Debt swaps soar as ailing companies restructure; non-bankruptcy workouts provide creditor alternative.

Debt swaps soar as ailing companies restructure

To avoid the spectre of looming insolvency many companies are resorting to debt-for-equity swaps or similar real estate-related transactions to keep creditors from the door.

Jeff Chanin, president of Los Angeles-based Chanin & Co., said he is seeing a dramatic increase in business at his financial restructuring firm. "The phones have been ringing off the hook," he said.

Jeffrey Werbalowsky, a director at investment banker Houlihan, Lokey, Howard & Zukin Capital, said that his firm is "seeing more business opportunities than ever before."

Before restructuring, companies must identify whether the problem stems from operational or financial distress. In a recent analysis, Werbalowsky defined operational distress as failure caused by "mismanagement, product inadequacy, manufacturing and marketing inefficiency and industry downturn" among other factors. Financial distress deals with debt. And most companies hold a significant amount of it because the tax code offers juicy rewards to firms who carry debt instead of equity.

For companies exploring ways to restructure financially, there are several options. Werbalowsky said he is working on a linear regression analysis which factors into a mathematical equation pertinent variables to assess the true value of equity in a distressed situation.

And while firms have other options, many of them are filing for bankruptcy because current tax codes penalize those that work out financial problems through debt-for-equity swaps.

Non-bankruptcy, out-of-court workouts often carry hefty drawbacks. When a company exchanges debt for equity it is actually realizing the difference between the book and market value of the real estate. Because the transaction occurs out of court, the Internal Revenue System requires the company to pay taxes on any cancellation of indebtedness income because it is considered a capital gain. Bankruptcy law precludes the IRS from taking a share of gains from a discharge of debt.

Kenneth Klee, a lawyer with Stutman, Treister, Glatt in Los Angeles said that these workouts are complex "because court opinions have provided disincentives to swapping debt for equity outside the court." One such case that has thrown a monkey wrench into the dealings is known as the LTV decision. According to Werbalowsky, the decision "creates material risks for bondholders who participate in out-of-court exchanges prior to a bankruptcy filling. It's never going to help the creditor."

Klee predicted that as the insolvency business continues to burst at the seams of society, there will soon be "a shortage of experienced bankruptcy lawyers."

The outlook for businesses which referee these transactions is favorable. One such firm, Los Angeles-based Goodtab Corp. specializes in out-of-court workouts between issuers and bondholders of financially distressed companies. Goodtab Corp. primarily handles real estate transactions because the firm "has the most expertise in that area," said chairman Robert Goodman.

Goodman adds a new twist to the debt-for-equity concept by trading debt for assets. This way the creditors can walk away after the transaction is complete rather than remain involved in a troubled business. Goodman said he strives to swap for assets with a short maturity that can be sold for cash in approximately six to 18 months. To date, the company has negotiated the trade of about $250 million in high-yield bonds.

Davis Blaine, chairman of The Mentor Group appraisal firm in Pasadena, noted that one of the "biggest problems" is negotiating a deal satisfactory to all those involved. Goodman said he searches out the large but single bondholder as opposed to a group of creditors. "One bondholder has control over his destiny" in the transaction whereas the terms of the deal may not satisfy everyone in a group of creditors, he noted.