As a result of current economic conditions, many companies have been having difficulty generating sufficient cash flow and net income to comply with their covenants and, often, satisfying their payment obligations under their existing credit facilities. Many of these companies seek to restructure their debt in order to avoid a bankruptcy proceeding. If such a restructuring is unsuccessful or unavailable, the company‟s creditors (including bank lenders) may force the company into a bankruptcy proceeding to take advantage of the protection afforded by such a proceeding. The ultimate outcome of either of these options is often conversion of lenders‟ existing debt into equity of the company.
The following are some important issues that should be considered in contemplating a debt to equity conversion.
- Capital Structure
The existing capital structure must be analyzed and a determination made regarding what, if any, existing equity will remain outstanding after the restructuring and what, if any, rights the pre-restructuring equityholders (the “Pre-Equityholders”) will have in the company following the restructuring. The Pre-Equityholders may retain only a nominal amount of the equity (or none at all) in the reorganized entity or may only receive warrants to acquire equity with certain exercisability triggers (i.e., time vesting or requirements relating to the value of the company increasing by an amount that provides for the lenders to receive a certain percentage of their investment back). As described below, there will be various approvals necessary for the reorganization to be consummated. Therefore, providing the Pre-Equityholders with a continuing interest in the company may facilitate obtaining the necessary approvals.
- Outstanding Debt
The terms of the outstanding debt must be analyzed, including the relative rights and preferences of the debtholders. If there are various classes of debt (secured, unsecured, senior, junior, etc.), a determination needs to be made as to how each of these classes will be treated in the proposed restructuring. The senior secured debtholders generally receive most, if not all, of the equity in the reorganized company. Holders of other classes of debt may receive equity that is subordinate to the equity to be received by the senior secured debtholders, such as common vs. preferred stock, or warrants that are exercisable when certain trigger events have been satisfied, usually relating to time vesting or valuation issues as noted above. In addition, consideration needs to be given to how much of the existing debt will be extinguished and if the company requires an additional working capital facility to continue operations after the restructuring.
- Lenders as Equityholders
A major issue to be resolved in any debt to equity conversion relates to the manner in which the lenders will hold the equity to be issued in exchange for the debt to be extinguished. Choosing the appropriate method may be influenced by factors such as the number of lenders that will be receiving equity, such lenders‟ internal policies, the anticipated exit plan for the investment, regulatory restrictions and potential tax consequences of holding equity.
The two principal methods for lenders to hold equity are (a) directly, where each lender would own its percentage of the equity of the company, or (b) indirectly, through an entity such as a limited liability company (a “Holdco”) in which each lender would hold its pro rata percentage of the equity of the Holdco. If there are relatively few lenders, or if there would be a public market for the shares following the restructuring, then it is likely that the lenders would want to hold the shares directly. If no public market exists and the lenders hold shares directly, then they will likely enter into a stockholders agreement to provide for certain rights relating to owning and transferring the shares.
These agreements typically provide for rights relating to appointing the board of directors, special voting rights, pre-emptive rights and agreements relating to transfer restrictions. The transfer restrictions may include rights of first refusal, tag-along and drag-along rights, restrictions on transferring to a competitor, and restrictions on transfers that would result in a change of control.
In addition, if the lenders are also funding a new working capital or credit facility, there may be requirements to keep the new debt and equity stapled for a period of time (i.e., those who hold the debt must hold a proportionate amount of the equity and vice versa).
The other principal way for lenders to hold equity issued in the conversion of debt is indirectly through a Holdco where each lender receives an interest in the Holdco and the Holdco owns the equity of the company. As members of the Holdco, which often will be structured as a limited liability company, the lenders would become parties to a limited liability company agreement. This limited liability company agreement would contain arrangements with respect to the management of the Holdco and transfer restrictions similar to those described above for the stockholders agreement.
It may also contain specific provisions to determine how the Holdco will vote on certain matters presented to Holdco as the equityholder of the underlying company. Having the lenders hold their equity through a Holdco may be helpful for the ultimate sale of the company as the company will have one controlling shareholder, assuming the Pre-Equityholders and management receive only a small piece of the equity.
This would facilitate a sale of the equity of the company as the Holdco would be able to approve a sale of assets or merger of the company, subject to the special voting rights that are contained in the limited liability company agreement. The Holdco would also be able to sell the shares it owns in the company without requiring each lender to individually sell its shares. In addition, if the lenders hold the equity through a Holdco, they will not hold both the debt and the equity of the same entity, which could raise equitable subordination issues. In determining how the lenders would hold their shares, each lender will need to review their individual needs.
- Corporate Governance Issues
The lenders will need to decide how involved they want to be in the management of the company. If they have a majority of the equity they will have the right to elect a majority of the board of directors, or all directors, subject to rights they agree to give to Pre-Equityholders, subordinated debt or management to have representatives on the board. Often, these rights are provided to the lenders receiving the larger equity stakes in the company, but they may also be provided to the former administrative agent who has historically served as the representative of the lenders.
A determination needs to be made as to the size of the board, management‟s role on the board and the inclusion or exclusion of outside directors on the board, including, if desired, recruiting such outside directors. Some lenders may not want to be involved directly on the board and may rely on independent directors that the company may retain. In some cases, there may be trigger events that change the composition of the board, such as changes in ownership percentages, satisfaction of certain financial conditions, passage of time.
If the restructuring is acceptable outside of a bankruptcy proceeding, then (a) the existing credit documents will govern what percent of the lenders need to approve modifications to the existing arrangements, and (b) the existing shareholder agreements (or similar agreements), bylaws and applicable corporate law will govern what approvals are required by the equityholders and board of directors of the company.
In a bankruptcy reorganization, the lender approvals needed will be determined by the bankruptcy plan, which plan the board of directors of the company must, and the bankruptcy court will need to, approve. There are no equityholder approvals necessary. In certain out-of-court restructurings, the lenders may also request releases from the equityholders to confirm that they have no further rights in the company. Typically, these will only be obtainable if the Pre-Equityholders receive some equity in the reorganized company.
In order to retain those members of management who the lenders desire to retain or to attract new management members, the lenders will have to determine what type of compensation, including incentive compensation, should be offered, such as whether such incentive compensation will take the form of equity in the restructured company.
Since companies considering debt to equity conversions are often short on cash, equity compensation may be able to provide compensation to key employees who can‟t otherwise get salary increases. Such equity incentive can be in several different forms, including direct equity, equity with vesting restrictions, options to acquire equity at a later date or if certain targets are met, and phantom equity. As described below, there will also be tax consequences to management that receives equity compensation.
- Tax Consequences
The tax consequences of converting debt to equity must be analyzed. Certain lenders may have already taken write-downs on their debt. If this is the case, those lenders will have a different basis in the equity they receive than other lenders. The tax consequences to the company will depend on a number of factors. If the company is a partnership, such tax consequences will flow through to the current owners of the partnership.
If the company is a corporation, the exchange of debt for equity will result in taxable cancellation of indebtedness (COD) income to the extent that the amount of debt forgiven exceeds the value of the equity that is received in the exchange unless (i) the company is insolvent, or (ii) the exchange is made pursuant to a reorganization approved by the bankruptcy court.
To the extent that the company is not required to recognize taxable income as a result of having COD income, certain favorable tax attributes — primarily, net operating loss carryovers (NOLs) — will be reduced. Moreover, use of the company‟s remaining NOLs following a change with respect to the ownership of its equity will be limited. The impact of such limitation may sometimes be reduced by advance tax planning.
In addition, the tax rules with respect to the application of the post-ownership limitation on the use of NOLs are, in the case of a bankruptcy reorganization, dependent on an election that may be available to the company. In addition, depending on the type of equity to be granted under the management incentive plan, and the value of the equity at the time of issuance, management may have taxable income on the equity it receives, either at the date of grant or at a later date.
The type of equity to be provided to management will also have different tax consequences to the company. Although lenders should not have adverse tax consequences due to holding the equity directly or through a Holdco, it should be noted that lenders who exchange indebtedness with an initial maturity of more than five years may not be permitted to claim a current tax loss even though the fair market value of the equity received is less that the amount of the indebtedness that is exchanged therefor in the reorganization.