Capital Markets

Bondholder Backlash

LBO debtholders are getting tougher about protecting their interests.
Ronald FinkFebruary 2, 2006

When Neiman Marcus became the focus of a leveraged buyout by two private-equity funds last year, it also became the latest battleground in an escalating war between equity holders and bondholders. As LBOs have become more highly leveraged, investors have found it more difficult to exit via a sale or initial public offering. Instead, they have been taking their returns in the form of dividends. That drain on cash has made companies less financially flexible, which in turn has made bondholders nervous.

They fought back in the Neiman Marcus case by making an unusual demand: in exchange for accepting (under certain circumstances) interest payments in the form of new bonds — a provision known as a payment-in-kind, or PIK — the investors insisted that Neiman not pay out the cash thus conserved to its equity holders.

While the PIK provision provides, as CFO James Skinner notes, “a security blanket in case of financial stress,” bondholders didn’t want to see shareholders be rewarded at their expense, hence the extraction of the promise that any cash conserved would be retained. “You want to make sure there’s enough cash available to pay debt [rather than see it] go out to the equity holders,” says Paul Scanlon, a manager of high-yield funds for Putnam Investments, which bought more than $13 million of the bond offering.

Unlike publicly held companies, LBO firms find it especially difficult to resist demands from their shareholders, given the latter’s large holdings of both common and preferred shares. But as the Neiman case illustrates, bondholders are growing more aggressive about protecting their interests. For instance, more than half of Hertz’s $15 billion LBO last December represents asset-backed securities based on the group’s car fleet. “When markets get tighter, covenants get tight, and interest rates go higher,” says Scanlon.

Overall, LBO activity soared in 2005 — topping $120 billion at the end of the third quarter, according to Morgan Stanley — and so did the leverage levels on private-equity deals, a fact not lost on bondholders. “LBO activity has firmly established its place atop the list of bondholder concerns,” wrote the authors of a Morgan Stanley report last November. Given the increasingly aggressive terms of the deals, they added, “all we need is Michael Douglas to squeeze back into his bespoke suit, his Gucci loafers, and release Wall Street II, and we’ll know the end of the LBO boom can’t be far behind.”

A different sort of sequel is more likely: should the economy go south and cash-strapped LBO companies stumble, a new spate of legal battles, a hallmark of the late 1980s, when several highly leveraged private-equity firms collapsed, may erupt, albeit with a twist. Back then, bondholders and other unsecured creditors had to prove that managers were engaged in fraudulent conveyance, and proving fraud is “a hard wire to trip,” observes William Bratton, a law professor at Georgetown University.

Today, bondholders may be able to sue on different grounds: fiduciary liability. That possibility was first glimpsed in 1991, when the Delaware Court of Chancery, which has great influence over corporate law, posited the idea of fiduciary duties to unsecured creditors. By that time, the ’80s LBO wave had subsided. But as a result of that decision and others that cited it as precedent, Bratton warns, bondholders are likely to be much more aggressive in court during the next round of LBO failures.

The Zone of Insolvency

It isn’t yet clear just how much the legal climate surrounding such insolvencies has changed since the last LBO boom. But the Delaware court’s decision in 1991 in a case involving the Dutch subsidiary of French bank Credit Lyonnais is widely considered a legal landmark.

In that case, a Delaware chancery court judge stated for the first time that creditors were owed fiduciary duties within the “zone” or “vicinity” of insolvency (see “Debating Creditors’ Rights” at the end of this article). Legal experts vigorously debate the merits of this view of fiduciary liability and its meaning for cases going forward. But many fear that empowering creditors could ultimately hamper the ability of directors and officers to run companies — and even, perhaps, subject LBO managers to claims for damages if their companies go bankrupt.

Complicating the issue, insolvency is ill-defined for legal purposes. Courts have accepted two traditional definitions: a balance-sheet definition, in which liabilities exceed assets; and an equity or cash-flow standard, where a company is unable to meet its obligations as they come due. But a company may be insolvent under one definition but not another, and there is no standard as to which test courts apply. They can even apply both, says Bratton.

Worse, two accountants employing the same definition may come to different conclusions. As a 2003 white paper by law firm Dorsey & Whitney LLP put it, “It is difficult for a corporation to know whether a court would find it to be insolvent, or ‘in the zone’ of insolvency.” While third-party advisers often supply courts with solvency opinions, these don’t always carry much weight.

As a result, experts fear that the cases in question have established an opportunity for unsecured creditors to sue individual directors and officers for fiduciary liability if they take actions to boost shareholder value once their companies encounter financial difficulty. Some experts dismiss such fears by pointing out that the Delaware cases do not necessarily provide unsecured creditors with the standing to sue for fiduciary liability, and that the judicial views outlining fiduciary duties to such creditors are merely footnotes, or “dicta” in legal terms. Yet Georgetown’s Bratton notes that bankruptcy judges, while bound by Delaware law on Delaware claims, are not required to follow it elsewhere. “They’re federal actors,” says Bratton, “and they might take dicta and apply them as if they’re real.”

Even some experts who doubt the courts will act in this fashion concede that market participants take the prospect seriously. David Skeel, a law professor at the University of Pennsylvania, notes that the possibility that courts would find a fiduciary liability owed to unsecured creditors has made banks wary of becoming too deeply involved in restructuring efforts. The banks fear that if they go so far as to select individuals to direct such efforts, they will become fiduciaries and see their own claims to the assets subordinated to those of such creditors. Even in cases in the 1980s and 1990s, says Skeel, “banks acted as if it was a serious risk.”

For its part, Standard & Poor’s takes claims from unsecured creditors into account when estimating potential recovery values on senior secured debt. “We can see some accommodation” given to such creditors by bankruptcy courts going forward, says William Chew, managing director of Standard & Poor’s.

There is a risk of fraudulent conveyance, if not fiduciary liability, in virtually any transaction that benefits shareholders at bondholders’ expense, so those who arrange such a deal have to hope that a significant amount of time passes before the company involved goes belly up. But there’s no rule of thumb as to how much time is enough to prevent a claim from advancing in court. “As much as possible” is how one lawyer put it at a recent conference.

Based on the 1991 Delaware court decision, however, a company need only be found to be approaching insolvency to trigger a claim of fiduciary liability. Once in the vicinity of insolvency, warns Bratton, “all side deals made by issuers of bonds with equity holders or other insiders become legally questionable.”

The CFO’s Biggest Challenge

To head off potential legal problems, experts caution that CFOs should take bondholders’ complaints more seriously than they may have in the past. At a minimum, notes David DeBerry, vice president of Hartford Financial Products, which sells insurance coverage for directors and officers, CFOs should see to it that decisions favoring shareholders during periods of financial stress are approved by independent board members after obtaining the guidance of financial experts. As DeBerry puts it: “These are changing times for directors.” (For specific actions to avoid, see “On the Hook” at the end of this article.)

That view was seconded at a recent Standard & Poor’s conference by Ronald Nelson, president and CFO of Cendant Corp., itself rumored to be an LBO candidate. Nelson insisted that demands for dividends and share buybacks from such shareholders must be met with “management fortitude.” Legal issues aside, he warned that managers otherwise run a risk of being “left holding the bag without enough capital to grow the business.”

That risk may seem distant when credit conditions have been as easy as in recent years. Even now, defaults by U.S. companies remain few and far between, and their bonds are trading at narrow spreads over Treasuries. But a growing number of observers worry that current trends are unsustainable in light of rising interest rates. S&P’s Chew, for one, contends that current market conditions fail to reflect the amount of financial risk facing companies, but points out that those conditions can change dramatically. “Credit means nothing one moment,” notes Chew, “and then it’s the only thing.”

Of course, the problems associated with a reversal in credit conditions aren’t limited to companies in private-equity portfolios. Even CFOs of publicly owned investment-grade companies are growing more wary of rewarding shareholders at the expense of bondholders. At a panel discussion with Nelson, Carol Tome of Home Depot, which is rated AA by S&P, called the “balancing act” of managing the conflicts of interest between these two sets of investors “the biggest challenge we face going forward.” (Still, Tome noted that Home Depot’s board no longer thinks a AAA rating is worth shooting for, and the company recently announced a $3.5 billion acquisition that will be financed in part with debt.) On the same panel, Devon Energy CFO Brian Jennings warned that bond investors would be even quicker to react to negative developments than they were in the 1990s because they take creditworthiness much more seriously following the failures of Enron and WorldCom. Jennings attributed that to “the lack of [such] focus earlier that led to disastrous results for all constituencies involved.”

Tellingly, perhaps, a number of junk-bond deals in recent weeks have been pulled, reduced in size, or taken to market with stiffer conditions attached. Since mid-September, School Specialty Inc., Euramax International Inc., and Pregis Corp. canceled junk-bond offerings worth $1.2 billion, while six non-investment-grade companies reduced the size of their issues, according to Bloomberg News Service.

And dividend payments for LBO sponsors are starting to encounter resistance from bondholders of issuers besides Neiman Marcus. Consider satellite company Intelsat’s pending acquisition of rival PanAmSat. While the bond financing the acquisition itself was well received, the same cannot be said for Intelsat’s attempt to raise another $200 million that same day for a share buyback for its private-equity sponsors. After investors balked, the company withdrew the offering. But they now expect Intelsat to return to the market at some point with that purpose in mind, a prospect that one high-yield fund manager who asked not to be identified finds “troubling.”

By now, it should be obvious to CFOs of highly leveraged companies that shareholders don’t always come first. But if it isn’t, the odds seem to be growing that judges as well as bondholders will remind them.

Ronald Fink is a deputy editor at CFO.

Debating Creditors’ Rights

Delaware court decisions that say officers and directors owe a fiduciary duty to creditors when a company is in the “zone of insolvency” have sparked considerable debate within the legal community.

On the one hand, it is widely accepted that the closer a company is to insolvency, the greater the incentive for managers to make risky and even “negative expected value” investments in order to maximize shareholders returns. In the 1991 case of Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., however, the Delaware Court of Chancery observed that as a result, directors should include creditors with shareholders in a “community of interests” to whom directors owe fiduciary duties. In that case and others, Delaware courts argued that shareholders’ special status begins to fade even before the company becomes insolvent.

“At least where a corporation is operating in the vicinity of insolvency,” the chancery court noted in Credit Lyonnais, “a board of directors is not merely the agent of the residue risk bearers but owes its duty to the corporate enterprise.” The court gave creditors priority over employees, taxpayers, and other stakeholders in the enterprise, because creditors bear the residual risk once it becomes insolvent. And the court made no distinction between secured creditors and unsecured ones when it came to fiduciary duty.

Critics of this view concede that while corporate directors and officers may have perverse incentives to reward shareholders when a company nears insolvency, creditors already have contractual rights that enable them to sue for fraudulent conveyance. Therefore, critics say, giving creditors fiduciary rights as well makes no sense. Moreover, these observers contend, doing so raises the troubling prospect that the judgment of courts will substitute for that of managers in running corporations. Proponents of enhanced creditors’ rights counter that such contracts have gaps, particularly for bondholders and other unsecured lenders, and that these need to be plugged via fiduciary obligations.

Whatever the merits of either side, the most pressing question for CFOs is whether courts will allow creditors to sue them directly. Here a decision in a 2004 Delaware case involving Production Resources Group LLC, an entertainment technology firm, may be reassuring. The court decided in that case that officers and directors were protected against the fiduciary claims of creditors by the business judgment rule, which has long shielded managers in cases involving shareholder claims. If that case serves as precedent, creditors would have no standing apart from the corporation to sue officers and directors except in cases of fraud.

But much depends on how federal bankruptcy judges choose to apply that finding. And since bankruptcy proceedings take place in “courts of equity,” judicial decisions there are seldom overturned on appeal. — R.F.

On the Hook

A company’s obligations to creditors in the zone of insolvency are yet another reason to follow good governance practices. In particular, attorneys advise officers and directors of such companies to avoid the following actions, for which, under recent Delaware court decisions, they could be held personally liable:

  • Failing to pay taxes
  • Failing to pay wages
  • Paying dividends to shareholders
  • Sales or transfers for inadequate consideration
  • Violating duties under ERISA

Source: Dorsey & Whitney LLP

Boom and Bust?

Some predict the LBO vogue will be followed by a wave of failures.

Is a downturn in credit conditions imminent? John Addeo, a high-yield bond fund manager for Massachusetts Financial Services (MFS) in Boston, contends that the tougher terms seen recently on high-yield bonds are essentially “deal specific,” and he notes that buyers of bonds financing leveraged buyouts (LBOs) can draw comfort from the vast sums that have been finding their way into the private-equity funds that sponsor the deals.

With the public-equity markets providing mediocre returns, the total raised for private-equity investments was expected (as this issue went to press) to hit a record $250 billion in 2005, according to London-based research group Private Equity Intelligence. What’s more, LBO sponsors now typically put up about a third of the financing themselves. As Addeo notes, that suggests that “sponsors are putting in real dollars, at least initially.”

Yet the proportion of equity in deals involving companies with more than $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) has fallen from nearly 37 percent in 2002 to about 29 percent at the end of Q3 2005, according to Standard & Poor’s. Meanwhile, the average ratio of debt to EBITDA exceeded five times at the end of Q3 2005 — up almost a full turn from 2004 and topping the ratio of 4.96 last seen in 1997, according to S&P (see “Leveraged Up” at the end of this article).

That’s still shy of the ratio at the peak of the LBO boom in the late 1980s, which was around six times EBITDA, and equity during that time averaged no more than 10 percent of total financing. However, some of the largest recent deals, including the buyout of Danish telecommunications giant TDC in early December, match the 1980s in terms of leverage.

Even Addeo acknowledges that “there’s been some deterioration in the quality of issuance,” and adds that investors have become more “mistake-aware” of late. Consider, for instance, the case of Tronox Inc., a pigment maker that Kerr-McGee Corp. recently spun off 25 percent of to the public. Originally, Addeo notes, Kerr-McGee hoped to sell the subsidiary to private-equity investors, but couldn’t drum up enough interest, because of the business’s less-than-compelling prospects. And the spin-off came to market at only $14 a share, more than 20 percent below the expected price. Also, Kerr-McGee had to pay a 9.5 percent interest coupon to entice investors to buy a bond issued for Tronox, fully 100 basis points more than initially expected.

It’s that sort of development that leads some bankers and bankruptcy attorneys to predict a wave of debt-driven failures ahead, followed by intense litigation over creditors’ claims. True, corporate defaults have recently been relatively scarce outside the auto and airline industries. But even if rates remain at their current level, marginal companies in other industries will “collapse under the weight of their debt,” predicts Rick Chance, managing director of New York–based Trenwith Securities LLC, a middle-market investment bank. — R.F.