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Debt-Exchange Offers Get a New Lease

on Life
In Debt

By STEPHEN J. LUBBEN JAN. 20, 2017

Exchange offers — where the issuing company offers to exchange its

outstanding debt for something else, often cash or new debt — are important
tools for a company that is feeling pressed by creditors, but does not want to file
for bankruptcy.

For example, bondholders who are due to be repaid next month may accept
payment in two years instead, if offered a high enough interest rate. The old
debt would be swapped for new debt with the new terms.

The trick is that exchange offers are voluntary. If the bondholder would
rather get paid next month, he will refuse the offer.

One way to encourage participation in the exchange is to offer a premium —

for example, a really high interest rate, or combination of cash and new debt
that is worth a lot more than the current value of the old debt. But when a
company is in financial distress, there are limits to how far this can go. After all,
at some point all this generosity is going to be more painful than just paying the
debt according to its original terms.

So there are sticks that go along with the carrots in exchange offers.
 A commonly used technique is to have the old bondholders agree to change
the bond indenture on the way out the door. That is, just before you exchange
into the new debt, you agree to, say, strip all the really important covenants out
of the old debt.

Another, more recent technique, takes advantage of the fact that in recent years
a lot of debt was issued without covenants. This “cov light” debt — named by
those who can’t be bothered with multiple syllables — often has no provision
that prevents the introduction of senior debt into the capital structure.

Thus, an exchange offer funded by a senior secured loan can provide

bondholders with lots of incentives to participate — knowing that they will be
subordinated by the senior loan after the exchange — with less need to offer a
big premium.

The outer limit to all this, at least in the corporate context, is provided by
the Trust Indenture Act of 1939, also know as the T.I.A. At heart, this law was
designed to force restructuring into the then newly created federal corporate
bankruptcy system. If companies really needed to impose losses on
bondholders, the feeling was that they should do so in the light of day, rather
than through an opaque, potentially high-pressure deal.

Most important, the act prevents changing the core terms of a bond —
principal, interest rate and maturity date — without the consent of each
bondholder. Only a restructuring under the bankruptcy code can change those.

But it was historically thought that if an exchange offer did not touch the
core terms of the bond, there was no issue under the T.I.A., even if the result
might be to leave the bondholder very nervous about the company’s ability to
pay off the old bonds according to their terms.

For example, a bondholder who held out in an exchange offer funded with
senior debt might worry that the company would be no more able to pay that
senior debt than it was able to pay the old bonds according to their terms. If the
company ends up in bankruptcy, the old bondholders will get paid only if the
secured creditors are paid in full first, so maybe the exchange offer has actually
affected the core terms of the debt instrument in a way that the T.I.A. sought to
prohibit.

Until recent years, that sort of argument was widely rejected by courts. But
then a few trial courts in New York began to suggest that some extreme moves
done in connection with exchange offers might raise a valid claim under the
T.I.A.

This week, the United States Court of Appeals for the Second Circuit, the
federal appeals court that covers New York, among other states, put an end to
that idea.

The case involved a company that could not file for bankruptcy without
destroying its business. So instead it adopted a very aggressive out-of-court
restructuring plan. The company had both secured and unsecured debt
outstanding and was teetering on the brink of breaching its obligations under
the former.

The company and a large number of its creditors came up with a plan to sell
all of the company’s assets to a new subsidiary. Those who consented to the plan
would receive new securities in the new subsidiary. Shades are here of the old
railroad receiverships, where the assets of the Short Line Railroad Inc. would be
sold to Shortline Railway Inc., with only those who agreed to the deal getting to
participate in the new company.

While in this case nonconsenting secured creditors would still receive debt
in the new subsidiary, that debt would be junior to the debt of consenting
secured creditors. And nonconsenting unsecured bondholders would not receive
anything from the new company.

The trial judge said this went far enough to raise concerns under the T.I.A.,
because there was no real likelihood that the dissenting bondholders were going
to get paid after the dust settled on this deal. The bonds were still outstanding,
but the companies that were obliged to pay them no longer had any assets.

The appeals court, with one dissent, said that the T.I.A. covered only
changes to the core terms of bonds. None of those core terms were changed in
this little scheme, so there was no issue under the act.

Which means that the restructuring advisers can go back to being cunning
about designing new and ever more forcible exchange offers. And bondholders
who want real protection from that need to think about getting that protection
in the form of real covenants in the bond indenture.
© 2017 The New York Times Company