With economic activity down and frozen credit markets clogging the financing spigot, debt exchanges can be a powerful restructuring tool for issuers facing uncertain cash flows. If structured properly, a debt exchange can provide an opportunity for both issuers and noteholders to benefit. Noteholders gain improved recoveries at premiums unavailable in the broader market. Issuers may be able to avoid difficult and expensive discussions with unmotivated lenders and extend maturities, while preserving opportunity for increased returns to shareholders. However, complex issues that need to be addressed quickly in order to get bondholders to participate often arise during the exchange offer process. Therefore, companies considering debt exchanges need to understand both market and legal dynamics to benefit fully.
Harrah's Entertainment Inc., the world's largest casino company by revenue, recently announced its second such transaction, an offer to swap $5 billion in bonds for $2.8 billion in new notes to reduce debt and extend maturities to buy time for Harrah's traditional gamblers to increase the "house advantage." This follows a successful offering completed in December in which $2.2 billion of unsecured notes due 2010 through 2016 were exchanged for $1.4 billion second lien notes due 2015 through 2018. Although only 37% of the $6.6 billion outstanding tendered, the reduction in shorter-term maturities gave Harrah's some much-needed breathing room. Additionally, the first exchange offer resulted in a reduction in principal balances of $1.1 billion, improvement in leverage ratios and extension of the weighted average maturity by about two years. Additionally, the company's credit rating improved from CCC to B-, although it was subsequently downgraded two notches to CC due to continued pressure on refinancing coupled with downward spiraling economics.
The Harrah's participating noteholders received cash for earlier maturities at a small premium to market and new secured, second-lien notes for much healthier premiums of 70% to 354%, resulting in weighted average pricing at 64% of par. The transaction was viewed as positive from all sides. Noteholders got much-needed liquidity on an instrument that might have otherwise plummeted in value, equity holders increased their opportunity to recover previously unachievable returns by delevering cash flows, and the banks benefited from increased coverage reducing the likelihood of a near-term covenant breach. Assuming none were betting on failure, a positive result all around.
The second Harrah's offering, announced March 4, was a tender offer for $5 billion of senior and senior subordinated notes due 2010-2011 in exchange for 10% second-priority senior secured notes due 2018. The bonds were trading at 25% to 34% of par and are being tendered at prices rumored to be materially higher.
Completion of an exchange offer does not, however, always lead to the intended result. Fleetwood Enterprises Inc., a builder of manufactured housing and recreational vehicles, consummated an exchange offer in December. About 80% of Fleetwood's convertible subordinated debentures were exchanged for common stock and new senior secured notes. In March 2008, Fleetwood's continuing liquidity problems forced it to file for bankruptcy and seek to undo the exchange offer to avoid breaking covenants on secured credit facilities. If not for the exchange offer, the debenture holders would have had the right to immediately force Fleetwood to repurchase their bonds. Because the exchange passed the 50.1% threshold required for covenant stripping, the old covenants no longer protect the remaining holders of the debt and likely had some coercive influence on the high participation rate. Fleetwood now needs to restructure in order to avoid falling below the revised liquidity requirements of its secured loan facilities, which would cause a cross default under the new bonds.
In an ironic twist, Leon Black lost out to his previous client and fellow investor Carl Icahn in a debt exchange involving Realogy Corp., the Parsippany, N.J.-based owner of Coldwell Banker and Century 21 brands. Realogy was sued by Icahn's High River LP because it was argued that its senior toggle notes were being unfairly pushed behind new noteholders in the exchange. The Delaware Court of Chancery granted summary judgment to the holders of Realogy's senior toggle notes and ruled that the proposed exchange would have violated the terms of the senior secured credit facility, which forced Realogy to pull the exchange. Vice Chancellor Stephen Lamb of the Delaware Court of Chancery decided not to prejudice the senior lenders by ruling that an interpretation of "Permitted Refinancing Indebtedness" excluded the new second-lien term loan offered in the exchange, despite the accordion feature of its credit agreement. The subordinated debt declined in value substantially after the cancellation of the exchange.
Bondholders will often form ad hoc committees after an issuer launches an exchange offer or announces its intention to do so. They may also seek to have an issuer pay the expenses of the committee, including the fees of any professional advisers engaged by the committee. The formation of a bondholder committee may increase the likelihood of success of an exchange offer, as the committee provides a vehicle for an issuer to negotiate with a large block of bondholders, rather than having to negotiate with a number of individual holders. A committee that holds a majority of outstanding bonds typically has the ability to waive defaults and rescind accelerations. However, without sufficient bondholder participation, the presence of a bondholder committee may reduce the probability of a successful exchange offer, as was the case with Station Casinos Inc.
In December, Station Casinos withdrew its debt exchange offer after an ad hoc committee consisting of more than two-thirds of bondholders notified Station that the new bonds being offered were deficient. As a result, Station recently announced that it intends to file for bankruptcy. Time will tell whether Station's bondholders made the right decision by rejecting the terms of the exchange offer.
Negotiations between GMAC LLC and a bondholder committee in December resulted in GMAC sweetening the terms of its exchange offer for $38 billion of its debt; however, its efforts to qualify as a bank holding company were nearly derailed after Pimco withdrew from the bondholder committee and did not tender its bonds. GMAC successfully obtained bank holding company status and $5 billion in Troubled Asset Relief Program funds, causing Pimco's interest to soar.
In connection with the exchange offer negotiation process, bondholders often request from an issuer certain material nonpublic information, such as detailed information about the issuer's financial situation. Prior to disclosing such information, issuers will require that bondholders enter into confidentiality and standstill agreements. In addition to preventing disclosure, these agreements generally prevent bondholders from selling their bonds or pursuing enforcement rights under the governing debt documents during the term of the agreement. If an issuer proceeds to negotiate without having in place a restriction on sales by a bondholder, it runs the risk that the bondholder sells its securities during the negotiation process, leaving the issuer in a position of having to start the negotiation process over with new holders, a luxury potentially unavailable in today's environment. Bondholders typically insist on short durations for these types of agreements (30 to 60 days is fairly standard) and may require that the issuer publicly disclose any material nonpublic information at the expiration of the term, which allows bondholders to resume trading in the issuer's securities without violating insider trading laws.
A properly structured debt exchange can be a useful tool to delever a balance sheet and provide much-needed cash flow relief for an issuer, while at the same time creating liquidity and price stability for holders. Both debtors and creditors need to work with their financial and legal advisers to handle the complex issues that arise during the process in order to successfully consummate a debt exchange.
Lorre Jay is a managing director in the transaction opinions group of Duff & Phelps specializing in fairness and solvency opinions. Steven Khadavi is a corporate partner in Dorsey & Whitney LLP's New York office and co-chair of Dorsey's capital markets group.