The leap-frog dilemma

As the credit crunch continues and liquidity remains scarce, highly leveraged companies continue to explore opportunities to refinance debt and, when possible, delever.

As a result, late 2008 and the first quarter of 2009 witnessed a parade of debt-for-debt exchange offers. Generally, the exchange offers enable a company to refinance existing debt on a noncash basis by offering bondholders the opportunity to exchange existing bonds for newly issued debt having a face amount equal to or slightly higher than the current market value of the existing debt. Because targeted existing bonds are typically trading at a significant discount from their face amount, companies are able to use the exchange offer to reduce their total outstanding indebtedness. In addition, the new debt received by participating bondholders often has a later maturity date, relieving the company, in the near term, of the debt repayment. As an additional incentive, the recently enacted American Recovery and Reinvestment Tax Act of 2009 eases the tax burden associated with debt exchanges.

Bondholders are willing to participate in these exchanges for a few reasons. First, in certain, but not all, exchanges, the new debt pays a higher coupon than the existing bonds. More importantly, however, the new debt is often more senior in the company's capital structure than the existing bonds (that is, senior, secured or guaranteed). This provides a strong incentive to tender and a stronger disincentive to not tender, as a non-tendering bondholder is left with a bond that is now more junior in the capital structure than the exchanged debt. In other words, the non-tendering bondholder finds it has been "leap-frogged" in the capital structure as a result of the exchange. Because of this risk, these exchanges are often viewed as coercive.

Naturally, holders of debt in coercive exchanges are increasingly scrutinizing the documentation governing their holdings (as well as the company's other debt instruments) to determine whether the documents permit the company to implement the exchanges. In certain instances, holders of the debt have determined that the governing documents do not in fact permit the coercive exchange and have challenged the exchange in court. The closely watched exchange offer proposed by Realogy Corp., for example, resulted in a legal challenge by certain Realogy bondholders on the basis that the company's credit agreement and the relevant indenture did not permit the exchange. Realogy had offered to exchange existing unsecured bonds for new secured term loans to be issued under an incremental facility available under its credit agreement. The plaintiffs in the legal action argued that although Realogy was contractually permitted to repurchase the existing unsecured bonds, it was not permitted to do so in an exchange for secured debt. The court ruled in favor of the bondholders and the exchange did not go forward. The ultimate determination by the court in Realogy focused on a proviso within an exception to a negative covenant in Realogy's credit agreement.

More recently, certain senior lenders under Freescale Semiconductor Inc.'s credit agreement filed a complaint alleging that the company's two recently completed exchange offers violated the credit agreement. In each offer, Freescale offered to exchange unsecured bonds for secured incremental term loans. The complaint alleges, among other things, that Freescale had experienced a material adverse effect with respect to its business. As such, the complaint alleges, Freescale was not able to satisfy the conditions precedent to the incurrence of new debt and thus violated the terms of the credit agreement by issuing the new incremental term loans.

In what could be a significant development in the area of exchange offers, the Freescale lenders have also named as defendants the Freescale bondholders that participated in the exchange offers. The lenders have argued that the bondholders tortiously interfered with the credit agreement by inducing and colluding with Freescale to issue the new term loans in violation of the credit agreement. In addition to damages, the lenders request that the claims of the bondholders be equitably subordinated to the priority of the original notes held by them prior to the exchange. Depending on the outcome of this litigation, debtholders that elect to participate in future exchanges may be faced with a difficult choice: participate in an exchange and be exposed to potential liability, or sit back and watch other investors move ahead of them, or leapfrog over them, in the capital structure.

Until a meaningful thawing of the credit markets is achieved, it is likely that debt-for-debt exchanges will maintain their popularity with overleveraged companies. It is critical for investors to analyze accurately the risk of these exchanges occurring with respect to their debt holdings and prospective investments. Investors also need to be prepared to challenge debt exchanges when appropriate. Familiarity with the documents governing the debt is, of course, critical. It is particularly important to consider what additional indebtedness the company's credit agreement and indentures permit, the scope of any restricted payment covenants, and the ability of the company to grant additional liens over its assets. In each instance it is also critical to examine closely the exceptions and baskets to the general prohibitions. Although each contract will be unique, we have found certain features to be important indicators in assessing whether a company's debt documentation permits one or more of its debt instruments to be exchanged for new secured debt: