The Hertz Corporation must look at AMC Entertainment and wonder what might have been. Hertz, pummelled in the early weeks of pandemic, filed for Chapter 11 bankruptcy in May last year. However, in the weeks afterwards, its shares surprisingly rallied around 800 per cent amid a surge of buying by retail traders on the Robinhood app.
The company quickly received court approval to take advantage of its quirky trading to sell new shares where proceeds would partially fund its restructuring. Ultimately it proved all for naught as the US Securities and Exchange Commission declined to sign off on the risk disclosures made to investors. Hertz would never sell its shares, instead moving on to an expensive senior loan.
Meanwhile, the cinema chain AMC has arguably been hammered at least as much by stay-at-home orders as Hertz. In its most recent quarter, AMC’s recently stated that its US attendance is down 91 per cent year-over-year. To stay afloat the company has executed a series of financial engineering manoeuvres including debt issuances and swaps. But it also has sold $250m worth of stock in recent months.
AMC in its disclosures has even broached the possibility of a bankruptcy filing and warned that stockholders “would likely suffer a total loss of their investment”. However, the SEC, unlike in the case of Hertz, has not objected despite the similar plights of the two companies. The key distinction between the two: Hertz has formally entered bankruptcy, a decision that has constrained its options to raise cheap financing just when it needs it most.
Given its efficiency and fairness, the American Chapter 11 process in many ways is the envy of the world. But the Hertz saga has some experts wondering if change is needed to enhance the system.
For those making a risky bet on Hertz shares after its bankruptcy, the worry was less that its equity would remain worthless forever. Rather, bankruptcy law triggered the “absolute priority rule”. According to this standard, every creditor at the end of the bankruptcy stint must be repaid 100 cents on the dollar before any lower-ranked claimholder can receive a penny of recovery. Hertz’s shareholders would have had to hope that the company’s prospects recovered quickly enough to pay off its creditors before the bankruptcy ended in a year or 18 months.
Analysts at the research firm CreditSights have estimated that the most junior Hertz debt, which is trading at under 50 cents, will be impaired in the restructuring aimed at being completed this year. As such, the absolute priority rule holds that shareholders, who rank below junior bondholders, will have their investment wiped out.
The absolute priority rule tends to shift power to senior creditors. Two University of Chicago professors, Anthony Casey and Joshua Macey, wrote in a recent paper about Hertz: “By giving senior investors significant control rights, the absolute priority rule reduces the likelihood that junior creditors and shareholders will provide new financing to a debtor in bankruptcy even if those investors place the highest value on the firm.”
Hertz argued that selling stock to willing buyers was a great deal for all parties in the case. It would have avoided having to pay interest or give up collateral that a loan would require. Moreover, since equity was at the bottom of the totem pole, Hertz creditors did not worry about being leapfrogged.
Profs Casey and Macey now argue for a new “relative priority” standard in Chapter 11 where junior creditors or equity holders would have a chance to wager on a sharp but unlikely turnround and such would be willing to provide cheaper financing in exchange. “Unlike absolute priority, relative priority allows junior investors to recover their option value even if senior creditors are not paid in full,” the pair write.
Absolute priority has persisted because it is straightforward and easy to apply. Departing from that could introduce complexity and weaken the rights of senior creditors.
AMC’s junior debt is trading at severely distressed levels. Those brave or foolish enough to buy its shares are betting the company will see a recovery before being forced to file for bankruptcy and reorganise.
Most companies try desperately to avoid bankruptcy and restructure out of court. The generic reasons are that it is highly expensive and time-consuming. With the Chapter 11 absolute priority rule, the process has proven even tougher for companies such as Hertz.