Transcript BA Section 6b: Debt finance - University of Illinois

Mergers & acquisitions
Section 3b:
Debt finance
Prof. Amitai Aviram
[email protected]
University of Illinois College of Law
Copyright © Amitai Aviram. All Rights Reserved
F15D
Debt finance
Overview of Section 3b
1. Bond basics
2. Contractual solutions to creditor vulnerabilities
3. FD to creditors
2
© Amitai Aviram. All rights reserved.
Bond basics
Some terminology

Bonds are IOUs given by a firm (issuer) to investors
(debtholders; “DHs”), usually in order to raise money for the
firm (i.e., as an alternative to raising money by selling shares)




Bond sometimes refers strictly to long-term secured debt
Debentures usually refer to long-term unsecured debt
Notes usually refer to short-term debt
How do bonds compare with loans?
Public financing
Private financing
• Access to more capital
• Ability to spread risks
• Close monitoring of creditor
Bilateral loan
Bonds issued
Multilateral loan Bonds issued in
to the public
private placement
Securitization
(e.g., CLOs, MBSs)
3
© Amitai Aviram. All rights reserved.
Bond basics
Some terminology
• Fixed features of bonds
– Principal (face value/par value): amount bond states is owed to DHs
• Bonds usually have face value of $1,000
– Maturity: the date the principal needs to be repaid
– Coupon: annual interest that the bond states issuer will pay
– Optional features
• Secured bond: certain assets serve as collateral
• Guaranteed bond: someone other than issuer guarantees payment
• Callable (redeemable) bond: issuer may redeem (pay) bond before
maturity, often requires paying call premium (e.g., one year’s worth of extra
interest). Why would issuer want to redeem bonds?
• Convertible bond: DHs can convert bond into shares
• Other covenants: issuer obligations, breach of which = default
4
© Amitai Aviram. All rights reserved.
Bond basics
Some terminology
• Changing features of bonds
– Rating: credit rating agencies evaluate
the likelihood of default
– Bond rating may be modified as issuer’s
financial situation changes
– Bond price & yield are related to bond’s
rating (investors compare bond’s yield to
those of similarly-rated issuers; demand
higher yield the lower the bond’s rating)
5
© Amitai Aviram. All rights reserved.
Bond basics
Some terminology
• Changing features of bonds
– Price: how much you currently need to pay to buy a bond
• Price usually quoted with base of 100. Example: Bond has face value of
$1,000; price is quoted as 99.5; so to buy one bond costs $995.
• Par means price of 100
• Below par (discount) means price below 100
• Above par (premium) means price above 100
– Yield: annual return on bond if purchased at current price and assuming
issuer does not default
• Simple example: if price is 100 & coupon is 5%, then yield=coupon=5%
• If price=96, coupon=5%, maturity=1 yr., then yield=9.375% [105/96]
• If price=104, coupon=5%, maturity=1 yr., then yield=0.96% [105/104]
6
© Amitai Aviram. All rights reserved.
Bond basics
Price & yield
• Relationship between price and yield
– When price goes up, yield goes down (and vice versa)
• Example 1 (change in price affects yield): Acme issues 1 yr. bonds at par
with 5% coupon. Later Acme’s financial situation worsens, causing its bond
price to drop by 4%. Yield is now 9.375%.
• Example 2 (change in yield affects price): Acme issues 1 yr. bonds at par
with 5% coupon, which is then the prevalent interest rate for AAA ranked
firms. Later the Fed raises interest rates so that prevalent rate for AAA firms
is 9.375%. Acme’s financial situation is unchanged, but its bond price will
drop by 4% to reflect investor demand for higher interest rates
• Example 3 (same as 1, but price increase): Acme issues 1 yr. bonds at par
with 5% coupon. Later Acme’s financial situation improves, causing its bond
price to rise by 4%. Yield is now 0.96%.
7
© Amitai Aviram. All rights reserved.
Bond basics
Price & yield
• Yields & changes in yields are often expressed not in percents but in
basis points (100 bp = 1%)
– Example: If bond’s yield changed from 5.12% to 5.33%, it increased by 21 basis
points
• What affects yield (and price)? Major factors include:
– Risk of investment in issuer (reflected by the bond’s rating)
– Yield of a risk-free investment (e.g., treasury bonds)
– Maturity: usually, longer-duration bonds have higher yields. Why?
8
© Amitai Aviram. All rights reserved.
Bond basics
Price & yield
• When do price & yield (rather than principal & coupon) matter to issuer?
– Issuer is obligated to pay interest equal to the coupon, no matter what the yield
(i.e., pays same interest whether bond price goes up or down)
• However, if issuer is trying to issue a bond with a coupon that is below the
yield the market expects, issuer will either fail to sell the bond or will sell it
at below par (raising less money and effectively paying an interest equal to
the yield)
• Also, yield indicates what coupon issuer would need to offer if it wants to
issue new bonds
• When do price & yield matter to DH?
– If DH holds bond to maturity, she will get a return equal to the yield at the price
she purchased the bonds (e.g., if she purchased at par, return=coupon)
– If DH sells bonds before maturity, she will get market price, which may be lower
or higher than par (i.e., yield may be lower or higher than coupon)
9
© Amitai Aviram. All rights reserved.
Bond basics
Creditor vulnerabilities
• Firms are likely to act to maximize SH interests
– Directors are elected by SHs, so they’ll try to please them to get reelected
– Most jurisdictions require directors to maximize SH interests
• Therefore, DHs need to be aware of (& seek protection against)
situations in which their own interests conflict with SHs’
10
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
SH-DH conflicts
1. Asset withdrawal: firm may distribute so many of its assets to SHs (either
as dividends or by repurchasing its shares), that it does not have enough
assets meet obligations to DHs
– Example: Firm has $100 in equity; borrows $900. Firm then issues its SHs a dividend
of $600 (or uses $600 to repurchase shares @ inflated price). Firm now has $400 in
assets and $900 in debt – likely to default on debt
2. Claim dilution: firm may issue new bonds/take new loans that have the
same or higher priority on firm’s assets, diluting existing DHs
– Example: Firm has $100 in equity, borrows $900 (unsecured), uses all $1,000 to buy
manufacturing plant. Firm then borrows another $800, using the plant as collateral.
Firm loses money, ultimately having only its plant (which it can sell for $1,000) & no
money. The secured ($800) creditor has first priority to the plant, so gets repaid all
$800. Other DHs have $200 in assets to pay for $900 in debt.
11
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
SH-DH conflicts
3. Underinvestment: if firm’s assets<debt, profits go to DHs, not SHs. SHs still
control firm, and they have low incentive to invest profitably
– Example: Firm has $100 in equity; borrows $900. After years of losses, firm has only
$700 in assets. Firm has opportunity to invest in a project that will result in a $150
profit. SHs will see none of that profit (since after project firm still has only $850 in
assets vs. $900 in debt), so firm does not invest. Firm may not invest even if profit is
$210, if effort in investing is costs them >$10
4. Asset substitution: SHs want firm to take more risk than DHs want; firm
borrows @ low rates because it is low-risk; raises risk after borrowing
– Example: Firm has $100 in equity; borrows $900. Considers project that has 50%
chance to lose $800 & 50% chance to profit $600 (expected value:-$100). For SHs,
this means 50%: -$100; 50%: +$600 (expected value: +$250), so firm invests in
project
– Even if project has positive expected value, DHs suffer more of the downside and
gain less of the upside, so they want firm to take minimum risk, but SHs can
increase risk-taking after debt is issued
12
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
MetLife v. RJR Nabisco [SDNY 1989]
• Private equity firm KKR takes over RJR Nabisco in an LBO that caused
RJR to assume $19B in additional debt, decreasing the value of
existing RJR debt
– This is a form of claim dilution
• MetLife, an RJR DH, sues RJR claiming bonds must be redeemed (at
face value) because of:
– Breach of implied covenant of good faith & fair dealing
– Entitlement to an equitable remedy
• Policy argument
– LBO resulted in RJR’s SHs receiving value ($109/share) while DHs (who are
supposed to have superior claim) lost value (because of claim dilution)
– RJR emphasized its creditworthiness in speeches to DHs
13
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
MetLife v. RJR Nabisco
• Irrelevance of RJR officers’ statements (the Sharon Steel rule)
– Court: “Parol evidence rule bars plaintiffs from arguing that the speeches made
by company executives prove defendants agreed or acquiesced to a term that
does not appear in the indentures. In interpreting these contracts, this Court
must be concerned with what the parties intended, but only to the extent that
what they intended is evidenced by what is written in the indentures.”
– Applies rule in Sharon Steel Corp. v. Chase Manhattan Bank
(CA2 1982), that in interpreting boilerplate provisions in
indentures, court should avoid considering extrinsic evidence
– What’s a boilerplate provision?
– Why exclude extrinsic evidence in interpreting boilerplate?
• So, MetLife’s claims depend on language of the indenture
14
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
MetLife v. RJR Nabisco
• Language of the indenture
– Issuer is in default if it•
•
•
•
Fails to pay principal when due
Fails to make timely payment to a sinking fund
Fails to pay interest within 30 days of due date
Breaches any express covenant
– Relevant express covenants
• Restrictions on subordinating existing debt to new debt (e.g., via mortgage/lien)
– But no restriction on adding debt of equal priority
• RJR Nabisco “may consolidate with, or sell or convey, all or substantially all of its
assets to, or merge into or with any other corporation” so long as
– New entity is a US corporation
– New entity assumes RJR Nabisco's debt
– Transaction does not result in RJR’s default under any indenture provision
15
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
MetLife v. RJR Nabisco
• Implied covenant of good faith & fair dealing
– Court: “the implied covenant will only aid and further the explicit terms of the
agreement and will never impose an obligation ‘which would be inconsistent
with other terms of the contractual relationship.’”
– Example: Van Gemert (CA2 1975) – Indenture required issuer to notify DHs
before redeeming bonds (so DHs can decide if they want to convert their
bonds). Issuer issued press release mentioning possibility of redemption
without mentioning date of redemption or DHs’ conversion rights. Court found
this violated covenant of good faith & fair dealing.
– Court: no implied covenant prohibiting LBO debt
• Express language of indenture allows undertaking LBO debt
• No breach of express, bargained-for contractual rights
• No objective standard for implied term: what risky business decision would be
OK? (e.g., entering new line of business?)
• Plaintiff is sophisticated party that anticipated the LBO risk
16
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
MetLife v. RJR Nabisco
• Claim in equity – plaintiffs base claim on
–
–
–
–
Unjust enrichment
Frustration of purpose
Unconscionability
Breach of fiduciary duty
• Fiduciary duty
– Court notes Simons v. Cogan [Del.1988], which states that a corporate bond is a
contractual entitlement that does not create a fiduciary duty
• Exception when corporation is insolvent or in “zone of insolvency”
– While NY and not Delaware law applies, court finds that under NY law, DHs not
entitled to FD, at least when they are “sophisticated investors who are
unsecured creditors”
• Odd qualification; existence of FD usually depends on type of relationship, not
sophistication of parties (though the latter may affect scope of duty)
• What could MetLife bargained for to protect it from an LBO?
17
© Amitai Aviram. All rights reserved.
Creditor vulnerabilities
Options for solutions
• Creditors have several solutions to their vulnerabilities
– Convertibility: give creditors option to convert bonds into shares
– Covenants: contractual obligations of borrower
– Fiduciary duties: force directors to protect creditors’ interests
18
© Amitai Aviram. All rights reserved.
Debt finance
Overview of Section 3b
1. Bond basics
2. Contractual solutions to creditor vulnerabilities
3. FD to creditors
19
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Convertibility
• Convertibility: give DHs option to convert bonds into shares
– Gives DHs the upside of pro-SH actions (e.g., taking greater risk)
– Dilutes existing SHs, so they don’t gain as much from pro-SH actions
– Not complete protection
• DHs may not want the increased risk involved in owning shares
• SHs may still gain some excess profit as long as the conversion price is
higher than the market price of the shares
20
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Covenants
• Covenants: contractual obligations of borrower
– When bonds are issued, and indenture (contract) created to specify borrower
obligations
– Three common types of covenants
• Obligations that reduce borrower’s ability to exploit DH vulnerabilities (e.g.,
limits on paying dividends or taking new loans with superior claims)
• Obligations that indicate worsening financial conditions and, if breached, cause
loan to be in default and payable immediately – borrower will likely not be able
to pay immediately, but DHs’ can leverage their power to force borrower into
bankruptcy, to veto or modify undesirable transactions
• Obligations that reduce cost of monitoring borrower (e.g., reporting duties)
21
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Katz v. Oak Industries [Del. Ch. 1986]
• Oak is in poor financial shape. It brings in a new equity investor, Allied-Signal, but
AS’s $15M investment is conditioned on restructuring Oak’s debt:
– Voluntary exchange of ~$39M in debt for common shares
– Voluntary exchange of remaining debt for cash, at $655-918 per $1,000 face value
(i.e., a 8.2%-34.5% “haircut”)
– Removing from indenture of remaining bonds the financial covenants &
requirement to redeem all bond classes proportionally. Why is this important to
Oak?
• Under bond indentures, amendments require approval by holders of 50% or 66⅔%
of the principal
• Oak conditions cash for debt exchange in:
– Success of the shares for debt exchange; and
– Consent to amending the indenture
• Why does Oak need each of these conditions?
22
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Katz v. Oak Industries
• Katz, a DH, sues to enjoin the exchanges
– DHs are structurally coerced into tendering and consenting to indenture
amendments, because if a dissenting DH does not tender and majority of DHs
do, then dissenting DH is left holding a bond w/weakened covenants
– Viewed differently, dissenting DHs may be forced to accept an indenture
amendment approved by the votes of those who are no longer DHs (since they
exchanged their bonds for cash)
• Court: Oak doesn’t owe FD to DHs, but to SHs, so structuring the
exchange offer to benefit SHs is permitted, expected & even required
– as long as all contractual duties to DHs (express & implied) are
honored
• No express indenture provisions were violated
– We’re left with implied covenant of good faith & fair dealing
23
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Katz v. Oak Industries
• Implied duty of good faith & fair dealing
– Standard: “is it clear from what was expressly agreed upon that the parties who
negotiated the express terms of the contract would have agreed to proscribe the
act later complained of as a breach of the implied covenant of good faith – had they
thought to negotiate with respect to that matter”?
– As in MetLife, implied covenant must facilitate express terms of the indenture.
What express terms does Katz point out to?
• Applying to the indenture clauses Katz addresses
– Express terms suggest a commercial relationship, so no implication that
inducements to provide consent are prohibited
• Structural coercion is OK here. How does this compare with Unocal?
– Purpose of clause banning Oak from voting its bonds is to prevent CoI; here,
consenting DHs have no such CoI
– Redemption clause applies to forced redemption; exchange is voluntary
24
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Covenants
• Enforcement – the indenture trustee
– DHs face a collective action problem
• Each may have too little an investment to justify enforcement expenses
• Hard to exclude from benefits of enforcement, so each DH will try to free ride
on others’ enforcement efforts
• In public bond offerings, too many investors to negotiate covenant terms with,
and many investors don’t know in advance that they’ll invest, so aren’t around
to negotiate indenture terms
– Solution: the indenture trustee
• Borrower pays a reputable, independent firm to negotiate and enforce
indenture on DHs’ behalf
25
© Amitai Aviram. All rights reserved.
Debt finance
Overview of Section 3b
1. Bond basics
2. Contractual solutions to creditor vulnerabilities
3. FD to creditors
26
© Amitai Aviram. All rights reserved.
Solutions to DH vulnerabilities
Fiduciary duties
• Fiduciary duties: force directors to protect DHs’ interests
– This protects DH interests better than contractual protection, because
managers are likely to find loopholes in any contractual restriction
– But directors already owe FD to SHs, who have no ability to protect themselves
contractually
• If directors owe FD to DH and not to SHs, then SHs would be completely
vulnerable, and may not agree to invest in firm
• If directors owe FD to both SHs and DH, SHs are still very vulnerable, and
directors may pick which side they protect based on self-interest
– Therefore, in most US jurisdictions, directors do not owe FD to DHs in a solvent
corporation
• This is the rule expressed in MetLife and Katz
27
© Amitai Aviram. All rights reserved.
Fiduciary duties to creditors
FD of an insolvent firm
• Hypo: Acme’s gamble
– Acme was formed selling 100 shares for total of $100, then borrowing another
$900. Total assets: $1,000
– Acme suffers losses of $300. Total assets: $700; debt: $900
• If Acme is liquidated now, SHs get 0; DHs get $700
– Acme’s board is offered a business opportunity that requires a $500
investment, and has a 90% chance of failing (investment lost), and a 10%
chance of success (investment worth $1,500)
• 90%: investment fails, assets = $200. SHs get 0; DHs get $200
• 10%; investment succeeds, assets = $1,700. SHs get $800; DHs get $900
– Would SHs want to invest? Would DHs?
– What maximizes total firm value (i.e., total assets)?
• Expected value of investment: $150 (90%x0 + 10% x $1,500); cost: $500
• This is why, in an insolvent firm, a FD to DHs may make sense
28
© Amitai Aviram. All rights reserved.
Fiduciary duties to creditors
FD of an insolvent firm
• Delaware accepts this rule
– Gheewalla: “When a corporation is insolvent […] its creditors take the place of
the shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to [sue]
for breaches of fiduciary duties. The corporation's insolvency ‘makes the
creditors the principal constituency injured by any fiduciary breaches that
diminish the firm's value.’”
– In Gheewalla, creditor NACEPF claimed that Clearwire continued operating,
burning through $2.1M/month with no revenues, to keep SH’s investment “in
play”
• This is similar to our hypo’s $500 investment
29
© Amitai Aviram. All rights reserved.
Fiduciary duties to creditors
FD of an insolvent firm
•
When does the duty start: when the firm is insolvent, or before that,
in the “zone of insolvency”?
–
SHs have an incentive to take excessive risks even before firm is actually
insolvent, but when it is close to that situation
–
Example: in previous hypo, suppose Acme lost $90, so assets = $910. If it invests
$500 and fails (90%), SHs lose $10, DHs lose $490. If it invests & succeeds (10%),
SHs gain $1,500, DHs gain nothing. SHs go for it.
–
Nonetheless, Gheewalla suggests no “zone of insolvency” duty to creditors:
“When a solvent corporation is navigating in the zone of insolvency, the focus
for Delaware directors does not change: directors must continue to discharge
their fiduciary duties to the corporation and its shareholders by exercising
their business judgment in the best interests of the corporation for the benefit
of its shareholder owners.”
Reason: providing directors with clear goals (zone of insolvency is difficult to
define)
–
30
© Amitai Aviram. All rights reserved.
Fiduciary duties to creditors
FD of an insolvent firm
•
When does the duty start: how to prove insolvency? Either –
1.
2.
•
“a deficiency of assets below liabilities with no reasonable prospect that the
business can be successfully continued in the face thereof,” or
“an inability to meet maturing obligations as they fall due in the ordinary
course of business.”
Who has the legal claim: DHs (direct) or firm (derivative)?
• Gheewalla: Claim belongs to firm, and is therefore derivative
• Quoting from Production Resources: “At all times, claims of this kind belong
to the corporation itself because even if the improper acts occur when the
firm is insolvent, they operate to injure the firm in the first instance by
reducing its value, injuring creditors only indirectly by diminishing the value
of the firm and therefore the assets from which the creditors may satisfy
their claims.”
31
© Amitai Aviram. All rights reserved.