Editor: Please describe your background for our readers.
Lopez: I am a partner in the Corporate group at Proskauer Rose. My background is primarily in debt and equity capital markets with a concentration in high-yield bonds. In a good market I represent underwriters, initial purchasers, placement agents and issuers in a wide range of debt capital markets work. When there is a downturn in the economy, my skill set is perfect for restructuring work, particularly in the high-yield bond area. I create the bonds in good times, but as issuers approach or enter distressed situations, I am in the best position to tweak the bond covenants and terms in negotiations with bondholders to enable issuers to continue as a going concern or buy some breathing room as they face liquidity constraints.
Editor: Frank, what is there about the current market environment that will lead to an uptick in bond restructurings in 2009 and beyond?
Lopez: It has been well documented that in recent years, particularly 2006 and 2007, we saw levels of high yield bond deals like we have never seen in the past, even in previous LBO frenzies. As a result, we currently have many companies that were previously investment grade or were high yield but are now very distressed owing to the significant downturn in the economy. Because of this situation, we are going to see situations where hundreds of companies will be forced to restructure, probably in the next year to two years.
According to the statistics that I have read, almost half the bonds of corporate borrowers, approximately one trillion, are considered to be below investment grade. We are expecting over one hundred billion dollars worth of high yield bonds to mature over the next few years. Taking this factor into account, together with plummeting cash flows represented by significant decreases in earnings, we have a perfect recipe for both interest, principle and covenant defaults in the very near term.
Unlike in recent downturns such as 2001 and 2002, the primary markets are effectively closed both on the debt and equity side to anyone, but solid well-known issuers. The traditional method of addressing a liquidity crisis is refinancing the bonds through a tender offer or redemptions but today raising cash is not a viable option.
Although cash infusions are always a great supplement to an exchange offer, what I expect we are going to increasingly see is a significant upturn in exchange offers where there is no or minimal new cash coming into the company as part of the recapitalization. I think for the most part we are going to see straight exchange offers where bonds are restructured to delever the balance sheet to the "right" level and afford some liquidity to the borrowers.
Editor: Do you expect to see both new equity along with newly issued bonds or strictly all bonds?
Lopez: I don't expect to see much new equity, at least not in the form of cash infusions. I think that what happens is that the companies will go out to their existing bond holders and sponsors for relief. For instance, if there is an interest payment coming due in the next two to three months and the company knows that it just doesn't have the liquidity to make the payment, it will go to its existing bondholders and make a new offer, such as a bond offering with credit enhancers and tighter covenants and some sort of equity kicker. There is no real cash changing hands - it is effectively a cash-less recapitalization.
Editor: What are the various types of bond restructurings that a company can consider?
Lopez: This subject is discussed in part on the adjoining page in Joshua Thompson's interview. I shall focus more on bond exchange offers as opposed to cash tenders or other refinancings since the traditional types of refinancings are not viable at this point in time. There are typically three types of exchange offers. A company needs to think about its own characteristics when determining which is best for it. It can do a registered exchange offer, a "3(a)(9)" exchange offer under Section 3(a)(9) of the Securities Act or a private exchange offer. A registered exchange offer is fairly unique although you will see it occasionally with large publicly held companies. The reason is that it is potentially time consuming because a company has to file with the SEC; if you are in a distressed situation, time is not on your side.
A Section 3(a)(9) is a relatively unused exemption. Section 3(a)(9) is interesting because it effectively states that if you do an exchange offer to your current base of bondholders, and you are not paying a dealer manager or others for soliciting bonds or going to any new bondholders, and the consideration for restructuring is only bonds with no new cash from bondholders in the exchange, then such restructuring is not going to require registration with the SEC. A key advantage of 3(a)(9) is that so long as the securities being exchanged are freely tradable, then so will the new exchange bonds.
The third option is a private exchange offer, which is akin to an 144A-type offering - the terms and process looks a lot like the original offering that you might do for a high yield bond offering. An issuer would go out to institutional buyers with an offering document, but with more negotiation than in a primary capital markets deal. You would typically pre-negotiate with the largest bondholders under NDAs to find your anchors before going to the rest of the bondholder base.
Editor: Wouldn't the institutional buyers demand more control as a quid pro quo?
Lopez: Absolutely. So what ends up happening, depending on whether you have a dealer manager or if the company does it directly themselves, there would be a dialogue internally within the company, which would come up with a kind of wish list from the company perspective. The company would create a term sheet and would go out to its existing bondholders describing the new security. There will be negotiation usually beginning with valuations - the valuation discussion will set the tone for whether the bondholders view their debt as underwater and therefore little incentive to leave current equity holders with little more than an option if performance comes back to traditional levels. Lenders and bondholders will often ask for collateral, tighter covenants as well as other constraints on the company.
Editor: Which do you recommend of the three options for refinancing?
Lopez: As I said earlier, registered exchange offers are rarely used owing to time constraints because you have to go through the SEC. I would rarely recommend doing a registered exchange, particularly in the context of a private company. Under 3(a)(9) you can hire someone to be an information agent to perform ministerial tasks, but the agent cannot proactively be entering into a dialogue in the solicitation process. The question for most companies is whether they need a dealer manager to represent the issuer in leading the negotiations with the lenders or bondholders. That can turn on the number of bondholders and whether a committee has been formed. Interestingly, 3(a)(9) may afford itself better to a company with a sophisticated management team to enter into dialogue directly with the bondholders. If the issuer lacks sophistication, it should probably hire an advisor to negotiate since institutional bondholders are, generally speaking, a very savvy bunch, which may lead to the inadvertent result of penalizing less sophisticated companies that need to engage a dealer manager and thus fall out of the exemption.
Editor: What market trends are you seeing today in terms of buybacks of bonds?
Lopez: Over the last decade, we have seen a lot of funds that were not traditionally buyers of high yield bonds come into the market for high yield securities. As the market has turned and with prices of bonds at such low levels, we are seeing an influx of various types of funds buying up distressed bonds. I think that is leading, and will lead, to more organized bondholder activism. Traditionally under Delaware law, where most companies in the U.S. are incorporated, a board only owes a duty to its shareholders. Bonds are governed by their indentures, which generally confine the rights of bondholders to the terms of the contract with no independent duties under state law from directors to bondholders. However, recent case law indicates that once a company hits a certain level of distress, a term of art known as the "zone of insolvency," a board may have some duties to the entire enterprise, meaning all stakeholders including creditors like bondholders, employees and suppliers. Once you get to that level the board has to think of everyone involved in the company beyond preserving the equity value for its shareholders.
Editor: Is there a case that you can site where this has occurred?
Lopez: The Credit Lyonnais Bank v. Pathe Communication case is one where the court felt that once a company has entered a zone of insolvency, directors should view duties as running towards the company as an entire enterprise, not towards stockholders or creditors as individual constituents.
Editor: Any particular key issues that companies and advisors should consider before undertaking a bond restructuring?
Lopez: The level of liquidity is very important to monitor. Once a company hits a level of distress, its board should start meeting as frequently as possible. It should immediately consider engaging both a legal bankruptcy or restructuring counsel specialist, or a financial advisor who can help it run analyses on the company and think about strategy. Advisors will be instrumental in getting the right information to the board to make strategic decisions. This should be done sooner rather than later to set a clear process to recovery. The distressed company should also be very careful about the record it creates, including emails, minutes of meetings or other correspondence. It is important to set out a strategy that considers and encompasses the whole enterprise.
Many of the transactions that we are discussing today can be planned for or anticipated well in advance of insolvency, which is a fluid concept. The ability to consummate a debt buyback transaction or do a debt exchange is something which boards of directors or management of a company can put on its agenda for consideration well before the company's performance declines to a point of a liquidity crisis.
Published March 31, 2009.
