based on publicly available information, that Enron was the seventh-largest company in the U.S. with a market value in 2000 of $65 billion and an enterprise value in excess of $80 billion. Clearly, in a volatile market with drastic shifts in investor appetite and valuation viewpoints, what was once a “darling” of Wall Street can quickly become the symbol of a faltering economy. In hot markets, many things are forgiven that are put under significant scrutiny when markets falter. These times can have serious repercussions for investors. Bondholders of a company that has filed a bankruptcy petition face a number of issues. The ultimate outcome for bondholders will depend on, among other things, the nature of the instrument (i.e., secured, unsecured) and the ranking of the instrument (i.e., senior, junior, subordinated), negotiations between the various estate constituencies and how aligned the exit objectives are of the individual bondholders. There are studies that indicate that the legal priorities are not adhered to in a majority of filings. SeeEdward I. Altman and Allan C. Eberhart, “Do seniority provisions protect bondholders’ investments?” Journal of Portfolio Management, June 22, 1994, at 67. An additional consideration for bondholders to understand is whether or not the instrument will entitle holders to be paid interest during the period in which the issuer is in Chapter 11. A financial advisor can assist bondholders in Chapter 11 to understand their position and maximize their return. BONDHOLDERS’ CONSIDERATIONS The downturn in the economy over the past year and a half has had a significant adverse impact on a broad array of industries, ranging from telecom to retail to the rust belt. In addition, the default rates on debt have skyrocketed. This is bad news for all stakeholders of financially distressed companies, but especially for bondholders, given their frequently subordinated position in the priority chain and tendency to have little opportunity to impact the company and its restructuring efforts before a filing. The bondholders may benefit from institutional research and publicly available financial statements, but, unlike lenders and trade vendors, generally do not have the same degree of access to “of the moment” financial information nor are they positioned to observe firsthand changes at the company. The various classes of lending institutions are usually in more regular contact with the company through the monitoring of loan covenants and audits. Trade vendors are, in most cases, in regular contact with the company through the company’s purchase of goods and the payment on its accounts, which, when coupled with significant changes in behavioral patterns, may signal a downward trend in the company’s financial situation. Bondholders, on the other hand, generally do not interact with the company until there has been a default on an interest payment, or some other manifestation or official notification of impending financial difficulty, which is most likely to occur well along the downward continuum of the company’s economic decline. By way of contrast, trade creditors benefit not only from daily interaction with the company but they also gain information through the “industry grapevine.” Bondholders do not have this advantage. Bondholders need to be very careful not to acquire nonpublic information or they would be prohibited from trading in the bonds, a situation that is usually against most bondholders’ internal policies. The typical bond indenture gives the holder little opportunity to be at the table. OUT OF THE LOOP As a result of the generally poor information flow as well as the growing frequency of defaults, bondholders are attempting to maximize the recovery of their investment. Bondholders are becoming more proactive and taking roles to ensure that a distressed company cuts cash spending and increases liquidity, including selling assets to raise cash prior to a default. This activism comes at a price, however. Bondholders form ad hoc groups. Complex agreements are negotiated with debtors conditioned on the bondholders agreeing to certain trading restrictions and negotiated complex confidentiality agreements before filing for bankruptcy protection. Getting the debtor to pay for counsel and advisors for the committee is also difficult. Therefore, the bondholders may find themselves going out of pocket in the first instance in order to preserve their rights and influence the debtor. This recent activism invokes the emerging doctrine of the “zone of insolvency.” Bondholders are testing the point at which the fiduciary duty of the company’s board of directors and management shifts to a responsibility to all stakeholders, not just the equity holders. This concept was developed in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991) and has created a standard of which boards and managements of companies must be cognizant. It typically comes into play somewhere along the line of declining economic performance and the actual filing of a bankruptcy petition and, in many cases, while management and the board are still in denial about the company’s condition. The status of a creditor holding prepetition debt is of paramount importance in determining both the probability and amount of recovery. Priority in bankruptcy determines the order in which the creditors are paid. Secured creditors have the highest ranking among all creditors. A secured creditor claim where the collateral is valued at less than the entire debt claim will then fall into secured (to the extent of the value of the collateral) and unsecured categories. Significantly, secured lenders are entitled to be paid interest on their claims post-petition. Next come unsecured creditors, which typically include vendors. Bondholders can be in a secured position. More often, however, they hold the status of an unsecured creditor in bankruptcy. Even within the category of unsecured creditors, bondholders may be subordinated to other lenders or different classes of bondholders due to contractual conditions in the indenture so that one class of bonds is junior to or has a lower priority than that of another class. The bondholders as a class, however, may have a very different perspective than either unsecured financial lenders or trade vendors. These two broad categories of creditors may be balancing their current status and claims against their potential for business opportunities if a successful bankruptcy plan is adopted and, therefore, the debtor exits bankruptcy as a going-concern company. Many creditors in this position may be willing to compromise their current claims in order to ensure that the debtor exits bankruptcy and continues to do business. Typically, however, the bondholders are in a position that is more analogous to that of shareholders (preferred and common) — they are investors who are interested in recouping their investment. The secured creditors are paid first, leaving the unsecured creditors, including the bondholders, to negotiate their recovery to the extent that there are recoverable assets. In some instances, the bondholders will receive some equity, either alone or in combination with cash and/or reissued/restructured debt. The creditor priority rules described above have come to be described as the “absolute priority rule.” This steadfast principle provides that one class of creditors must be satisfied in full before the next may be satisfied. Over time, a new value corollary to the absolute priority rule evolved whereby, if the old equity holders contributed new capital or money in order to allow the company to reorganize and, therefore, add new value, they could retain their equity interest. The driving force for this was the recognition that it was only the old equity holders who wanted to reorganize the company. Therefore, as the new value corollary developed, it overrode the absolute priority rule, which under certain circumstances might operate in a way to be damaging to the bondholders’ interests. Bondholders could lose significant value. SOME RELIEF However, in 1999, the U.S. Supreme Court in a landmark case, Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411 (1999), provided relief to the unsecured creditors (including bondholders) who were in a position senior to that of the prepetition equity holders. The Court held that the prepetition equity holders may not receive an interest in the reorganized company under the new value corollary if that opportunity is presented exclusively to such equity holders. That is, it was done while the debtor had exclusivity and there was no process for ensuring that no one else wanted to invest in the company. Some form of market testing or competition was required so that a determination was made that the old equity holders were allowed to continue on account of the infusion of new capital rather than as a consequence of the prior ownership. The bondholders’ priority in bankruptcy may also be compromised by what is known as a cramdown plan. Each impaired stakeholder in a bankruptcy may vote to accept or reject a plan that is developed that confirms the settlement of each party’s claim. A plan is deemed accepted by a class of creditors if those creditors hold at least two-thirds in amount and more than one-half in number of the allowed claims. However, even if the plan has not been accepted by all the impaired creditor classes, a debtor may request a bankruptcy judge to confirm a plan over the objections of a dissenting class. The cramdown process for imposing a plan may be allowed if it is fair and equitable with respect to the classes of impaired creditors. See11 U.S.C. 1129(b)(2)(A). The Bankruptcy Code states that for secured claims, the plan is fair and equitable if the secured creditor retains a lien on the property, or the proceeds of the property, and receives payments in deferred installments totaling at least the amount of the allowed secured claim, and having a present value, as of the date of the effective date of the plan, of at least the value of the collateral or the secured creditor receives the “indubitable” equivalent of its secured claim. The cramdown may be to the detriment of the bondholders because it permits dilution of the equity that the bondholders might otherwise have received in a Chapter 11 reorganization or forces a restructured debt resolution that the bondholders find objectionable for reasons that may be valid, but insufficient to void the Chapter 11 plan. Based on the economic reality that the bondholders are frequently in a precarious situation when it comes to recouping their investment, they may be more likely to recommend liquidation or an all-or- nothing negotiation strategy to maximize their return. These tactics will depend on the makeup of the bondholders, i.e., if they invested when the bonds were issued or at a subsequent time. As in the early 1990s, vulture investors are still around and investing in distressed debt with the expectation of making extraordinarily high returns. Therefore, in some cases, the distressed bond investors will want to accept a plan to earn high returns while the original-issue unsecured bondholder may realize relatively little on the initial investment without a revised plan or even liquidation of the distressed company. Additionally, there is often a dispute about the value of collateral that impacts whether the secured lenders also have claims as unsecured creditors if their collateral is insufficient to fully satisfy their claims. FINANCIAL ADVISORS CAN HELP Given the different types of priority that bondholders have, it follows that strategic as well as legal considerations are often involved when the distressed company files for bankruptcy. Based on experience honed from many cases, a financial advisor is well equipped to aid bondholders in devising their strategy and helping gain the highest recovery possible. The advisor must be prepared to complete a rapid assessment of the above considerations through industry and operational experts. Depending on the facts of the capital structure, the bondholders may have their own committee or may be part of an unsecured creditors committee. A financial advisor will provide knowledge to the creditors that will allow them to understand the situation and quickly get “up to speed” on the company’s financial condition and prospects. This is especially useful to bondholders, who often lack information. In addition, the financial advisor will be able to complete the tasks that the creditors may not necessarily have the expertise to complete, such as valuing collateral or understanding some of the permutations of the restructuring plan, thereby saving valuable time and costly resources. The financial advisor will be able to assess the viability of the distressed company to determine if a reorganization is possible and what is needed to effectuate that reorganization or whether a complete or partial liquidation is the best option. Advisors can assess the company’s ability to reorganize by evaluating factors such as its cash position and cash-flow forecast, financing and working capital requirements, Chapter 11 administrative costs, individual asset and business unit or product values and management capabilities. Advisors are skilled at isolating the financial and operational issues that have the potential to immediately improve a stakeholder’s position. He or she can also perform due diligence, conduct negotiations with lenders and create independent valuations. Financial advisors can also evaluate a plan of reorganization or create an alternative plan, ensuring that the plan is fair to creditors and feasible. Most importantly, however, the advisor’s role may be as mediator and negotiator. There are emotions involved when people are losing money. And, the more complex the estate, the more varied the restructuring options are and the more constituencies must be part of the consensual process. A seasoned advisor can help lead a client through these negotiations and ensure that the best outcome is attained for a constituency. Advisors come from different backgrounds, but are generally persons with extensive business, legal or accounting experience, or some combination of these talents. Stephen M. Brecher, Ruth E. Ford and Joel M. Simon are principals in the New York office of Crossroads LLC. Kelley Hoeckele, a consultant at Crossroads, contributed to the article. Crossroads consults on restructuring, turnaround management and corporate finance operations.

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