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Mergers & acquisitions Section 3b: Debt finance Prof. Amitai Aviram Aviram@illinois.edu 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 © Amitai Aviram. All rights reserved. 2
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? Private financing Close monitoring of creditor Bilateral loan Bonds issued in private placement Public financing Access to more capital Ability to spread risks Multilateral loan Bonds issued to the public Securitization (e.g., CLOs, MBSs) © Amitai Aviram. All rights reserved. 3
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 © Amitai Aviram. All rights reserved. 4
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) © Amitai Aviram. All rights reserved. 5
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] © Amitai Aviram. All rights reserved. 6
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%. © Amitai Aviram. All rights reserved. 7
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? © Amitai Aviram. All rights reserved. 8
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) © Amitai Aviram. All rights reserved. 9
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’ © Amitai Aviram. All rights reserved. 10
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. © Amitai Aviram. All rights reserved. 11
Creditor vulnerabilities SH-DH conflicts 3.Underinvestment: if firm’s assets$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 © Amitai Aviram. All rights reserved. 12
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 © Amitai Aviram. All rights reserved. 13
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 © Amitai Aviram. All rights reserved. 14
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 © Amitai Aviram. All rights reserved. 15
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 © Amitai Aviram. All rights reserved. 16
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? © Amitai Aviram. All rights reserved. 17
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 © Amitai Aviram. All rights reserved. 18
Debt finance Overview of Section 3b 1.Bond basics 2.Contractual solutions to creditor vulnerabilities 3.FD to creditors © Amitai Aviram. All rights reserved. 19
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 © Amitai Aviram. All rights reserved. 20
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) © Amitai Aviram. All rights reserved. 21
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? © Amitai Aviram. All rights reserved. 22
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 © Amitai Aviram. All rights reserved. 23
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 © Amitai Aviram. All rights reserved. 24
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 © Amitai Aviram. All rights reserved. 25
Debt finance Overview of Section 3b 1.Bond basics 2.Contractual solutions to creditor vulnerabilities 3.FD to creditors © Amitai Aviram. All rights reserved. 26
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 © Amitai Aviram. All rights reserved. 27
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 © Amitai Aviram. All rights reserved. 28
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 © Amitai Aviram. All rights reserved. 29
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) © Amitai Aviram. All rights reserved. 30
Fiduciary duties to creditors FD of an insolvent firm When does the duty start: how to prove insolvency? Either – 1.“a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof,” or 2.“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.” © Amitai Aviram. All rights reserved. 31
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