Bondholders forced to reckon with $4B tax threat in bitter credit feud

Patrick Drahi was running out of options to save his debt-ridden telecom empire.

Creditors had closed ranks under a cooperation pact, making it difficult for Optimum Communications to raise cash, and some had begun weighing whether to push the company, and its $26 billion debt load, into bankruptcy.

Then, Drahi's camp uncovered a new source of leverage they had on them: taxes. On June 1, the company told creditors that if they forced the issue, they risked triggering more than $4 billion of tax liabilities, a potential massive blow to their recoveries. The warning, part of a broader restructuring gambit, came as a shock to many investors, according to people with knowledge of the situation. Some rushed to sell out of their positions.

At the heart of the matter is whether the forced foreclosure of an Optimum unit, and a likely debt-for-equity swap, would trigger what tax lawyers call deconsolidation, essentially a kind of corporate divorce that could cause the IRS to treat the transaction as if assets had been sold, turning years of deferred gains into one enormous bill. Optimum's advisors, who unearthed the potential liability while orchestrating a controversial capital raise, quickly realized that because the penalty stood to be dramatically reduced if the parties instead came to a deal, it could be used to drag creditors back to the table.

Industry observers say that while deconsolidation is a known risk in restructurings, they can't recall a multibillion-dollar tax bomb ever being wielded so brazenly to gain an advantage.

Deconsolidation "costs, especially if immediate and painful, can incentivize all parties to reach a deal, and they're typically one pressure point in a much broader, highly complex negotiation," said Ari Lefkovits, founder of Apotheo Capital, a special situations-focused financial advisory and private investment firm.

Representatives for Optimum and creditor adviser PJT Partners declined to comment. White & Case, the company's legal counsel, and Akin Gump Strauss Hauer & Feld, another adviser to the creditors, didn't respond to requests for comment.

The tax threat marks Drahi's latest escalation in an increasingly bare-knuckled fight with creditors, testing the limits of distressed-debt warfare as he tries to keep control of a telecom empire spanning the US, Europe and Israel.

Late last year Optimum sued Apollo Global Management Inc., BlackRock Inc. and others on antitrust grounds, claiming their cooperation pact was an "illegal cartel."

Shortly after, Optimum raised billions from JPMorgan Chase & Co. using collateral that it shifted beyond the reach of some existing lenders.

Then came the June 1 announcement. Optimum unveiled a series of new moves that weakened creditors' hand further, including transferring key assets into an unrestricted subsidiary and raising capital at that entity. The most surprising element, though, was the taxes.

Just hours after the warning, lenders were holding calls questioning the $4 billion price tag and whether the company was simply bluffing, said the people familiar, who asked not to be identified discussing confidential talks.

Deconsolidation is essentially a corporate breakup that occurs when a parent no longer owns enough of a subsidiary for the two to be treated as a combined entity for tax purposes.

At Optimum the pressure point is CSC Holdings, the unit with more than $20 billion of borrowings at the center of the restructuring fight. If creditors try to take assets — including broadband, mobile and pay-TV businesses — or equity in the unit by putting it into bankruptcy, the tax code could treat it as a split from the parent, with the debt being wiped out effectively serving as the sale price. The bigger the debt pile, the larger the potential bill could become.

Creditors could, in essence, win control of CSC Holdings, only to see billions of dollars diverted to the government.

If "creditors try to force a hardball outcome, they risk significant value leakage and further pressure on their own recoveries," said Spencer Rolfe, a portfolio manager at CrossingBridge Advisors.

Optimum, for its part, is proposing a "consensual" restructuring in which CSC Holdings creditors get equity interests in the parent, a solution it says would mitigate the potential tax liability.

It would also likely benefit equity holders, including Drahi himself.

Bob Willens, a corporate accounting and tax expert at Columbia Business School, called the threat of deconsolidation "an effective negotiating tool." 

"Every dollar of tax liability avoided inures to the benefit of the creditors, so it would seem to be an easy sell to convince them," he said.

Next move

As lenders consider their next move, they're trying to determine how much leverage Optimum's warning really gives the company, the people familiar said. Some are convinced the threat isn't credible, and is simply an attempt to weaponize an otherwise arcane corner of the tax code.

That debate is already showing up in the debt. The company's $2.1 billion of 11.75% bonds due 2029 have stabilized just above 60 cents on the dollar. Still, that's down from the mid-70 cent range two months earlier. Its $2.8 billion term B5 loan is quoted at around 70 cents, according to Bloomberg pricing.

The creditor steering committee is in the process of deciding how to respond, the people added. Akin Gump, one of the committee's advisers, has been given access to the underlying tax analysis and is actively reviewing the basis for the company's claims, they noted.

"These creditors are giants of Wall Street, and I don't expect them to go down without a fight," said Vikash Harlalka, a media and telecom equity research analyst at New Street Research.