Debt Exchanges: Companies Adapt to Continued Restrictions in the Credit Market | Practical Law

Debt Exchanges: Companies Adapt to Continued Restrictions in the Credit Market | Practical Law

This article discusses the proliferation of debt exchanges in the current financial climate.

Debt Exchanges: Companies Adapt to Continued Restrictions in the Credit Market

by Nadia Khattak, Practical Law Company
Published on 02 Feb 2009 • USA (National/Federal)
This article discusses the proliferation of debt exchanges in the current financial climate.
Companies are increasingly turning to debt exchange offers, by which a company offers to exchange newly-issued debt or equity for its outstanding debt securities, as a refinancing method to deal with liquidity problems, high leverage or possible bankruptcy. The new securities typically carry additional collateral or a higher interest rate in return for a lower amount of debt or more time to repay it.
The volume of debt exchanges in 2008 surged to $30 billion, compared to a total of $9 billion from 1984 to 2007, according to research conducted by Professor Edward Altman at New York Stern School of Business. This exponential increase is set to continue throughout 2009.
In this month's special feature, we examine the reasons why debt exchanges are so popular, how they are being used and structured in practice and whether they are having the intended effect for companies that use them.

Dwindling Options to Refinance and Restructure

Debt exchange offers were traditionally just one of a range of options for a company seeking to refinance and restructure its debt and capital (see Practice Note, Debt Exchange Offers: Purpose and Process).
However, as alternative refinancing options have dwindled, the popularity of debt exchange offers has increased. According to Davis Polk & Wardwell partner, Richard Truesdell, "where traditional capital markets financing is becoming increasingly difficult, this exponentially increasing growing practice area is becoming mainstream". With liquidity scarce, banks are unwilling to lend new money to all but a small number of highly-rated companies. Negotiating amendments to existing loan agreements now looks less appealing than negotiating with noteholders.
In addition, the outlook for restructuring within Chapter 11 proceedings is bleak. "Companies are seeking to avoid bankruptcy more than ever before because debtor-in-possession (DIP) financing is very limited and expensive. They are scrambling for money," says Professor Altman.
At the same time, the number of companies needing to refinance has increased. A period of frenzied leveraged buyout (LBO) activity has left many highly-leveraged companies with complicated debt capital structures that they need to refinance, either because they are struggling to meet interest payments or because they risk breaching covenants or defaulting under their loan agreements. Standard & Poor's (S&P) Global Fixed Income Research Group reported last year that over the next five quarters, US financial and non-financial companies face $794 billion in debt maturities that must be refinanced.
In addition, the depressed value of debt securities presents an opportunity for some companies to retire their debt cheaply. A debt-for-equity exchange offer, where the company offers equity in exchange for outstanding debt securities, is one way to achieve that end.
The reaction of noteholders to recent exchange offers has been mixed. A number of companies successfully completed exchanges in 2008, including Tyco International, Residential Capital and CIT (see Box, Recent Exchange Offers). Some exchange offers, such as those by Station Casinos and Realogy, failed. Others closed but did not reach the target, such as Harrah's Entertainment, Inc. The GMAC offer failed to reach its target but closed because the company reached its goal with the help of government intervention.

Innovation and Coercion Emerging Trends in the Market

"We are seeing a number of innovative approaches in light of each company's particular situation, and companies are not shying away from using aggressive tactics," says Theodore Farris, a partner at Dorsey & Whitney.
For example, some financial companies on the brink of insolvency have offered to exchange debt and equity to restructure their regulatory capital to enable them to qualify for government bailout funds under the Troubled Assets Relief Program (TARP) by meeting the requirements to become a bank holding company under the Bank Holding Company Act of 1956. In the GMAC exchange, the likelihood of a government bailout of General Motors, while not explicitly part of the offer, was a factor in noteholder negotiations.
The terms of the exchange offer must be sufficiently attractive (or the alternative sufficiently unattractive) that noteholders can be persuaded to give up what they already have. For this reason, companies often offer new secured debt in exchange for old unsecured debt, along with a range of other sweeteners, including guaranties and higher coupons.
Where an initial offer has not been to the noteholders liking, companies have had to improve the terms. For example, GMAC noteholders were not happy with the guarantees that the company originally offered and successfully negotiated for something better. According to Farris, "Bondholders now have some leverage to drive the exchange process because refinancing options for companies are limited".
However, noteholders must work within the realm of the possible. Distressed companies such as Station Casinos are in a precarious position because they cannot sweeten an offer with equity and are limited by restrictions in their debt agreements.
Lawrence Wee, a partner at Paul, Weiss, Rifkind, Wharton & Garrison who, together with bankruptcy partner Andrew Rosenberg, represented noteholders in the GMAC debt exchange offer, adds that companies must strategize to make an offer that noteholders either "fear enough or love enough" to accept.
Fear is the key strategy behind the wave of "coercive" exchanges by companies such as Realogy and K Hovnanian Enterprises. Such exchanges are made for the benefit of one class of noteholders to the detriment of another, by subjecting different groups of noteholders to varying priorities in a waterfall under which those who accept the exchange are awarded priority over those who do not.
"Bondholders are faced with the prospect of accepting the lesser of two evils – if they don't accept the offer, they risk opening the offer to another group that will jump ahead of them in priority," says Robert Evans, a partner at Shearman & Sterling. However, to be effective, the threat in a coercive exchange must be strong and not perceived as a mere negotiation tactic.
Not surprisingly, these aggressive strategies have noteholders turning to the courts to protect their interests. The Delaware Chancery Court recently handed down its decision in the Realogy case, in which it agreed with noteholders that the company's loan-for-debt offer violated the terms of the loan agreement and indenture (The Bank of New York Mellon and High River Limited Partnership v. Realogy Corporation, (Del. Ch 2008)). A complaint has also been lodged against Harrah's Entertainment, Inc. by noteholders (Complaint, S. Blake Murchison, and Willis Shaw v. Harrah’s Entertainment, Inc., and others (Del. January 9, 2009)).

Debt-for-Loan Exchanges using Accordion Facilities

In addition to its coercive features, the Realogy offer also illustrates a variation on the straight debt-for-debt exchange. Like Harrah's Entertainment, Inc., Realogy offered new term loans pursuant to an accordion or incremental facility under an existing secured loan agreement in exchange for the old outstanding debt securities.
An accordion facility allows the borrower to add a new term loan tranche or increase the revolving loan commitments under an existing loan agreement. Such terms became relatively common during the buyout boom but it is unlikely the parties foresaw that the accordion would be used for the purpose of a debt-for-loan exchange.
The new term loans under the accordion facility may be offered to noteholders in a variety of ways: with a subsidiary guaranty or first, second or third lien, a higher coupon rate or a later maturity.
Wee points out that one helpful clarification arising from the Realogy case is the court's rejection of the noteholders' claim that an accordion facility cannot be used to issue or exchange notes, only cash. The decision reassures issuers that accordion facilities under loan agreements can be funded with assets other than cash, affirming one of the principal elements of this increasingly popular type of exchange offer.
While the use of accordion facilities in exchange offers is likely to continue, the longer-term future of accordion facilities generally in loan agreements is harder to predict. Given the scarcity of available credit, it is unlikely that lenders will be amenable to granting accordions in the near future.

A Buyback Alternative

Looking forward, Wee expects an increase in debt purchase offers for cash from "companies that have cash or equity sponsors, have the money to put into a repurchase and whose debt is trading at levels too low to be justified by the fundamentals of the business".
However, John Knight and Stephen Bigler of Richards, Layton & Finger, Delaware counsel to General Motors in the GMAC exchange, comment that debt-for-equity is not as common as it was in the past. In the current economic climate, many debtors prefer to receive cash rather than risk taking equity in a reorganizing company.

A Short-term Solution

While an exchange offer can help in the short term, given the depth of the current recession, it may ultimately not be enough to save a company. According to Professor Altman, historically a significant number of exchanges were followed by bankruptcy or insolvency within a year. Nonetheless, he says: "For the company, it buys time. For the creditors, it increases chances of recovery".
A ratings downgrade often follows an exchange. GMAC, Residential Capital and Harrah's Entertainment, Inc. were all downgraded to a selective default. S&P downgraded GMAC and Residential Capital because noteholders that tendered received less than their original investment and those that did not tender ended up being subordinated to those who accepted.
KDP Investment Advisors downgraded Harrah's Entertainment, Inc. because of very near term debt maturities. The company faces $710 million of debt due in 2010 and $308 million in 2011. While its overall debt was reduced as a consequence of the exchange and the maturity of some notes was pushed back, the company still has to contend with the debt it carries following its $30.7 billion leveraged buyout in January 2008.

Recent Exchange Offers

CIT

Commercial lender CIT Group, Inc. successfully completed its debt exchange offer on December 24, 2008, became a bank holding company and obtained $2.33 billion from TARP by selling perpetual preferred stock and related warrants.

GMAC

GMAC, the financial services arm of General Motors, closed a debt-for-equity exchange offer on December 31, 2008. While the offer did not reach the 75% acceptance target, the restructuring was sufficient for GMAC to convert to a bank holding company and qualify for TARP.

Realogy Corporation

In a loan-for-debt offer, Realogy Corporation invited three classes of unsecured high-yield noteholders to exchange their notes for new second lien term loans issued under an accordion facility of the company's senior secured loan agreement. The exchange was structured to subject different groups of noteholders to varying priorities within a waterfall pushing senior toggle noteholders to a lower payment priority in bankruptcy. The coercive nature of the offer provoked a group of senior toggle noteholders to challenge the offer successfully. The case turned on the specific terms of the loan agreement and indenture (The Bank of New York Mellon and High River Limited Partnership v. Realogy Corporation, (Del. Ch 2008)).

Harrah's Entertainment, Inc.

In a loan-for-debt exchange offer, Harrah's Entertainment, Inc. offered new term loans in exchange for its old notes. Harrah's used its restricted payments carve-out to refinance subordinated notes and the accordion feature in the loan agreement to incur and secure new notes. The deal closed on December 22, 2008, but on January 9, 2009, a group of senior noteholders filed a complaint with the US District Court for the District of Delaware against the company, alleging that the exchange offer was unlawfully restricted because the company "cherry-picked" investors and it effectively subordinated previously issued notes held by similarly situated holders.

Neff Corp.

Neff Corp. closed an exchange offer of new loans for notes on December 16, 2008. The company exchanged unsecured notes for first lien term loans. The new loans were secured by the collateral that secured the revolver. The original unsecured noteholders ended up jumping ahead in priority to holders of second lien notes.

Station Casinos

Noteholders rejected the exchange offer by casino operator, Station Casinos. They claimed that the offer to exchange senior and subordinated unsecured notes for new secured term loans with a 10% coupon, and issued a significant discount to par, was "deficient". Station Casinos could not sweeten its offer without tripping covenants under its loan agreement and the company pulled the exchange on December 15, 2008.