Other Thoughts on the Plan. In a bankruptcy, a debtor-in-possession serves as a fiduciary for the creditors and interests. The court oversees the case to ensure that the debtor fulfills its obligations. Yet, both the debtor and the court cannot ignore the practical aspects of achieving a consensus and moving expeditiously to address the company’s financial problems in order to facilitate its exit from bankruptcy.
Despite the debtor’s obligation, creditors and interests also have a responsibility to stand up for their rights. Bankruptcy is a process in which the creditors and interests compete to maximize their recoveries. This creates a potential conflict that can undermine an ideal conception of fairness. Any potential intervention by these referees can run the risk of undermining a consensus. It is also more difficult for the court to impose its concept of fairness when the constituency most negatively affected by a proposed plan fails to show up to plead its case.
Under today’s investment management practices, there are often few qualified professional investors available to represent the equity interests in a bankruptcy court proceeding. A high percentage of the outstanding shares of most equity issues are owned in passive investment vehicles, such as ETFs and index funds, which generally do not participate actively in corporate governance matters, let alone in bankruptcy proceedings.
Passive managers may be forced to sell an equity holding when it is ejected from an index. Active investment managers often dump their positions in stocks of companies that are headed to bankruptcy court to avoid continuing losses and the negative publicity of declaring a position in a stock that has lost nearly all of its value. Active managers may also be forced to sell when a stock is delisted from a major exchange.
To complicate matters, because trading in the stocks of bankrupt companies is usually driven by speculators, those stocks often trade well above any realistic assessment of their future value. Equity interests have very little leverage in bankruptcy. Consequently, it is not surprising that they are usually shunned by professional distressed investors.
Institutional investors have exited Peabody’s stock almost entirely. I could find only one institutional investor that holds 2.3% of its shares. Another holds a 0.1% position and the remainder hold less than 0.05% (or only a few thousand share each). With such an ownership profile, it is pretty good bet that ownership turnover is high and that the majority of shareholders have held their positions for only a short period of time.
The same is also true, but perhaps to a lesser extent, for unsecured creditors. Many bond funds are prohibited from owning the bonds of bankrupt companies and even bonds that are rated below a certain ratings threshold, such as “B.” With a predictable supply of sellers, it is not surprising that bond prices often fall sharply in price when problems become manifest. Deep discounts also suit the preferences of distressed investors who usually seek to earn a tidy profit and cash out quickly.
We have already seen this process at work in other coal bankruptcies. In all three major bankruptcy cases, shareholders and unsecured creditors were not represented because their interests and claims were deemed to have no value. Yet, as a result of the sharp rise in metallurgical coal prices in the second half of 2016, the shares of the reorganized companies rebounded much more quickly than anticipated. Thus, Arch Coal’s senior lenders received a package of securities that was worth more than 100% of their claims within one month after the company’s emergence from bankruptcy. Reorganized companies from two earlier coal bankruptcies, Walter Energy and Alpha Natural Resources, are now preparing to go public, only a year or so after their emergence from bankruptcy.
According to Peabody’s disclosure statement, as of January 12, its bankruptcy plan had the support of 17.7% of the first-lien lender claims, 41.3% of second-lien noteholder claims and 48.8% of general unsecured claims. It is a fair bet that a sufficient number of noteholders will also vote in favor of the plan. With such a strong level of support and considering the likely short-term orientation of Peabody’s shareholder base, it may hardly be justifiable for the court to intervene in support of junior creditors and equity interests. Doing so might jeopardize the consensus of creditors in this complex bankruptcy proceeding and thus compromise the debtor’s fiduciary responsibility to other stakeholders.
Yet, given the recent experience of the coal company bankruptcies, those junior creditors and equity interests of Peabody are likely to receive less than what they might have been entitled to under a truly fair plan. Without a meaningful change in the investment community’s treatment of bankrupt and distressed securities, this outcome is likely to be repeated, especially in cases where there is the potential for a quick turnaround in the debtor’s fortunes.
In my view, the debtors and courts should remain responsive to the rights of junior creditors and equity interests, but they should also remain reluctant to take an activist approach (except perhaps in unusual circumstances). Accordingly, the court should support the formation of equity committees and the representation of junior interests on creditor committees early on in the bankruptcy process when holders of those claims and interests appear to protect their rights. (In Peabody’s case, I believe that the request to form an equity committee was made too late, essentially after the framework of the plan had already been put together.)
Conclusion. While Peabody’s financial performance may or may not fall back toward the 2016 lows over the next year or two depending upon market conditions, I believe that the odds favor improved performance over the next five years. Accordingly, I view Peabody’s 2nd Lien Notes and unsecured senior notes as attractive over the long-run, even at prices modestly above my recovery estimates. My analysis suggests that the 2nd lien notes offer a higher return at lower risk, but the unsecured senior notes have considerably more upside potential, if Peabody’s future performance exceeds plan projections.
February 15, 2017 (revised from the original).
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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