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    May 13, 2009

    I. About the Speakers

    II. Overview of Key Issues to Consider in Connectionwith a Capital Structure Analysis

    III. Basic Issues for Distressed Bank Debt MarketParticipants

    IV. PowerPoint Presentation

    Schulte Roth & Zabel LLP

    New York | Washington DC | London | www.srz.com

    2009 Schulte Roth & Zabel LLP. All Rights Reserved.

    distressed investing

    Capital Structure Analysis andDebt Trading

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    I. About the Speakers

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    Distressed Investing Seminar: Capital Structure Analysis and Debt Trading

    2009 Schulte Roth & Zabel LLP. All Rights Reserved.

    Kirby Chin is a partner in the Finance Group at Schulte Roth & Zabel LLP. His practicefocuses on secured financing transactions, including first-out/last-out and second lienand financings, term B financings, debtor-in-possession and exit financings, acquisitionand leveraged buyout financings, hedge fund and fund of funds financings, capital call

    and liquidity facilities for private equity funds, asset-based and working-capitalfinancings, factoring transactions, private placements and public offerings of senior and subordinated debt securities, and restructurings and workouts.

    Kirby recently represented private equity investors in connection with the senior creditfacilities for the acquisition of Chrysler automotive and Chrysler financial services.

    Some of his other representative matters include:

    Representation of a financial institution in a $1.0 billion senior credit facility to afund of funds secured by a pool of diversified portfolio fund investments.

    Representation of a media distributor in a $325 million senior financing facility,a $165 million secured bond offering and a $35 million holding company loanin connection with an acquisition by a private equity fund.

    Representation of a group of private equity investors in connection withfinancing their acquisition of LNR Property Corp.

    Representation of a lead agent in a syndicated $515 million debtor-in-possession financing facility to a chemicals and resins company.

    Representation of a private equity fund in a $190 million senior credit facilityfor working capital liquidity.

    Representation of a lead agent in a syndicated $125 million senior creditfacility to an independent oil and gas company operating offshore and in the

    United Kingdom. Representation of a lead B agent in a syndicated $190 million senior credit

    facility to an automobile hauling and transportation company.

    Kirby earned his J.D. from the New York University School of Law, in 1995, where heserved on the Journal of International Law and Politics , and his B.A., cum laude , fromNew York University in 1992. He is a member of the American Bar Association and theNew York City Bar Association.

    Kirby Chin919 Third AvenueNew York, NY 10022212.756.2555 | [email protected]

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    Distressed Investing Seminar: Capital Structure Analysis and Debt Trading

    2009 Schulte Roth & Zabel LLP. All Rights Reserved.

    Ronald B. Risdon is a partner in the Finance Group at Schulte Roth & Zabel LLP. Hispractice concentrates in syndicated credit facilities, public and private offerings of debtsecurities, asset-based lending, and restructurings and bankruptcy, including debtor-in-possession financing.

    Representative transactions include:

    Represented agent lender in an exit term loan facility for a specialty printer. Represented automotive manufacturer and automotive financial services

    business in connection with financing from the U.S. Treasury under TARP. Represented term lender in exit financing for a wire manufacturer. Represented private equity investors with respect to a euro-denominated.

    credit facility in connection with the acquisition of an Austrian banking group. Represented agent bank in connection with a debtor-in-possession credit

    facility in a pre-arranged Chapter 11 case and the exit financing for the

    reorganized company. Represented borrowers in connection with the issuance of yen-denominated

    senior secured floating rate notes to finance investment in a Japanese bank. Represented private equity investors in connection with the senior credit

    facilities for the acquisition of Chryslers automotive and financial servicesbusinesses.

    Represented private equity fund in connection with senior secured creditfacilities and high-yield notes to finance the acquisition of a provider of information management and business process outsourcing services.

    Represented major money-center bank in the Enron Corp. Chapter 11 cases,including representing the bank as agent in four structured transactions, and in

    connection with the sale of the Enron corporate headquarters. Represented agent lender in an asset-based facility for a nationwide school

    bus operator.

    Ron is a graduate of University of Virginia School of Law and the College of William &Mary. He is a member of the American Bar Association and the New York City Bar

    Association.

    Ronald B. Risdon919 Third AvenueNew York, NY 10022212.756.2203 | [email protected]

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    II. Overview of Key Issues to Considerin Connection with a CapitalStructure Analysis

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    Overview of Key Issues to Consider in Connection with a CapitalStructure AnalysisKirby Chin

    This article briefly summarizes some critical issues that an investor should consider before making aninvestment in the securities of a distressed company.

    I. Identification of a Potential Investment

    Whether the potential investment is a bond, note, tranche of debt comprised of a senior secured loan,

    mezzanine loan, subordinated indebtedness or other debt investment in the capital structure, theessential starting point for an investor is determining whether the documents governing such debtsecurity 1 afford the investor sufficient protection and rights necessary to achieve the desired outcome(i.e., its investment realization or exit strategy).

    After an investor identifies the potential debt security, it is often necessary to engage legal counsel toreview of the underlying documents governing the debt security to determine whether it has the essentialcharacteristics to serve as the security in which to invest. The protections and rights of a debt security aretypically set forth as covenants and other agreements in the applicable credit documentation and theprimary credit document may take the form of a credit agreement, a note purchase agreement or anindenture.

    Because of the potential complexity of credit documents, it is important to set forth the proper scope of review. 2 It is important to identify the investors exit strategy; the anticipated realization of value from theproposed investment will set the scope of the review. The exit strategy may be a loan-to-own, a debtrestructuring, debtor-in-possession financing or a trade and quick realization of value. It may also entailoffering the company an incremental loan facility with attractive fees or in exchange for an issuance of warrants or other equity securities.

    II. Analysis of a Potential Investment

    To determine whether a potential investment in a distressed company would serve to realize value, theinvestor should:

    Examine the basic structural considerations related to the organization and business of thecompany.

    Determine the rights of the debt holder against the company.

    1 While the term security usually refers to notes issued pursuant to 144A or private-for-life offerings, for purposes of this article, anyinvestment in a debt instrument, regardless of whether it was issued pursuant to a securities offering, will be referred to simply as asecurity or a debt security.2 One challenge may be obtaining all the documentation relevant to the debt security. Even if the debt security is issued by a publiccompany, there may be a limited number of documents publicly available. While the companys periodic filings may summarize theterms of the documents, such summaries often lack the level of detail necessary to conduct an appropriate review. It is important toexamine the actual provisions of the agreements. If the company is not public, the investor will need to obtain the relevantdocuments by other means.

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    periods to obtain the necessary consents from the appropriate governmental authorities toconsummate the transaction.

    To the extent the debt security is secured, the potential investor should also carefully consider thescope of the collateral package and the type of assets owned by the company. Tangible, or brick-and-mortar, assets may be more easily manageable than intangible assets, such as intellectualproperty rights.

    If the debt security is secured not by all assets but just certain specific assets (e.g., accountsreceivables, a pledge of stock of the parent company, cash and bank accounts), an investor should determine whether the assets would provide sufficient value or would ensure that theinvestor can execute its exit strategy. For example, to the extent the investor purchases a debtsecurity prior to a bankruptcy filing to better position itself to fund a debtor-in-possession financingfacility in a bankruptcy, thereby exerting certain controls over the company during thoseproceedings, it may be essential to ensure that the pre-bankruptcy debt security is secured byliens on the companys bank accounts and to determine whether the company may maintainsignificant cash or other assets in foreign jurisdictions outside of the reach of any creditors lien.

    As a practical matter, identifying the assets that are not part of the collateral package is asimportant as identifying the assets that are part of the package.

    B. Rights Between the Investor and the Company

    The second area to focus on is the rights the investor would have under the proposed debt securitysdocumentation.

    1. Restrictive Covenants and Events of Default Under Existing Documentation

    Below are brief descriptions of relevant covenants typically contained in credit documentation for loan instruments as well as bond securities.

    (a) Indebtedness. Indebtedness covenants limit the amount of indebtedness a company mayincur that may be senior to, or pari passu with, the subject debt security. Any permittedindebtedness must be evaluated to determine whether it is senior or junior to, or pari

    passu with, the proposed debt security in terms of payment, lien priority or both.

    A popular feature in credit facilities during the past several years are accordion or incremental term loan facilities, which are essentially uncommitted lines of credit wherea company may incur, to the extent it identifies willing lenders, more debt on substantiallythe same terms as any existing loan under the same credit facilities. An investor shouldbe cognizant of any ability of the company to incur such additional indebtedness andunderstand fully the terms and pricing of such loans and the dilutive effect that suchincurrence would have on the value of the debt security the potential investor maypurchase. Typically, loans made under these accordion/incremental facilities share, pari

    passu , in the liens securing the outstanding loans, which would dilute the value of theloans to the extent the investor is considering an investment in an outstanding loan.

    (b) Liens. Credit documents usually include limitations on the incurrence of liens on thecompanys assets which are designed to protect the priority position of the investor regardless of whether the debt security is secured. Typical lien covenants prohibit allliens other than any applicable to the debt security and certain ordinary course carve-outs(e.g., for taxes and other governmental charges, non-material liens related to realproperty, capital leases or purchase money debt). The investor needs to identifyadditional negotiated exceptions to determine the amount of secured debt which may bedilutive to collateral available to the potential debt security, if secured, or which may bepotentially senior in recoveries to the debt security if the debt security which is beingconsidered for investment is not secured.

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    In certain bond indentures there are equal and ratable lien covenants, requiring acompany to grant liens to the secure bonds that may initially be unsecured to the extentthe company agrees to grant liens to secure other debt exceeding a certain dollar threshold. A restructuring of a debt security may trigger an equal or ratable lien provisiondiluting the collateral which may otherwise be available exclusively to secure the debtsecurity.

    Many of these provisions are written as an affirmative requirement to provide an equal

    and ratable lien, and remain silent on whether such liens may be released to the extentthe companys debt is restructured so that it is below the triggering dollar threshold.There has been at least one instance where the court has upheld the position that whenoutstanding debt no longer triggers the requirements to provide an equal and ratable liento the bondholders, the liens securing the bonds may be decollateralized. 3

    (c) Anti-Cash Leakage Covenants. There are several covenants which usually govern theability of the company to use its cash: investments, restricted payments, affiliatetransactions and mandatory prepayments.

    (i) Investments . Investment covenants restrict the use of cash to purchase certainnon-ordinary course assets. These covenants also usually limits the acquisition of theequity of a company or the purchase of all or substantially all of the assets of a

    division or business unit of a company or the entering into of a joint venture with athird party.

    (ii) Restricted Payments . Restricted payments typically refers to equity-based payments,such as dividends, distributions or repurchases or redemptions of equity. Other broader restricted payment covenants might restrict any payments to sponsors,including management/sponsor fees, transaction fees and expense reimbursements,and any payments on indebtedness subordinated to the applicable debt security or any optional or early repayment of pari passu indebtedness. In many indentures, theconcept of restricted payments will include the investment prohibitions as well.

    (iii) Affiliate Transactions . Similar to restricted payments covenants, the principal concernaddressed by an affiliate transaction covenant is the monitoring of a companys ability

    to excise money from the corporate enterprise by entering into preferentialarrangements with its affiliatespayments that would be more than the affiliateswould be entitled to receive in arms length transactions. Credit documents typicallypermit affiliate transactions only on an arms-length basis. Sometimes the covenantimposes further restrictions such as requiring that transactions be in the ordinarycourse of business or, to the extent exceeding a certain dollar threshold, be approvedby the board of directors or considered fair by an investment bank.

    (iv) Prepayments upon Certain Events . While not strictly an anti-cash leakage covenant,debt documents commonly require prepayments of the outstanding debt securities incertain circumstances, such as asset sales, receipt of insurance or condemnationproceeds, issuances of indebtedness or equity, generation of excess cash flow or after a change of control. Some debt documents may require the company to make amandatory prepayment of the debt securities and other debt documents may requirethe company to tender for the debt securitiesa put right. A company may havesome relief from this provision in the form of reinvestment rights, where the company

    3 The Indenture was drafted to take a look at a single benchmark. It states that when over 15 percent of the [Consolidated NetTangible Assets] are liened, the Equal and Ratable Lien is automatically in place. It follows, therefore that when less than 15 percentof the CNTA are liened there is no right to an Equal and Ratable Lien. . . . The Indenture Trustees own representative . . .conceded that the release of the Equal and Ratable Liens was a routine event * * * anticipated by the terms of the [Indenture]. . . .[I]f the circumstances are right, [the Debtor] decollateralizes * * * the Company is entitled under the terms of its document, to dothis, and they did. Wilmington Trust Co. v. Solutia Inc . ( In re Solutia Inc.), 2007WL 1302609 (Bkrtcy S.D.N.Y.), 10 (2007).

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    would be permitted to avoid a mandatory prepayment or a tender by buying assetsuseful in the business.

    (d) Fundamental Changes. Other covenants govern the ability of the company to change itsfundamental operations. These include restrictions on non-ordinary course asset sales,fundamental changes (such as mergers or consolidations) and change of control.

    (i) Non-Ordinary Course Asset Sales . Asset sale limitations aim to ensure that the

    assets of the company on which investors made their credit decisions and, in thecase of secured investors, the assets on which their liens have attached, are notdepleted without replacement of value during the term of the investment. Debtdocuments usually limit asset sales outside of the ordinary course of the companysbusiness without the consent of investors.

    (ii) Fundamental Changes . Covenants prohibiting mergers, consolidations, sales of all or substantially all assets, or dispositions of a business unit or a division ensure that thecompany seeks advance consent of the investor before making significant changesto its corporate or capital structure.

    In indentures, the fundamental change provisions typically do not prohibit suchtransactions. Instead, the provisions require any new entity with which the issuer

    engages in a fundamental transaction to assume the obligations of the debt securityand agree to be bound by the terms of the indenture. In some indentures, there maybe an additional financial measure requirement (e.g., that the new entity has thesame or better consolidated net worth).

    (iii) Change of Control . To make sure that the companys sponsor or management groupremains in place, change of control provisions may be tied to the current equityholders control of the board of the company, a drop below a certain ownershippercentage, or any other equity holders gaining ownership of more than a certainpercentage. A change of control may also occur where the majority of directors areno longer the directors that were in place at the time the transaction originally closed,when the current directors were not appointed by the original board members atclosing, or when a key management personnel no longer works with the company.

    In loan transactions, a change of control typically results in an event of default thatallows all of the loans under the facility to be accelerated. In bond documents, on theother hand, a change of control often gives each bondholder an option to put thebonds to the companytypically at 101% of the principal amount of the bond.

    (e) Financial Covenants and Equity Cures. Most credit facilities have some financialcovenants that set baseline financial levels to give lenders an early warning system to apotential problem company. Almost categorically, breaches of financial covenants resultin an immediate event of default. In the past few years, many credit facilities contain nofinancial covenants (or one financial covenant which may not be tested until theoccurrence of some event), commonly referred to as covenant-lite loans.

    In addition, in deals where financial covenants exist, some companies negotiated theright to cure financial covenants defaults with contributions of cash by the sponsor intothe company (in the form of common equity or subordinated debt). The exercise of suchcure rights, if permitted at all, are usually limited in frequency and by a maximum amountthat may be injected on any single occasion or over the life of the loan. A cash infusion bythe sponsor often increases the companys EBITDA or decreases its net indebtedness,which, in turn, provides the company relief on its financial covenants.

    Other indirect cures that may be in credit documentation may take the form of aggregating baskets over several covenants or increasing the size of certain baskets by

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    adding the portion of excess cash flow not subject to a mandatory repayment or addingthe amount of an equity contribution. While none of these may have as direct an impacton the financial covenants on the company, the added flexibility could permit thecompany some ability to manage through a difficult financial situation which would havebenefited the company beyond the financial covenants.

    It is important to understand the implications of covenant-lite loans and cure rights(whether direct or indirect). These mechanisms provide a measure of relief to a company

    and potentially delay or frustrate the ability of an investor to engage in meaningfuldialogues with the company to restructure the credit or otherwise affect change.

    In most credit facilities, financial covenants are established as maintenance covenants, ineffect, requiring the company to achieve a measure of financial success. On the other hand, in most bond indentures, there are no financial covenants with financial measuresbeing used for incurrence based tests operative only to the extent the company desires totake certain actions. Incurrence-based tests provide much more flexibility to a companysince the company does not need to maintain a benchmark, but would just be restrictedfrom taking certain action. Maintenance covenants would require the company to performat a certain financial level and a failure to do so would result in a default.

    (f) Loan Assignments and Participation Restrictions. Many credit facilities may restrict the

    holder of a debt security to entities meeting certain eligibility requirements, such asfinancial institutions with a certain amount of capital or investment funds that ordinarilyinvest in debt securities. Some credit facilities may even require consent from thecompany in order for a lender to assign its debt securities. These hurdles may hamper the liquidity of the debt security to the extent the investor intends to assign the debt to athird party.

    (g) Ability of the Company to Purchase its Own Debt. Loan assignments and participationprovisions in credit facilities agreement should be carefully reviewed to determine if thecompany has the ability to purchase its own debt securities. Such an option may beattractive to a company if its loans are trading below par. An investment in its own loanscould enable a borrower to avoid more expensive prepayments at par and couldpotentially permit the company access to privileged communication which wouldotherwise be reserved solely among the lender group. Additionally, a company couldreceive a benefit under its financial covenants by repurchasing its own debt below facevalue.

    Some credit facilities attempt to restrict the ability of the company or an affiliate frompurchasing its own debt, limiting the ability to vote the debt it has acquired and control thedissemination of sensitive information about the company. In many bond indentures, theright to vote by affiliates of the issuer is limited as it relates to an affiliate by deeming suchsecurities not to be outstanding for purposes of voting.

    C. Rights Between the Investor and Other Investors

    In expanding the scope of review, the other area of concern should be on the rights of the potentialinvestor against other investorsboth within the same class of indebtedness and in separate classesof indebtedness.

    1. Other Investors Within Potential Investors Class of Security

    (a) Lender Voting Rights and Required Lenders. Understanding the voting structures of debtsecurities is critical and an investor needs to examine the operation of these provisionscarefully. Voting will be especially important in the context where an investor seeks totake a controlling position in a facility or purchases a stake sufficient to control anyrestructuring. Generally, amendments, waivers or other modifications require the consent

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    3. Intercreditor and Subordination Agreements. Investors in two or more classes may have anintercreditor/subordination arrangement to govern the rights between them. Thesearrangements may take the form of debt subordination, lien subordination or a combination of both. The terms of such arrangements vary considerably. In the absence of an agreement,the indebtedness would be pari passu and the liens would be governed by the lien priorityrules at law.

    (a) Some examples of debt subordination provisions are as follows:

    (i) Application of Collateral Proceeds. The debt holders typically agree that the senior debt holders must be paid in full before any proceeds are to be paid to the junior debtholders. Sometimes these provisions require the junior debt holders to turn over anyproceeds received by them in violation of this priority of payment.

    (ii) Payment Blockage. Senior debt holders may have rights to block payments to the junior debt holders upon a default or event of default under the senior debtdocuments or an acceleration of the senior debt. The length of a blockage periodusually varies depending on the triggering event. If the triggering event is a paymentdefault, the blockage period may be indefinite. On the other hand, if the triggeringevent is a covenant default (without an acceleration of the senior debt), the blockageperiod may be for a certain number of days, and the number of blockage periods may

    be limited.

    (iii) Waiver and Amendment Limitations. Senior and junior debt holders may agree tocertain limitations in amending their respective debt documents without the consentof the other class. Junior debt holders often agree not to amend their debt documentsin any material respect without the consent of the senior debt holders. Somerestrictions that may be agreed to by the senior or junior debt holders are restrictionson increasing the amount of senior debt, changing the interest rate and fees abovean agreed-to cushion, accelerating the amortization schedule and shortening thematurity date.

    (b) Some examples of lien subordination provisions are as follows:

    (i) Acknowledgment of Liens and Relative Priorities. Senior and junior lien holdersprovide mutual acknowledgements of their respective liens and their relative priorities(as to each other) and agree not to challenge those liens or priorities.

    (ii) Remedies Standstills. The senior lien holders may restrict the junior debt holdersfrom exercising remedies for a certain period. The standstill typically continuesbeyond the expiration of the applicable period if the senior debt holders havecommenced and are pursuing remedies against the company.

    (iii) Collateral Access Rights. Senior and junior lien holders typically agree to providemutual access rights to any shared collateral.

    (iv) Asset Sales and Releases of Liens . Usually, senior lien holders have the right tomake determinations regarding the release or disposition of shared collateral duringthe period when neither class is exercising remedies.

    (v) Buy-Out Rights . Intercreditor agreements may provide a junior lien holder with rightsto buy out the senior lien holders debt typically exercisable after the occurrence of anevent of default, an acceleration or other similar trigger. The purchase price for suchdebt is usually at par value.

    (vi) Senior Debt Cap. Junior lien holders may require the senior lien holders to agree tolimit the total amount of outstanding senior lien debt, which often is limited to the

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    maximum permitted principal amount (sometimes based on a borrowing baseformula) of the senior debt plus a cushion. The cushion may apply to a refinancing or to debtor-in-possession financing extended by the senior lien holders.

    (c) Some intercreditor arrangements include agreements if and when the company files for bankruptcy. Some typical bankruptcy provisions are as follows:

    (i) DIP Financing. Separate investor classes may agree that the senior debt holders

    may provide debtor-in-possession financing to the company within a certain dollar limit and agree not to object to such DIP financing or the priming liens granted inconnection therewith. In exchange, the junior debt holders may negotiate protectionssuch as receiving the same replacement liens as the senior debt holder receives or restricting a roll-up of the senior debt holders pre-petition indebtedness.

    (ii) Adequate Protection. In bankruptcy, secured creditors may be entitled to adequateprotection against diminution in the value of their collateral during the case.

    Adequate protection may take many forms, including replacement liens or currentcash interest payments on the outstanding principal amount of the pre-petitionindebtedness. Senior debt holders may attempt to negotiate a waiver by the junior debt holders of their rights to receive adequate protection for their junior debt.

    (iii) Use of Cash Collateral. To run its business in bankruptcy, a company may need touse its own cash cash collateral of the existing secured lenders. Under theBankruptcy Code, a company cannot use cash collateral unless the secured creditorsconsent or the company provides such creditors with adequate protection for suchuse. Oftentimes, junior debt holders waive their rights to object to the companys useof cash collateral in bankruptcy if such use is supported by the senior debt holders.

    (iv) Plan Voting. While atypical, some senior debt holders may be successful in requiring junior debt holders to waive certain voting rights on a plan of reorganization or towaive voting rights with respect to the appointment of a trustee.

    (v) Classification of Claims . The parties may agree that the senior lien holders and junior lien holders agree to support a motion to place each of them into separate classes of

    claims under a plan of reorganization for plan voting and distribution purposes whichmay make it easier for a senior debt holder to have its plan approved.

    (vi) Section 1111(b) Elections . In bankruptcy, if a secured creditor is under-secured, ithas a two-part claim. The first part is a secured claim equal to the value of thecollateral, and the deficiency is the unsecured second part. Under section 1111(b) of the Bankruptcy Code, a lien holder has the option of waiving the unsecureddeficiency component of its allowed claim and electing to have its entire allowedclaim treated as a secured claim.

    4. Rights of Other Investors Not Set Forth in Intercreditor Agreements. A potential investor mustalso be aware of the rights of other investors set forth in documentation underlying thecompanys other securities which may impact the potential investors rights under its debtsecurity. These rights may not be in the form of an intercreditor or subordination agreement,but may be set forth as a provision in the operative credit documentation. However, apractical effect of the operation of these provisions may serve to alter intercreditor rights.

    Cross-default and cross-acceleration provisions in debt securities other than the debt securityin which an investor may purchase could undermine the leverage of the investor. If aseparate class of debt securities cross-defaults or cross-accelerates upon an event of defaultor an acceleration of the debt security in which the investor holds, any negotiation or reorganization is complicated by the necessity of accommodating the cross-defaulted or cross-accelerated debt.

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    In addition, anti-layering provisions, which are usually in bond indentures and mezzanineloan documentation, could have an impact on restructuring the debt of a company. Theseprovisions typically prohibit companies from incurring debt that is senior in right of payment toexisting subordinated bond debt but junior to the companys senior secured debt. Theseprovisions effectively eliminate the creation of a middle class of debt securities and may limitwhat the company may be permitted to issue to the extent, for example, the company ismaking a debt exchange as part of its reorganization.

    While rare, other investors may benefit from more restrictive covenants that were thought tobe solely for the benefit of the one particular class of debt securities pursuant to theapplicable most-favored nation clause. Most-favored nation clauses provide that if any other debt security enjoys more advantageous provisions, such as covenants which may limit moreactions by the company or defaults with lower thresholds, that debt security is automaticallyamended to include such more advantageous provisions.

    In short, provisions such as those described in this section could provide rights to other classes of the companys security holders that may not be evident from a review of the creditdocumentation governing the debt security that the investor may purchase.

    III. Conclusion

    It is essential for an investor to understand the full scope of rights that a debt security may have at itsdisposal. It is also essential to understand the full scope of limitations. Equally important is anidentification of rights and limitations that may be absent. Many of these rights and limitations are set forthin the governing credit documentation, as well as intercreditor and subordination arrangements. Some of these rights and limitations may be structural, arising as a function of a companys corporate organizationor line of business. Conducting a thorough review of the credit documentation and the structuralorganization of a company will ultimately ensure the investor that the identified debt security is aworthwhile investment.

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    III. Basic Issues for Distressed BankDebt Market Participants

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    Basic Issues for Distressed Bank Debt Market ParticipantsDavid J. Karp

    Bank debt trading is largely unregulated, but industry participants and trade associations such as theLoan Syndications and Trading Association (LSTA) have developed standards and guidelines tostreamline the trading of bank debt. 1 This alert highlights some important issues that debt trading marketparticipants should consider as they trade. It is for general informational purposes only, and does notconstitute, nor should it be relied upon as, formal legal advice or a formal legal opinion. For trade-specificadvice, please consult with legal counsel regarding such trades particular circumstances.

    I. Determination of Proper Documentation (Par vs. Distressed)

    There are two kinds of bank debt trades: par and distressed. Each requires different documentation andraises different issues. Par trades require less documentation than distressed trades, as they only requirea Confirm, Assignment Agreement and a pricing letter, whereas distressed trades require a Purchase andSale Agreement (PSA), which is a standard LSTA form, but includes trade-specific terms along withstandard terms and conditions. In general, the distressed PSA provides for representations, warrantiesand indemnities relating to ownership, principal amount, funding requirements and the bad acts of prior holders.

    The choice of trade documentation is within the discretion of the parties. A potential for bankruptcy is themain reason credits will trade on distressed documents. When negotiating the transaction, the partiesshould consider a full range of factors regarding the borrower and the loan, including market price, currentor anticipated defaults, ratings downgrades and negative earnings trends or a spike in CDS levels, to

    determine whether par or distressed documentation is appropriate.2

    There is no bright-line test. Generally,once the parties have agreed, the type of trading documentation is binding regardless of subsequentchanges in the financial condition of the borrower or its business environment.

    II. Upstream Review and Step-Up Provisions for Distressed Trades

    Often, the loan that is the subject of a trade has been traded previously, perhaps multiple times.Upstreams are the documents pursuant to which previous trades were completed. At some point, acredit may shift from par to distressed (the Shift Date). Once a credit shifts, trades should becompleted on distressed documents. For many large credits, once a credit shifts, the LSTA conductsanonymous polls of dealers to assist in a determination of when certain credits began trading ondistressed documentation. The results of these Shift Date polls are available to facilitate discussionsbetween sellers and buyers and have no binding effect. Distressed trade buyers must review upstreams

    to confirm that previous trades were documented on distressed documents at any time after the credit

    1 Additional information may be found on the LSTA website at www.lsta.org.2 At the end of the fourth quarter of 2008, 57% of loans traded on the secondary market had a price of less than 70 cents on thedollar, while only 8% had a price greater than 90 cents on the dollar. See the 1Q09 LSTA Secondary Trading & Settlement Study. Atthe end of the first quarter of 2009, 39% of loans traded on the secondary market had a price of less than 70 cents on the dollar,while 28% had a price greater than 90 cents on the dollar. See the 1Q09 LSTA Secondary Trading & Settlement Study. Eventhough loan default volume slowed in April 2009, loan defaults still rose to their highest levels ever, with a default rate of 8.03% byprincipal amount. See S&P Leveraged Commentary & Data; May 1, 2009.

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    shifted from par to distressed. Trades on par documents after the Shift Date are defective and consideredless marketable.

    A buyer may request the inclusion of Step-Up Provisions in the PSA to cure defective trades. Step-UpProvisions make a sellers representations, warranties, indemnities and other covered provisions apply tothe current sale and to each previous sale after the Shift Date as of the date on which the closingconditions have been satisfied. Step-Up Provisions are designed to put the buyer in the same position itwould have been in without the defective upstream.

    III. Timing and Delayed Compensation

    The Trade Date is the date on which the buyer and broker agree to the material terms of the trade. According to LSTA standards, par trades are supposed to close in T+7 (Trade Date plus 7 days), anddistressed trades in T+20 (Trade Date plus 20 days) (each date, a Settlement Date). In practice, tradesrarely close on the Settlement Date. For example, according to a recent LSTA report, the current meantime to close a distressed trade is T+48. 3 Despite the prevalence of delays, the buyer must compensatethe seller for a trade that does not settle by its Settlement Date, unless the trade confirmation providesotherwise. This compensation is intended to put the parties in the same economic position they wouldhave been in had the trade closed by the Settlement Date, and is calculated pursuant to LSTA guidelines.

    IV. Assignment vs. Participation

    If the buyer meets the assignee eligibility requirements of the underlying credit agreement and obtainsrequisite consents, the trade may close as an assignment. As an assignment, the buyer becomes a partyto the credit agreement as a lender with the same rights as the original lenders, and the seller transfers tothe buyer all of its right, title and interest under the loan. 4

    If the buyer does not meet the eligibility requirements to take by assignment, the trade may close as aparticipation or other structure agreed upon by the parties. As a participation, the buyer receives abeneficial and economic interest in the loan but does not become a party to the credit agreement. Theseller remains the lender of record and the agent continues to deal solely with the seller.

    Generally, an assignment is preferable to a participation because the seller is removed from the process.Because funds first flow through the seller, a participation subjects the buyer to greater risk, such as

    commingling of funds and payment delays, as well as uncertainty as to whether the participation would becharacterized as a true participation by a court. If the participation is not a true participation, a court couldfind that the underlying asset is part of the bankruptcy estate of an insolvent seller, and the buyer wouldhave the same status as other unsecured creditors of the seller.

    V. Taint of Claim by Prior Holder

    Investors in the distressed bank debt trading space should be aware that, over the past several years,there have been significant developments in the law related to investor risk exposure when purchasingdistressed bank debt. In 2006, the U.S. Bankruptcy Court for the Southern District of New York ruled thatgood faith purchasers of bank debt were not protected from equitable subordination of their claims in abankruptcy proceeding if a prior holder of the claims had acted fraudulently (i.e., the taint caused by theprior holder ran with the claim). The U.S. District Court for the Southern District of New York in Springfield

    Associates L.L.C. v. Enron Corp. 5 reversed the bankruptcy courts ruling and reinstituted some protectionagainst equitable subordination for good faith purchasers of distressed bank debt.

    3 See the 2008 LSTA Secondary Trading & Settlement Year-in-Review.4 The scope of the rights that are subject of a sale/assignment agreement and the Fabrikant case regarding this issue are discussedfurther below.5 In re Enron Corp. , 379 B.R. 425 (S.D.N.Y. 2007).

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    The District Court ruled that even if a transferred claim would have been equitably subordinated in thehands of the prior holder, a subsequent purchaser of the claim who had no notice of the taint would beprotected against equitable subordination in a bankruptcy proceeding. Although the District Courts rulingwas seen as a win for traders in the distressed debt trading market in the wake of the worrisomebankruptcy court ruling, it was not a complete victory and investors should be aware of the rulingsimplications.

    The District Court made a distinction between a transfer by assignment and sale. An investor taking

    distressed bank debt by assignment would take the claim subject to the limitations it had in the hands of the assignor, namely subject to a taint caused by the assignors unlawful or fraudulent actions. Incontrast, an investor who purchases a claim under a sale takes the claim free of the taint. Therefore, theclaim assigned would be subject to, and the claim sold would be insulated from, equitable subordination.

    While the District Court did not give much guidance as to how investors can limit their exposure toequitable subordination by ensuring that their trades go forward as sales rather than assignments,investors should be careful to describe their trades as sales and notify their counterparties that their trades should be deemed such.

    More recent authority from the 7th U.S Circuit Court of Appeals has further helped to alleviate concernsabout the threat of equitable subordination of distressed bank debt by creating a limited safe harbor for purchasers of distressed bank debt while sidestepping the question of sales versus assignments

    addressed by the District Court in Enron . In In re Kreisler , the 7th Circuit held that a creditor that acquireda secured claim against a debtor by assignment would not be subject to having its claim equitablysubordinated to those of other creditors in the bankruptcy case, despite arguably inequitable conductengaged in by the original holder of the claim, unless evidence of actual harm to other creditors arisingfrom inequitable conduct was established in the case. 6 The Kreisler court used the terms sale andassignment interchangeably, indicating that the court did not view the distinction as dispositive, butinstead focused on whether the inequitable conduct by the original holder that tainted the claim actuallyharmed other creditors. If Kreisler ultimately receives positive treatment by other courts, purchasers of distressed bank debt can expect to receive protection from equitable subordination in the event that harmto other creditors cannot be shown.

    After Enron and Kreisler , the trend appears to be to provide greater protection from equitablesubordination to purchasers of distressed bank debt. However, as these matters are far from settled,investors should continue to be mindful of the Enron rule and other developments in this area as theyinvest in distressed bank debt.

    VI. Counterparty Risk

    An entity that files for protection under Chapter 11 is permitted to assume (affirm) or reject (disaffirm) itsexecutory contracts. 7 There is a risk in maintaining open trades with a counterparty who may file for bankruptcy protection. The risk is that the counterparty will be able to renege on the open trade, andrefuse to fund a purchase if prices have gone down (or refuse to sell if prices have gone up) since theTrade Date. The risk is magnified by the ability of a debtor to wait until the end of the bankruptcy case todecide how to proceed with executory contracts, such as open trades.

    VII. Information Access Considerations

    Bank debt trades presently fall outside the scope of federal securities laws, which prohibit securitiestransactions based on material non-public information (MNPI). Information may be considered MNPI if there is a substantial likelihood that a reasonable investor would consider the information important inmaking an investment decision, and such information has not been made available to general investors.Bank debt investors may gain access to MNPI and, therefore, need to take precautionary measures to

    6 In re Kreisler , 546 F.3d 863 (7th Cir. 2008).7 See 11 U.S.C. 365.

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    limit the use of such information for other trades considered securities transactions. Bank debt investorsshould take appropriate measures to minimize potential exposure to MNPI. Some firms establishinformation walls to separate traders that have received MNPI from those parts of the firm that tradesolely based upon public information.

    Bank debt investors may gain access to Syndicate Information, which is borrower information madeavailable to lenders and potential lenders, subject to a confidentiality agreement.

    In addition to Syndicate Information, an investor may gain confidential borrower information that otherwisehas not been made available to members or potential members of the syndicate (Borrower Information).

    An investor may gain access to such information in an advisory capacity or through participation on asteering committee or creditors committee.

    Engaging in a sale transaction with a counterparty lacking the same information (either SyndicateInformation or Borrower Information) could potentially raise common law fraud and/or misrepresentationconcerns. To resolve this issue, some parties have resorted to the use of big boy letters, in which bothparties acknowledge that they are sophisticated investors who may not have access to the sameinformation regarding the borrower, specifically disclaim any reliance on the others disclosures or omissions, and represent that they are entering into the transaction despite the information disparity andits potential effect on the value of the transaction. If drafted correctly a big boy letter may be useful indefending a fraud claim brought by a counterparty arising from the purchase and sale of distressed bank

    debt. To increase the likelihood of enforcement, the parties should clearly describe the type of informationbeing withheld (i.e., business plans, earnings projections, financial statements) as well as the withholdingpartys relationship with the issuer (i.e., committee member, advisor, board member).

    VIII. Transferred Rights

    Under the standard LSTA documents for sale/assignment transactions, the seller transfers to the buyer allof its rights (the Transferred Rights) 8 except those explicitly retained in the transfer documents. Thestandard documents provide for customary retained rights known as the Retained Interest. 9 Recently, inIn re M. Fabrikant & Sons, Inc. ,10 the Bankruptcy Court for the Southern District of New York examinedthe standard LSTA documents to determine whether a sellers reimbursement rights were transferredalong with the debt sold.

    In Fabrikant , the court authorized the debtors to use cash collateral pledged to its lenders as security for pre-petition loans, and granted the lenders, as adequate protection, an administrative priority claim for reimbursement of certain expenses, including attorneys fees (Reimbursement Rights). Soon thereafter,the lenders sold their loans on the secondary market pursuant to standard LSTA documents. Thecreditors committee later sued the lenders seeking to avoid the liens securing the pre-petition loans. Thelenders incurred substantial legal fees in defending these actions. When the debtors plan of reorganization failed to provide for the payment of the lenders legal fees, the lenders objected. Thelenders argued that the legal fees constituted Reimbursement Rights, that the Reimbursement Rightswere a Retained Interest not transferred to the buyers, and that the failure to provide for the payment of such fees rendered the plan not confirmable. Rejecting the lenders arguments, the Bankruptcy Courtheld that the Reimbursement Rights did not need to be paid to the lenders under the plan because these

    8 Transferred Rights is defined as any and all of [s]ellers right, title, and interest in, to and under the [l]oans and, to the extentrelated thereto, the following ( excluding, however , the Retained Interest (if any)): (e) all claims (including claims as defined in theBankruptcy Code 101(5)) and any other right of [s]eller against [b]orrower, any [o]bligor, or any of their respective [a]ffiliates See LSTA Purchase and Sale Agreement for Distressed Trades Standard Terms and Conditions.9 Retained Interest is defined as if Settled Without Accrued Interest is specified in the Transaction Specific Terms, the right retainedby [s]eller to receive. . . . payments or other distributions, whether received by setoff or otherwise, of cash (including interest), notes,securities or other property (including Collateral) or proceeds paid or delivered in respect of the Pre-Settlement Date Accruals or the

    Adequate Protection Payments (if any); provided that the Retained Interest shall not include any PIK Interest. See LSTA Purchaseand Sale Agreement for Distressed Trades Standard Terms and Conditions.10 In re M. Fabrikant & Sons, Inc. , 385 B.R. 87 (Bankr. S.D.N.Y. 2008).

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    rights fell squarely within the definition of Transferred Rights in the LSTA standard agreement and theBankruptcy Codes definition of claim 11 and, therefore, were assigned to the buyers of the loans.

    This decision confirms that the scope of rights assigned to a purchaser under LSTA documents is broad,and provides caution to sellers who may want to explicitly carve out certain rights aside from the RetainedInterest as part of a trade.

    IX. Conclusion

    The world of bank debt trading contains a number of legal issues that require careful diligence as well asthe assistance of counsel. Credit documents as well as trading documents need to be read and carefullyanalyzed in order to implement an effective investment strategy.

    11 Claim is defined as (a) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed,contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or (b) right to an equitable remedyfor breach of performance if such breach gives rise to a right of payment, whether or not such right to an equitable remedy isreduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured. See 11U.S.C. 101(5).

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    IV. PowerPoint Presentation

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    Disclaimer

    This information has been prepared by Schulte Roth & Zabel LLP for general informational purposes only. It does not constitute legal advice,and is presented without any representation or warranty whatsoever asto the accuracy or completeness of the information. Distribution of thisinformation is not intended to create, and its receipt does not constitute,an attorney-client relationship between SRZ and you or anyone else.

    Electronic mail or other communications to SRZ (or any of its attorneys,staff, employees, agents or representatives) resulting from your receiptof this information will not, and should not be construed to, create an

    attorney-client relationship. No one should, or is entitled to, rely in anymanner on any of this information. Parties seeking advice shouldconsult with legal counsel familiar with their particular circumstances.

    2009 Schulte Roth & Zabel LLP. All Rights Reserved.

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    Capital Structure AnalysisPresented byKirby ChinRonald B. Risdon

    Organizational Considerations

    Corporate organization

    Nature of a Companys Business

    Asset and Operations

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    Organizational Considerations

    Corporate organization

    Nature of a Companys Business

    Asset and Operations

    Covenant Package to Review

    Indebtedness

    Liens

    Financial covenants

    Investments

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    Interlender and Intercreditor Rights

    Unanimous lender actions

    Required lender actions

    Interlender and Intercreditor Rights (cont)

    Debt subordination

    Lien subordination

    Bankruptcy provisions

    Other rights

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    Distressed Investing:Trading ConsiderationsPresented byDavid J. Karp

    Purchasing Distressed Bank Debt

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    Par vs. Distressed Trades

    - Price is not a reliableindicator

    - Loans which are inbankruptcy or otherwiseconsidered to be in financialdistress

    - Still performing and paying

    Distressed Trades:Par Trades:

    What Makes a Credit Distressed

    Price is not a reliable indicator, so look at:

    Bankruptcy

    Potential need for restructuring or bankruptcy

    Is there a default or anticipated default?

    Ratings downgrade

    Negatives trends: earnings, ratings, macro pressureson the industry (ex. newspapers, gaming,automotive)

    Spike in CDS levels

    Market convention Shift Date Polls

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    Documentation

    - Upstream documents arereviewed

    - No upstream review

    - Seller provides reps andwarranties

    - Confirm, Purchase and SaleAgreement, AssignmentAgreement, Pricing

    - Confirm, AssignmentAgreement, Pricing

    DistressedPar

    Time to Settlement

    T+20T+7

    Distressed TimingPar Timing

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    Bankruptcy

    Bankruptcy is the overriding concern and themain reason a credit trades with distresseddocuments

    When the music stops, creditors are at risk of equitable subordination, recharacterization or vote designation

    Benefits of Distressed Documents

    Expanded and clarified description of what youare buying (litigation rights; rights againstupstream parties)

    Representations, warranties, indemnities whichinclude:

    Ownership, principal amount, no further funding,no litigation, no bad acts, no set-offs, noconsents required, no other documents

    Rights against prior holders

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    No Protection on Distressed Documents

    Generic credit risk

    Deficient collateral or structure

    Upstream Review

    Upstreams are the documents pursuant towhich the debt was previously traded

    Par trades do not require upstream review

    Distressed trades require upstream review

    Are step-up reps needed?

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    Step-up Provisions

    The Shift Date The date on which a credit shifts from par to distressed

    If an upstream trade was done on par documents after theShift Date, the trade is defective

    Step-Up Provisions Cure the defect

    Make Sellers representations, warranties, indemnities andother covered provisions speak to both the Seller andcovered prior Seller

    Uninterrupted chain of distressed upstreams from the ShiftDate onward

    Marketable to downstreams

    Assignment vs. Participation

    - If Buyer cannot meet the assignmentrequirements

    - Buyer may fail to qualify as an eligibletransferee by assignment for reasonsunique to Buyer ( e.g. , it lacks a sufficientcredit rating) or unique to the trade ( e.g. ,does not meet minimum trade or post-trade holding requirements of the CreditAgreement would not be satisfied)

    - Buyer receives a beneficial and

    economic interest in the loan but does notbecome a party to the Credit Agreement

    - If Buyer is eligible, the trade will closeas an assignment

    - Buyer becomes a lender with thesame rights as the original lenders

    - Agent, Borrower consent is generallyneeded

    ParticipationAssignment

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    Loan Repayment Flow of Funds Risk

    Bankruptcyof ExistingLender

    Participation

    NonBankruptcy

    Assignment

    Transferred Rights

    To Sell Is To Sell It All

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    Confidentiality and Ad HocGroup Issues

    Why Form an Ad Hoc Group?

    Common interests with a stronger unified voice

    Pool resources and expenses

    Shape or veto plan of reorganization

    Not appointed by U.S. Trustee

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    Borrower Confidential Information

    Usually includes MNPI that has been madeavailable to a lender because of its positionon a steering committee or creditorscommittee of the Borrower

    If a party trades on the basis of MNPI gleanedfrom Borrower Confidential Information, itmay be susceptible to allegations of

    (i) breach of fiduciary duty to the borrower, to thebankruptcy estate or to other creditors or;

    (ii) fraud claims

    Borrower Confidential Information

    Breach of Fiduciary Duty

    Bankruptcy Courts may approve informationblocking procedures and permit trading upon theestablishment of screening walls

    Fraud

    A big boy letter may provide protection in certaininstances

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    Big Boy Letters Keys to Enforceability

    Clear description of type and quality of informationbeing withheld business plans earnings projections or financial statements

    Non-disclosing partys relationships with the issuer committee member advisor member of the Board of Directors

    Counterparty acknowledges it has had the opportunity

    to conduct its own diligence

    Bankruptcy Rule 2019

    Verified statement setting forth:

    Names and addresses of the creditors or equitysecurity holders represented

    Nature and amount of the claims or interests

    Amounts paid for the claims and interests

    Any sales or other disposition of the claims or interests

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    Rule 2019 Disclosure of Trading Positions

    As of this date the application of Rule 2019 to adhoc groups remains unsettled

    Does not explicitly require disclosure of short or hedging positions

    2007 Scotia/Northwest

    2009 and beyond?

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    This information has been prepared by Schulte Roth & Zabel LLP (SRZ) for general informational purposes only.It does not constitute legal advice, and is presented without any representation or warranty whatsoever as to theaccuracy or completeness of the information. Distribution of this information is not intended to create, and its receiptdoes not constitute, an attorney-client relationship between SRZ and you or anyone else.

    Electronic mail or other communications to SRZ (or any of its attorneys, staff, employees, agents or representatives)