The looming maturity wall and funding gap

Executive summary

A large amount of debt will come due in the next few years (the maturity wall) and companies will not be able refinance their debt at the same interest rates or perhaps even refinance for the same principal amount (the funding gap).  

This article was originally published in the AIRA Journal.

Introduction

During the pandemic, an unprecedented amount of countercyclical fiscal and monetary stimulus was provided to the US economy to address a steep and sudden recession.  Congress provided over $1 trillion of fiscal stimulus through such programs as the $800 billion SBA Paycheck Protection Programs and the $230 billion Employee Retention Credit program.  In addition, the Federal Reserve dramatically reduced the federal funds rate^[1] and thus greatly decreased the cost of borrowing debt.  As a result, companies were able to incur debt at record low interest rates. Many companies and business owners took advantage of these very low interest rates and incurred large amounts of debt.  However, many of these loans will become due within the next few years.

We are thus seeing the effects of this “maturity wall” and “funding gap”.^[2]  In other words, a large amount of debt will come due in the next few years (the maturity wall) and companies will not be able refinance their debt at the same interest rates or perhaps even refinance for the same principal amount (the funding gap). 

Multiple investment management firms and financial news providers have estimated that over $1.5 trillion in US commercial real estate debt will mature by 2025.^[3]   In addition, $3 trillion in corporate debt will need to be rolled over in coming years.^[4]

One issue relating to replacing this debt is the consensus that interest rates will be 4-5% higher over a longer period and that creditors may not be willing to lend similar principal amounts. For example, a debt issued in 2020 of $900 million with a 4% interest rate will not be repeated in 2025.  Instead, a bank might be willing to make a loan for $350 million at a 7.5% interest rate.  This leaves $550 million funding gap that will still need to be paid off.  Debtors may have to turn to private creditors or other alternatives who still may not lend a company enough funds to cover their outstanding debt. This looming maturity wall is beginning to arrive now.  The more quickly corporations can foresee and address these issues, the more maneuverability they will have in controlling the process. 

The fictional case below is meant to highlight the issues corporations may face – as well as to highlight the relevant tax issues that may correlatively arise.

Case Study

Fabco, Inc. was formed in 2019 with $100 million of capitalization by its four founders.^[5] They were able to raise an additional $50 million in an IPO during the same year. In February of 2020, Fabco opened its semiconductor fabrication factory that was considered the most automated in the world at that time.  In April of 2020, the corporation closed on a $200 million debt financing with a 2.5% interest rate and a due date in 2025.

Due to shutdowns and supply chain issues during the pandemic, Fabco was unable to meet the large demand for its microchips during this time and thus lost out on a substantial amount of revenue.  By the 2023, the company had generated $300 million in losses.  In addition, their microchips had become obsolete per “Moore’s Law”^[6] and their order volume declined precipitously.  Fabco then made the prudent business decision to close their factory.  The company then focused all of its efforts to pursue patent litigation relating to infringements of its robotic automation and microchip design patents.  

Fabco’s market capitalization decreased from $50 million in 2020 to $2 million in 2023.  In 2024, Fabco issued a “clean” 10-K for the year ending December 31, 2023 and for their first quarter ending March 30, 2024.  As such, their auditor did not issue a “going concern” opinion^[7] based partially on the belief that they would prevail in their IP litigation. While Fabco’s debt was not publicly traded on an exchange, S&P Global (formerly IHS Markit) did reflect “indicative quotes”^[8] for its debt. This indicative quote reflected that the $200 million of debt was currently “trading” at 40% of face value.

Fabco received an unsolicited offer from its lead senior secured creditor to modify its $200 million debt by extending the maturity from 2025 to 2029, reduce the debt to an adjusted issue price of $50 million with 12% PIK interest,^[9] and to include “out of the money” warrants.^[10]  As such, if the IP litigation is successful, the creditors would have an equity “upside” based on the out of the money warrants.   

Fabco’s board of directors reached out to professional advisors to determine if they should accept the offer.  Fabco’s advisors noted that since the debt was publicly traded due to the indicative quotes and was in excess of $100 million, the proposed debt transaction would be treated as a taxable exchange rather than as a debt modification for federal income tax purposes.^[11] This would result in $150 million of taxable debt income, otherwise known as cancellation of debt income (“CODI”).^[12]

Cancellation of indebtedness income is taxable to the extent Fabco was solvent immediately before the exchange and Fabco would have to pay tax on the gain to the extent of such solvency.^[13]  The advisors then considered whether any of the CODI could be excluded from taxable income due to insolvency.  If a taxpayer is insolvent immediately before a CODI event, they may exclude the COD income, however only to the extent of such insolvency.^[14]  If insolvent, Fabco would then reduce its tax attributes, such as net operating losses, by the amount of such excluded CODI.^[15]

Fabco’s advisors noted that multiple factors will prove a challenge to argue that Fabco was insolvent immediately before the debt exchange: (1) the company still has a positive market capitalization which may indicate that the fair market value of the assets exceeds its liabilities; (2) the SEC 10-K filing did not reflect a going concern opinion; and (3) Fabco did not book significant impairments to intangibles for GAAP purposes.  There is thus not a reasonable likelihood that Fabco would prevail with the IRS in taking a tax position that they were insolvent, to any extent, immediately prior to the debt exchange.^[16]

The company then asked its advisors if they could avoid CODI by arranging for a related party to acquire its debt from the creditor at a discount. The advisors noted that section 108(e)(4) was enacted to prevent that tactic.  That section provides that if a person or entity related to the debtor purchases debt from an unrelated creditor, the purchase is treated for federal tax purposes as if the debtor purchased the debt from the creditor. Therefore, the purchase would generate CODI to the extent of the discount.

With insolvency being difficult to prove, the advisors discussed three potential alternatives: (1) reflecting the taxable CODI on the company’s 2024 tax returns; (2) pre-packaged bankruptcy; or (3) a Bankruptcy Code (“BK Code”) section 363 asset sale.

Taxable CODI

In this alternative, Fabco would reflect $150 million of taxable COD income on their 2024 tax return.  This taxable income could be offset dollar for dollar by the small projected 2024 loss relating to winddown and patent litigation costs. They could also use the net operating losses from 2019 through 2023, subject to the 80% taxable income limitation applicable to post 2017 net operating losses.^[17]

Assuming $0 operating income or loss for 2024, before the $150 million taxable CODI, $120 million could be offset by the net operating losses from 2019-2023.  This would result in $30 million of taxable income with a $7.5 million tax liability, assuming a 25% combined federal and state tax rate. In this scenario, the existing equity holders would continue to own the company in the short-term.  In the best-case scenario, if there is a substantial windfall from the litigation claims, the warrants issued to the creditor would produce a considerable amount of equity for them. In a worst-case scenario, if the litigation claims fail and the company would not be able to pay off the debt, inclusive of PIK interest, Fabco would likely file a liquidating bankruptcy where the shareholders would receive no consideration and the creditors would receive the FMV of the net proceeds from selling the remaining corporate assets.

Pre-packaged bankruptcy

Fabco could also reject the current offer and negotiate terms for a pre-packaged bankruptcy with its creditors.  In a prepackaged bankruptcy, the company and debtor agree on terms before the bankruptcy is filed.^[18]  This agreement must be voted upon by the shareholders before the company files for bankruptcy.^[19] The goal of a prepackaged bankruptcy is to have a much shorter proceeding with a considerable reduction in professional fees.^[20]

In Fabco’s circumstance, the existing shareholders would probably not retain their equity as the creditors would likely receive equity in exchange for their outstanding debt. The shareholders could, however, take a section 165(g)(1) capital loss.  This loss is available when a capital asset which has become wholly worthless anytime during the taxable year and thus could result in a deduction as if it is a loss from a sale or exchange.^[21]  

As the creditors would likely own 100% of the equity upon the effective date of the bankruptcy plan of reorganization, the company could avail itself of special bankruptcy rules under section 382(l)(5) or (l)(6) which might preserve some of the company’s net operating losses (“NOLs”) after emerging from bankruptcy.  Section 382 was enacted to prevent a corporation from being acquired solely for the use of tax attributes, such NOLs.^[22]  These special bankruptcy rules provide exceptions to the normal rules of section 382 that otherwise would place a substantial limitation on the ability of the loss corporation to utilize its tax attributes.^[23]  For Fabco, these losses might be available to offset a potential tax liability relating to any subsequent gains from the resolution of the IP litigation efforts and/or any sales of the IP.

Section 363 asset sale

Another alternative is that the company may choose to enter into bankruptcy and go through a BK Code section 363 asset sale.^[24]  In this case, the company would sell its assets and then satisfy its debt to the extent of the net proceeds from asset sale.^[25]  In a section 363 sale, the debtor auctions its assets to potential purchasers.  The Bankruptcy Court selects the bidder that is considered the highest and/or best bidder. The debtor and bidder then negotiate an asset purchase agreement.  Finally, the debtor will file a motion with the bankruptcy court seeking approval of the sale of the company’s assets at a bankruptcy auction and approval of the bid procedures that would govern the process of the auction. The bid procedures are intended to encourage competitive bidding to fully maximize the value of the assets. For Fabco, the creditors would most likely receive the IP.  However, in this case, it is possible that the creditor might accept the purchase of the IP by the founders, if they could mutually agree upon value. The creditors might accept such a sale of the IP to the founders if the founders believe there is a higher NPV for the IP claims than the creditors would.

Conclusion

In this hypothetical case study, Fabco was able to consider multiple alternatives to address their looming maturity wall.  The first option was a taxable modification of its $200 million debt with correlative CODI issues.  If the IP proceedings fail, the company may find itself in a liquidating bankruptcy procedure.   The company also considered a prepackaged bankruptcy and/or a section 363 asset sale.

The earlier a company identifies its debt issues and seeks professional advice, the more options the company will likely have to control the process.  Companies that have debt coming due in the next few years should seek counsel from their tax advisor to address this looming maturity wall and funding gap.

_{[1] The federal funds rate almost went to 0%.  For example, the rate was 0.05% in April of 2020.  See, https://fred.stlouisfed.org/series/FEDFUNDS.}

_{[2] Special acknowledgement to Joe Bruseulas, Chief Economist for RSM US LLP, for this terminology.  https://rsmus.com/people/joe-brusuelas.html}

_{[3] A $1.5 Trillion Wall of Debt is Looming for US Commercial Properties - Bloomberg}

_{[4] The logic of a Fed policy pause and then rate cuts in 2024 (rsmus.com)}

_{[5] This “Fab Four” should not be confused with the same appellation for the Beatles:)}

_{[6] In 1965, Gordon Moore, the co-founder of Intel, predicted that the number of transistors on an integrated chip would double between 12 and 24 months.  After 50 years – “Moore’s Law” has generally still held true despite tremendous technological advances.  As such, a microchip factory would become obsolete after a few years of operations.}

_{[7] Going concern is a presumption that there is substantial doubt that an entity has the ability to continue.}

_{[8] Indicative quote is a reasonable estimate of a current market price.}

_{[9] PIK is payment-in-kind interest.}

_{[10] “Out of the money” warrants  have an exercise price higher than the current market price of the instrument.} 

_{[11] In other words, this would be treated as Internal Revenue Code (“IRC”) section 1001 taxable exchange rather than a modification of debt, as this constituted a significant modification of a debt instrument per IRC regulation section 1.1001-3.  If the debt is >$100M and is deemed to be publicly traded (as is this debt instrument since there were indicative quotes) then there would be cancellation of indebtedness income equal to the difference between the adjusted issue price of the debt and the FMV of the debt if such modification occurred.  As further described, such cancellation of debt income would be taxable to the extent the corporation was solvent immediately before the exchange.}

_{[12] The actual determination of CODI would be more complex, and would include, for example, the NPV of the out the money warrants.}

_{[13] IRC section 61(a)(11).} 

_{[14] IRC sections 108(a)(1)(B) and (a)(3)}

_{[15] The order of attribute reduction is described in section IRC 108(b)(2).  While CODI is excluded from taxable income to the extent of insolvency, the loss of tax attributes can result in greater tax liabilities in years after the CODI event as such tax attributes would not be available to offset future taxable income / federal income tax.  As such, the taxpayer is provided a “fresh start” to extinguish debt without current federal income tax.  However,  federal income tax may thus be higher in later years due to the loss of such tax attributes.}

_{[16] The burden of proof is with the taxpayer to prove insolvency, in whole or in part.  This fact pattern is designed to put maximum stress on the determination of solvency / insolvency.  While the creditor appears to be accepting consideration that is below the adjusted issue price of the debt  - there are countervailing factors that make it difficult to assert the company is insolvent to any extent.  It is possible a formal valuation might establish some level of insolvency.}

_{[17] See, e.g., Net operating losses | Internal Revenue Service (irs.gov).}

_{[18] Bankruptcy Code section 1126.}

_{[19] See, [PFP#292021910] (uscourts.gov).}

_{[20] A prepackaged bankruptcy proceeding can be concluded in a period as short as one day.}

_{[21] IRC section 165(g)(1) and IRC regulation section 1.165-5.}

_{[22] See, for example, T.D. 8531; 59 F.R. 12832-12840.}

_{[23] IRC section 382(l)(5) provides that there is no section 382 limitation if certain creditors receive the equity of the corporation pursuant to a bankruptcy filing (though the net operating loss is reduced by interest paid to creditors during the change and prior 3 years).  If IRC section 382(l)(5) does not apply or the taxpayer elects out of the provision, IRC section 382(l)(6) would apply.  IRC section 382(l)(6) provides that the equity value of the corporation does not equal the pre-change value (the general rule) but rather equals the pre-change value plus the increase in value (if any) resulting from the surrender or cancellation of the creditor’s claim in the transaction.}

_{[24] Note that a BK Section 382 asset sale can also occur in conjunction with a prepackaged bankruptcy.}

_{[25] BK Code section 363.}