HIGH YIELD

30 January 2002
Martin S. Fridson, CFA Chief High Yield Strategist (1) 212 449-1102 Martin_Fridson@ml.com

"Coercive" Exchange Offers

United States

High Yield

The greatly increased incidence of corporate financial distress over the past two years1 has produced a corresponding surge in restructuring activity. Through exchange offers, a number of issuers are attempting to renegotiate the terms of their bonds to avoid bankruptcy. To high yield market veterans, the environment is reminiscent of the early 1990s.2 In contrast to that period, the current downturn in credit conditions has witnessed no widespread allegations of abusive and coercive exchange offers. The latter term does not refer to literal use of force, which is the dictionarys definition. Rather, the finance literature characterizes an exchange offer as coercive if it treats bondholders who reject the offer less favorably than bondholders who accept it. 3 One likely reason for todays comparative lack of rancor over exchange offers is that the great wave of early-stage telecom financings of the late Nineties spawned many airballs, i.e., defaulted bonds for which there are no material assets worth fighting over. Additionally, the architects of some of this cycles attempted restructuring have begun by acquiring the greater part of companies capital structures at steep discounts to face value. With control of the liabilities already in hand, the restructurers do not need to impose draconian reductions in interest payments on other holders. Notwithstanding such differences between conditions of ten years ago and today, it may be that calm currently predominates only because the cycle has not yet reached the point at which debt restructuring will inevitably become more contentious. After all, complex exchange offers of the sort described below take considerable time to plan and launch. Moreover, many potential suppliers of fresh equity may not even begin putting out feelers until they perceive that the United States economy has started to emerge from recession. The give-and-take between issuers and investors, in short, may heat up considerably during 2002. Under such conditions, rhetoric is likely to escalate. If past experience is a guide, loose talk and fuzzy thinking will probably sow confusion about the validity of issuers tactics. In hopes of helping market participants to evaluate future exchange offers with clear minds, let us briefly discuss whether various types of exchanges offers are inherently abusive or coercive.

As one indication of increased credit problems, the percentage of issues within Merrill Lynchs Yield-to-Worst universe outyielding Treasuries by 1,000 basis points or more rose from 11.8% in December 1999 to 24.1% in December 2001. Chatterjee, Dhillon, and Ramrez (1995), p. 334, report an increase in the amount of debt in default and troubled exchanges from $2.5 billion in 1988 to a peak of $17.8 billion in 1990. See Chatterjee, Dhillon, and Ramirez.

Merrill Lynch & Co. Global Securities Research & Economics Group High Yield Strategy

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.
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Mistaken Sense of Entitlement

To hear some investors talk, it is inherently abusive for a financial operator to offer to take them out of their investment at a small fraction of face value. A more rational assessment is that a bondholder who considers an offer too low can just say no. Understandably, emotions sometimes take over when an investment entered into with high confidence loses the bulk of its value. Hard though it may be to admit a mistake,4 the most self-benefiting response to the comment, I dont want to insult you with a low bid, is: Go ahead, insult me. One market participants throwaway bid may be anothers found money. Even among bondholders who face up to the fact that their loss occurred before anybody came in offering them 50 cents on the dollar, a deep-discount offer may ruffle some feathers. In a hypothetical case, the complaint may run along the following lines: Billionaire Byron Bigwheel is taking advantage of a temporary downturn to scoop up this great company at a fraction of its long-run value, complains the aggrieved bondholder. Not content with grabbing these assets at a bargain-basement price, he expects me to take a haircut on my bonds. Im the one who has stuck with the company through the fat times and the lean times, yet Bigwheel is offering me only a five-point premium to the market value of my bonds. His self-serving proposition doesnt share the benefits fairly.

Who would invest new equity to create a windfall for creditors?

Again, the sentiments are understandable, but in many such cases, the bondholders interpretation of the matter is skewed. If the markets verdict, prior to the exchange offer, is that the bonds are worth 45, then that is what the bondholder is entitled to, absent Bigwheels offer. The risk capitalist is offering a five-point premium only because he must induce bondholders to sell. True, the bonds may be worth considerably more than 45 after Bigwheel reduces their default risk by injecting several hundred million dollars of new equity into the company. Like any other investor, though, he aims to capture the wealth created by his investment, not to create a windfall for others. The billionaire may sympathize with the plight of a distressed companys creditors, but he is under no obligation to compensate them for their loss. Indeed, we believe it would be economically inefficient to protect bondholders from the possibility of losing money. If the expected return on an equity injection exceeds the cost of capital, society benefits from the investment. Placing a tax on equity infusions, in the form of a requirement that new investors make up losses for which they bear no responsibility, would reduce the number of companies rescued and thereby impede the efficient deployment of capital.

Misleading financial information is a legitimate basis for complaint

Certainly, bondholders can legitimately complain of unfairness if they are put at an informational disadvantage. If the company and Bigwheel collude to present the companys finances in an unrealistically bad light, bondholders may be tricked into selling too cheaply. The case is the same if the company borrows from the banks to finance an offer lower than the intrinsic value of the bonds, while misrepresenting the companys financial position. Either way, the purchase offer is unfair not because the party making it improperly prevents bondholders from participating in the benefits of new investment, but because the purchaser
4

The mere fact that an investment loses money does not necessarily imply that the investor made a mistake. Such a conclusion ignores the distinction between a bad decision and a bad outcome. Accurate assessment of the risks of a series of investments will result in selection of both winners and losers, netting to a fair, risk-adjusted return on capital. Some investors unrealistically strive for perfect foresight, though. Maintaining this hope demands that they regard the losers as outcomes of analytical errors that, having learned their lesson, they will surely not repeat. Invariably, the next round of security selections produces new varieties of mistakes to which already-learned lessons supposedly do not apply. (As an alternative mea culpa, portfolio managers sometimes confess to having strayed from their discipline.) demands that they regard the losers as outcomes of analytical errors that, having learned their lesson, they will surely not repeat. Invariably, the next round of security selections produces new varieties of mistakes to which already-learned lessons supposedly do not apply. (As an alternative mea culpa, portfolio managers sometimes confess to having strayed from their discipline.)

"Coercive" Exchange Offers 30 January 2002

unlawfully withholds material information. Bondholders must rely on the securities laws financial disclosure provisions for protection against this sort of abuse.

Solving the Holdout Problem

In the preceding case of an offer by Byron Bigwheel, bondholders face a simple choice: Accept or reject. Those who accept the offer depart with 50 cents in hand for each dollar of face value. Bondholders who reject Bigwheels offer continue on the same terms as formerly, collecting interest at the originally contracted rate and enjoying the protection of the original covenants.

Controversy arises from transactions that penalize holdouts

Complaints of coercion arise from a more complex decision, in which rejection entails adverse consequences. By way of illustration, suppose Walking Wounded Corporations widely owned 10-1/2% debentures are trading at 45. The financially distressed company attempts to lower its fixed charges by offering to exchange the outstanding issue for a like face amount of new 9% debentures maturing in the same year, and with covenant protection equivalent to that of, the 10-1/2s. Pro forma analysis indicates that if all bondholders accept the exchange, the resulting credit quality improvement will more than offset the coupon reduction, causing the 9% debentures to trade at 50. On the face of it, bondholders have a collective interest in Walking Woundeds offer being accepted. If the deal succeeds, their holdings will rise in market value, while their risk of default will decline. From the standpoint of a single bondholder, however, there is a powerful incentive to reject the companys offer. Suppose Cagey Fund, which owns 1% of the outstanding face amount of Walking Wounded 10-1/2s were to hold out, while owners of the remaining 99% exchanged their bonds for the 9s. The improvement in credit quality resulting from 99% acceptance would not be materially less than the improvement resulting from 100% acceptance. Cagey Funds 10-1/2s would be worth considerably more than 50, however, by virtue of having a much higher coupon than the 9s. By opting out, in short, Cagey Fund would gain more than the bondholders who accepted the offer and thereby raised Walking Woundeds credit quality.

Bondholders may reject an offer that is in their interest

Each of the other bondholders has the same incentive as Cagey Fund to hold out. Therefore, contrary to the outcome just suggested, in which 99% accept the offer, all of the holders, it turns out, reject it. One by one, the bondholders turn down a proposal that would make them collectively better off. To boot, Walking Woundeds shareholders fail to achieve their aim of reduced bankruptcy risk. Surely, these results must be judged to be unfortunate. Fortunately, there is a solution to the holdout problem, known as an exit consent. Suppose that in lieu of the exchange offer described above, Walking Wounded makes the following proposal: The company exchanges old 10-1/2% debentures for a like face amount of new 9% debentures maturing in the same year, and with covenant protection equivalent to that of the 10-1/2s. Consummation of the exchange is contingent on acceptance by holders of two-thirds of the face amount of outstanding 10-1/2s. To accept the exchange, the exiting bondholders must consent to a removal of protective covenants from the 10-1/2s. (Note that the effect of this change will be felt not by the exiting bondholders, but rather by those who reject the offer.)

Exiting bondholders must consent to evisceration of the covenants

The significance of the two-thirds threshold is that it is the percentage required, under the indenture of the 10-1/2s, for amendment (or in this case, rescinding) of a covenant. If holders of at least two-thirds of the issue accept the exchange offer, holdouts will be left with a 10-1/2% debenture stripped of protective covenants. Furthermore, the issues outstanding face amount of the 10-1/2s will decline by two-thirds or more, resulting in a drastic reduction in secondary market liquidity.

"Coercive" Exchange Offers 30 January 2002

Credit analysis indicates that holdouts will then own bonds with a market value lower than that of the new 9s and even lower than the previous trading price of the 10-1/2s. The exit consent, in short, makes holding out unattractive by ensuring that if the deal succeeds, holdouts will be worse off, rather than better off, than bondholders who accept the exchange offer.5

Draconian Exchanges: Immoral? Unlawful? Neither?

Is an exit consent coercive? The finance literature has characterized the mechanism in that way6. Consider an analogy from the realm of romance. The recipient of an ultimatum (Agree to marry me or I will break off our five-year relationship) may consider it coercive, yet we doubt that many would favor outlawing such tactics.7 Indeed, observers who perceive a social benefit in family formation may applaud the forcing of a decision.

A 1995 study finds no harm to bondholders from coercive exchanges

In a similar vein, Chatterjee, Dhillon, and Ramirez (1995) argue, based on empirical analysis of public workouts of distressed debt, that the so-called coercion does not hurt bondholders on the whole. These types of offers may even benefit security holders, they contend, by increasing the likelihood of companies restructuring their debt outside of court, rather than through the more costly bankruptcy process. If the conclusions of Chatterjee et al. are correct, it seems to us that the state should proceed cautiously, rather than leap into intervention in the free contracting of bond indentures and amendments.8 Bondholders who have been on the receiving end of exit consents, however, have not invariably formed their opinions of the mechanism on purely laissez-faire principles. In the 1986 Delaware Chancery Court case Katz v. Oak Industries, Inc., a bondholder sought a preliminary injunction against an exchange offer involving an exit consent, arguing that the offer was coercive and violated the issuers obligation to act in good faith toward its bondholders. The court rejected the request for an injunction, on grounds that: Implicit fiduciary responsibilities on the corporations part should not be read into a contract between the corporation and its debtholders that is contractual in nature. Characterization of an offer as coercive, if valid, is of limited analytical value. The important question is whether the coercion is wrongful. The appropriate legal criterion for establishing a breach of the corporations obligation to act fairly and in good faith is whether, at the time of the
In lieu of the exit consent mechanism, some exchange offers pursue bondholders acceptance by making the exchange securities senior to, or shorter in maturity than, the outstanding issue. See, for example, Chatterjee, Dhillon, and Ramrez (1995). Against the possible objection that an example drawn from an unregulated activity has no bearing on financial transaction, which are subject to countless laws and regulations, we note that the state does not stay entirely out of the field of interpersonal relations between consenting adults. For example, the government affords individuals protection against stalking. The Trust Indenture Act of 1939 limits the free contracting to the extent of prohibiting indentures from permitting the elimination of core terms (payment of interest and principal) without the unanimous consent of holders. This feature of the legislation was aimed at preventing a historical abuse whereby a distressed company (possibly in collusion with outside parties) bought a controlling block of a bond issue at a deep discount, then voted to eliminate interest payments on the entire issue. Hardcore opponents of intervention in the market could argue that such legislation is unnecessary. After all, if bondholders choose not to demand such a clause in unfettered negotiations, ought we not assume that they recognize the risk of having their coupons revoked and price that risk into the bonds? We think it safe to assume, however, that no member of Congress will introduce a bill to repeal the 1939 Acts unanimous consent provisions.

The court has refused to read fiduciary duties into a contract

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underwriting, bondholders would have demanded indenture language prohibiting the type of exchange offer that the issuer made, had they foreseen such an event. In the case of Oak Industries, it was not clear that bondholders would have barred an offer to all participating holders that entailed a payment of cash greater than the prevailing market price of the bonds. In approving the exchange offer, Oaks board of directors may reasonably have concluded that it represented the only remaining means of keeping the company viable.

Claims against fellow bondholders appear unlikely to succeed

Buchheit and Gulati (2000) note, in light of the Delaware courts rejection of an implicit fiduciary duty on the issuers part, that holdouts to an exit consent might instead argue that the departing bondholders tortiously interfered with their contract rights. The authors see little chance of this argument succeeding, however. For one thing, they say, the plaintiffs would have to show that the exiting bondholders had breached a contract in the old bond, which would be difficult to argue in view of a clause expressly permitting amendments of nonpayment terms. Buccheit and Gulati comment: If the black letter of the debt instrument in question gives each lender the right to vote for certain types of amendments or waivers, only very extraordinary circumstances will justify disregarding such a vote. Selfishness on the part of the lenders casting such a vote, their manifest disdain for the Golden Rule, their lack of empathy or charity toward other creditors or even profound ignorance as to what might be in their (or anyone elses) bests interests, are not adequate grounds for disenfranchisement.9

Communication may solve the prisoners dilemma

Regardless of existing court decisions and legal arguments, the use of coercive exchange offers remain controversial. Critics contend that bondholders may agree to an offer that does not improve their position, simply out of fear that two-thirds of holders will accept the proposition and leave those who fail to participate with bonds much reduced in value. Defenders of exit consents counter that bondholders can escape this classic prisoners dilemma10 by communicating with one another before deciding to accept or reject the offer. Kahan and Tuckman (1993) comment: If bondholders can coordinate their actions, the analysis of consent solicitations is simple: bondholders will accept an issuers proposal if and only if they benefit from the changes. Consequently, firms will propose only those changes that increase the value of the firm as a whole and share at least some of the increased value with the bondholders. Clearly, the feasibility of communication depends on whether the ownership of the bonds is widely dispersed or concentrated within a comparatively small number of institutional holders. For most high yield issues, we believe, the latter presumption is not unrealistic. Defenders of the exit consent also cite empirical evidence that holdouts have not suffered significant loss of value as a result of covenant changes. Kahan and Tuckman (1993) find statistically significant, positive abnormal returns on bonds involved in coercive consent solicitations around the time of announcement, indicating that firms cannot, or do not, exploit the coercive nature of their solicitations. Kahan and Tuckman infer that in practice, communication among bondholders through informal channels prevents coercion.11
9

Buchheit and Gulati (2000), p.22. The prisoners dilemma, a core concept in game theory, refers to conditions under which individuals have incentives to behave in a particular way, even though they would be better off as a group to behave in a different manner. For further discussion, see Bannock, Baxter, and Davis (1998), p. 330. Kahan and Tuckman (1993).

10

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"Coercive" Exchange Offers 30 January 2002

Conclusion
Clear thinking is imperative when assessing the fairness of, and legitimacy of complaints about, exchange offers. Contrary to the grumbling sometimes heard in the marketplace, bondholders who have lost money through credit deterioration have no inherent right to be made whole by risk-takers who are willing to inject new capital into the issuer. Although many market participants characterized exit consents as coercive, we do not believe they are intrinsically bad or economically undesirable. In fact, by solving the holdout problem, the mechanism may cause many cases of corporate distress to be resolved outside the context of bankruptcy, where administrative costs are lower. To be sure, this vision may not mollify bondholders hoping to capture a bigger share of the restructuring benefits. As Buchheit and Gulati observe:

Exit consents may be impolite, but they are not obviously unlawful

At the very least, it seems impolite to disfigure a debt instrument by amendment once one has made a commercial decision to leave that instrument. The legal question is whether a bondholder staying behind can claim that either the issuer of the bonds or the exiting bondholders have been guilty of something more than bad manners.12 Certainly, bondholders have a valid gripe if they can show that an issuer has stampeded them into consenting by presenting an unrealistically bleak portrait of its financial condition. Similarly, it is legitimate to squawk if an underwriter makes an exchange offer appear more attractive than it is in reality by driving down the price of the issuers thinly traded outstanding bonds. The securities laws, however, prohibit both misleading disclosure and price manipulation. Bibliography Bannock, Graham, R.E. Baxter, and Evan Davis. Dictionary of Economics. New York: John Wiley & Sons, Inc., 1998. Buchheit, Lee C. and G. Mitu Gulati. Exit Consents in Foreign Bond Exchanges. UCLA Law Review 48:1, October 2000, pp. 59-84. Chatterjee, Sris, Upinder S. Dhillon, and Gabriel G. Ramrez. Coercive Tender and Exchange Offers in Distressed High-Yield Debt Restructurings: An Empirical Analysis. Journal of Financial Economics 38 (1995), pp. 333-360. Kahan, Marcel and Bruce Tuckman. Do Bondholders Lose from Junk Bond Covenant Changes? Journal of Business 66:4 (October 1993), pp. 499-512.

12

Buchheit and Gulati (2000), p. 14.

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