Floorless Debt

FLOORLESS DEBT
The Devil's Candy

A once-obscure debenture dubbed the "death spiral" is becoming a popular option for desperate companies whose only other alternative is bankruptcy. Also known as floorless or convertible preferred debt, the fixed-income instrument translates into extreme risk for all players.

"I dislike the term death spiral," says Jody Eisenman, CEO of Perrin, Holden & Davenport, a New York­based investment bank. "They are convertible Regulation D instruments," he says, referring to the Securities and Exchange Commission's private placement designation.

Nomenclature aside, the debt instrument usually works like this: The issuer gives the lender the right to convert all or part of the outstanding principal amount of the debt into common shares of the company. Because of solvency problems, the debt is almost never repaid, nor are the bonds likely to be called.

A typical conversion has some sort of discount off the average of the last several trading days of the stock, explains Eisenman. Interest accrued on the debt is also converted into common shares.

Herein lies the spiral. Essentially, the lender can exercise its right and sell shares into the market, forcing the price down and allowing the lender to acquire more shares at lower prices. In theory, the bondholders can ac-quire control of the company as other shares are diluted ad infinitum.

"Companies would be very ill-advised to take this type of loan," explains David Beim, a professor of finance at Columbia University's Graduate School of Business. "A death spiral precipitates a crisis."

This debenture has been making the rounds at a number of cash- strapped dot-coms, and was even on the books of eToys before the high- flying E-tailer went bankrupt. While the company was experiencing severe financial problems last year, it still "structured a very intelligent deal," says Alex Cappello, CEO of investment banking firm CappelloGroup Inc., in Santa Monica, Calif.

According to Cappello, eToys's management, not its investors, decided when the stock conversions would take place, and exerted tremendous control over investors' money. Few realize that when eToys announced the deal, the stockactually shot up, adds Cappello.

-- Jake Wengroff

WISH LIST

CFOs want a cut in the income tax rate, a pay-down of the national debt with the budget surplus, and additional interest rate reductions, says an Association for Financial Professionals survey.

Cheating & Cheating

If you suspect a colleague of marital infidelity, double-check his or her expense reports. So says Gary Zeune, president of The Pros and The Cons, a speakers bureau for white-collar criminals, in Columbus, Ohio. "Most embezzlers are con artists," says Zeune, who conducted an informal study. "Philandering goes with the lifestyle, and nobody saves up for a possible affair."

Some embezzlers need so much extra scratch that they can hobble an organization. Zeune cites a former executive director of the Natural Gas Supply Association who had a series of affairs over 15 years. His tryst tab ran so high that he had to lay off a third of his workforce to stay afloat. The moral: trifling liaisons can become serious finance issues.

"Having an affair isn't smart, but it's also not illegal," says attorney Michael Nosler of Rothgerber, Johnson & Lyons LLP, in Denver. "And many states have statutes to prevent employers from prying into an employee's private life." Zeune is aware of such laws, but says that if you overhear a married co-worker bragging about sexual indiscretions, "your embezzlement antennae should go up." 

-- Leslie Schultz

IN THE LAST QUARTER of 2000, banks tightened lending standards faster than they had in the past 10 years, says the Federal Reserve.

CREDIT DOWNGRADES
Paradise Lost

How many fallen angels can dance on the head of a pin? If the pin is on Wall Street, the total is climbing.

The number of fallen angels, or investment-grade companies that have tumbled to speculative grade, rose substantially in the fourth quarter of last year, according to Moody's Investors Service, based in New York. And expectations for the first quarter of this year are fairly bleak, says John Puchalla, a senior economist at Moody's.

Fourth-quarter 2000 produced 57 investment-grade company downgrades and only 24 upgrades. Among the noteworthy companies that fell from grace last year were Tommy Hilfiger (Baa3 to Ba1), HealthSouth (Baa3 to Ba1), Champion Enterprises (Baa3 to Ba3), and USG (Baa1 to Ba2).

Downgrades sometimes have an upside, though: they usually increase a company's credit risk, which means if company bonds are sold, investors will require a higher rate of return. "In some cases, downgrades are an overt trade-off by companies that view the credit drop as an opportunity to increase shareholder return," says Puchalla. He adds that companies can choose to increase leverage, for example, by debt financing mergers or equity buybacks, thereby betting that a higher credit risk will yield higher returns.

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