Bondholder Backlash

LBO debtholders are getting tougher about protecting their interests.

For its part, Standard & Poor’s takes claims from unsecured creditors into account when estimating potential recovery values on senior secured debt. “We can see some accommodation” given to such creditors by bankruptcy courts going forward, says William Chew, managing director of Standard & Poor’s.

There is a risk of fraudulent conveyance, if not fiduciary liability, in virtually any transaction that benefits shareholders at bondholders’ expense, so those who arrange such a deal have to hope that a significant amount of time passes before the company involved goes belly up. But there’s no rule of thumb as to how much time is enough to prevent a claim from advancing in court. “As much as possible” is how one lawyer put it at a recent conference.

Based on the 1991 Delaware court decision, however, a company need only be found to be approaching insolvency to trigger a claim of fiduciary liability. Once in the vicinity of insolvency, warns Bratton, “all side deals made by issuers of bonds with equity holders or other insiders become legally questionable.”

The CFO’s Biggest Challenge

To head off potential legal problems, experts caution that CFOs should take bondholders’ complaints more seriously than they may have in the past. At a minimum, notes David DeBerry, vice president of Hartford Financial Products, which sells insurance coverage for directors and officers, CFOs should see to it that decisions favoring shareholders during periods of financial stress are approved by independent board members after obtaining the guidance of financial experts. As DeBerry puts it: “These are changing times for directors.” (For specific actions to avoid, see “On the Hook” at the end of this article.)

That view was seconded at a recent Standard & Poor’s conference by Ronald Nelson, president and CFO of Cendant Corp., itself rumored to be an LBO candidate. Nelson insisted that demands for dividends and share buybacks from such shareholders must be met with “management fortitude.” Legal issues aside, he warned that managers otherwise run a risk of being “left holding the bag without enough capital to grow the business.”

That risk may seem distant when credit conditions have been as easy as in recent years. Even now, defaults by U.S. companies remain few and far between, and their bonds are trading at narrow spreads over Treasuries. But a growing number of observers worry that current trends are unsustainable in light of rising interest rates. S&P’s Chew, for one, contends that current market conditions fail to reflect the amount of financial risk facing companies, but points out that those conditions can change dramatically. “Credit means nothing one moment,” notes Chew, “and then it’s the only thing.”

Of course, the problems associated with a reversal in credit conditions aren’t limited to companies in private-equity portfolios. Even CFOs of publicly owned investment-grade companies are growing more wary of rewarding shareholders at the expense of bondholders. At a panel discussion with Nelson, Carol Tome of Home Depot, which is rated AA by S&P, called the “balancing act” of managing the conflicts of interest between these two sets of investors “the biggest challenge we face going forward.” (Still, Tome noted that Home Depot’s board no longer thinks a AAA rating is worth shooting for, and the company recently announced a $3.5 billion acquisition that will be financed in part with debt.) On the same panel, Devon Energy CFO Brian Jennings warned that bond investors would be even quicker to react to negative developments than they were in the 1990s because they take creditworthiness much more seriously following the failures of Enron and WorldCom. Jennings attributed that to “the lack of [such] focus earlier that led to disastrous results for all constituencies involved.”


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