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Wednesday, March 26, 2014

M*Modal: Obsolete Technology?

I'm always intrigued when I hear of a company restructuring shortly after being sponsored by a private equity firm and getting new debt on the balance sheet. It takes a lot of due diligence, time and capital to sponsor a business, so when that business has to restructure so soon, I always wonder what the sponsors were trying to achieve and what drove their plans astray.

M*Modal is a good case study. It is a medical transcription company that was purchased by J.P. Morgan's One Equity Partners in a $1.1 billion deal in 2012. The company filed for Chapter 11 protection on March 20, 2014. Here's more:

"One Equity Partners, which J.P. Morgan has said it is spinning off as an independent firm, acquired M*Modal about 18 months ago in a $1.1 billion leveraged buyout. One Equity contributed approximately $447 million in addition to $20 million to pay down part of M*Modal's debt.

M*Modal owes about $500 million to a group of lenders led by Royal Bank of Canada,stemming from a $445 million term loan and $75 million revolving facility made in 2012. The company also owes more than $250 million in unsecured notes, for which US Bank is the trustee." WSJ

" 'The acquisition was financed with a capital structure aligned with a specific set of assumptions that are no longer relevant. As a result, there is a need to restructure the company's balance sheet to better align with changing market dynamics and refinements to our strategy,' Duncan James, M*Modal's chief executive said in a statement." Reuters

The first thing I thought of when I read the CEO's quote was fraudulent conveyance! Actual fraud would be very difficult to prove because it requires demonstration of intent to deceive the creditors. 

The M*Modal scenario could be grounds for constructive fraud, though. That is, creditors could surmise that the LBO was done at a valuation that was too high. As a result, shareholders received payment for which they surrendered less than equivalent value of stock, rendering the debtor insolvent. But, there's a safe harbor provision of the bankruptcy code that prevents constructive fraud to be used for failed LBOs: 

"The “safe harbor” of Section 546(e) provides, among other things, that a trustee may not avoid a transfer that is a “settlement payment” made pursuant to a “securities contract,” unless such transfer was made with actual intent to hinder, delay or defraud creditors. As a result, a trustee cannot avoid such a transfer under a constructive fraudulent transfer theory—i.e., that the transfer was made for less than reasonably equivalent value while the debtor was insolvent. Thus, it is fairly well settled that the Section 546(e) safe harbor prevents a trustee from avoiding payments to shareholders in connection with an LBO under a constructive fraud theory." Kevin Walsh and Joe Dunn at Mintz Levin

However, as the Lyondell case decision suggests, the safe harbor provision does not apply to fraudulent transfers under state law. 

"Notably, the claims were not asserted under any provision of the Bankruptcy Code (including Sections 544, 548 or 550), but were asserted by the Creditor Trust solely in its capacity as assignee of the creditors’ state law rights...

The Court adopted the reasoning of In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013) (“Tribune”), holding that the safe harbor in Section 546(e) does not apply to state law claims brought on behalf of individual creditors. Importantly, the Court drew no distinction between state law claims asserted by the creditors themselves (as in Tribune), or by the Creditor Trust as assignee of such claims." Kevin Walsh and Joe Dunn at Mintz Levin

So any claims of fraudulent transfers would have to be brought under state law. But the question remains: was this a case of a zealous buyout or did something happen to change the fundamentals of the company?

In the affidavit in support for the first day motions, CFO of M*Modal David Woodworth describes the crux of the problem in the following way: 

"Core Transcription Outsource Services (“TOS”)... constitutes transcription outsource labor, speech understanding, and workflow technology. In 2013, TOS accounted for more than 80% of  consolidated revenue.

Physicians generally use one of two methods to capture clinical data in a digital format: dictation or templated direct data entry through clinical documentation systems. Dictation allows physicians to use their voice to document patient interactions, which is converted into a text format for insertion into the Electronic Health Record (“EHR”). Direct data entry directly populates an EHR through templates or drop-down menus, typically with a laptop or other hardware device. The adoption of direct data entry with EHRs by the Company’s customers has proven to be highly erosive to TOS volumes."

Despite volume erosion, EBITDA margins have been steady at 21%. The company hired financial advisors in the fourth quarter of 2013 and took up cost-cutting measures. 

So, in my opinion, M*Modal doesn't seem like the story of a highly levered company that was expected to "grow into" its bloated capital structure. Rather, this appears to be a story of declining earnings due to a lack of demand for the company's products in a highly competitive marketplace, coupled with a mismatched corporate strategy. 

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