Description

Executive Summary 

The 10% First Lien Secured Notes (the “1L Notes”) of Mallinckrodt plc (“Mallinckrodt” or the “Company”), a pharmaceutical manufacturer which filed for Chapter 11 bankruptcy protection in October 2020 is an attractive investment.  The investment is a high convexity opportunity given that current trading levels seem to ascribe almost no value to a potential 21.2 points that would be realized upon a successful appeal of the recent denial of a make-whole premium triggered by the bankruptcy filing.  At current levels of 106.125% of par, the 1L Notes offer a 6% yield to the April 2022 call date (at 105%), thereby providing good downside protection under the current plan for these bonds to be reinstated under their current terms.

INVESTMENT THESIS

The 1L Notes, currently offered at 106.125% of par, is a high convexity investment opportunity with minimal downside and significant potential upside.  The 1L Notes, issued through an exchange offer in April 2020, are over-collateralized (~60% LTV) and receiving current 10% annual adequate protection payments paid quarterly.  According to the stated terms of the indenture, the 1L Notes are entitled to a “make-whole” claim, including interest, of approximately 21.2 bond points.  The strength of the make-whole claim lies not only in the clear language of the indenture, but also on an inter-creditor claim against second-lien bondholders, an independent basis for the make-whole. 

While I believe strongly in the propriety of the make-whole obligations, on November 5, 2021, the bankruptcy court rejected these claims.  Judge Dorsey of the Delaware Bankruptcy Court ruled that the 1L Notes could be reinstated, pursuant to the Company’s bankruptcy plan, without triggering these rights.  He determined that the bankruptcy default could be unwound and that the 1L Notes would be considered unimpaired upon reinstatement.  In addition, he ruled that the sharing provisions of the second lien intercreditor agreement would not be violated by the distribution of new notes to those bondholders, and that the 1L Notes could not look to those holders for make-whole recovery. 

As a result of Judge Dorsey’s ruling, the 1L Notes will likely be reinstated under their current terms.  While there is still a possibility that a settlement could be reached in order to make the bankruptcy plan consensual, my assumption is that the 1L Notes will be reinstated and subsequently redeemed on their April 15, 2022, call date at 105% of par.  I believe that the current 106.125% trading levels, implying a 6% yield to this first call date, represents good value and, therefore, strong downside protection.

Post-emergence, the 1L Notes will retain their rights to appeal Judge Dorsey’s decision.  I believe that the bankruptcy court ruled incorrectly on the make-whole claim and that strong grounds exist for the Third Circuit Court of Appeals to reverse this decision.  A successful appeal would provide for an upside case representing full payment of the 21.2% make-whole claim. 

BUSINESS OVERVIEW

Mallinckrodt is a pharmaceuticals manufacturer of specialty and generic drugs with its corporate headquarters in Dublin, Ireland.  The Company produces a range of medical and pharmaceutical products including rare disease treatments, immunotherapy products, acute care products, opioid and non-opioid pain products like acetaminophen and addiction treatment medications.  Its most prominent product, Acthar Gel, is an adrenocorticotropic hormone used to treat relapsing multiple sclerosis, infantile spasms, nephrotic syndrome, and a variety of other diseases.  The Company operates in two distinct business segments – Specialty Brands, which generated $2.1 bn of 2020 net sales, and Specialty Generics, which generated $690M in net sales. 

SITUATION OVERVIEW

On October 12, 2020, Mallinckrodt filed for bankruptcy in Delaware due primarily to an onslaught of pending litigation claims.  Entities associated with the Company’s specialty generics business had been named in over 3,000 lawsuits stemming from the Company’s production and sale of opioid medications.  Despite having spent more than $100 mm defending those suits, the Company still had faced significant unresolved claims.  On the specialty brands side, the Company faced more than 25 litigations and government investigations which exposed it to over $15bn in potential damages.  The majority of these litigations related to Acthar, which was the subject of a rebate pricing dispute with the Centers for Medicare and Medicaid Services (CMS). 

The Company took several liability management steps prior to its bankruptcy filing to address its highly-levered capital structure.  With numerous unsecured bond maturities approaching, the Company exchanged several issues of its outstanding notes for $495mm of new 1L Notes and $323mm of new 10% Second Lien Secured Notes (the “2L Notes”).  Pro forma for these exchanges, the Company has $1.6bn of unsecured notes outstanding.  In addition, the capital structure includes additional first lien debt comprised of two term loans and a revolving credit facility totaling $2.8bn. 

Given the large number of claimant classes seeking recovery from the Company, the restructuring process has been complex and contentious.  Over the course of the past year, the Company resolved many of these claims and, on April 20, 2021, filed a proposed Plan of Reorganization incorporating these settlements.  The Plan, as subsequently amended, now has the support of most claimant classes.  The Plan compensates opioid plaintiffs through the establishment of an opioid claims trust funded with $1.6bn over seven years and warrants for 19.99% of the reorganized equity.  Government Acthar claims, including CMS, the DOJ and state governments would receive $260mm of cash payouts over a seven-year period.  The first lien revolving facility would be paid in full in cash, first lien term loans would be either paid in full in cash or issued new take-back term loans, 2L Noteholders would receive new 2L Notes and general unsecured claims be compensated through a GUC trust pool initially funded with $135mm of cash.  The Company’s unsecured noteholders would receive $375mm of new seven-year second lien notes plus 100% of the reorganized equity, subject to dilution by the opioid trust warrants and a 10% management incentive plan. 

Confirmation of the debtor’s proposed Plan of Reorganization began on November 1, 2021.  The first phase of the confirmation process was completed on November 5, with the second phase scheduled to begin on December 6.  In the interim, the court held a trial to resolve a significant outstanding issue involving claims brought by Attestor, a holder of insurance company claims, and insurance company Humana.  These claimants alleged that the Company had charged highly inflated prices for Acthar as a result of illicit monopolistic actions.  They have sought recognition of a post-petition administrative claim of approximately $300mm, an amount that would likely require the current Plan of Reorganization to be scrapped and fully renegotiated.  The market’s concern over this issue was reflected by the approximately 15 point decline in the price of the Company’s unsecured notes when Judge Dorsey denied a summary judgment motion against these claims on September 29.  Since then, these bonds have recouped much of those losses as the trial has been seen as highly favorable for the Company. 

While I expect phase 2 of confirmation to also raise contentious issues (including claims by an ad hoc group of Acthar plaintiffs consisting of various municipalities and unions), the Company’s Plan is likely to be approved by the end of January.  A required subsequent filing of Mallinckrodt’s holding company in Ireland will likely take another few months to wrap up, leading to a likely bankruptcy emergence around the end of the first quarter 2022.  After emergence, the 1L Notes will be well positioned to pursue their appeal.

ANALYSIS

The indenture governing the 1L Notes provides, in exceptionally strong terms, that the 1L Notes are entitled to the payment of an “applicable premium” upon a bankruptcy filing.  Specifically, Section 6.02 of the Indenture states that upon an event of default pursuant to a bankruptcy filing the Notes become “immediately due and payable” and entitled to receive “an amount equal to the Applicable Premium.”  The Applicable Premium is defined according to a make-whole formula equal to the redemption price of the Notes at the first call date plus all interest payments due on the Notes through that date, using a discount rate equal to the prevailing Treasury Rate plus 50 basis points.  Further, the indenture makes clear that the Applicable Premium “shall be deemed to be principal of the Notes and interest shall accrue on the full principal amount.”  I calculate this full make-whole claim as equal to 121.2% of the Notes’ par value.

The indenture includes explicit Company acknowledgments that the make-whole payment is “reasonable”, “the product of an arm’s length transaction between sophisticated business entities ably represented by counsel,” a “material inducement to holders to acquire the Notes” and that the Company “expressly waive[s]” the provisions of any law or statue that may prohibit the premium.  This additional language was added in conjunction with the 1L exchange that created the 1L Notes in April 2020.  It is clear that the 1L holders demanded such representations given that the parties clearly knew at that time how likely a bankruptcy would remain even with the exchange.  Unsurprisingly, the bankruptcy filing occurred only six months after the issuance of the 1L Notes.  I believe the 1L make-whole language to be of the strongest such provisions I have seen in a major public bond issue.

Despite this strong language, the bankruptcy court rejected the 1L make-whole claim.  Judge Dorsey ruled that the 1L Notes were not impaired, due to the quarterly 2.5% adequate protection payments they have been receiving, which closely approximates the 10% semi-annual coupon they were supposed to receive.  He also relied on a supporting case from Texas (EP Energy) where a bankruptcy judge issued a preliminary ruling in a similar matter denying a make-whole claim where the bankruptcy filing was the only such trigger for the claim.  I find Judge Dorsey’s ruling to be unconvincing and believe he failed to recognize the circumstances that led to the indenture’s negotiation.  The Third Circuit, which has shown a strong propensity to recognize bondholder make-whole rights (as demonstrated by its 2016 Energy Future Holdings ruling) is more likely to appreciate the steps taken by the parties to include language specifically designed to trigger a make-whole payment in this circumstance.  As a result, I believe the Third Circuit will ultimately reverse Judge Dorsey’s decision.

The Company’s proposed Plan had created a toggle structure for the 1L Notes, depending on how Judge Dorsey ruled on the make-whole claim.  In the event that the bankruptcy court had awarded the 1L make-whole claim, the Plan called for the issuance of new “cram-down takeback notes” to the 1L Note holders.  I was skeptical that these new notes would trade at par, thereby reducing the 1L recovery.  However, with the court rejecting the make-whole claim, the Plan instead called for reinstatement of the 1L Notes under its current terms pursuant to Section 1124(2) of the Bankruptcy Code.  I believe the Company will choose to call these high-coupon bonds at its 105% call price on the April 15, 2022 call date, providing a downside yield of ~6% based on current market levels. 

The ad hoc 1L Noteholders group includes a group of funds holding over 50% of the outstanding 1L Notes.  Negotiations with the Company to settle the make-whole dispute had focused on the issuance of new notes with varying proposals regarding the allowed claim (as reflected in the new principal amount), the coupon and possible fees to the holders.  Negotiations over the summer did not lead to a settlement but revealed proposals for a recovery range in the range of 112-116% of par.  It is still possible that a settlement could be reached.  However, given the court’s ruling on the make-whole claim, any settlement would likely be lower than these prior levels.

I also believe that the Third Circuit will allow for the 1L Notes to pursue recoveries against the 2L Notes pursuant to the existing intercreditor agreement between the parties.  I believe Judge Dorsey ruled incorrectly that the new notes to be awarded to the existing holders of 2L Notes did not constitute a distribution of the debtors’ property.  If the Plan had simply reinstated the 2L Notes, I believe the intercreditor provisions would have been more difficult to apply, but that the issuance of new notes clearly represents a new distribution of property.  I believe the Third Circuit would likely agree with this interpretation.  While several procedural obstacles need to be overcome, I believe that, at a minimum, the 2L Notes could be forced to turn over adequate protection payments it had received during the pendency of the bankruptcy case to the 1L Notes. 

After a final order on the make-whole dispute is issued by the bankruptcy court, the 1L Notes will be able to pursue its appeal.  Interestingly, the principles of equitable mootness should not apply since a future damage award to the 1L Notes would not materially disrupt the Company’s emergence plans or the recoveries to other classes.  The amount at stake for the make-whole is approximately $95 mm, an amount the Company could reserve against and satisfy either as a cash payment or as additional principal to the bonds.  Further, the potential overhang of this potential appeal to the capital markets could serve as a motivating factor for the Company to settle this claim prior to exiting bankruptcy protection. 

Catalyst

I believe that the upcoming plan confirmation and subsequent emergence will be an ideal opportunity for the Ad Hoc Committee to file their appeal to the Third Circuit Court of Appeals.  Based on historical precedents, it is likely that the Third Circuit Court of Appeals will rule in favor of the Ad Hoc Committee and reverse Judge Dorsey’s ruling.