Are debt exchanges really the path to salvation for companies with too much leverage, on all (or many) of the wrong terms, to boot?  Just as leveraging (or over-leveraging) a company’s capital structure was all the rage during the “golden” days of private equity-led leveraged buyouts, de-leveraging through debt exchanges is in vogue today.  The newest members of the attempted-debt-exchange club are GM and Chrysler, which recently submitted reorganization plans both call for massive out of court debt reductions.  However, they are not alone – they join an eminent list, some more successful than others, including golden-era golden children Harrah’s, GMAC and Realogy, to name a few. With debt exchanges proving harder to complete, for reasons both financial and legal, GM and Chrysler and all other over-levered companies should take heed.

The auto manufacturers’ reorganization plans call for everything from workforce reductions to brand divestures, crystallizing most recently in the recent filing by GM-unit Saab for bankruptcy in its native Sweden.  However, while operating changes are needed, the reorganizations are largely contingent upon the firms successfully reducing debt.  As with any good reorganization, the restructuring of these companies’ capital structures is a must-have. Since both GM and Chrysler are planning to restructure through debt exchanges, it’s worth understanding the types of issues companies typically (and recently) run into with exchanges.  These issues include free-rider concerns, inequitable subordination, and the more prosaic breach of indenture, to name but a few.  Given the large number of restructuring efforts underway, it’s critical to learn lessons from other recent exchange offers, as with those of GMAC, Realogy, Neff, and Harrah’s. And, with future debt exchanges hoped for at many debt-overburdened companies, the lessons spread far and wide.

The free-rider issue is front and center in the GMAC debt exchange imbroglio. A form of “prisoner’s dilemma,” it arises in every proposed debt exchange.  Every bondholder has an incentive to hold out in the exchange offer, believing that the other bondholders will tender and stave off insolvency – yet if it’s wrong, the one holding back loses its shirt along with everyone else’s. GMAC, the onetime captive finance-arm of GM, was imperiled by bad loans and was in desperate need of capital. The company needed to reduce its debt and raise $30 billion in capital in order to qualify as a bank holding company (BHC) and qualify for TARP assistance. GMAC’s main weapon was the exchange offer. It was offering cash, notes, and preferred stock in order to reduce debt. Everything was going fine until the Pacific Investment Management Company (PIMCO) decided to renege on an agreement to join other creditors in the debt swap and saw it holdings soar when the Treasury’s CPP money was injected into lower levels of GMAC’s capital structure. The Federal Reserve ultimately approved GMAC’s BHC application, despite the company’s failure to meet the capital requirements for BHC status.  PIMCO showed that playing chicken with the U.S. government could be a profitable venture. The Feds would probably like to avoid this in the future.

With capital structure shifting at the heart of exchange offers, inequitable subordination claims are always a danger. Creditors filed suit against Neff, a construction company, also claiming that the terms of an exchange offer breached a credit agreement.  In Springfield Associates LLC v. Neff Corp. second-lien lenders sought injunctive relief because the note holders were poised to leapfrog them in the claims structure, but the court found the argument less than compelling and allowed the exchange offer to go forward. However, there is a case seeking unspecified damages for the transaction pending in New York civil court.

Often, claims of inequitable subordination are joined with assertions of breach of indenture, as seen in the recent case brought against Harrah’s, one of the last of the PE-led LBOs of frothy days of long ago.  In Murchison v. Harrah's Entertainment Inc., a suit stemming from $1 billion exchange offer closed last year, some excluded shareholders are alleging breach of indenture, violation of the “All Shares/Best Price” Rule – 15 U.S.C. §78n(d)(7) (a rule that requires that a tender or exchange offer for a class of securities must be made to all the shareholders in that class), and alleging that certain participants where “unilaterally and arbitrarily” precluded from participating in the exchange. The suit also asserts that the plaintiff’s notes were inequitably subordinated.  The new bonds ranked senior to the old bonds, but some bondholders were not given the opportunity to participate in the offer. The new bonds were offered pursuant Rule 144A a Regulation S and as such only “qualified institutional buyers” and non-U.S. investors could participate. A number of interesting questions arise from the Harrah’s case. How can a company undo a debt exchange? Or if cannot be undone, what will the cure look like?

Breach of indenture is always a concern and puts debtor, bondholder and Indenture trustee collectively in the hot seat.  Look no further than the recent Realogy exchange offer, leading Carl Icahn to sue for breach of a credit agreement.  Realogy, the real estate brokerage company, attempted to exchange different notes throughout its capital structure for new and more senior notes. A major problem with this plan was that High River, a venture capital fund controlled by Carl Icahn, owned most of the notes in a particular class that stood to be adversely affected by the exchange offer. So the case of Bank of New York Mellon and High River Limited Partnership v. Realogy was born. The case ended with the Delaware Chancery Court issuing injunctive relief to the note holders. The court reasoned that as currently structured, Realogy’s senior credit facility did not permit notes to be refinanced with secured debt under the agreement’s “accordion” feature (an option to expand a credit facility). Therefore, the issuance of the secured accordion loans, the new notes, would have violated the indenture. Realogy promptly cancelled the exchange offer, but what would have happened if it had already completed it?

Potential cures for closed-debt exchanges could prove to be an important issue for the 800 pound gorillas of impending debt exchanges: GM and Chrysler. The auto manufacturers have until March 31, 2009 to cut their respective debt loads to levels acceptable to the government. Time is of the essence, but there is still a huge amount of uncertainty swirling around the legalities of debt exchanges. Even the disclosure requirements around a debt exchange can cause a fair amount of consternation, as Fleetword Enterprises found during the SEC’s two-month staff review of its offer. With the economy seeming headed further south and plenty of high-yield debt issued during the credit boom – and with yields moving ever higher – it seems assured that there will be more exchange offers, lawsuits, and staff reviews during the coming year. But the most pressing question at the moment is how GM and Chrysler will structure their exchange offers in light of both the uncertainty and the cautionary lessons from their predecessors.

Published: February 24, 2009