The recent spate of liability management transactions has curtailed the quantity and quality of Chapter 11 bankruptcy filings in 2023. Although these filings have seen a slight increase when compared to 2022, they still fall short of the tally during the pre-pandemic period. The surge in liability management transactions can be attributed to loose restrictive covenants within borrower-friendly loan agreements and bond indentures among other factors, as gleaned from Epiq Global.
These transactions can often be conducted outside of the courtroom and may involve any of the following:
- Debt exchanges where the borrower issues additional debt to an existing lender that is senior to existing debt (up-tiering).
- Businesses making open market discount debt repurchases.
- Transfer of a business or assets to a new subsidiary, which can take on additional debt (drop-down financing).
While the aforementioned ventures can be rewarding for the borrower, resulting in a significant debt reduction on their balance sheet, debt exchanges that materialize at a discount to face value bring forth considerable tax implications that necessitate carrying out the transactions through the bankruptcy process.
The role of CODI (Cancellation of Indebtedness Income) is pivotal in gauging the tax implications of chosen liability management alternatives. When debt is canceled for less than its face value, the borrower must recognize CODI. Tax on CODI can be evaded outside of bankruptcy under Section 108(a)(1)(B) of the Internal Revenue Code, by offsetting CODI via decreasing the tax attributes like net operating losses and the tax basis of assets; provided the borrower has met the criteria of insolvency.
Facets like customer impact, employee and supplier relationships, the concomitant cost, and negative publicity tied to bankruptcy, alongside the facility to involve non-consenters are all on the table when assessing a proceeding for bankruptcy. In addition, the potential exposure to significant cash tax liabilities tied to CODI often nudges borrowers to opt for bankruptcy filings to evade the subsequent dent in their liquidity and viability.
Obtaining accurate valuation and tax advice from a credible firm is a must for borrowers involving themselves in any liability management transaction. This will aid in making informed decisions on how to proceed—out-of-court versus bankruptcy—and protect against potential IRS scrutiny of their insolvency determination.
This article was penned by Jerry Schwartzman, Michael Krakovsky, and Adam Jorgensen at Stout, who specialize in the diverse dimensions involving liability management transactions.