January 15, 2021 - On January 14th, the LSTA hosted a webinar, Distressed Debt Investing, presented by Fried Frank partners, Emil Buchman, Darren Littlejohn, and Peter Siroka. The presentation provided an overview of investing in distressed debt, starting with the issues that an investor acquiring the debt must consider in order to become a lender of record under the applicable credit agreement. They then analyzed the rights of a lender and an agent under the credit agreement and also other sources of creditor rights, before analysing different mechanisms a distressed borrower may pursue to protect itself.
Other sources of creditor rights that were highlighted include recharacterization, equitable subordination, preference, and fraudulent conveyance. Under the doctrine of recharacterization, claims may be characterized as equity, which results in the holder of those claims being unable to receive payment until other claims are satisfied in full. Turning to equitable subordination, the Bankruptcy Code provides the court with the power to relegate a creditor’s claim to a lower priority than it would otherwise enjoy under non-bankruptcy law so that the claim is subordinated to the claims of other creditors that have been injured by the creditor’s conduct. Generally, this will require wrongful conduct by the creditor holding the subordinated claim. Insiders who are also creditors are the most likely targets of this scrutiny and challenge.
A preference is a transfer of the debtor’s property that the debtor made to a creditor for antecedent debt, while the debtor was insolvent, within 90 days prior to the filing of a bankruptcy petition for relief (one year if the transfer was made to an insider). The transfer enabled the creditor to receive more than it would have received if the transfer had not been made and the debtor had been liquidated. The panelists noted that preference claims are less likely to exist against lenders (payments to fully secured creditors are usually not preferences). Noting that the current trend is to apply the doctrine of substantive consolidation sparingly, the panelists discussed the elements of this equitable remedy that results in, amongst other things, combining the assets and liabilities of the entities to be consolidated, such that claims between those entities are eliminated and the unsecured creditors of the entities become creditors of the combined entity that are satisfied from the resultant common fund. This effectively redistributes wealth among creditors of various entities because the entities are likely to have different debt-to-asset ratios, and it negates any structural subordination among the entities consolidated.
Finally, the panelists reviewed the defensive mechanisms which a borrower in financial distress could use to protect itself, such as an exchange of its existing loans for new loans at a discounted price. The panelists concluded by cautioning investors to understand the investment risks of each particular credit before investing, because any identified holes that are not plugged should at least be fully understood at the outset.