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Dealing with debtholders.

Dealing With Debtholders

The 1980s taught American corporate managers an important lesson: the importance of managing for public ownership. The combined forces of takeover mania, junk bond financing, institutional activism, and a stock market increasingly influenced by technical factors forced corporate boards and managers to recognize that they had long been neglecting an important part of their job. Programs to improve the management of public ownership began to emerge in the 1980s, initially as defensive tactics and then as programs to identify and communicate with beneficial owners.

The 1990s add a new dimension to the management of public ownership: debtholders. Largely because of the overleveraging policies of the '80s combined with the current recession, an increasing number of companies are being forced to recognize that relations with their debtholders, rather than just equityholders, have become a critical part of their responsibility. The statistics are revealing: * According to a recent Commerce Department report, in the third quarter of 1990 interest expense of American corporations was 25.4% of total cash flow vs. 15.1% in 1988. Unlike the 1980s, companies facing financial difficulties in the 1990s are generally those with fundamentally sound businesses. Because of business pressures created by the current economic slowdown, cash flows are falling short of aggressive growth projections (a legacy of the '80s) and are insufficient to service debt. * This trend is confirmed by a Moody's Investors Service Inc. report that in 1990, downgrades of corporate debt outpaced upgrades by 4.4 to 1. This record pace compares with a ratio of 3 to 1 during the 1982 recession - the previous record for the post-World War II period. In dollar terms, these downgrades amounted to $354 billion, or 38.7% of American companies' total outstanding bonds in the domestic and international markets. * Standard & Poor's Corp. reported that in 1990 the number of downgrades of corporate issues increased to 768 from 419 in 1989. These downgrades represent $510.1 billion (vs. $174.4 billion in 1989), of which $14 billion went into default. The default increase compares with a mere four companies with $217 million of public debt in 1980. Standard & Poor's expects defaults on corporate issues to rise to between $15 billion and $20 billion in 1991.

Faced with these problems and a cash flow squeeze, a corporation must address the problem of dealing with debtholders. For most companies, this presents a special set of challenges. Even when a company has been diligent in its relations with equityholders, it is likely to have neglected its debtholders. Because of historical differences in the nature of debt and equity and our tradition of corporate governance that gives voting rights to debtholders only under extraordinary circumstances, we have developed some bad habits. Most companies make no effort to communicate with their debtholders, or even to identify who they are, until the point of a crisis.

This approach puts companies at a severe disadvantage. They are automatically on the defensive, and they must approach debtholders hat in hand, with no established relationship and no base of understanding upon which to argue for support in their recapitalization. Starting from scratch is always more difficult than building on a base of understanding.

When management has concluded that a recapitalization is necessary, three methods are available: exchange offer, Chapter 11 reorganization, or prepackaged bankruptcy reorganization.

Exchange Offers

Exchange offers are designed to substitute new forms of corporate securities, with differing maturities, priorities, face amounts, principals, and interest rates, in exchange for existing obligations that the company is unable to meet. Waivers of different provisions of bond indentures necessary for the exchange require various levels of support from bondholders. Certain covenants can be waived by a majority of the bondholders; others require two-thirds approval. Generally, principal and interest payments cannot be waived, therefore requiring unanimous consent.

Companies may make offers to buy out creditors for cash, with the consideration representing a substantial haircut from the face value of the claim but at a premium over the then current market value. However, due to the voluntary nature of an exchange offer, no bondholder can be forced to give up rights to cash interest or principal payments outside of a Chapter 11 plan.

A less expensive type of exchange offer is provided under Section 3(a)(9) of the Securities Act of 1933, which exempts the transaction from registration requirements provided that the entity offering the new securities is the issuer of the old securities (for example, a subsidiary cannot make an exchange offer to its parent's bondholders), the exchange is made exclusively to current holders, and no commission or remuneration is paid to solicit exchanges. An information agent may be used in 3(a)(9) offers, but no recommendation regarding acceptance or rejection of the offer may be made.

Because of their voluntary nature, exchange offers present a situation in which it is critical for management to communicate effectively with debtholders. The complexity of these transactions, the tax implications, the high minimums usually required for successful resolution of the company's financial problems, and the opportunity for bondholders to play a game of "brinkmanship" to extract concessions and sweeteners from management are all factors that make an exchange offer a true test of a company's ability to "manage" its debtholders. Clearly, it is much easier to negotiate an effective exchange offer if management has kept its bondholders informed about both the company's business plans as well as its problems well in advance of the recapitalization crisis. Debtholders who understand a company's business are much more likely to support measures designed for long-term results rather than focusing exclusively on their short-term interests.

Chapter 11 Reorganization

In contrast to the voluntary nature of an exchange offer, a Chapter 11 recapitalization is compulsory. During the first 120 days of the Chapter 11 case, the debtor company is granted the exclusive right to propose a plan of reorganization. During this period of "exclusivity," the company has the opportunity to negotiate with interested parties a plan of reorganization. If formulated, a company has an additional 60 days to solicit consents to its plan.

A class of claims is deemed to have accepted the plan if two-thirds in dollar amount and more than one-half in number of the members of the class vote to accept. A class of equity interests is deemed to have accepted the plan if two-thirds shares of the voting accept.

In addition, if some impaired classes of claims and equity holders approve the plan and other classes reject the plan, the bankruptcy court may confirm and "cram down" the plan on dissenting classes if the court determines that the plan does not discriminate unfairly, is fair and equitable to each class, and that the dissenting classes will receive more under the plan of reorganization than they would if the company were liquidated. However, there can be no cram down of a rejecting class if the rejecting class will obtain less than the full value of their claims and a more junior class will receive any value at all under the plan of reorganization.

Obviously, the negotiations between a debtor company and its creditors under a Chapter 11 reorganization are shaped by the rules of bankruptcy. Nevertheless, the measure of goodwill and understanding the parties bring to the bargaining table is just as important under these circumstances as in a voluntary recapitalization. Whether or not a company's cash flow problems lead to Chapter 11, the need for ongoing communication with debtholders is apparent.

Prepackaged Plans

The last method, a prepackaged bankruptcy reorganization, is provided for in Section 1126(b) of the Bankruptcy Code. This approach combines the speed of out-of-court settlement and the advantages of Chapter 11.

In a prepackaged plan, the company devises its restructuring and seeks approval from at least 50% of its bondholders holding at least two-thirds of its debt prior to the Chapter 11 filing. In addition, if the court confirms the prepackaged plan, its terms are then imposed upon the dissenting minority, and the company can leave bankruptcy sooner than the usual 18 months to three years. The ability to solicit acceptances of its plan before creditors and equityholders are organized with official committees affords the company an advantage in achieving a speedy resolution to its problem.

Whitman, Heffernan, Rhein & Co. recently advised Intrenet Inc. (formerly Circle Express Inc.) through its successful prepackaged bankruptcy, which commenced solicitation in August 1990 and was confirmed by the court in November 1990. LaSalle Energy Corp. started soliciting votes for its prepackaged reorganization in June 1990, and the plan was confirmed in September 1990.

Tactical Considerations

The three recapitalization methods outlined cannot be chosen in a vacuum. They must be evaluated in the context of the issuer's investor base. Who are the beneficial owners behind the street names who will be voting? What are their modi operandi? By identifying and analyzing the bondholder composition prior to structuring the recapitalization, the debtor company can avoid costly mistakes and delays and can complete the transaction without the extensions that have become all too common.

The mix of beneficial owners of a company's bonds, no doubt, will have changed considerably during the time after original issuance. Thrift institutions and life insurance companies may have been required to dispose of high-yield securities. The Resolution Trust Corp. may own some bonds now. Mutual funds will have bought and sold bonds to upgrade credit quality of portfolios and reduce commitments to riskier investments.

The nature and negotiating parameters of bondholders vary considerably. Insurance companies typically do not mark their securities to market. They want to preserve their original investment. By contrast, mutual funds mark their securities to market daily and tend to evaluate recapitalization proposals in the light of their current carrying value.

A new type of investor, the "vulture fund," was certainly not on the company's original bondholder list. Vulture funds purchase bonds at deep discounts, hoping to recognize significant gains either in a restructuring or as a result of bankruptcy. They are generally highly motivated to complete an out-of-court restructuring as long as the value exceeds their estimate of a bankruptcy recovery. Vulture funds view the reorganization value of their securities as their "downside" and often seek to take control of the company through an equity exchange.

Both mutual funds and vulture funds generally want highly liquid securities and are willing to accept equity. On the other hand, insurance companies usually want to preserve their principal and are less concerned about liquidity. These objectives are key determinants in the voting position taken by the various institutions.

Leadership has emerged. Bondholders have become highly organized, forming bondholder committees and steering committees. The steering committee is often given access to an issuer's confidential data to assist in negotiations. In the negotiation, bondholders' principal concerns are:

- their absolute level of recovery;

- the form of consideration given;

- the viability of the restructured business;

- their estimation of the value of legal claims against the issuer and/or senior lenders that must be foregone in order to accept out-of-court restructuring; and

- treatment of holdouts.

Whether the company is negotiating with par buyers (investors that have owned the bonds since they were originally issued at par) or vulture investors, it can expect a much higher degree of sophistication and aggressiveness.

As a group, investors are demanding better terms, including cash and other sweeteners. They are more often willing to take controlling equity stakes. People and funds, some familiar (such as Carl Icahn and George Soros), and some not (such as Stanford Phelps, Michael Steinhardt, Water Street Recovery Fund I, and R.D. Smith & Co.), are emerging as key market participants. And then there is Sam Zell, self-proclaimed as "The Gravedancer," who, for the holidays, sent money managers six-inch statuettes of himself dancing on a company's grave.

Every transaction these days has a story. Southland Corp., after three extensions, failed to get 95% approval in each of five classes of bondholders. Southland then filed a prepackaged bankruptcy plan, requiring only two-thirds approval from the bondholders, and got it. However, dissident bondholders objected on the grounds that Southland gave only minimal time for creditors to consider the plan. As a result, a federal bankruptcy judge ordered Southland to solicit a new vote of its creditors on the company's reorganization plan.

In another recent example, Carl Icahn was the prime holdout, threatening to force Western Union into bankruptcy and thwarting the company's exchange offer. Western Union then agreed to launch a cash tender offer of fifty cents on the dollar - to which Icahn agreed.

Because Carl Icahn controls almost a quarter of Donald Trump's Taj Mahal casino bonds, he was able to become the major stumbling block in the restructuring negotiations. He demanded certain changes in the governance of the company. Under the proposal, bondholders would receive 50% equity in the casino in exchange for having their interest reduced from 14% to 12%, of which 10% would be paid in cash. If Trump improves operations, he can eventually recapture as much as 80% of the company stock. If operations decline below projections set by the board, Trump would lose control of the board but he would retain 50% equity in the casino. The story continues.

With the recession, cash shortage, and tightening credit scene, more companies will have to face these aggressive creditors. Since "knowledge is power," companies that begin now to put in place the mechanisms to identify, begin a dialogue, and communicate with these holders, proactively bringing them into the corporate "family," will be the ones to survive and prosper even under the most difficult circumstances.

Diane J. Vazza is a Senior Vice President of Georgeson & Co. Inc., which specializes in proxy solicitation, investor relations, and corporate governance. She heads the firm's debt services division.
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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests
Author:Vazza, Diane J.
Publication:Directors & Boards
Date:Mar 22, 1991
Words:2284
Previous Article:Put managements' own capital at risk.
Next Article:Time to retarget the individual investor.
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