Financial engineering to be put on trial in bankruptcy courts

US corporate bankruptcy lawyers may suddenly have to cancel their summer holidays. They may not object as they have been mostly unoccupied for at least two years.

Even though stock markets have been retreating all year, financial conditions have only tightened markedly of late. The result is that several companies facing a cash or supply chain crunch have not so easily been able to raise fresh rescue capital, money that would have flowed easily at most any point in the last decade.

Lacking liquidity, the likes of Revlon, Scandinavian Airlines and Voyager Digital have recently been forced to hastily file for Chapter 11 bankruptcy. Their court papers have described just how quickly distress overwhelmed them, providing evidence on how quickly a recession may be approaching.

As for the bankruptcy cases themselves, expect many of them to be intrinsically compelling. Years of low interest rates after the financial crisis inspired all sorts of financial engineering and, in the case of cryptocurrency, a new financial paradigm all together. Much of that innovation was not fully understood at the time but will have to be untangled now with lawyers and judges.

At the end of May, a distressed debt ratio calculated by S&P showed that under 3 per cent of the corporate credit securities it tracked were trading with yields greater than 10 percentage points above US Treasuries, indicating elevated default risk. By the first week of July, the ratio was at nearly 9 per cent. The effective yield for the lowest-rated category of junk bonds tracked by the Intercontinental Exchange and Bank of America is now 15 per cent, more than double a year ago.

The higher cost of debt is indicative of just how scarce capital has become. Multiple investors pointed to Avaya, the telecom hardware company that recently borrowed $350mn in the form of a senior secured loan at an annual whopping 15 per cent cost. One hedge fund executive said that with the broad sell-off in risk assets recently, there was enough dislocation in the debt of high-quality companies, there was little need to a chance on the drugs.

The Swedish air carrier SAS found this out the hard way. The company, in the midst of a labor stoppage, filed for bankruptcy in New York without agreeing to subsequent financing or a revised deal with aircraft lessors. Companies that do file for bankruptcy often prefer to have a deal with creditors in place in order to quickly exit the process.

Similarly, the cosmetics maker Revlon filed for bankruptcy when negotiations with creditors for an out-of-court deal fell short just as its suppliers were increasingly hesitant to deal with the troubled company.

The company had raised $880mn of cash in 2020 to avoid going under in the midst of Covid. That new loan required pitting one group of hedge funds against each other in a transaction known as an “uptier exchange”. In such deals, a disfavoured group of eleven-senior lenders get their debt pushed down in seniority. That structure has increasingly become common among highly indebted companies even if it is also legally controversial. And sorting out the property of that manoeuvre is a barrier to resolving the Revlon bankruptcy.

New bankruptcies will also put the overall increased complexity of capital markets under the microscope.

“There is a lot of hidden leverage in the system,” says Elizabeth Tabas Carson, an attorney at the law firm, Sidley Austin. She referred to esoteric structures with names such as back-leverage, NAV financing and subscription financings that are as yet untested in a “down market”.

The most novel resolutions will almost certainly be in the crypto world. Last week the Canadian crypto broker and lender, Voyager Digital, filed for bankruptcy in New York after it had suspended account holders from withdrawing assets from their accounts. Voyager had lent $650mn worth of crypto to a hedge fund, Three Arrows, which itself had gone bust.

Voyager had hired the prominent law firm Kirkland & Ellis to represent it in proceedings and, while the bankruptcy was filed under duress, Voyager said in court papers it already had a tentative plan of restructuring. Account holders would be repaid in the form of crypto “coins” and “tokens”, proceeds from the litigation with Three Arrows, and equity in reorganized Voyager. The bankruptcy process determines the priority of creditors and the valuation of assets, novel tasks in crypto-world. This is no time for the experts to go on holiday.

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