B a n k r u p t c y Primer

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1 B a n k r u p t c y Primer j a n n e y corporat e credit The bankruptcy process is a complex one, with no two the same, but knowing what to expect is key for investors. Jody Lurie, CFA Corporate Credit Analyst jlurie@janney.com See page 7 for important information regarding certifications, our ratings system as well as other disclaimers. Default rates have risen and are expected to rise even further this year as companies in the energy and metals space run into liquidity issues thanks to the bout of lower prices. Many bondholders have been forced into the unfamiliar territory of the bankruptcy process, so knowing the basic concepts and procedures is key in deciding whether to ride through or exit a position once a company files for bankruptcy protection. The roller coaster ride brought on by the fall in energy and commodity prices starting in fall 2014 has left a mark on investors attitude towards the space. Although prices have recovered from the low in February, the effects are evident in the rise in default rates from the lows of a few years ago to the highest level since Both Moody s and S&P have guided that default rates will likely increase through year-end, as some companies will be unable to right the proverbial ship before energy and commodity prices recover to levels that result in corporate profitability and cash flow. Many investors who participated in the rally of the past few years in energy and commodities credits, are now faced with the bankruptcy process, which may result in them swimming in unfamiliar waters. We attempt to identify key terms related to and the various events that occur during the bankruptcy process. Speculative-Grade Default Rates Have Been Creeping Up this Year 5.50% 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% Moody's US LTM Default Rates S&P US LTM Default Rates 0.50% 0.00% Jan-2011 Sep-2011 May-2012 Jan-2013 Sep-2013 May-2014 Jan-2015 Sep-2015 May-2016 Source: Janney FISR; Moody s; S&P; Moody s data reflects US trailing 12-month issuer-weighted speculative-grade default rate forecasts; S&P data reflects US trailing 12-month speculative-grade default rates There are two types of insolvency. In a balance sheet insolvency, a company s liabilities are greater than its assets. A company may have the ability to pay the next interest payment, but may not have a situation that allows for long-term company health. In a cash flow insolvency, a company is unable to meet debt obligations when they come due. Such a situation may be more of a timing issue between cash inflow and outflow, or it could be indicative of a company being unable to produce the necessary cash to meet obligations long-term. A company defaults on a debt security when it fails to meet the requirements outlined in the secu- Bankruptcy Primer Page 1

2 rity s prospectus and indenture. There are several different types of defaults that can occur. In a technical default, the debtor violates a specific covenant it promised to maintain. As an example, a company may be bound by the terms of the credit agreement to keep leverage at or below 4.0x. If the company exceeds 4.0x, the event triggers a technical default. Typically, a company will have a certain amount of time before such a situation triggers an event of default. Companies typically foresee technical defaults, and will work with their lenders to avoid triggering an event of default. Depending on the situation, the lender may provide the debtor additional leeway for a period of time. In a debt service default, a company misses a scheduled interest or principal payment. Typically, a company will have a certain amount of time (e.g. 30 days) before such a situation triggers an event of default. After that time period expires, the company would be in default, and this event may trigger events of default on other securities, whereby creditors can demand immediate payment or force the company into filing for bankruptcy. In a strategic default, a debtor may have the ability, but not the willingness to pay. The debtor may have the financial capacity to meet payment, but may opt to default on such payment. Strategic defaults are more common with residential mortgages, when an individual sees his/ her home value erode, thereby decreasing the desire to meet debt obligations. Number of Corporate/Preferred Issuers That Filed May Exceed Each of the Past 5 Yrs A typical Chapter 7 process takes about 4 to 6 months, though it can be more or less, depending on various factors Source: Janney FISR; Bloomberg; Shows companies with USD corporates or preferreds that are domiciled in the US and that filed for bankruptcy from Jan 2011 to Jul 2016 In the US, bankruptcy is a process governed by federal laws in the US Code, under title 11 known as the Bankruptcy Code. It gives corporations, and other entities, the ability to restructure or liquidity in the event they become insolvent and cannot meet creditors demands. Bankruptcy Primer Page 2 In a Chapter 7 bankruptcy process, a company liquidates its assets to meet its obligations under court supervision. During a Chapter 7 process, a trustee is assigned to sell the assets and distribute proceeds to the creditors. In a liquidation, not all creditors are likely to collect. In fact, the amount usually is distributed via a waterfall payment process, whereby the highest ranked creditors get first priority, and until they are made whole, the next level of creditors do not receive anything. As higher ranked creditors get paid, the next level collects payment. A typical Chapter 7 process takes about 4 to 6 months, though it can be more or less, depending on various factors. In a Chapter 11 bankruptcy process, a company is looking to restructure the balance sheet, while still remaining operational through the process. The company s goal during the Chapter 11 process is to wipe the balance sheet clean, so that the firm can emerge with minimal to no obligations outstanding. Some companies have pursued a Chapter 11 process in hopes to restructure only to be forced into liquidation. A typical Chapter 11 process can range anywhere from 6 months to 2 years, though

3 it can be more or less, depending on various factors. In Chapter 7, a creditor s expected recovery value could span from zero to full recovery, though both extremes are unlikely. The major factor in a liquidation is the actual market value of the assets the bankrupt entity owns. Some liquidations have resulted in pieces of the business intellectual property, certain subsidiaries, etc. selling to a competitor or investor for well above the book value of the asset and well above the initially perceived value of the company when the liquidation process began. That does not mean that creditors should advocate for Chapter 7, however. Sample Waterfall Analysis and Recovery Amounts Most Recent Recovery ($ in thousands) Financials Waterfall Percent Total Assets (or total amount recovered) $9,528 Short-term Liabilities 85 9, % A typical Chapter 11 process can range anywhere from 6 months to 2 years, though it can be more or less, depending on various factors. Credit Facility 1,000 8, % Term Loan 500 7, % Second Liens 1,000 6, % 7% Senior Unsecureds due Oct ,500 1,235 49% 8% Senior Unsecureds due Nov ,500 1,730 49% 12% Senior Unsecureds due Jan ,250 2,100 49% 13% Senior Unsecureds due May ,800 1,878 49% 10% Senior Subordinates due Jun , % } Because senior unsecured creditors were not made whole, lower ranked securities received nothing. 15% Preferred Equity % Source: Janney FISR In Chapter 11, the expected recovery amount is harder to value. Like Chapter 7, creditors could receive nothing or full recovery, but the form of payment could be cash, stock, a mix of both, or some other creative structure. If the creditor receives a stock component, the security is newly issued common equity in the company that emerged from bankruptcy. Different creditor classes will receive a different number of shares in the newly issued equity, and the equity may trade when issued at Annual Corporate Bond Recoveries Have Changed Over Time Bankruptcy Primer Page 3 75% 70% Snr. Unsec. Bonds 65% Snr. Sub. Bonds 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% Source: Janney FISR; Moody s; measured by trading prices

4 The bankruptcy process is a complicated one, and often times requires someone fluent in legalese to make sense of every step of the process. Bankruptcy Primer Page 4 a value below the pre-bankruptcy value, though not necessarily. Over time, however, the price could change, as any common equity price does. The firm can benefit from its clean post-bankruptcy balance sheet, which provides flexibility for growth initiatives. Per Moody s, senior secured bondholders on average expect to receive 71% of par value, while senior unsecured bondholders 36%, and subordinated bondholders 34%. Over time the expected recovery value can change. The average for senior unsecured bonds, for example, was at 49% between 1987 and 2015, per Moody s. The bankruptcy process is a complicated one, and often times requires someone fluent in legalese to make sense of every step of the process. If a company is nearing bankruptcy, creditors will often times begin to value the potential recovery rate for the securities they own. For publicly traded debt and equity, the trading price will reflect the expected recovery value. Note, however, that the ultimate recovery value can deviate from the expected recovery value, though the market price is a good proxy for those investors less willing or able to cull through the financials and determine their likely payouts. Once a company files for bankruptcy, its publicly traded bonds trade flat (i.e. without accrued interest payments embedded in the trading price). Typically, during the days right after the filing, many investors will opt to sell their positions to forgo the lengthy bankruptcy process and cut their losses. At the same time, some investors, including certain hedge funds, will be active buyers of the debt, thereby driving up the price. Sometimes these investors are buying the bonds to accumulate a meaningful percentage of the debt outstanding, which becomes important in the negotiation process, as we discuss below. Whether an investor should exit a position or hold onto it as a company nears and enters bankruptcy should be considered on a case-by-case basis. Some investors may want to avoid receiving all the paperwork related to the A Typical Order of Priority of Claims Debtor-in-possession lenders restructuring process and reorganization plan. Others may consider Vendors & customers, other admin claims Taxes & other governmental claims the potential downside versus the Unions & employee agreements (i.e. potential upside and choose to see pensions) the situation through to completion. First Lien Loans & Bonds For both Chapter 7 and Chapter 11 Order of Second Lien Loans & Bonds processes, the ultimate recovery may Priority of Senior Unsecured Bonds/Baby Bonds change significantly. For Chapter 7, Claims Senior Subordinated Bonds the amount is dependent on the actual sale price of the assets. For Chapter Junior Subordinated Bonds Trust Preferreds 11, the negotiations could shift, and Hybrid/Cumulative Preferreds the courts could take a pro-creditor or Noncumulative Preferreds anti-creditor stance. At the onset of Convertible Preferreds/CoCos the bankruptcy process, it is difficult Common Stock to say what the resolution for each creditor will be. Source: Janney FISR Average Corporate Debt Recovery Rates Lien Position Default Year Loans 80.4% Senior Secured Bonds 63.3% Senior Unsecured Bonds 48.8% Subordinated Bonds 28.2% Source: Janney FISR; Moody s; measured by ultimate recoveries; sub bonds includes senior subordinated, subordinated, and junior subordinated bonds. In general, a company s goal is to complete the Chapter 11 proceedings as soon as possible so that the company can return to normal operations with a clean balance sheet. A fundamental concept in the restructuring process requires that creditors receive a recovery value that is at least, if not better, than what they would receive with the liquidation of the company. Otherwise, creditors would not agree to the restructuring terms, and instead force the company into liquidation. In some instances, a company will work with creditors in advance of filing for Chapter 11 protection in a pre-packaged bankruptcy. During such a situation, the company and creditors hope to shorten the in-court process, as it can be costly. Often times, companies that file a pre-packaged bankruptcy will work through the bankruptcy process quicker than a company files a free-fall Chapter 11

5 The Chapter 11 process is more expensive than out-ofcourt restructurings, owing to transaction costs and legal and court fees. Bankruptcy Primer Page 5 process. After all, a free-fall bankruptcy can sometimes take investors off-guard, and the resulting process could lead to the company restructuring or liquidating, depending on the analysis. The Chapter 11 process is more expensive than out-of-court restructurings, owing to transaction costs and legal and court fees. At the same time, the laws were written to protect the debtor. One such example is through an automatic stay. When a company files for bankruptcy, it receives protection against its creditors in terms of forcing the company to deliver on obligations and stops pending prepetition lawsuits against the company. At the same time, the debtor needs court approval to pay prepetition claims once it is in the bankruptcy process. What s more, any transaction considered outside of the normal course of business needs court approval. Creditors can, of course, form groups to ensure proper representation on their side. Additionally, for individual and retail investors that do not have the industry presence that their institutional counterparts have, the US Dept. of Justice has a US Trustee program, whereby the trustee is tasked with ensuring all creditors best interests are in mind. As described by the DOJ s site, The primary role of the US Trustee Program is to serve as the watchdog over the bankruptcy process. Recent events have called to question the effectiveness of this program, but the idea of creating a voice for the underrepresented is notable. Basic Chapter 11 Timeline Company looking for alternative financing options Chapter 11 petition filed Automatic stay triggered Initial Stages, data collection First day motion Debtor in Possession financing (if needed) 341 meeting Proofs of claim deadline (if applicable) Within 1 st 120 days: debtor files reorganization plan Within 1 st 180 days: reorganization plan accepted by impaired creditors Source: Janney FISR; alllaw.com; phaseeleven.com; uscourts.gov; americanbar.org Negotiations, resolution Debtor receives approval from creditors Executes payment to creditors Emerges from bankruptcy Automatic stay ends New company operates debtfree and with new common equity For Chapter 11, there are timelines of procedures and required filings mandated by the court to ensure the process has some structure to it and moves forward to allow the company ultimately to emerge from bankruptcy with minimal to no debt. First the company files the Chapter 11 bankruptcy petition. The company often includes in the filing its basic financial information (assets, liabilities, income, expenses, etc.), but sometimes the company will utilize the 2-week period after the petition to file financial information. Note that the company can request additional time to file such information. For most of the timeline requirements, companies are able to request from the courts additional time. Additionally, the company must file with the court its updated financial information each month during the process. During the first day motions, the company, now called the debtor in possession, requests permission from the court to continue business as usual to the best of its ability in terms of meeting payments for payroll, workers comp, vendors, and basic overhead expenses. Any expense outside of this scope, such as paying prepetition debts, requires court approval before the cash can be used. Some companies can operate through bankruptcy without needing additional financing, while others must request debtor-in-possession financing, which is a debt security issued after the company filed for bankruptcy protection. Within the first week or two, all creditors are notified that the company filed for bankruptcy. A creditors committee is formed to represent creditors that may not be able to represent themselves in the case. Other committees may also form. A meeting of creditors, known as the 341 meeting, usually occurs a month after the company files the petition. At the meeting, creditors can confront the company and its rationale for filing for bankruptcy. A proofs of claim deadline is the date by which all creditors must file a claim listing what the debtor owes the creditor. With the Chapter 11 process, filing the claim may not be a requirement

6 in some instances, unlike other forms of bankruptcies, provided the creditor s claim is properly listed (e.g. amount or category) in the company s filing. Once the basic information related to the case is filed, the long process begins of negotiations with creditors and forming a plan of reorganization. Within the first 120 days after the petition, only the debtor can file a reorganization plan, which must be accepted within the first 180 days by impaired creditor classes. If the debtor runs out of time, however, another party involved in the bankruptcy can propose a reorganization plan. Once the plan is formed, creditors whose claims are impaired (i.e. those who would not be made whole by the reorganization plan) vote on the plan. The company must receive a majority of votes from each creditor class s members and an approval of the plan from voters holding two-thirds of the class value in order to execute on the plan. Creditors receiving nothing from the plan do not vote, as the assumption is they would vote no. A cramdown occurs when at least one class of impaired creditors voted against, but at least one in favor of, a reorganization plan. The plan can still go through if the company can prove to the courts that it is the fair and equitable option. For individual and retail investors that do not have the industry presence that their institutional counterparts have, the US Dept. of Justice has a US Trustee program, whereby the trustee is tasked with ensuring all creditors best interests are in mind. Although there are guidelines and rules that govern over the restructuring process, each proceeding is different. In some situations, the process can run smoothly and quickly, and in others, the process can be fraught with feuds among creditor classes and the company. An investor faced with the bankruptcy process should consider all his/her options prior to acting, as in some cases holding onto the security could be a better decision than selling before the process is completed, while in other cases, exiting at the threat of bankruptcy could make sense. Working with financial and legal advisors can help those investors less informed about the various steps of a restructuring. *Please consult your financial and legal advisors on specific questions about restructurings and bankruptcies. Bankruptcy Primer Page 6

7 Analyst Certification I, Jody Lurie, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Janney Montgomery Scott LLC ( Janney ) Debt Research Disclosure Legend Janney may seek compensation for investment banking services for any company listed in this report in the next 3 months. The research analyst is compensated based on, in part, Janney s profitability, which includes its investment banking revenues. Additional information available upon request. Definition of Issuer/Company Outlooks Janney FIS employs a rating system which considers the company, but not any specific debt or equity securities of the company and is not making a recommendation with regard to any specific debt securities of the company. Outlooks reflect our opinion about how credit factors of the company may affect its credit rating(s). Positive: Janney FIS believes there are factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Sector/Industry Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return. Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return. Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return. Janney FIS Outlooks Distribution as of 07/27/2016 IB Serv./Past 12 Mos. Outlook Count Percent Count Percent Positive Stable Cautious Negative Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the Barclay s U.S. Aggregate Bond Market Index as a benchmark. Treasuries: Janney FIS ratings employ the Barclay s U.S. Treasury Index as a benchmark. Agencies: Janney FIS ratings employ the Barclay s U.S. Agency Index as a benchmark. Mortgages: Janney FIS ratings employ the Barclay s U.S. MBS Index as a benchmark. Investment Grade Credit: Janney FIS ratings employ the Barclay s U.S. Credit Index as a benchmark. High Yield Credit: Janney FIS ratings for employ Barclay s U.S. Corporate High Yield Index as a benchmark. Municipals: Janney FIS ratings employ the Barclay s Municipal Bond Index as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change. Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor. Bankruptcy Primer Page 7