I recently had the pleasure of attending two conferences sponsored by the American Bankruptcy Institute (“ABI”). First, the Valcon conference in Las Vegas, which focused primarily on issues relating to bankruptcy and valuation. Second, the yearly spring meeting of the ABI, held in Washington, D.C., during the annual cherry blossom weekend. Las Vegas was only slightly warmer than Washington, D.C. and while it was nice to visit the Capital and see all the tourists on their cherry blossom photo safaris, I noted that most of them were bundled up in their down parkas, shoulders hunched up against a chilling wind. At the risk of stating the obvious, while the calendar says it’s supposed to be spring, Mother Nature is not fully cooperating.
While at the conferences, I observed that a handful of cases had really caught the attention of the panelists and attendees alike, including Scotia Pacific, Tousa, Extended Stay, Visteon, Blockbuster and Madoff. These topical cases raise important issues to be considered and understood by all practitioners in the world of distressed debt and bankruptcy, whether investor, advisor or attorney.
Interestingly, excluding Madoff, the cases being discussed were ones in which I was either invested or at least covered while running the investment portfolio at Murray Capital Management. This note will focus on Scotia Pacific/Pacific Lumber (Scopac), a Redwood and Douglas Fir timberland company and mill operator in Northern Calif. The Scopac case has special significance for me, as it was one of my larger portfolio positions at Murray Capital. As investors, my team and I were deeply involved with the case, working as part of the Scopac secured bondholder group, retaining independent counsel and carefully monitoring the proceedings in Bankruptcy Court and at the Fifth Circuit Court of Appeals. The case was heavily litigated – the docket has close to 4,500 entries – and needless to say, had some interesting and unexpected twists and turns along the way. This was particularly true for the secured creditors at the Scotia Pacific special purpose entity.
Despite the assistance of our very capable counsel, the secured lenders were repeatedly challenged at seemingly every turn while working to protect our rights and position. Now, it is apparent that the plan sponsors in this case have not been immune to setbacks and unpleasant surprises either. A recent Fifth Circuit court decision, issued more than two years after the bankruptcy plan was consummated, determined that the post-reorganized company owes the Scopac secured creditors another $29.7 million. This extra sum would represent an additional recovery on the Scopac bonds of approximately 4 cents on the dollar added to the earlier recovery of approximately 72 cents on the dollar. The additional liability would also represent an increase of approximately 5% in consideration due from the plan sponsors. In addition, there is still the contingency of an additional $11 million due the Scopac creditors from the plan sponsors. Close to three years post confirmation, material financial issues still remain unresolved, and the docket continues to grow.
My observations and key takeaways on the Scotia bankruptcy are my own – as an investor in the Scopac bonds and as part of my twenty-five year journey through the world of bankruptcy and distressed company investing. I am also a teacher, and as such, I try to remember the importance of learning the lessons that history offers us as a means to better navigate our future. The Scotia Pacific case demonstrates some important lessons – not only to those market participants who find themselves in the seat of the secured creditor, but also to plan sponsors. I am considering using it as a case study in the Bankruptcy and Distressed Debt Investing course I co-teach at NYU’s Stern School of Business, or perhaps in a repeat of the Valuation course I have also taught at Stern. As always, I would also very much appreciate any feedback from all readers.
Scotia Pacific/Pacific Lumber – If a Tree Falls in the Forest, Who Gets to Figure Out What it’s Worth?
Some of the key issues addressed here include:
Single Asset Real Estate Debtor –What is a SARE? Can a real estate asset that has employees for anything other than rent collection ever actually be considered a SARE?
Rights to Credit Bid – What are the circumstances under which a secured creditor’s right to credit bid can be stripped? How important is it that I can prove to the Court that I have a credible business plan and the resources and capability to manage the business for which I am bidding?
Blocking positions – If I’m an undersecured creditor and my deficiency claim is the largest unsecured claim in a case by far, how can a plan proponent gerrymander the classes of claims, and therefore the vote, to get an otherwise non-confirmable plan confirmed?
Protecting rights to adequate protection, diminution of value and administrative claims – As a secured creditor, how do I track the proceeds of my collateral so I can properly quantify any administrative claim that I may have for adequate protection at the end of the case?
Tail liability exposure for Plan Sponsors – Should I sponsor a plan of reorganization if it’s not fully consensual? Can I be exposed to liabilities that extend past confirmation to the extent that there is ongoing litigation with disgruntled creditor constituencies?
Special Purpose Bankruptcy Remote Entities – Do SPEs consistently deliver the promised protection?
Valuation Trials/ Expert Testimony – What can I do to optimize my position in a valuation trial? Are the results of an M & A process conducted before or during a bankruptcy dispositive as to value?
Background
The Business
Scotia Pacific and Pacific Lumber collectively owned and operated timberlands, a mill and the local town of Scotia, approximately 250 miles North of San Francisco. The redwood trees that grew on the land were harvested and the output primarily went to the homebuilding industry, mostly used for decking and fencing. Historically, there were four major California redwood companies: Pacific Lumber, Green Diamond, Mendocino Redwood and Hawthorne Timber. In 1986, Charles Hurwitz sponsored a leveraged buy-out of Pacific Lumber. Later in 1993, as part of a major financing transaction, the assets of Pacific Lumber were bifurcated between two entities – Scotia Pacific (Scopac) and Pacific Lumber (Palco). Scotia Pacific was formed as a bankruptcy-remote special purpose entity and approximately 200,000 acres of timberland and associated timber rights were dropped into it. Pacific Lumber retained the mill and the town of Scotia. Scopac planted and maintained the land, while Palco harvested and milled the timber. The relationship between Scopac & Palco was governed by a services agreement.
This corporate structure theoretically allowed for more attractive financing terms for the ultimate owners, as lenders would be more comfortable being close to the timber assets in a special purpose company. While corporate formalities were observed between the two legal entities, in practical terms there was a symbiotic relationship. In addition to cross board memberships and shared management, Palco needed Scopac to operate and Scopac likewise needed Palco. It is possible that Scopac might have been able to harvest the timber and ship it elsewhere for processing into finished product, but the practicality and economic effect of an alternative arrangement was never tested.
After the Scopac financing was put in place, the company’s financial position deteriorated. The timberland harvesting rates originally projected turned out to be limited by environmental considerations mandated by the State of California Forestry is a heavily-regulated enterprise, with no less than 15 Federal, State, and County agencies having authority. Restrictions placed on harvesting materially affected cash flow, a situation exacerbated by a declining housing market in 2007.
The Bankruptcy
Both Scotia Pacific and Pacific Lumber filed for bankruptcy protection in early 2007. The case was brought and prosecuted in Corpus Christi, Texas. While a change of venue was attempted by the California regulatory authorities, it was unsuccessful. Chief Judge Edith Jones of the Fifth Circuit Court of Appeals later made note of the fact that the Corpus Christi jurisdiction was “a venue not known for its redwood forests.” Bank of N.Y. Trust Co. v. Official Unsecured Creditors’ Comm. (In re Pac. Lumber Co.), 584 F.3d 229, 236 (5th Cir. 2009).
At the time of the bankruptcy there were total funded debt claims at Scotia Pacific of approximately $750 million – a relatively small first lien claim held by Bank of America in the amount of $36 million, and a second lien claim held by the Scopac bondholders in the amount of $714 million. It was clear at all times that the value of the assets far exceeded the amount of Bank of America’s claim – the question was by how much. Pacific Lumber separately had debt of $160 million which was held by Marathon Asset Management. It was widely assumed that Marathon’s secured debt at Pacific Lumber was undersecured.
The Plans
Two plans of reorganization were ultimately presented to the creditors for a vote:
- Marathon/Mendocino Redwood Plan
In this plan, Marathon, a secured creditor at Palco teamed up with an experienced operator who owned a similarly-sized property in Mendocino County. The Marathon/Mendocino Redwood plan offered a global solution in which the Marathon/Mendocino Redwood partnership would take control of both companies and all assets, and the creditor claims at both the Scopac and Palco entities would be resolved.
- Scopac Bondholder Plan
The Bondholder plan addressed only the Scotia entity and called for an auction of the timberland collateral after a six-month marketing period. One of the largest bondholders had provided a stalking horse bid for the timberlands of $603 million.
Ultimately, the Marathon/Mendocino plan was confirmed over the strenuous and continuous objections of the Scopac Bondholders.
Single Asset Real Estate Debtor
In the early days of the case, the Scopac bondholders attempted to have the bankruptcy turned into a single asset real estate company case (SARE). A SARE characterization would have limited the period of time the debtor had to file a feasible plan to only 90 days. At the end of that time, if the company had not filed a plan with a reasonable likelihood of being confirmed, they would need to start making monthly interest payments at the non-default contract rate. If the debtor was unable file a plan or pay interest, then the lender would be able to foreclose on the property. Had the Scopac bondholders been successful in this effort, it would most likely have improved their negotiating position considerably and allowed for greater control over the pace of the case.
The bondholder’s motion for SARE classification was denied by the Bankruptcy Court, and that decision was upheld by the Fifth Circuit. The basis for that denial was that Scopac was not just passively accepting income from its property. Instead, it was actively engaging in revenue generating activities.
The decisions point out that there is a three pronged test to meet the qualifications of a SARE. First, a debtor must have real property that is a single property or project (other than residential with less than four units). Second, the entity must generate substantially all the debtor’s revenues. Third, there must be no substantial business being conducted other than operating the real property and incidental activities. Failure on any one of these three tests disqualifies an entity from being a SARE. Both courts found that Scopac’s business activities through its employees were varied and diverse and represented more than just the passive receipt of revenues. Scopac did have employees – at the time of the bankruptcy, there were approximately 60 employees. The Courts used an active versus passive test and ultimately came to the conclusion that Scopac employees were active enough even though they did not harvest the timber. In addition, the Court also said that Scotia sold timber, not real estate, and under Calif. law, timber is defined as “goods.”
The Bankruptcy Court and the Fifth Circuit opinions suggested the following types of enterprises might be considered a SARE:
Apartment Complexes
Property owned for flipping
Property owned for rent collection
Homebuilders
Conversely, the following types of enterprises are likely not a SARE:
Hotels
Golf Clubs
Ski Areas
Commercial Farms
Mining Operations
Oil & Gas Owners
Marinas
Rights to Credit Bid
As the Scopac case progressed, it became apparent that Marathon, as a Palco creditor, was going to sponsor a plan of reorganization that would effectively get control of the timber assets at Scopac. Without the timber for input, Marathon’s collateral, which consisted of the mill and the town of Scotia, would most likely have diminished value. Marathon teamed up with Mendocino Redwood, a company controlled by the Fisher family, the founders of the Gap. Mendocino Redwood was formed in 1998 when the Fisher Family bought the timberlands from Louisiana Pacific. The Mendocino properties were located approximately 120 miles South of Scotia. Marathon and Mendocino together offered a plan of reorganization that would effectively give them control over all the assets at Scopac and Palco, including the collateral securing the Scopac bonds. Unfortunately, the Scopac bondholders were not happy with the consideration offered them for their timber collateral. At the same time, they were denied the right to credit bid their $714MM in secured debt. The reasons given by the Courts were as follows:
At the Bankruptcy Court – the transaction in which Marathon/Mendocino proposed to move the bondholder’s collateral out of the estate was not a sale, it was a transfer. Secured creditors do not have a right to credit bid in a situation where the assets are being transferred – only in a sale. Moreover, the fact that exclusivity had been terminated, that an investment bank had tried to sell the asset prior to bankruptcy, and the transparency of the bankruptcy process including some expressions of interest from certain parties provided enough of a market test.
After a valuation trial, the Scotia timberlands were valued by the Court at “not more than $510MM,” (In re Scotia Dev. LLC., No. 07-20027-C-11, at *61 (Bankr. S.D. Tex. June 6, 2008). (“E. Final Valuation Conclusion”) considerably below the $714 million in debt outstanding. The Court’s valuation noted that there was a stalking horse bid for the assets at a value of $603 million - almost $100 million higher than the $510 million judicially determined by the Bankruptcy Court and offered in the Marathon/Mendocino plan. The $603 million bid was provided by one of the larger Scopac bondholders, but was not given much weight because the Court found that the bidder did not have prior experience operating timber assets and would not be able to comply with environmental rules and regulations. In addition, the Court cited some contingencies in the offer and the fact that the Court believed the indenture trustee did not accept the stalking horse bid thereforemaking it unreliable.
At the Fifth Circuit Court of Appeals – Reversed the Bankruptcy Court on the transfer versus sale point, but said that because the Scopac secured bondholders received the judicially determined value of the assets at consummation in cash they did not have a right to credit bid. Importantly, the Court took the position that an auction process was not required to determine value, that the bondholders had never argued that they were receiving less in the plan than they would have in a liquidation (which would have led to foreclosure), and that the Court found that the Timberlands had been well marketed before and during the bankruptcy case. The Court made note of the $603MM stalking horse bid and the Bankruptcy Court’s concerns with the bid, but otherwise did not comment on it.
The Court focused on the suggestion that the Timberlands had been widely shopped before and during the pendency of the case.
In looking at valuation for all plan purposes, does the debtor get the benefit of an assumed fresh start, free of the bankruptcy taint?
Blocking Positions
One might think that the Scopac secured creditors could take some comfort in the fact that even if a plan was proposed that they did not like, they would be able to block it since by any standard, they were the largest creditor in the case. What’s more, they would also be the largest unsecured creditor by virtue of the fact that they were undersecured and their deficiency claim (the difference between the total claim of $714 million and the value of the collateral) would dwarf all other unsecured claims. In order to cram them into treatment they didn’t like, the plan sponsor would have to get the affirmative plan votes from at least one class of impaired unsecured creditors.
In response to this issue, the plan sponsor created a special class of claims for trade creditors who hadn’t previously been designated as critical vendors. They then offered those creditors a very high cash recovery of between 75-90%. In addition, the secured claim of Bank of America was paid off in cash other than $1 million in default interest which was to be paid out over time. In this way, the plan impaired the claim and the sponsor was able to obtain the affirmative vote of Bank of America as an impaired creditor. Conversely, the deficiency claim of the Scopac bondholders was offered a deminimus recovery. By obtaining an affirmative vote on the plan from small trade creditors who got cashed out and by getting Bank of America’s vote by arguably artificially impairing their claim, the plan sponsor was able to theoretically clear the voting requirement. The bondholders challenged the claims classification but it was upheld by the Bankruptcy Court. The Fifth Circuit Court of Appeals did not agree with the claims classification. The Court stated that “[T]hou shalt not classify similar claims differently in order to gerrymander an affirmative vote on reorganization.” In re Pacific Lumber Co., 584 F.3d at 251.
Despite the Fifth Circuit’s rejection of the claims classification methodology in this case, the Court viewed this issue as moot because the plan had already been consummated and the egg could not be unscrambled without causing hardship to the unsecured creditors who had already received their cash recovery. It is important to note that the Scopac bondholders made vigorous attempts to stay plan consummation so this issue, among others, could be reviewed prior to cash disbursements. However, those attempts were denied by both the Bankruptcy Court and Fifth Circuit Court of Appeals. Later, the Fifth Circuit commented that a denial of a stay to confirmation was “perhaps in error.” Bank of N.Y. Trust Co. v. Pac. Lumber Co. (In re Scopac), 624 F.3d 274, 279 n.3 (5th Cir. 2010).
Unless claims classification is successfully challenged prior to confirmation and consummation, it becomes difficult to obtain meaningful relief on this basis later because it may be equitably moot.
Protecting Rights to Adequate Protection and Administrative Expense Claims for Diminution of Value
As the case neared a conclusion, the Scopac creditors pursued an administrative priority claim for the diminution in value of their collateral during the pendency of the case. The significance of this action was that it would have resulted in an additional and immediate cash payment requirement to them in the amount of the administrative claim, thereby providing a boost to the bondholders’ recovery. This matter was processed separately from plan confirmation and took on a life of its own. The bankruptcy judge awarded the Scopac bondholders an administrative claim of $3.6 million – not a successful outcome for the bondholders – and ruled that this claim would need to be paid off in cash. Post-confirmation, the bondholders pursued an appeal on the size of administrative claim, which was allowed because the matter had been raised distinct from confirmation and was not mooted by plan consummation. More than two years later, the Fifth Circuit ruled that the Scopac bondholders were owed an additional $29.7 million in cash. The Court’s finding was based on the view that the Scopac bondholders needed to be compensated for sales of their timber collateral during the pendency of the case and that the Bankruptcy Court had focused on the diminution of their cash collateral only. Sales of timber from the start of the case until conclusion were $29.7 million and therefore this amount was added to the bondholder’s administrative claim. Because there was only one type of asset, it was fairly easy to track the sale of their collateral. In addition, there remains another $11 million in potential administrative claims that relates to a payable that Pacific Lumber owed to Scopac which was never satisfied. This claim was remanded to the Bankruptcy Court for additional proceedings.
Secured creditors should carefully monitor the sale of their collateral during the pendency of a bankruptcy case to ensure they are adequately equipped to prosecute an administrative priority claim for diminution of value. Absent a negotiated consensual solution, this type of claim would need to be satisfied in cash at consummation in order for the plan to go forward.
Tail Liability for Plan Sponsors
After the Bankruptcy Court opined on the valuation of Scotia’s assets and deemed the bondholders auction-based plan unconfirmable, the Marathon/Mendocino plan was ready for advancement. Despite vigorous attempts by the bondholders, neither the Bankruptcy Court nor the Fifth Circuit Court of Appeals was willing to grant a stay of the proceedings pending appeal. Later on and after further review of what had occurred in the case, the Fifth Circuit did fashion a remedy and admit that perhaps they had been mistaken in not granting a stay. The remedy was the additional $29.7 million administrative expense that the reorganized entity was going to owe the bondholders as compensation for the sale of collateral during the pendency of the case.
While the plan sponsors are seeking a rehearing on this issue, the developments in Scotia have significant implications for plan sponsors who should consider whether it is worth the risk to them that their activities during a contested bankruptcy case may be challenged long after plan consummation, resulting in potentially unpleasant surprises. If the plan sponsors are not successful in their efforts to have the ruling reversed, a judgment will be entered against the reorganized company which they own. Perhaps they would have been more insulated from such liabilities had they pursued a Section 363 asset sale, but blocking the Scopac secured creditors’ right to credit bid might have been more difficult to do in a Section 363 asset sale scenario.
In addition, the plan sponsors have now apparently lost the protection of the releases granted to them as part of the plan confirmation. Theoretically, at least, it appears that they could be exposed to claims for negligence. The Fifth Circuit Court of Appeals commented that “adverse consequences to MRC/Marathon is not only a natural result of any ordinary appeal – one side goes away disappointed – but adverse appellate consequences were foreseeable to them as sophisticated investors who opted to press the limits of bankruptcy confirmation and valuation rules.” In re Scopac, 624 F.3d at 282. The Court went on to comment that “[e]quitable mootness should protect legitimate expectations of parties to bankruptcy cases, but should not be a shield for sharp or unauthorized practices.” In re Pacific Lumber Co., 584 F.3d at 244 n.19.
The plan sponsors were successful in defeating attempts to stay confirmation and consummation. However these victories in the end did not eliminate their risk of tail liabilities related to sponsoring a plan over the objections of a major creditor constituency.
In addition, the releases granted to the plan sponsors by the Bankruptcy Court for any potential negligence claims related to the plan proceedings was reversed by the Fifth Circuit Court of Appeals, theoretically leaving the plan sponsors open to further litigation.
Special Purpose Bankruptcy Remote Entities
The Scotia Pacific entity was originally set up to isolate the timberlands from the rest of Pacific Lumber, ostensibly to obtain improved terms for a financing. Lenders to the special purpose entity were supposed to feel reassured that they were close to the assets and would maintain control over those assets should there be financial difficulties at the affiliated Pacific Lumber. The reality was quite to the contrary – for all practical purposes, at the end of the bankruptcy case, the secured lenders at the special purpose entity lost control of their collateral.
Interestingly, a written business plan from Marathon/Mendocino for the proposed reorganized entity noted that, in their opinion the separation of Scopac from Palco had hurt the business and destroyed value.
In the end, the special purpose entity did not isolate the Scopac creditors from Palco because the businesses were too intertwined. The feasibility of a going-forward business plan, an experienced operator and the importance of the combined entity as an employer in Humboldt County trumped the ability of the secured creditors to control their collateral.
The Valuation Trial/Expert Witness Testimony
At the end of the day, the Scopac bondholder’s recovery all came down to the valuation trial. The judge’s decision on valuation became the bondholder’s indubitable equivalent. The Marathon/Mendocino expert was a timberland appraiser who, the Bankruptcy Court noted, had performed over 200 timberland appraisals. He valued the collateral at $430 million using the income approach and $425 million using a comparable transactions approach. The bondholders used two experts – one with a valuation of $605 million and one with a range of $575-$605 million. The bankruptcy judge had issues with these higher valuations. Among the issues he raised with the bondholders’ valuations were:
- Expert lacks experience in valuing like assets/businesses. The Court pointed out that the largest timberland appraisal done by one expert was 1/10th the size of Scotia and that had been performed in 1978. The other expert had never appraised timberland;
- Incorrect Start Date and failure to take changed industry and pricing conditions into account;
- Valuation Methodology and lack of specificity with respect to harvest rates, growth rates and discount rate used;
- The valuation report was done by the firm, as opposed to the individual expert and the individual expert appeared to have spent limited time on it;
- The use of preliminary bids for the business is not an accepted valuation methodology because they are indicative only. In addition, there was no contact with the actual bidders and therefore no knowledge of the due diligence the bidders had performed.
- The bondholders used two experts; however the second expert’s report was contingent on the first expert being right. The judge found faults with the first expert which then affected his view of the second expert;
- The comparable company analysis was based on a run rate ebitda although the expert who used it testified he had not used a run-rate ebitda to do a valuation in the last 5-10 years. The future EBITDA used to calculate the run rate ebitda were outside of the company’s ten year projection;
- The comparable company analysis focused on the multiple of only one comparable which was not subject to Calif. regulation and whose business was partly manufacturing based. Other comparable companies traded at lower multiples.
Valuation testimony is frequently critical to the outcome for constituencies in a bankruptcy case, making the choice of expert, the quality of their report, and their communication skills key factors for success.
Conclusion
The Scopac/Palco bankruptcy was an all-out intellectual battle between highly sophisticated investors and counsel that was never settled on the Corpus Christi courthouse steps. At the end of the day, the Bankruptcy Court believed that the bondholder’s plan looked like a liquidating plan in which the mill would likely be shut down, jobs would be lost and the town of Scotia would lose its economic engine.
One can only speculate as to whether anything done differently would have created a different outcome for the Scopac bondholders. Could they have reverse engineered what Marathon ultimately did by teaming up with Mendocino Redwood themselves first (or another industry player) and then fashioning a plan that paid off Marathon in cash at their “indubitable equivalent?” It certainly would have been an interesting exercise to come up with a valuation for the town of Scotia. A holistic solution would naturally have required the bondholders to come up with cash to pay off the Palco debt, but theoretically, they had the resources, as at least one of the bondholders was prepared to provide a stalking horse bid for the entire timberlands property at over $600 million.
Perhaps this approach might have alleviated the Bankruptcy Court’s concern about the mill, the town of Scotia, and the bondholder’s lack of forestry experience. Equally important, with the benefit of hindsight, would owning the timber assets have been a better outcome for the bondholders in any event given the subsequent downdraft in the US economy and the financial markets that followed? Key variables in the valuation of timberland assets are “stumpage prices,” harvest forecasts, and the discount rate appropriate for the asset class. During 2008 when the valuation of the timberlands was being judicially determined, prices for young-growth redwood were in the range of $800-$850/mbf. According to statistics from the Calif. State Board of Equalization (www.boe.ca.gov), those prices are now $570-$750/mbf, a decline of over 20%. Prices are expected to drop further in the second half of 2011.
Perhaps it is time for a revaluation of some timber assets.