Conseco: Restructuring an Insurance Giant with a Subprime Lending Arm

Case Study: Conseco, Inc. Sarah Woo, Stanford University

Working Paper 2/4/08 Page 1

This working paper is licensed under a Creative Commons Attribution-Noncommercial-Share Alike 3.0 United States License.

CONSECO, INC. RESTRUCTURING AN INSURANCE GIANT WITH A SUBPRIME LENDING ARM

http://creativecommons.org/licenses/by-nc-sa/3.0/us/�





1 Objectives of Case Study This case study on Conseco, Inc. (“CNC”) is part of a larger empirical study investigating the determinants of loss given default (“LGD”) and developing predictive econometric models for LGD on publicly-traded bonds and loans. The objective is to extend prior work through an analysis of common LGD drivers contextualized in the intricacies of bankruptcy and restructuring cases, i.e., bridging the gap between law and finance. Specifically, we hope to confirm findings in the literature, reveal additional determinants, examine factor interdependence and causality issues, consider the sources of uncertainty bearing on the level of LGD; and most significantly, generate new hypotheses to test on cross-sectional data.

2 Overview and Chronology of Events

2.1 The Company The Conseco Group was one of the largest insurance conglomerates in the United States, with numerous subsidiaries operating in the business of health insurance, annuity, life insurance and other insurance products. In 2001, the group had over $5.5 billion of annual premium and asset accumulation product collections and more than $24 billion of insurance-related investments.1

2.2 Organizational Structure

The group grew to this size primarily through acquisitions – since its inception in 1982, it has acquired 19 insurance groups. A pivotal acquisition occurred in the spring of 1998 when CNC, the holding company, purchased Green Tree Financial Corp (renamed as Conseco Finance (“CFC”)), a consumer finance company, for $6 billion in stock. CFC was a market leader in subprime manufactured housing lending. Underlying this acquisition was the vision of building the Conseco franchise into a one-stop financial stop through cross-selling initiatives between CFC and the insurance operations, one which was never materialized.

CNC was the top tier holding company for both the insurance and finance businesses. The insurance business was operated through subsidiaries owned directly and indirectly by CIHC, an intermediate holding company controlled by CNC. The finance business was operated through CFC, a wholly-owned subsidiary of CIHC.2

A simplified snapshot of the organizational structure is presented as follows. For more details,

1 Conseco, Inc., Annual Report (10-K filing) for the year ended December 31, 2001. 2 Re Conseco, Inc., et al, Second Amended Disclosure Statement for Reorganizing Debtors' Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code, pp13.






refer to the complete organizational structure provided in Appendix A. Figure 1: Organizational Structure of Conseco Group

Source: Extract from Re Conseco, Inc., Disclosure Statement, January 31, 2003.3

2.3 Initial Signs of Distress

It is important to note the multi-tiered structure of the group for two main reasons. First, it enabled the use of structural subordination of various debt obligations through the use of guarantees and pledges of subsidiary stock – an issue affecting the priority of claims. Second, it implies a mosaic of intercompany liabilities, the treatment of which is unclear prior to bankruptcy. This is a source of uncertainty in LGD levels and raises the issue as to whether we should set the prior in the Bayesian LGD model to allow for higher standard deviation where a company is flagged as having multi-tiered structures.

In 1999, cracks began to surface on several levels. CNC’s stock price had declined around 68% since the CFC acquisition, leading the company to change an accounting method in CFC (which investors had criticized for inflating earnings).4 This resulted in a fall of third-quarter earnings by 19%, amidst a dividend cut and warnings by the company its 2000 earnings would be below estimates.5

3 The shaded boxes represent entities which were not included in the Chapter 11 petition. 4 See Conseco 3rd-Quarter Earnings Fall 19% on Accounting Change, Bloomberg, October 27, 1999; and Conseco refocuses on its balance sheet and gets an immediate response, New York Times, Dec 1, 1999. 5 Conseco Warns of Below-Expected Earnings in 2000, Cuts Dividend, Bloomberg, November 30, 1999.

Complicating the situation was the substantial increase in indebtedness – Conseco






incurred substantial debt and trust-preferred obligations primarily to fund CFC's business following its acquisition. Between 1997 and 1999, the total liabilities of the consolidated entity almost doubled from $21.8 billion to $43.0 billion. To maintain an investment grade rating, CNC obtained a $500 million capital infusion from the buyout firm, Thomas H. Lee Group, in return for convertible preferred stock in late 1999.6

Things came to a head on March 31, 2000. CNC announced that it was reviewing the value of CFC's interest-only securities and servicing rights, and that it expected to record a write-down of around $350 million after taxes. The company also announced that it would explore the sale of CFC,

7 which had turned out to be a severe cash drain. Between August 1999 and February 2000, CNC injected $1.7 billion into CFC’s business.8

During the interim, executives from the Thomas H. Lee Group ran the firm and the investment group pushed for the appointment of Gary Wendt, the former head of GE Capital, as the CEO of the company in June 2000. Wendt began a series of measures to turn around the company, mainly through job cuts and sales of non-core assets. For the rest of 2000, the company posted losses in its quarterly earnings report. However, the prices of the company's shares and publicly-traded senior notes took a temporary boost in the middle of 2001 when the company posted operating earnings of $545 million. Nonetheless, the company's problems continued as it faced increasing defaults on the loans originated by CFC with the slowdown in economy.

In April 2000, the company filed its annual report for 1999 which included restated results for 1999 and it disclosed that it had over-stated its net income for the first three quarters of 1999. Following these events, the long-time CEO, Stephen Hilbert, and the CFO, Rollin Dick, resigned by the end of April, and Conseco began its arduous path towards restructuring.

9

In 2002, CNC suffered one blow after another. CFC exposed CNC to higher than expected losses in the subprime lending market. As the group's deteriorating financial condition became well-publicized, there was a fall in sales of insurance products and an increased number of policy redemptions and lapses, worsening a business which was already hurt by the market slump and low interest rates. In April 2002, CNC attempted to manage its debt load by undertaking an

It suffered a net loss of $419 million in the 2001 fiscal year, though its interest expense amounted to $1,609 million. The situation was exacerbated by legal problems. CNC was plagued by class action lawsuits filed by shareholders and TOPRS holders, alleging that the company violated federal securities laws by making false and misleading statements about the current state and future prospects of CFC (particularly with respect to the performance of CFC's loan portfolio). Shareholder derivative suits were also filed against directors and officers for breach of fiduciary duties by, amongst others, disseminating false statements concerning CFC and engaging in corporate waste by causing the company to guarantee loans for directors and officers to purchase the company's stock.

6 Supra, n4. 7 Conseco Announces Plan To Sell Its Consumer Finance Business, Business Wire, March 31, 2000. 8 Conseco Finance in Troubled Times, CNN Money, May 26, 2000. 9 Conseco's Wendt Tries to Reassure Investors on Credit Defaults, Bloomberg, November 15, 2000.






exchange offer. Under this exchange offer, qualified holders and accredited investors of the senior notes were offered a swap for new notes with an extended maturity in exchange for priority over the original notes. More than half of the holders tendered their notes in this exercise. In CNC’s second-quarter report in 2002, it announced a net loss of $4.4 billion which reduced shareholder equity to $533 million. The reduction in shareholder equity negatively impacted its debt ratings and the financial strength ratings of the insurance subsidiaries, thereby precluding them from raising additional capital to ease liquidity problems.

2.4 Events Leading to Default In August 2002, CNC announced that it had failed to make interest and principal payments on various senior notes, corporate obligations and trust-preferred securities. The failure to make such payments constituted an event of default under these instruments, and this triggered cross-default provisions in other facilities. CNC pursued private restructuring efforts, having received temporary waivers and forbearances from its creditors. It announced that it had retained Lazard Freres and CSFB to advise the company with respect to the restructuring, including the sale of CFC which was its top priority. At this point, the stock had traded down to around $1, and the NYSE halted trading in Conseco's common stock. CFC had also defaulted under its warehouse and credit facilities, leading to a withdrawal of its debt ratings by Moody’s. With heightened uncertainty in the market involving its potential insolvency, it was no longer able to access the securitization market. This loss of liquidity severely affected CFC's ability to originate, purchase and sell loans, i.e., to conduct its core business.10

Shortly after, Gary Wendt resigned, leading Standard & Poor’s to further downgrade CNC’s counterparty credit rating from ‘SD’ (selective default) to ‘D’ (default).

11

2.5 Chapter 11 Proceedings

As the rating agency explained, ‘the ‘D’ rating reflects Standard & Poor’s view that Mr Wendt’s resignation is a prelude to an ultimate bankruptcy filing.’ Worse news broke out in November 2002 when Conseco posted a $1.8 billion third-quarter loss, mostly attributed to write-downs in the value of its investment portfolio and goodwill.

On December 17, 2002, Conseco Inc. (the holding company) (“CNC”) filed a voluntary petition under Chapter 11 in the Northern District of Illinois (Eastern Division), along with four subsidiaries, namely CIHC (the intermediate holding company), CFC, Conseco Finance Servicing Corp., CTIHC, Inc. and Partners Health Group, Inc. Most of the other insurance subsidiaries

10 Supra, n2, pp26. 11 S&P Lowers Conseco Inc. Ratings to 'D', Business Wire, October 4, 2002.






were not party to Conseco's indebtedness and they remained out of the Chapter 11 process. The companies attempted a pre-packaged bankruptcy. 12

Source: Conseco, Inc.’s Disclosure Statement, January 31, 2003. *The above table does not include the amount of post-petition interest, default interest and fees, administrative fees, etc. In the disclosure statement, CNC proposed a reorganization plan whereby the senior lender claims (the bank credit facility and guarantees under the Directors & Officers (“D&O”) facilities) would receive a pro rata share of reinstated debt, with the remainder of their claim being satisfied with preferred stock and warrants in the restructured company. The holders of the new notes under the April 2002 exchange offer (the “Exchange Notes”) agreed to make a “gift distribution” to the holders of the notes which were not tendered (the “Original Notes”) and other junior classes, including a residual distribution to the common stock. This plan was met with vehement objection by the trust-preferred securities holders (the “TOPRS”) which insisted on a higher recovery.

On December 19, 2002, CFC entered into an Asset Purchase Agreement with CFN, a vehicle of Fortress Investment Group, JC Flowers and Cerberus, under which CFC would sell substantially all its assets in a section 363 sale. In January 2003, CNC filed its disclosure statement, reporting its liabilities as follows: Figure 2: Post-Petition Disclosure of Liabilities

On March 18, 2003, CNC received approval of its Amended disclosure statement – see the details on proposed recoveries in the disclosure statement and the

12 As the holding company which was heavily reliant on dividends from subsidiaries (especially after losing access to liquidity facilities), CNC was under too much time pressure to pursue a private workout. Several subsidiaries were prevented from up-streaming dividends and other distributions to CNC as a result of regulatory intervention (regulators were preserving capital for policyholders).

Amended disclosure statement in Appendix B. By this point, the common stock had been eliminated from the junior recovery, with the residual distribution going towards one of the two classes of preferred stock (the one held by the Thomas H. Lee Group) and the TOPRS. CNC solicited votes from eligible creditors for approval of the plan and the voting ended on June 6, 2003. There were sufficient votes from all classes to accept the plan, except for the TOPRS who continued to object to the

Liabilities ($ millions)Bank Credit Facility 1,537.0 Intercompany Claims 9.0 Guarantees under D&O Facilities 500.0 Senior Secured 93/94 Notes 93.7 Senior Guaranteed Notes ("Exchange Notes") 1,371.0 Senior Notes ("Original Notes") 1,242.0 CIHC Unsecured Claims 140.0 CNC Unsecured Claims 60.0 Trust Preferred Securities/Subordinated Debentures 2,019.0 Total Liabilities 6,971.7






plan.13 Following this, bankruptcy court proceedings to confirm the reorganization plan commenced. Over the next few months, legal battles were fought as the TOPRS objected, amongst others, to the valuation of CNC. There was a full hearing conducted in relation to the valuation of the company. However, prior to the court ruling, the company and senior creditors reached a compromise with the TOPRS, offering them common stock, warrants and rights to 45% of the net D&O litigation proceeds (capped at $30 million). Under this plan, all classes of preferred stock and common stock were extinguished. In the meantime, on March 14, 2003, the court approved the sale of CFC to CFN subsequent to an auction process. The rest of CFC assets, carved out from the sale, were liquidated, with the main warehouse lender, Lehman, obtaining nearly full recovery (albeit adversary proceedings). The asset-backed certificates issued by CFC suffered a series of downgrades and defaults, given changes in the servicing fee agreements and extremely low recoveries in relation to guarantee claims on CFC. On September 9, 2003, the bankruptcy court confirmed the company’s

Source: Conseco, Inc.’s 6th Amended Joint Plan for Reorganization, September 9, 2003.

Amended Joint Plan of Reorganization, allowing CNC to begin its emergence from bankruptcy. The company emerged as an insurance pure-play. Its new capital structure incorporating lower leverage, based on a valuation of $3.8 billion (using “fresh start accounting”) is presented as follows: Figure 3: Capital Structure of the Restructured Conseco, Inc.

3 Comparing Recoveries to Historical Estimates In this section, we examine the recoveries (i.e., the complement of LGD) on CNC’s debt instruments according to the final plan of reorganization, against historical mean estimates from

13 Conseco Inc: TOPrS Panel Voices Plan Distribution Objection, Bankruptcy News, Issue No. 22 (Bankruptcy Creditors' Service, June 2003)

Capital Structure of Conseco, Inc. at Emergence($ millions)

Bank Loan Tranche A 1,000Bank Loan Tranche B 300Total Debt Outstanding 1,300

Preferred Stock 860Common Stock 1,640Total Equity 2,500






Standard & Poor’s LossStats Database.14 A bifurcated approach is taken as we examine both the ultimate recoveries and prices of the traded debt subsequent to default.15

The former refers to the market value of payments and instruments received at the resolution of distress. Figure 4: Historical Mean Recovery Rates (1988-2003)

Source: S&P’s Research (2004).16

Figure 5: Creditors' Ultimate Recoveries in CNC

Source: Conseco, Inc.’s 6th Final Reorganization Plan. We observe that recoveries under the senior bank debt, senior secured notes and senior unsecured notes are much higher than historical mean estimates. The recovery under the senior subordinated notes is close to the historical mean, while the TOPRS recovery is substantially less than that for subordinated notes, being around 1%.

14 2003 Recovery Highlights, Standard & Poor’s Research Report, February 6, 2004. 15 Market prices are typically observed within 30 days after the date of default, subject to data availability. 16 The discounted recoveries are arrived at using an assumption of 10% for the discount rate. Setting the level of the discount rate for the purposes of calculating economic recovery rates or LGD has been a topic of much debate – see, generally, Ian Maclachlan, Choosing the Discount Factor for Estimating Economic LGD in ‘Recovery Risk: The Next Challenge in Credit Risk Management’, Ch 16 (Risk Books, 2006).

ObservationsNominal Ultimate

RecoveryDiscounted Ultimate

RecoveryTrading Price at

DefaultSenior Bank Debt 859 87.3% 78.3% 61.1%Senior Secured Notes 283 76.0% 64.9% 58.6%Senior Unsecured Notes 486 59.3% 42.2% 41.5%Senior Subordinated Notes 390 38.4% 30.4% 32.3%Subordinated Notes 354 34.8% 29.9% -

Claim Description Plan Treatment Nominal Recovery

Discounted Recovery

Senior Lender Claims Senior Bank Debt New Bank Debt &Preferred Stock

100.0% 90.9%

93/94 Notes Senior Secured Notes Cash (under Finance Debtors' Plan)

100.0% 90.9%

Exchange Notes Claim Senior Unsecured Notes 72.0% 65.5%Original Notes Claim Senior Subordinated Notes 42.0% 38.2%CIHC Unsecured Claims Unsecured Debt 100.0% 90.9%CNC Unsecured Claims Unsecured Debt 22.0% 20.0%TOPRS Subordinated Notes Add warrants+rights to

D&O liti proceeds1.3% 1.2%

Preferred Stock Preferred Stock 0.0% 0.0%Common Stock Common Stock 0.0% 0.0%

New Common Stock






The higher recoveries achieved by the senior bank debt are consistent with a finding from current literature that a higher debt cushion leads to higher recoveries.17

In CNC’s case, the debt cushion for senior bank debt is 71%. According to an empirical study, where the debt cushion for senior bank debt is at least 50%, the historical mean for discounted ultimate recovery improves to 89%, with much lower standard deviation for this estimate.

The debt cushion refers to the amount of junior liabilities that a given seniority has below its level. The underlying rationale is that the size of this cushion is largely determined by the credit capacity and support of the firm. The larger this is, the more likely there will be assets of value available for distribution to the more senior tranches in a liquidation or reorganization.

18

The issue then turns to whether this hypothesis can be applied in reverse in relation to the TOPRS – where the proportion of senior debt above is at a high level (71%), does this result in substantially lower recovery for subordinated notes? An alternative approach is to consider the depressed recovery for the TOPRS grounded in the premise that trust-preferred securities constitute a debt-equity hybrid closer to preferred stock. Nonetheless, this argument may not be tenable since the bankruptcy court did not recharacterize the TOPRS as equity.

This comes extremely close to the actual recovery in this case. We can also use this hypothesis to explain the relatively higher recovery for the senior unsecured notes in this case.

19

Source: Bloomberg.

Another argument is that the TOPRS recovery would have been 10% higher but for the existence of the unsecured claims. This raises the question of whether we might be able to incorporate in the model an adjustment for the extent of general unsecured claims and to test the use of leverage ratios in cross-sectional data as potential proxies for this phenomenon. Figure 6: Post-Default Prices of CNC's Traded Instruments

Turning to post-default prices, we observe that these prices are generally lower than ultimate recoveries – a finding which is in line with contemporary empirical studies showing that the two measures of recoveries are weakly correlated, with post-default recoveries being lower.20

17 Altman, E. et al, Corporate Financial Distress and Bankruptcy (2006), pp328.

This is, to much extent, related to the issue of risk-adjusted discounting. Logically, there should be some financial incentives for holding on and participating in the bankruptcy process.

18 Supra, n14. 19 Many courts have held that their general equitable powers under the Bankruptcy Code authorize recharacterization. See, e.g., Bayer Corp. v. Mascotech, Inc. (In re Autostyle Plastics, Inc.), 269 F.2d 726, 750 (6th Cir. 2001). 20 Brand L. and Bahar R., Recoveries on defaulted bonds tied to seniority rankings (Special report, Standard & Poor’s, 1998). See also Servigny, A. and Renault, O., Measuring and Managing Credit Risk (McGraw Hill, 2005) at pp123.

Post-Default Trading Prices

Senior Secured 93/94 Notes $80Senior Unsecured "Original" Notes $8-13TOPRS $1-2






A rough calculation of the level of internal rate of return (IRR) produces 18% for the senior secured notes and 300% for the senior subordinated notes. The high level for the latter suggests market expectations of the type of ultimate recovery – holders of the senior subordinated notes are more likely to obtain a combination of various classes of equity in the restructured entity, i.e., instruments bearing higher risk than cash (which the holders would get if they had sold upon default). Another major observation is that the senior secured notes were trading at a much higher level than historical estimates of post-default prices, while the senior subordinated notes were trading at more than 50% lower than historical numbers. One explanation is that market participants had priced in the subordination of the Original Notes to the Exchange Notes (as reflected in Fitch's downgrade of the Original Notes from 'B-' to 'CCC+' following the Exchange Offer), but not the possibility of deviations from absolute priority at that point. Also, it is possible that the signal-to-noise ratio is low, given the supply-demand situation for defaulted bonds in markets during the 2002-3 downturn, and we should test for market supply-demand effects on cross-sectional data.21

4 Effective Leverage and Relative Seniority

To properly model LGD, one needs to accurately factor in the extent of liabilities in the capital structure (to determine drivers such as debt cushion) and thereby the effective leverage of the company. However, the effective leverage at default is often under-stated by the book value of liabilities – an input commonly captured by current LGD models. CNC provides an instructive example as to certain types of adjustments which we should consider in the model development process. First, we highlight the extent of contingent liabilities present in Conseco's case which might have contributed to the divergence of the recoveries of junior creditors from historical estimates.22

21 It should be noted that the Original Notes were traded very infrequently after the Chapter 11 petition. The year of 2002 was a year with unprecedented default volume, posting the highest total dollar volume of defaulted debt (in nominal and real terms) since 1930 - see Hamilton, D. et al, Default & Recovery Rates of Corporate Bond Issuers, Moody’s Investors Service Report (January 2004). 22 CNC’s contingent liabilities extended beyond its guarantee obligations under the D&O credit facilities. Part of the CNC unsecured claims derive from securities fraud class action settlements.

The company guaranteed bank loans (the “D&O credit facilities), and made related interest loans, to certain directors, officers and key employees for the purchase of the company's stocks. As the company’s stock price sagged, the company made provisions for these liabilities in its financial statements (amounting to $110.2 million in 2001, $150 million in 2000 and $11.9 in 1999). However, these amounts fell far short of the aggregate amount which, as of the petition date, was around $580 million. Given that these were senior bank debt ranking above other claims, the failure to properly adjust for the full extent of these liabilities may lead to misleading predictions.






Figure 7: CNC's Capital Structure as of the last Annual Report prior to default

Source: Conseco, Inc.,’s Annual Report (10-K Filing) as of December 31, 2001.23

23 In CNC’s case, we need to do a further adjustment to add back the trust-preferred securities – which was akin to subordinated notes – to Total Liabilities, since the company reported it below the line, but above the Stockholder’s Equity section.

Second, we note the difficulties of estimating the level of liabilities for an entity in a conglomerate reporting consolidated statements. As the figure below shows, inter-company obligations constitute a substantial portion of CNC’s liabilities. During Chapter 11 proceedings, certain obligations were cancelled and the rest were reinstated, with the latter being part of the unsecured claims. As discussed above in the section on Organization Structure, we may test whether it is useful to include a variable flagging multi-tiered structures and complex inter-company obligations. This leads us to the next issue – why are the CIHC unsecured claims ranking ahead at a relative seniority of 1 (see the following figure summarizing the relative seniority of claims on CNC)? This relates to the use of structural subordination to manage a company’s capital structure, while not being in violation of debt:capital ratios found in covenants of bank credit facilities. In this case, the creditors of CIHC, the intermediate holding company, are necessarily senior to those of CNC since CNC holds CIHC stock as the primary asset, and therefore has value to the extent that CIHC creditors are paid in full and equity value flows upstream. In current LGD models, the relative seniority variable usually reflects only contractual subordination. Structural subordination is occasionally considered through the collateral quality using dummy variables to flag the presence of subsidiary guarantees and pledges of capital stock of subsidiaries. This method may not adequately reflect the relative seniority of unsecured obligations – in this case, the ultimate recovery stood at 100%. It would be worth testing whether the model is more predictive, where the relative seniority variable takes into account priorities among instruments through their placement in multi-tiered corporate structures. Figure 8: Relative Seniority of Claims on CNC

Liabilities ($ millions)Notes payable and commercial paper 4,087.6 Notes payable to subsidiaries (eliminated in consolidation) 353.5 Payable to subsidiaries (eliminated in consolidation) 41.9 Other Liabilities 589.5 Total Liabilities 5,072.5 Trust-Preferred Securities 1,914.5






Source: Conseco’s 2nd Amended Disclosure Statement, March 18, 2003.

5 Deviations from the Absolute Priority Rule (“APR”) A general doctrine of bankruptcy law is that of absolute priority, which stipulates that creditors should be compensated for their claims in a certain hierarchical order and the most senior creditors are entitled to being paid in full before a less senior claim receives anything. However, deviations from this doctrine are common and well-documented.24

Absolute priority in CNC’s case would mean distributions (after administrative and priority claims) to the senior bank debt, senior secured notes, CIHC unsecured claims and senior unsecured Exchange Notes, making them whole. Based on a valuation of $3.8 billion, this would

The question then turns to how we should model the presence and extent of such deviations.

24 See, for example, LoPucki, L. and Whitford, W., (1990). Bargaining over equity’s share in the bankruptcy reorganization of large, publicly held companies, Penn. Law Rev. 139 and Weiss, L., Bankruptcy Costs and Violation of Claims Priority in Bankruptcy & Distressed Restructurings edited by Altman, E. (Beard Books, 1999).

Claim Description Estimated Amt ($ M)

Seniority/Collateral Relative Seniority

Intercompany Claims Notes incurred with various subsidiaries 9.0 Reinstated. 1

Bank Credit Facility Credit facility with Bank of America and other banks

1537.0 Subordination provisions in "Senior Notes" indentures; CIHC Guarantees

1

Guarantees of D&O Facilities

Guarantees of credit facilities provided by Bank of America, etc, to directors and officers to purchase CNC's common stock

500.0 Subordination provisions in "Senior Notes" indentures); CIHC Guarantees; 1999 D&O facility further secured by pledges of stock of CIHC, CFC, CCM and certain intercompany notes

1

93/94 Notes Senior notes issued in 1993 and 1994 93.7 Secured by stock of CIHC, CFC, CCM and other subsidiaries and intercompany notes

1

Senior Notes ("Exchange Notes")

Senior notes from 1998-2001 re-issued pursuant to an Exchange Offer extending maturity dates in return for CIHC guarantees

1371.0 Subordination provisions in Trust Preferred Securities indentures; CIHC Guarantee

2

Senior Notes ("Original Notes")

Senior notes issued between 1998-2001. 1242.0 Identical to the Exchange Notes except for the lack of CIHC Guarantee

3

CIHC Unsecured Claims Unsecured claims incurred by CIHC, the intermediate holding company which also guarantees certain debts of CFC

60.0 Unsecured; structurally senior to CNC obligations 1

CNC Unsecured Claims General unsecured claims incurred by CNC 140.0 Unsecured. 4

Trust Preferred Securities

Subordinated securities issued by subsidiary trusts, guaranteed by CNC

2019.0 Subordination provisions; unsecured. 5

Preferred Stock 90,000 Series E Preferred Stock;2,855,502 Series F Convertible Preferred Stock held by Thomas H. Lee Group in exchange for 1999 capital infusion

- 6

Common Stock 346 million shares (delisted from NYSE effective Sep 2002)

- 7






have left less than $200 million for the remaining creditors. This means around 15% recovery for the Original Notes and the interests of more junior creditors would be extinguished. Nonetheless, we observe two major deviations from absolute priority in this case – an observation in line with findings in the literature that firm size (CNC being the third largest bankruptcy in the United States after Enron and Worldcom) is important in predicting whether priority of claims will be violated. The larger and more complicated the bankruptcies present more opportunities for junior creditors to extract concessions from more senior creditors.25

We can take another angle, viewing these deviations as occurring primarily due to irregularities leading to litigation potential and uncertainty associated with the firm’s valuation. Since litigating these potential claims would be time-consuming and costly, the parties compromised with a plan deviating from absolute priority. This supports Baird & Bernstein’s general theory that the uncertainty inherent in restructuring a large corporation creates bargaining dynamics that explains the deviations.

26

5.1 Irregularities in Prior Restructuring Mechanisms

The valuation uncertainty issue will be analyzed in the Section 6, while we discuss how the issue of irregularities bears on two major deviations which played out in CNC’s case.

The first major deviation occurred where the holders of the Exchange Notes agreed to make a gift distribution to junior creditors, including common stockholders (as proposed in the

When CNC filed for Chapter 11, parties recognized the potential for litigation in relation to the exchange offer.

Disclosure Statement). The Exchange Notes were issued under a distressed exchange offer in April 2002. As an inducement to holders of senior notes (Original Notes) to tender their notes in exchange for new notes with extended maturities, the latter were issued with a guarantee by CIHC. This effected a structural subordination of the Original Notes to the Exchange Notes.

27 The offer exchange offer was not registered with the Securities Exchange Commission and was only made to certain classes of investors (“qualified institutional investors” and “accredited institutional investors” in the United States.28

In short, prior debt restructuring measures could have been flawed with irregularities, leading the door open for potential litigation over the priority of Exchange Notes. Against this backdrop, the Exchange Note holders agreed to re-allocate around $380 million from their distribution under absolute priority to enhance the recovery of the Original Notes and provide a portion of

This could have constituted a violation of indenture provisions prohibiting the company from impairing the noteholders’ right to receive payments or affecting their ability to enforce such rights.

25 Supra, Weiss, n24. 26 Baird, D. and Bernstein, D., Absolute Priority, Valuation Uncertainty, and the Reorganization Bargain (2005), John M. Olin Law & Economics Working Paper No. 259. 27 Re Conseco, Inc., Reorganizing Debtor's Memorandum of Law (June 13, 2003). 28 Conseco, Inc., Press Release in Current Report (Form 8-K), April 12, 2002).






recovery to other junior creditors. Following this, the question is how we should reflect such irregularities in the modeling process. One method would be to create a dummy variable for prior restructuring measures, recognizing the litigiousness of bankruptcy proceedings whereby junior creditors are likely to challenge restructuring measures undertaken not long from the time of entry into Chapter 11. Another way to reflect this might be to test a factor for “time in distress”, i.e., based on a hypothesis that more irregularities are likely to be found where a company had been in desperate straits for a longer time. CNC would provide good support for a “time in distress” variable – its agency ratings were first cut to junk status in March 2000 (1.5 years prior to its Chapter 11 petition).

5.2 Irregularities owing to Corporate Governance Issues The next major deviation emanates from the tussle of the TOPRS with CNC and their senior creditors. Constituting one of the largest claims in dollar amount, the TOPRS launched a multitude of objections against the proposed reorganization plan which initially left them with less than 1% recovery. They raised an attack on the company’s valuation of the company – a classic move in a junior creditors' holdout which will be discussed in the Section 6. What is more interesting is their other major attack on the D&O credit facilities. As discussed above, CNC’s guarantee obligations under D&O credit facilities came about as a result of its executive compensation plan. In the proposed reorganization plan, CNC proposed to pay the amounts owed under these facilities to the lending banks and release these officers and directors from their repayment obligations.29 This was a major source of contention in the Plan. The U.S. Trustee and the Securities & Exchange Commission objected to the plan as well, challenging the right of a Chapter 11 debtor to use a plan of reorganization as a vehicle to obtain a release for officers and directors.30

However, the issue did not end at this juncture. The TOPRS also claimed that the guarantees under D&O facilities should be void and unenforceable because, amongst others, they were in violation of Regulation U and section 402 of the Sarbanes-Oxley Act.

CNC later relented on this point and agreed to provide the TOPRS with 45% of the net D&O litigation proceeds (with a cap of $30 million).

31

29 Re Conseco, Inc., et al, Disclosure Statement for Reorganizing Debtors' Joint Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code, January 31, 2003. 30 These objections are generally based on Section 524(e) of the Bankruptcy Code which provides, in relevant part, that “discharge of a debt of the debtor does not affect the liability of any other entity on, or property of any other entity, for such debt”. There is also case law where the bankruptcy court was found to lack jurisdiction over the release of non-debtors – see, for example, Union Carbide 686 F.2d 595 (7th Cir., 1995).

The main basis for an assertion that the facilities violated Regulation U lay with the maximum loan value requirements of Regulation U, though the chances of successfully pursuing this argument might be low given that the facilities were structured to comply with Regulation U. The Sarbanes-Oxley argument was even weaker, given that the Act was effective as of July 2002 and the facilities at stake relate

31 Supra, n27.






to loans made in the 1990s and early 2000-1.32

The TOPRS staged a holdout, blocking the proposed reorganization plan in June 2003 and put up a strong fight throughout subsequent proceedings. Eventually, the senior lenders under the D&O facilities compromised and gave up the warrants (part of their initially proposed distribution) to the TOPRS.

33 Since this re-allocation of distribution from the senior lenders to the TOPRS was mainly a compromise owing to the litigation potential over the D&O facilities, the D&O lenders’ pro rata share of new preferred stock (with a liquidation preference of $7 million) was re-allocated to the non-D&O lenders classified under the same class of senior lenders.34

While this specific issue is very unlikely to recur now that the Sarbanes-Oxley Act is in force, it highlights how poor corporate governance may constitute a source of irregularities and potential litigation in bankruptcy. As such, we would test using cross-sectional data whether model accuracy improves with the incorporation of factors reflecting corporate governance behavior.

35

It should be noted, however, that empirical studies show that the correlation between corporate governance practices of U.S. firms and firm value has been considered to be relatively weak.

36

6 Asset Valuation

This may influence the type of testing to be undertaken. To illustrate, if the model does not show significant improvement with the use of corporate governance indices, it may be worth trying variables reflecting more extreme behavior, e.g., the presence of multiple class action and/or shareholder derivative suits against the company. Such variable would have flagged poor corporate governance in CNC as well. Prior to default, the company was plagued with securities fraud class action suits and shareholder derivative suits alleging corporate waste through its guarantees of D&O credit facilities and dissemination of false statements regarding CFC’s performance.

Valuation is at the heart of the bankruptcy process. The determination of the going concern value of the company is central to the negotiation and confirmation of the reorganization plan.

32 Id. 33 Note that the strike price of the warrants was set at a higher level than the initial level (where the company proposed to distribute the warrants to the senior lenders. 34 Re Conseco, Inc., et al, Reorganizing Debtors’ 6th Amended Joint Plan of Reorganization pursuant to Chapter 11 of the United States Bankruptcy Code, September 9, 2003. 35 Besides the D&O facilities, CNC was notorious for its extravagant executive compensation packages. The total cash compensation for the CEO and the 5 highest-paid executives amounted to $10.4 million and $6.2 million in 2000 and 2001 respectively, even though the company was reporting negative net income in both years. In terms of board independence, CNC had 4 directors out of 10 who were insiders. 36 Bhagat and B. Black , The uncertain relationship between board composition and firm performance. Bus. Lawyer 55 (1999), pp. 921–963.






In this section, we will examine the major drivers of valuation, or put another way, the main sources of uncertainty surrounding valuation, drawing themes from CNC’s valuation drama and the CFC subplot. CNC, supported by senior creditors, pegged the value of CNC at $3.8 billion; while the TOPRS committee37 argued for a value of over $5 billion. At $3.8 billion, the TOPRS was a constituency which was “out of the money”. While the court dismissed a motion by the TOPRS to file an alternative plan, it allowed the TOPRS to hire a financial adviser to provide an alternative valuation,38

On the other hand, CFC was acquired by CFN in a section 363 sale for $1.3 billion. This was a fairly low number, considering that a conservative valuation of CFC earlier was $2.2 billion to $3.0 billion.

and held a valuation hearing. The valuation gap was significant – at $5 billion, the TOPRS could have achieved at least 25% recovery, even if the absolute priority rule applied (see the figure below).

39

Source: Various CNC bankruptcy filings.

As a result, CNC did not receive any net proceeds from the sale beyond the extinguishment of CFC's liabilities and the related guarantees of CNC and CIHC. Figure 9: Impact of Valuation on Recoveries in CNC's Restructuring

The sources of valuation uncertainty are broadly classified into the following categories:40

37 Re Conseco, Inc., Official Committee of Trust Originated Preferred Debt Holders’ Post-Trial Memorandum of Law in Opposition to Confirmation of the Holding Company Debtors’ 4th Amended Plan of Reorganization, July 24, 2003. 38 It should be noted that, out of the three members of this committee, two were hedge funds – United Capital Markets and Oppenheimer Capital. 39 See, for example, Moody's Investors Service research report on Conseco, Inc. (July 2000).

40 This analytical framework is borrowed from a study done by Baird and Bernstein. See, supra, n26 at p30.






i. External Environment: Much is unknown about the prospects for the economy and the

particular industry sector in which the company operates. The uncertainty surrounding future market performance and expectations compound the difficulties in determining the cost of capital – the rate at which the market will discount the company’s future cash flows. This issue is especially interesting in this case since the Conseco Group filed for Chapter 11 during the downturn and emerged at the cusp of a market rebound.

ii. Firm-Specific Factors: Much is unknown about the company itself – the strength of its new management team, growth prospects, the quality of its financial information, the realization of tax loss carryforwards, etc. In particular, we will discuss how the accounting quality might have elevated the uncertainty in its asset value.

The corollary of valuation uncertainty is “appraisal variance” where parties to the reorganization negotiations come with different views of the enterprise value.41

6.1 External Environment: The Downturn

The scene then changes from one of analytical complexity to organizational complexity where negotiation dynamics, and occasionally the bankruptcy process itself (e.g., the section 363 sale), drive the valuation. We will investigate whether it is possible to find proxy factors to reflect the impact of parties’ negotiation strategies and their relative bargaining power on LGD.

The Conseco Group filed for Chapter 11 during a time of severe economic slowdown and in a year with an unprecedented peak in default volume.42 During bankruptcy proceedings in 2003, the Fed opined that there was still “considerable uncertainty attends the near-term outlook for the U.S. economy”, with a negative picture coming from production and employment statistics.43

The question is: how did the downturn affect LGD levels? This is a particularly interesting question given an ongoing debate on the Basel II requirement of downturn LGD in the regulatory capital formula. There is empirical research showing that LGD generally rise during the stress period,

Indeed unemployment rates peaked in the third quarter of 2003 while CNC was holding its valuation trial. However, the company emerged at the cusp of the market rebound, with the S&P 500 showing 15% growth between September 2003 and December 2002.

44 juxtaposed against research that the systematic variable had no effect on LGD after bond market conditions (supply-demand imbalances) were accounted for.45

41 Id.

Another school

42 Supra, Hamilton, n21. 43 Ferguson, R., Uncertain Times: Economic Challenges Facing the United States and Japan, FRB Speech (June 13, 2003) 44 See, for example, Carey, Mark and Michael Gordy, 2003, Systematic risk in recoveries on defaulted debt, Federal Reserve Board, Working Paper; and Araten, Michel, Jacobs, Jr., Michael and Peeyush Varshney, Measuring Loss Given Default on Commercial Loans for the JP Morgan Chase Wholesale Bank: An 18 Year Internal Study, RMA Journal, May 2004. 45 Altman, E., The PD/LGD Link: Empirical Evidence from the Bond Market, Recovery Risk edited by Altman, E. (Risk Books, 2006).






of thought found that LGD is more heavily influenced by industry-specific factors, rather than the macro-economic state.46

The filings in the valuation trial clearly show that parties were arguing their view of enterprise value in the shadow of economic and market indices. The valuation was undertaken using a comparable company analysis and an actuarial discounted cash flow approach. The first approach provided much fodder for the TOPRS argued for a higher value over time in light of the rising stock market in 2003 (see figure below).

47 In the TOPRS’ own words, “[the] change in the price earnings ratio materially increases [the] valuation of the company because under the comparable company method, the stock market acts as a benchmark or a measure against which to compare the company that is being valued”. This may support the empirical finding that the average S&P 500 equity return has a stronger correlation with LGD, compared to other macro-economic indicators such as GDP growth or the Moody’s All-Corporate Default Rate.48

In relation to the actuarial approach, parties fought vehemently over the appropriate discount rate.

49 The generally accepted method to arrive at the discount rate is the use of WACC analysis, which depends on the risk-free rate and a risk premium.50

Figure 11

This suggests the option of testing on cross-sectional data bond spreads to reflect the impact of risk premium on LGD (a factor generally overlooked in current LGD modeling). As shows, the composite spread index for speculative grade issues remained at fairly high levels (albeit off the 2002 peak) in the first half of 2003. This might have bolstered the arguments by the company and senior creditors based a high discount rate of 12%, instead of the typical hurdle rate of 10-11% for insurance companies.51

46 Acharya, Viral V., Bharath, Sreedhar T. and Anand Srinivasan, Understanding the recovery rates on defaulted securities, London Business School, Working Paper, 2003.

47 Supra, n37. 48 Jacobs, Michael, Understanding and Predicting Ultimate Loss-Given-Default on Bonds and Loans, Working Draft, September 2007. Available at SSRN: http://ssrn.com/abstract=1015331 49 TOPRS memo – insisted that the discount rate of 12% was artificially high and that the distress premium of 5% was unwarranted given positive developments in financial markets and CNC’s improved position. 50 See generally Chapter 12 in Scarberry, Klee, Newton & Nickles, Business Reorganization in Bankruptcy: Cases and Materials (2006). 51 According to an August 2002 White Paper for the American Council of Life Insurers, the typical hurdle rate for insurance companies in the US is around 10-11%.



http://ssrn.com/abstract=1015331�




Figure 10: S&P 500 Indices (1997-2006)

Source: Bloomberg.

Figure 11: Bond Spread Indices (1998-2004)

Source: Bloomberg.

On the other hand, the specific case of CFC may provide support for the school of thought






focusing on industry-specific factors and suggest that we should develop Bayesian priors relating to industries which tend to be more vulnerable to downturns. The downturn had an asymmetrically severe effect on CFC’s subprime lending business. Within the consumer finance sector, manufactured housing was the worst performer.52 In January 2002, one of the largest issuer of manufactured housing ABS and CFC's main rival, GreenPoint Credit exited the business, stating that the decision was driven by “the most severe downturn in the manufactured-housing business that has ever occurred”.53

6.2 Firm-Specific Factors: Accounting Quality

The deterioration in the sector hit CFC on all fronts. First, the rise in delinquencies and loss severity led to loan losses and its costs of servicing increased with the elevated foreclosures. Second, CFC suffered a material cash burden owing to its provision of credit enhancement to ABS holders (it provided guarantees to lower-rated tranches and its servicing fees were subordinated to payments to the tranches). Third, its substantially-weakened financial position of CFC precluded its access to securitization markets – a source which had been the company's lifeblood and the lack of which put to doubt the viability of its business model. In this light, it was not difficult to explain the low bids for CFC in its section 363 sale.

In terms of firm-specific factors, we observe an interesting source of valuation uncertainty in this case – its aggressive accounting treatment of financial statement data. CNC had been historically aggressive in its accounting practices, applying the purchased method for its acquisitions.54

Subsequently, to avoid charges to earnings where the actual present value of premiums were less than the present carry value of that asset, CNC shifted its bond portfolio from ‘held-to-maturity’ status to ‘actively managed’ to carry investments at the high prevailing market prices of the 1990s (a unique practice in the insurance industry).

The company would record the discounted value of the profits expected in the future from the acquired company’s operations, instead of goodwill which had to be amortized over time.

55

i. CFC historically used the gain on sale accounting method for the securitization of its financial receivables.

This accounting technique eventually backfired when the economy slowed down. The company reported unrealized losses on its fixed income portfolio of $781 million for the year of 2001. The accounting quality of financial statements filed by CFC was worse, ranging from aggressive treatment to fraud:

56

52 U.S. Fixed Income 2003 Mid-Year Outlook/Review, Nomura Research Report, June 27, 2003. 53 GreenPoint Credit Press Release (January 2002) 54 Abe Briloff Ponders Accounting's Current State, Barron’s, October 11, 1993. 55 Id.

In 1997 and 1998, prior to Conseco's acquisition, securitization

56 In the latest rules representing U.S. implementation of the Basel II Capital Accord, a financial institution has to






gains alone amounted to 60% and 52% of total revenues respectively. Gain on sale accounting relies on subjective and easily-manipulated assumptions, allowing management to front-load earnings. Note that CFC's accounting strategy, which focused on its own assumptions of discount rates, default rates and loss severity, predates the recent FAS 157 which states that “fair value is a market-based measurement, not an entity-specific measurement”.57

ii. The risk of over-stating asset values using gain on sale accounting materialized in late 1999 – CFC recognized an impairment charge of $554 million to reduce the book value of retained interests (mainly interest-only securities and servicing rights). Subsequently in 2000 and 2001, CFC recognized further impairment charges of $516 million and $387 million respectively. After September 1999, CFC switched to the portfolio method whereby the securitized debt remained on the balance sheet as secured borrowings. Theoretically, this method should be more conservative in terms of revenue recognition. However, it introduced another subjective dimension – CFC had more leeway to defer impairments as long as they can argue that the losses were temporary in nature.

iii. CFC adopted an aggressive stance in its treatment of loss provisions and guarantees. Between 1997 and 1999, CFC's loss provisions relative to total originations was less than 1%. This ratio stood at 0.16% in 1997. Assuming a typical loss severity of 40%, the default rate would have been projected at less than 1% - an extremely low number for subprime exposures! The loss provision eventually increased by 191% in 1999 and 175% in 2000. Furthermore, in its 1999 annual report, CFC stated in relation to its $1.6 billion guarantees of finance receivables that the “the likelihood of a significant loss from such guarantee is remote.” Subsequently in 2003, CFC projected that payments under the guarantees would exceed the gross cash flows from the retained interests for the next five years.

iv. The SEC eventually instituted cease-and-desist proceedings against the company for making materially false and misleading statements about their earnings, overstating their results by hundreds of millions of dollars.58 The SEC found that, in 1999, CNC’s CFO and Treasurer instructed the accounting department to change the historical basis of each IO security. This allowed the company to avoid taking charges to earnings albeit a weakening subprime market, and coupled with other improper adjustments, they falsely increased earnings.59

deduct gain on sale associated with securitization exposures from Tier 1 capital, to offset the aggressive accounting treatment that provides an increase in Tier 1 capital at the inception of securitization.

57 Under FAS 157, “[the] use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating the marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information…” This, however, does little to prevent “mark-to-make-believe” where the industry itself uses over-optimistic assumptions.

58 Re Conseco, Inc., Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing A Cease-And-Desist Order pursuant to Section 21c of the Securities Exchange Act Of 1934 (see order available at http://www.sec.gov/litigation/admin/34-49392.htm ). 59 Id.



http://www.sec.gov/litigation/admin/34-49392.htm�




The valuation trial took place in the context of poor accounting quality of the Conseco Group’s financial data. To illustrate, the TOPRS argued that an earlier Ernst & Young report valued CNC at $5.9 billion as of December 2001, asserting that “[the] Debtors failed to offer any quantitative analysis attempting to justify a $2 billion drop in value in six months (1/01/02 to 6/30/02)”.60 The retort by the debtor was premised on the uncertainty of further charges to earnings, e.g., citing a $900 million writedown in 2002. As a Fitch commentary put it simply, it was unclear whether policies adopted by the company would “ultimately generate lower loss results, or simply delay actual loss recognition”.61

6.3 Negotiation Dynamics and Stakeholder Incentives

As such, this case may support a hypothesis that a factor reflecting accounting quality should be useful in estimating LGD levels.

It is widely recognized that negotiation dynamics play a significant role in determining the valuation of a reorganized entity.62

Gilson et al suggest that we can develop empirical proxies to represent the likelihood that incentives of the senior and junior interests might influence plan value.

Typically, senior creditors argue for a lower valuation, while junior creditors and equity holders are better served by a relatively high valuation which allows some distributions to be allocated to these lower classes. This classic position played out in CNC’s case.

63 One possible proxy factor was the relative size of the creditor’s claim and the presence of vultures gaining a controlling stake in the debt class.64

As for management’s incentives in the negotiations, the general view is that management veers towards a low valuation where the plan provides equity incentive compensation to management priced in conjunction with the valuation, especially if they do not already own a significant share

In CNC’s restructuring, the senior lenders and the TOPRS were finely balanced 1:1 in terms of the relative size of their claims. In such a case, it is possible that the senior lenders had more bargaining leverage, since negotiations occur in the shadow of a potential cramdown and the threat of the case being moved into Chapter 7. In most cases, there is a high likelihood that some form of liquidation imposed if a reasonably prompt reorganization cannot be achieved and, this risk is exacerbated in CNC’s case where insurance regulators were ready to appoint receivers for Conseco's subsidiaries if restructuring was not quickly completed. This might explain why the TOPRS finally caved in and agreed to a settlement pegged at the lower $3.8 billion valuation level.

60 Supra, n37. 61 Fitch Rating Watch, Fitch Research Report (2002). 62 See, generally, Gilson, S. et al, Valuation of Bankrupt Firms, Review of Financial Studies v13 (2000) and Moyer, S., Distressed Debt Analysis (J Ross Publishing, 2005) at p336-9. 63 Supra, Gilson, n62 at p66. 64 The Oppenheimer Group had a substantial stake in the TOPRS and was in fact on the TOPRS committee. Interviews would be conducted for the next draft to explore in greater detail the impact of the participation of vultures in CNC’s restructuring process.






of the equity. This hypothesis is supported in CNC’s case where the management argued for a lower valuation. The management was relatively new and the proposed plan included a management incentive plan giving key executives 10% of equity holdings in the form of restricted stock.65

Nonetheless, we note that CNC’s management was driven by another key factor which might be harder to model. Management found it easier to convince the senior lenders to take a combination of reinstated debt and preferred stock and the noteholders to take common stock, where a lower valuation provided some upside for their acceptance of riskier instruments. In its legal memorandum, CNC stated that, if it had established a higher valuation, that would have affected the strategy to emerge with a lower leverage ratio.

This suggests that we should include variables relating to management’s post-petition stock incentive plan and management turnover.

66

Finally, we observe that the uncertainty over the outcome of the valuation generates option value, and this directly influences the allocation of securities whose value is contingent on a higher than expected valuation.

67

6.4 Process: Section 363 Sale

In the final settlement between the company, its senior lenders and the TOPRS, the latter were awarded warrants where the payoff was directly tied to the company attaining a high future value. At an exercise price of $27.60, the TOPRS would be “in the money” only if the company was indeed worth around $5 billion – the amount they asserted during proceedings.

In this section, we would briefly discuss whether the reorganization process itself, specifically the section 363 sale of CFC, substantially affects valuation. LoPucki and Doherty published a seminal work in late 2007 which found that recoveries from reorganization cases yielded more than double the recoveries from section 363 going concern sales and identified various sale characteristics contributing to the firesale.68

Many of these characteristics were present in CFC’s case. It was a rushed sale - two days into the Chapter 11 petition, CFN was chosen as the stalking horse and entered into an asset purchase agreement with CNC. CFN was protected from “outside” competition though the use of bid protections. The bid protection in this case consisted of a breakup fee of $30 million representing 4.0% of the stalking horse price and a requirement for an incremental bid of 5.3% higher than the stalking horse bid. This was way higher than historical estimates where breakup fees averaged 2.3% of the stalking horse price and terms of sale requiring the competing bid to,

65 In March 2004, the restructured CNC announced that its top executives made nearly $34 million in awards primarily from restricted stock granted during Chapter 11 proceedings – see the annual report for the fiscal year ended December 31, 2003. 66 Supra, n27. 67 Supra, Baird and Bernstein, n26. 68 LoPucki, L. and Doherty, J., Bankruptcy Fire Sales, UCLA Law & Economics Research Paper No. 07/07 (2007), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=980585.



http://papers.ssrn.com/sol3/papers.cfm?abstract_id=980585�




on average, be at least 3.7% higher.69 There were also bulk-sale and all-cash requirements which the Unofficial Committee of Noteholders objected to as procedures which would “chill potential bidders from submitting bids and maximizing value”.70 Furthermore, CFN was a DIP lender with a significant information advantage over other bidders.71

As expected (given the crucial advantages provided to the stalking horse), CFN won the auction with its final bid of $970 million in cash, plus assumption of certain liabilities, subject to certain adjustments and a restructuring of CFC's guarantees and fees in relation to the MH servicing business. A twist to the story happened, raising the final purchase price. Fannie Mae held an adequate protection lien and would only waive this in the event that Berkadia (a joint venture between Berkshire Hathaway and Leucadia National Corp) won the auction.

72

7 The Subprime Lending Subplot

After further negotiations, the purchase price was raised to approximately $1.3 billion and gained the support of the major constituencies for the sale. Nonetheless, though CFC’s section 363 sale fit the paradigm described by LoPucki and Doherty, the process itself probably had less influence on the valuation than the sources of valuation uncertainty discussed above. Following the order for sale, CFC reported in April 2003 a net loss of $1.1 billion for the 3 months ended December 31, 2002, resulting in a shareholder's deficit was $100 million.

An interesting question is: how did the creditors fare in CFC’s sale and liquidation? At the time of liquidation, CFC's primary debt obligations consisted of: (i) DIP financing;73

On Lehman’s part, it faced adversary proceedings brought by the Official Committee of Unsecured Creditors of CFC started adversary proceedings against Lehman arguing, amongst others, for avoidance for fraudulent or preferential transfer and equitable subordination, especially in relation to the 2002 transfers and fees incurred.

(ii) Warehouse credit facilities mainly owed to Lehman; (iii) Liabilities under guarantees of securities issued under securitization transactions.

74

69 Id. 70 Note, also, various objections entered by securitization trustee, noteholders committee, etc. 71 Baird, D. and Rasmussen, R., Private Debt and the Missing Lever of Corporate Governance, 154 U. PA.L.Rev. 1209 (2006) (commenting on the information advantage of a DIP lender who was concurrently a potential purchaser). 72 Daily Deal, Berkshire still on Conseco deal trail (March 12, 2003). 73 This includes the US Bank swingline facility which was rolled into the super-priority DIP Facility Agreement. 74 Statement of Position for the Estimation of Lehman Claims by The Official Committee of Unsecured Creditors, May 7, 2003. See retort by Lehman in Objection of Lehman ALI Inc., Lehman Brothers Inc., Lehman Commercial Paper, Inc. and Lehman Brothers Holdings Inc., to Finance Company Debtors’ 2nd Amended Joint Liquidating Plan of Reorganization Pursuant to Chapter 11 of the U.S. Bankruptcy Code, June 6, 2003.

The key argument proffered by the unsecured creditors, however, was substantive consolidation of CFC and two special purpose entities (SPEs).






These SPEs were the direct counterparties with Lehman for its warehouse facilities, though CFC and CIHC provided guarantees. These SPEs were set up for the sole purpose of being a conduit between CFC and Lehman, and to ringfence Lehman’s collateral in certain CFC assets transferred to the SPEs. They had no other counterparties or business purpose. The court ruled in favor of the substantive consolidation during the hearing, thereby eliminating Lehman's exclusive claim to the assets of the SPEs. In spite of this setback, Lehman as the senior secured lender recovered in full the principal and interest under the warehouse and residual facilities (i.e., a recovery rate close to 100%), though it was given a haircut adjustment for other claims in relation to additional fees incurred under forbearance agreements and other arrangements undertaken in 2002. This followed from the fact that the purchase price in the section 363 sale was primarily set to ensure that the senior secured liabilities would be paid off. In the Disclosure Statement, it was stated that the purchase price payable by CFN would be the sum of the Lehman Secured Debt and the DIP facility amount and approximately $159 million.75

i. Many tranches faced downgrades and defaults in light of the performance deterioration of the manufacturing housing loans asset pool and the decline of over-collateralization beyond target levels. These losses were exacerbated by CFC’s bankruptcy filing which led to changes in servicing practices. Since the suspension of CFC’s lending business, CFC was forced to liquidate repossessed units through wholesale channels rather than retail channels. In addition, CFC discontinued its financing and assumption programs to reduce servicing costs, causing repossessions to spike as loans previously eligible for this program were then taken as repossessions. This led to a flood of repossessed units in the wholesale market, further elevating loss severity rates.

On the other hand, the holders of CFC’s asset-backed securities fared worse. While the securitization trusts were not brought into bankruptcy and bankruptcy-remoteness issues were not at issue, the securities holders were adversely affected in three major ways:

ii. There was a reduction in the amount of excess spread available to cover losses. Excess

spread had been reduced since the court issued an interim order increasing the amount and priority of the servicing fee.76

The fee rose by more than 100% from 50 bps to 125 bps in 2003 and 115 bps in 2004. Prior to this order, the servicing fee was to be paid as an expense prior to distributions to the tranches, so the order essentially rewrote the cash waterfall.

iii. CFC provided $2.3 billion of guarantees for subordinated tranches, known as B2 certificates, of which $600 million had fallen due at the time of its liquidation

75 Re Conseco, Inc., Second Amended Disclosure Statement for Finance Company Debtors' Second Joint Plan, July 15, 2003. 76 See Re Conseco, Inc., Stipulation and Order on Continuation of Interim Servicing Arrangement, June 19, 2003. These changes were in exchange for the grant of an adequate protection lien on CFC's assets in favor of the securitization trust and the Trustee.






proceedings. In its final plan, the B2 guarantee claims were resolved in the aggregate amount of $34 million, i.e., a low 6% recovery.77 This dramatic reduction in credit enhancement, coupled with the weak performance of the underlying asset pools, produced multiple downgrades and defaults. It was reported that out of a MH default sample over 1991-2005, securities issued by CFC accounted for 36%.78 This problem also affected ABS deals backed by other types of assets. A record of 50 RMBS defaults were recorded in 2003, of which 33 resulted from guarantor defaults by CFC.79

8 A Closer Look at the Meaning of “Ultimate Recoveries” A final issue arising from this case study is how we should conceptualize “ultimate recoveries”. Currently, post-default trading prices are more commonly used to measure LGD, given the relative ease of collecting market data. However, there have been an increasing number of banks which considered ultimate recoveries to be a more accurate LGD measure and decided to use ultimate recoveries as an input in the Basel II regulatory capital formula. However, in a case where creditors receive a debt-equity swap in the restructuring process, should the ultimate recoveries be recorded as those at the time of emergence, i.e., the levels listed in Figure 5? As discussed above, negotiation dynamics had, to much extent, driven the valuation of the firm which was fiercely contested by the TOPRS. The final reorganization plan valued the common stock at $16.40. Events following CNC’s emergence from Chapter 11 for the next 3 years suggest that the $16.40 estimate might be too low. Ever since the stock of the newly-restructured CNC floated on the NYSE till the end of June 2007,80

77 Note that this recovery is limited to guarantee claims in relation to the B2 certificates which were on the record as of the day of the order confirming the final liquidation plan, i.e., CFC had no further contingent liabilities under these guarantees – see Order Confirming Finance Company Debtors' Sixth Amended Joint Liquidation Plan of Reorganization Pursuant to Chapter 11 of the United States Bankruptcy Code (September 9. 2003). 78 Fitch Global Structured Finance 1991-2005, Fitch Ratings (November 28, 2006). 79 U.S. RMBS Upgrades Are Down And Downgrades Are Up In 2006, Standard & Poor's (January 27, 2006). 80 In this analysis, we have excluded prices subsequent to that period, given the volatility and contagion generated in the 2007-8 market turmoil.

the average price was $21 and the price had only dipped below $16.40 for 4 days during this period. In fact, CNC completed a recapitalization in May 2004 with a secondary offering of 44 million shares of common stocks at a price of $18.25. Based on the average price of $21, there was a 28% increase in the ultimate recoveries for the creditors ranging from the Exchange Notes holders to the TOPRS.






Figure 12: Stock Price of the Restructured Conseco, Inc.

Source: Bloomberg.

Figure 13: Range of Recoveries based on Different Stock Prices

At a price of $21, it appeared that the market's valuation was more than $4 billion – a level close to the use of a discount rate of 10%, rather than 12% used in the plan).81 Part of the market’s perceptions of CNC’s enterprise value also stemmed from it realizing a substantial net operating losses (NOLs) carryforward. During the valuation trial, one of the TOPRS’ key arguments was the company’s failure to sufficiently include NOLs in establishing the valuation.82

81 See appraisal report done by Milliman USA Consultants and Actuaries. 82 For more details, see Re Conseco, Inc., Expert report of Wilfred J. Romero of Fox-Pitt, Kelton Inc. on behalf of the Official Committee of Holders of Trust Originated Preferred Debt of Conseco, Inc., May 7, 2003, attached to The Official Committee of Conseco Trust Originated Preferred Debt Holders’ Emergency Motion in Limine to preclude debtors from offering expert opinion testimony from William T. Devanney filed June 16, 2003.

This was successfully resisted by management and senior creditors. In 2004, Conseco and the IRS entered into “a closing agreement which determined that the tax loss recognized on the worthlessness of

No. of Shares ( millions)

Nominal Recovery @ $16.40/share

Nominal Recovery @ $21/share

Discounted Recovery @

$16.40/share

Discounted Recovery @ $21/share

Exchange Notes 60.6 72.0% 92.2% 65.5% 83.8%Original Notes 32.3 42.0% 53.8% 38.2% 48.9%CNC Unsecured Claims 1 22.0% 28.2% 20.0% 25.6%CIHC Unsecured Claims 1.9 100.0% 128.0% 90.9% 116.4%TOPRS 1.5 1.3% 1.6% 1.2% 1.5%






CFC was $6.7 billion, instead of our original estimate of $5.4 billion”.83

Put simply, how appropriate is it to use ‘ultimate recoveries’ at the point of emergence as a measure of LGD if the enterprise value was the result of ‘low-balling’ by parties with stronger bargaining leverage in negotiations? Should the subsequent average stock price be used to arrive at the recovery rate instead? Besides, how should the value of other instruments such as the warrants and preferred stock be properly determined? In this case, the preferred stock issued to the senior lenders was redeemed at par plus accrued dividends in 2004,

84

These questions are unlikely confined to CNC’s case. A 2005 report by Jefferies which maintains an index tracking post-Chapter 11 equities reported that the average re-org equity, based on 62 companies which emerged since 2000, delivered excess return of 67% compared to the S&P 500.

but the warrants were worthless since the stock price never rose up to the level of the exercise price.

85

83 Re Conseco, Inc., Annual Report (10-K filing) for fiscal year ended Dec 31, 2004. The loss was considered an ordinary loss for tax purposes, which meant that it could apply generally, instead of being limited to reduce future capital gains. 84 See Conseco, Inc’s press release in its Current Report (Form 8-K), May 12, 2004. 85 Special Situations: Risk and Reward in Post-Reorg Equities, Jefferies Research (October 2005). The post-reorg returns reported by Jefferies, which only started tracking the performance of companies emerging from bankruptcy in 2000, could have been driven by the 2003-7 boom.

In light of this, we propose further investigations in the other case studies and cross-sectional data in addressing this issue.



Date post:	12-Nov-2014
Category:	Documents
Upload:	sarah-woo
View:	478 times
Download:	0 times

Conseco: Restructuring an Insurance Giant with a Subprime Lending Arm

Documents