Debt reduction is the order of the day, and companies are doing whatever it takes to get these done.  Motivated by forces ranging from government demands relating to the Troubled Asset relief Program  (TARP) to undoing survival-threatening debt, companies from Ford to Harrah’s are now chancing the debt markets in the hopes of undoing heavy debt loads.  To do so, they are adopting different methods, ranging from debt conversions to debt exchange offers. At the same time, these companies must also be careful to avoid legal traps surrounding debt offers, not the least of which include inequitable subordination claims by creditors moved down the capital structure pile and breach of indenture claims.

Some, such as Ford and FLIR Systems, are choosing to convert their debt in an effort to reduce longer term debt and eliminate the interest payments. Essentially they choosing to convert the debt into equity early, usually along with a cash inducement. Other companies, Harrah's and CIT in our examples, are looking to exchange existing debt for new debt. In many instances this is done along with a consent solicitation in which the bondholders agree to change the terms of the existing indentures to loosen the restrictions put on the bond issuers. Depending on the structure the exchange offer may reduce over all debt or simply change existing restriction to give the company more flexibility.

Issues with debt exchange offers, including inequitable subordination and breach of indenture are highlighted by certain recent litigation. Inequitable subordination concerns were highlighted by litigation pending around a $1.14 billion debt exchange offer closed by Harrah’s Entertainment in December of 2008.  A class-action lawsuit followed, alleging that certain debt-holders were treated beneficially and to the detriment of the remaining debt-holders. This allegedly left those debt-holders who were not “qualified institutional buyers” as wrongfully subordinated. Breach of indenture was the subject of a separate suit brought against Realogy, a real estate brokerage company. It commenced an exchange offer of new senior notes for various existing notes. Original bondholders alleged that the exchange amounted to a refinancing with secured debt, violating the existing indenture, and the Delaware Chancery Court seemed to agree issuing injunctive relief to the existing bondholders.

Despite these issues, debt exchange offers are picking up speed, in large part due to the powerful forces driving debt reduction. One of the most powerful forces these days is the government, as CIT learned in its attempt to qualify for TARP funding and (in a related point) for bank holding company status. CIT announced a simultaneous exchange offer for certain of its outstanding debt as well as its equity units which represented interests in common stock and 7.50% Senior Notes. These offers were done to increase CIT’s regulatory capital as part of its effort to become a bank holding company. The note exchange was conditioned on CIT becoming a bank holding company upon approval of the Federal Reserve and CIT’s participation in the Capital Purchase Program (CPP) with the Treasury Department. On December 24 CIT announced the results of the note exchange offer after previously announcing its preliminary participation in the CPP and approval of its bank holding company application.

Along the same lines, undoing the over-leverage layered on by private equity acquirors is driving other debt exchanges. Harrah’s Entertainment has doubly proved this point with not one, but two debt exchanges, the second just launched on March 4. The second offer is exchanging up to $2.8 billion of new 10% Second Priority Senior Secured Notes due 2018 for select outstanding notes. At the same time cash tender offers are being made by Harrah’s BC, a subsidiary of Harrah’s Entertainment, as well as a separate $250 million cash tender offer for 10% Second-Priority Senior Secured Notes due 2015 and 2018 by Apollo Global Management and TPG Capital, the private equity firms which acquired Harrah’s Entertainment in a $31 billion leveraged buyout in early 2008. The note exchange offer and Harrah’s BC tender offer also are soliciting consents to eliminate or waive the restrictive covenants contained in the indentures of the old notes.

Inequitable subordination concerns are pervasive and the Harrah’s debt exchange offer is similarly at risk.  Like its predecessor offer, outlined above, Harrah’s second offer may be a target for litigation as well.  This second exchange offer states that it is being made to “qualified institutional buyers and accredited investors” as was the previous exchange offer that was subject to the suit.

Breach of indenture and inequitable subordination claims must be of particular concern to Ford Motor, which is undertaking a complex, multi-tranche debt exchange offer. Ford Motor is planning a restructuring that will ideally reduce its debt by approximately $10.4 billion or nearly 40%. It is pursuing this through a combination of conversion of its 4.25% Senior Convertible Notes as well as a $1.8 billion cash tender offer by Ford Motor Credit for non-convertible debt securities and senior secured term loan debt. Converting the senior convertible notes will result in an increase of approximately 530 million shares outstanding, significantly diluting the existing shareholders, as well as paying out an $80 premium for every $1000 principal amount of notes held to induce the conversion. One group who will not see its voting interest diluted is the Ford family who will continue to hold a controlling interest through class B stock.

Ford is pursuing the restructuring in an attempt to remain competitive with its largest domestic rivals, Chrysler and General Motors, both of which received government assistance while Ford has not. Ford has also announced that it will defer dividend payments on trust preferred securities beginning in April of this year as well as an earlier announcement regarding agreements with the United Auto Workers over reduced labor costs and the acceptance of up to half of Ford’s required payments to a retiree health care trust can be in stock.

Even those seemingly without over-leverage have jumped on this debt exchange movement. With forward looking in its very name, FLIR (an acronym for Forward Looking Infrared) Systems has decided to be forward looking and reduce its debt. FLIR Systems, a manufacturer of thermal imaging systems for military, commercial and industrial use, announced a debt exchange offer on February 5 of this year that is similar in structure to Ford’s. FLIR offered 90.1224 shares of its common stock and $20 cash for each $1000 principal amount of its 3% Senior Convertible Notes due 2023. FLIR is using this offer to reduce its debt by at least $190 million.

The continuing economic crisis and it restraint on credit will force companies to look for ways to shore up their balance sheets. These efforts may include exchanges or conversion of debt and the corresponding legal work that is required to execute these offers. Firms will need to be mindful of how they structure the deals so that not only do the companies benefit but that the bondholders and shareholders are not detrimentally affected to the point that they seek redress.

Published: March 10, 2009