Bondholder Backlash

LBO debtholders are getting tougher about protecting their interests.

Tellingly, perhaps, a number of junk-bond deals in recent weeks have been pulled, reduced in size, or taken to market with stiffer conditions attached. Since mid-September, School Specialty Inc., Euramax International Inc., and Pregis Corp. canceled junk-bond offerings worth $1.2 billion, while six non-investment-grade companies reduced the size of their issues, according to Bloomberg News Service.

And dividend payments for LBO sponsors are starting to encounter resistance from bondholders of issuers besides Neiman Marcus. Consider satellite company Intelsat’s pending acquisition of rival PanAmSat. While the bond financing the acquisition itself was well received, the same cannot be said for Intelsat’s attempt to raise another $200 million that same day for a share buyback for its private-equity sponsors. After investors balked, the company withdrew the offering. But they now expect Intelsat to return to the market at some point with that purpose in mind, a prospect that one high-yield fund manager who asked not to be identified finds “troubling.”

By now, it should be obvious to CFOs of highly leveraged companies that shareholders don’t always come first. But if it isn’t, the odds seem to be growing that judges as well as bondholders will remind them.

Ronald Fink is a deputy editor at CFO.


Debating Creditors’ Rights

Delaware court decisions that say officers and directors owe a fiduciary duty to creditors when a company is in the “zone of insolvency” have sparked considerable debate within the legal community.

On the one hand, it is widely accepted that the closer a company is to insolvency, the greater the incentive for managers to make risky and even “negative expected value” investments in order to maximize shareholders returns. In the 1991 case of Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., however, the Delaware Court of Chancery observed that as a result, directors should include creditors with shareholders in a “community of interests” to whom directors owe fiduciary duties. In that case and others, Delaware courts argued that shareholders’ special status begins to fade even before the company becomes insolvent.

“At least where a corporation is operating in the vicinity of insolvency,” the chancery court noted in Credit Lyonnais, “a board of directors is not merely the agent of the residue risk bearers but owes its duty to the corporate enterprise.” The court gave creditors priority over employees, taxpayers, and other stakeholders in the enterprise, because creditors bear the residual risk once it becomes insolvent. And the court made no distinction between secured creditors and unsecured ones when it came to fiduciary duty.

Critics of this view concede that while corporate directors and officers may have perverse incentives to reward shareholders when a company nears insolvency, creditors already have contractual rights that enable them to sue for fraudulent conveyance. Therefore, critics say, giving creditors fiduciary rights as well makes no sense. Moreover, these observers contend, doing so raises the troubling prospect that the judgment of courts will substitute for that of managers in running corporations. Proponents of enhanced creditors’ rights counter that such contracts have gaps, particularly for bondholders and other unsecured lenders, and that these need to be plugged via fiduciary obligations.

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