As the credit crunch continues and liquidity remains scarce, highly leveraged companies continue to explore opportunities to refinance debt and, when possible, de-lever. As a result, late 2008 and the first quarter of 2009 witnessed a parade of debt-for-debt exchange offers from such companies. Generally, the exchange offers enable a company to refinance existing debt on a non-cash basis by offering existing bondholders the opportunity to exchange existing bonds for newly issued debt. The existing bonds are typically exchanged for new 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, further relieving the company of financial pressure associated with ultimate repayment of the debt.

Bondholders are willing to participate in these exchanges for a few reasons. First, the bondholders are likely to have purchased the existing bonds at a significant discount to the face amount. Second, in certain, but not all, exchanges, the new debt pays a higher coupon than the existing bonds. Finally, and perhaps most importantly, the new debt is often more senior in the company’s capital structure than the existing bonds (e.g. senior, secured or guaranteed). This provides a strong incentive to tender and 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, and any debt already layered between it and the new debt, finds it has been “leap-frogged” in the capital structure as a result of the exchange.

Investors in distressed debt need to be cognizant of the elements of a capital structure and the terms of indebtedness documents that allow for these exchanges so they can better assess the risk of being leapfrogged in their investment. In addition, depending on the outcome of the recently commenced litigation discussed below, investors may also need to consider whether participating in an exchange offer could subject them to liability. If so, investors could be faced with a critical dilemma: participate in an exchange and be subject to liability, or sit back and watch other investors leap-frog over you in the capital structure.

Recent Debt Exchanges

Recent debt exchange offers have been launched by Realogy Corporation, Harrah’s Entertainment, Inc. (twice now in the last four months), ResCap, GMAC, Freescale Semiconductor, Inc., Station Casinos, Six Flags, NXP Semiconductors, Neff Corp., iStar and others.

Several companies have proposed exchanging existing bonds for new senior secured bank debt issued pursuant to an incremental facility under their existing senior secured credit facility. Although arguably not their originally intended use, the incremental facilities have provided a means to refinance existing bondholders, on a non-cash basis, and move such existing holders of debt up the capital structure. Successful completion of such an exchange using an incremental facility effectively converts existing unsecured bondholders into secured bank debt lenders, with either a first or second lien.

The recently enacted America Recovery and Reinvestment Tax Act of 2009 (the “Act”) provides additional incentive for companies to complete an exchange offer in 2009 or 2010. The Act enables companies to defer the recognition of cancellation of indebtedness (“COD”) income arising in 2009 or 2010 until 2014, at which point such income must be reported ratably over a five year period. The amount of COD income resulting from an exchange of publicly traded debt is generally based on the difference between the face amount of the extinguished debt (assuming it was not issued at a discount) and the initial trading price of the new debt issued in the exchange. Harrah’s most recent exchange offer proposal appears to have been enabled, at least in part, by this new tax incentive. Harrah’s exchange offer in December 2008 had been subject to a cap based on the amount of COD income that would be incurred as a result of that exchange. The current exchange offer is not limited by such consideration.

Not all of these debt exchanges have been successful, however. Because of the coercive nature of the exchanges, in addition to weighing the economics of a proposed exchange, investors have scrutinized the documentation governing their debt holdings to determine whether the relevant documents permit the borrower to implement the exchange. The closely watched exchange offer proposed by Realogy Corporation resulted in a legal challenge by certain of Realogy’s bondholders on the basis that Realogy’s credit agreement and the relevant indenture did not permit the exchange. As noted below, 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 Freescale’s recently completed exchange offers violate the credit agreement. More troubling for the investing community, the Freescale complaint also alleges that participating in the exchange offers constitutes tortious interference by the junior debt holders with respect to the credit agreement.

The Realogy and Freescale disputes highlight the need for investors to examine closely the documentation governing any of their holdings, or potential holdings, to determine whether or not they could be subject to or affected by a coercive exchange. More importantly, depending on the outcome of the Freescale litigation, investors may have to determine whether participating in an exchange can expose them to liability. Should the plaintiffs in Freescale prevail in their claims against the junior debt holders, it could have a significant chilling effect on the willingness of investors to participate in these exchanges.

The Realogy Exchange Offer

Realogy Corporation launched its proposed exchange offer in November 2008, inviting holders of its two issuances of senior notes and its senior subordinated notes, all of which were unsecured, the opportunity to exchange their holdings for new bank term loans secured by a second priority lien. The new term loans were to be issued pursuant to an incremental facility available under Realogy’s existing credit agreement. Holders of the senior toggle notes complained that the terms of the exchange offer discriminated against them and favored the other senior notes.1 After Realogy refused to address these concerns, certain holders of the senior toggle notes, led by Carl Icahn, filed a lawsuit in the Court of Chancery of the State of Delaware seeking a declaratory judgment that the proposed exchange offer violated the negative covenants of the senior toggle notes indenture.

The Court considered two arguments from the bondholders: that (i) the credit agreement did not permit the new indebtedness to be issued for non-cash consideration and (ii) even if the loans were permitted for non-cash consideration under the credit agreement, the loans could not be secured. If either argument were successful, it would also mean that the senior toggle notes indenture would prohibit Realogy from granting liens on the new indebtedness without granting equal and ratable liens to the senior toggle notes (a “negative pledge” provision). The Court gave little merit to the argument that the issuance of the new debt under the credit agreement must be for cash consideration. Rather, the case was ultimately decided on whether Realogy’s credit agreement prohibited Realogy from refinancing the existing unsecured bonds with secured debt.

The parties agreed that a lien validly granted under the credit agreement would not violate the negative pledge clause in the senior toggle notes indenture. Therefore, the Court had to determine whether the liens on the new term loans could be granted under the credit agreement. To comply with the negative covenant with respect to the repayment of bonds, the new term loans were being issued under the credit agreement as “Permitted Refinancing Indebtedness.” The Court therefore analyzed whether the definition of Permitted Refinancing Indebtedness allowed Realogy to grant liens on indebtedness issued to refinance unsecured debt.The definition of Permitted Refinancing Indebtedness stated that, generally, new debt issued as Permitted Refinancing Indebtedness could not be granted secured status greater than the debt being refinanced. The definition also contained a proviso, however. Realogy’s position was that the proviso permitted a lien to be granted in respect of the new term loans if the credit agreement otherwise allowed a lien to be granted with respect to the new indebtedness. The credit agreement allowed for the incremental facility term loans to be subject to liens. Realogy argued that, as a result, the bonds could be refinanced with secured incremental facility term loans. The bondholders argued, however, that in order to qualify under the proviso, the bonds being exchanged, and not the newly issued term loans, have to be permitted to be secured under the credit agreement. The bondholders argued that because any transaction ultimately would be required to satisfy the negative covenants in the credit agreement with respect to the placing of liens on new indebtedness, Realogy’s interpretation of the proviso would have rendered the general prohibition mere surplusage. The Court agreed with the bondholders and concluded that the bonds could not be refinanced with secured indebtedness. As such, the exchange offer, as structured, violated the senior toggle notes indenture.

The Freescale Exchange Offers

Freescale completed two exchange offers inMarch 2009. In each offering, similar to Realogy, Freescale offered to exchange existing bonds for new secured term loans to be issued under an incremental facility available under the credit agreement. On March 24, 2009, certain lenders under Freescale’s credit agreement filed a complaint in the Supreme Court of the State of New York. The complaint alleges, among other things, that Freescale violated the terms of the credit agreement by incurring the new incremental facility in the recently completed exchanges. In order to incur additional incremental loans, Freescale is required to represent that, among other things, no “Material Adverse Effect” has occurred since December 2006, the date of the original loan. The lenders argue that the deterioration in Freescale’s performance and value since that time has had or could reasonably be expected to have a Material Adverse Effect on Freescale. According to the complaint, Freescale’s shareholder equity has dropped 199% and unadjusted EBITDA has declined 358% in the relevant period and declines are expected to continue. The lenders argue that because a Material Adverse Effect has occurred, the incurrence of the incremental loans in the exchange offers is prohibited by the credit agreement.

In what could be a significant development in the area of exchange offers, the lenders have also named the participating bondholders as defendants in the complaint. 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. The lenders also argue that the bondholders would be unjustly enriched by the exchange offer because their current holdings are nearly worthless and would be exchanged for the valuable term loans. 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.

What to Look for in the Credit Documents

Current and prospective bondholders of highly leveraged companies need to be aware of whether the company’s debt documents provide the flexibility to undertake coercive debt exchanges. To determine whether a company has this flexibility, the investor must carefully consider existing covenants in the credit agreement and indentures of a borrower, including each of the applicable defined terms, and exceptions to the various negative covenants. As discussed above, the Realogy case was decided on the basis of a single defined term and a single proviso within it. The Freescale litigation will similarly turn on the interpretation of a single provision in the credit agreement.

Although each credit agreement and indenture is different and must be examined closely, 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. Below are a few issues in particular that require close scrutiny to determine whether a coercive exchange offer would be permissible:

  • Incremental Facility. Having an incremental facility is often a determining factor. If the borrower’s existing secured credit agreement permits it to issue new secured debt under an incremental facility, the secured debt being issued is typically permitted “credit facility” secured indebtedness under the borrower’s indentures as well.
  • What is a “Credit Facility”? As suggested in the prior bullet, indentures typically permit additional secured indebtedness in the form of “credit facility” debt. The definition of “credit facility” included in indentures of companies that were the subject of a leveraged buy-out during 2006-2007 may be quite broad and include indebtedness in the form of secured bonds i.e., not just ‘bank debt’ as the term might otherwise suggest. This provides additional flexibility to a borrower in structuring the exchange offer, facilitating, e.g., the issuance of secured bonds instead of indebtedness under an incremental facility of the secured credit agreement.
  • First LienMaintenance Covenants. It is important to know what indebtedness is covered by the maintenance covenants contained in the credit agreement. Beware of maintenance covenants that only address first lien indebtedness. This leaves open the possibility that the company could layer in significant second lien indebtedness without implicating the maintenance restriction. Combined with the incremental facility, this can be a powerful tool. This provision may also be instrumental for a company offering second lien bonds.
  • Restricted Payments. Repaying subordinated indebtedness is typically subject to restrictions as “restricted payments.” This is the case regardless of whether the bonds are being acquired for cash or for new debt, as in the exchange offers. If the borrower has senior notes in its capital structure, the restricted payment covenant in the borrower’s credit agreement or other indentures typically would not restrict the repurchase of those notes. Whether you hold second lien notes, or hold senior notes but do not tender in the exchange offer, you run a greater risk of an exchange offer in which senior notes are exchanged for debt that is ahead of you in the capital structure.
  • The “sharing provision.” In determining whether you can be the subject of a coercive exchange offer, it matters whether you hold bonds or a credit agreement loan. Typically, if a lender is repaid under a credit agreement, the lender is required to share such proceeds with the other lenders. This provision makes a tender for credit agreement loans impractical. The sharing provision does not typically exist in bond indentures. As a result, bonds, and not credit agreement loans, are typically the target of the coercive exchanges.

There are many permutations to debt exchange offers, and restrictions can vary greatly in scope from facility to facility. Where seemingly extensive restrictions exist, note that there often also exist significant exceptions or baskets that, intended or not, might provide a borrower with the flexibility to develop a coercive exchange offer. As the credit crisis continues, companies continue to launch coercive exchange offers in an attempt to improve their balance sheets. Bondholders must understand where they are in the capital structure, and whether they are susceptible to such an exchange or its implications, including being leap-frogged in the capital structure. Depending in part on the outcome of the Freescale litigation, bondholders will also need to consider carefully whether participating in the exchange could expose them to liability. If so, such investors would need to carefully consider the risks associated with that potential liability as against the possibility that other holders who choose to participate in the exchange might leap-frog them in the borrower’s capital structure.