Wrap Plans

Votes on proposals to increase common and/or preferred shares and to issue shares as part of a debt restructuring plan are determined on a CASE-BY-CASE basis, after evaluating:

• Dilution to existing shareholders' position
• Terms of the offer - discount/premium in purchase price to investor, including any fairness opinion; termination penalties; exit strategy
• Financial issues - company's financial situation; degree of need for capital; use of proceeds; effect of the financing on the company's cost of capital
• Management's efforts to pursue other alternatives
• Control issues - change in management; change in control, guaranteed board and committee seats; standstill provisions; voting agreements; veto power over certain corporate actions
• Conflict of interest - arm's length transaction, managerial incentives

Vote FOR the debt restructuring if it is expected that the company will file for bankruptcy if the transaction is not approved.

Discussion

Trends in Restructuring

When companies become overleveraged, they are often forced to drastically restructure their balance sheets in order to avoid bankruptcy. The assortment of refinancing schemes is endless, and it would be difficult to establish hard and fast rules for evaluating all restructuring proposals. Moreover, the standards with respect to routine common stock authorizations cannot be reasonably applied to debt restructurings. By the time a company has reached the point of having to restructure, it may be in desperate straits, and attempts to forestall a lifesaving financial operation by voting against large increases in share authorization and the resulting dilution from issuances of vast amounts of stock to creditors would be futile. However, shareholders need to be able to recognize the different types of restructurings and decide whether a given approach provides the necessary financing to save the company from involuntary bankruptcy, which could wipe out shareholder value.

Types of restructurings

The following is a brief description of various types of "workouts" and their key features that affect existing shareholders.

Reverse Leveraged Buyouts

These transactions simply involve a direct equity investment in a troubled company, usually as part of a private placement. The additional capital infusion is used to reduce debt to a more manageable level. Reverse LBOs often result in extreme dilution of a shareholder's ownership interest and in some cases may result in or lead to a change in control of the company. Some investors have brought lawsuits against boards based on their objection to this sort of transaction, arguing that the change in control entitles them to a premium for their shares.

Another potentially adverse consequence of such transactions to existing shareholders is that the capital provider may receive stock in a given company at below market prices. However, in some cases, the discount that these providers enjoy may be justified by the risk they absorb by infusing large amounts of their capital in a very troubled company.

Prepackaged Bankruptcy Plans

The prepackaged bankruptcy plan is a somewhat coercive weapon by which management may induce creditors and shareholders to agree to restructuring terms. These plans are essentially a prearranged bankruptcy settlement which usually involves a debt-for-debt or debt and stock-for-debt exchange. The key terms of the exchange offer (which is usually conducted as a consent solicitation) and plan of reorganization are agreed upon by creditors and shareholders in advance of a bankruptcy filing. An exchange offer cannot be implemented unless an exceedingly high percentage of creditors (approximately 90 to 95 percent of each class of debt) accept the offer.

The prepackaged bankruptcy plan comes into play if the out-of-court exchange offer is not successful. If creditors do not cooperate, management can take the company into bankruptcy, at which time the plan will likely be approved and imposed on a dissenting minority, provided that the exchange offer was accepted by one-half of the creditors who represent two-thirds of the amount of debt actually voting, and provided that a majority of shareholders approve the reorganization plan. This tactic presumes that creditors and shareholders who approved the offer and the out-of-court plan are bound to approve it again when submitted to them as a Chapter 11 reorganization plan.

Table 7-3. Factors to Consider When Reviewing Debt Restructuring Proxies

Dilution How much will the ownership interest of existing company shareholders be reduced by the deal, and how extreme will the dilution to any future earnings be? Are these disadvantages outweighed by the prospective survival of the company? Change in Control Will the transaction result in a change in control of the company immediately or in the near future (through the exercise of warrants or options)? Changes in control of a troubled company in a debt restructuring may result in the loss of valuable net operating loss carryforwards. Bankruptcy The main factor driving most debt restructurings is the threat of bankruptcy. Because bankruptcy, whether voluntary or involuntary, will result in severe losses in shareholder value, shareholders will likely find it in their best interest to approve proposals that facilitate debt restructurings unless there are clear signs of self-dealing or other abuses.

While seen by some as coercive, these plans can ward off an expensive bankruptcy proceeding. If voluntary bankruptcy occurs, the proceeding can be greatly simplified and shortened, saving valuable resources which would be better directed toward the company's turnaround. However, the results of this scheme are not always positive. If there is dissension between the company and its creditors, there is nothing to stop individual creditors from foiling the plan by filing an involuntary bankruptcy petition. Like the reverse LBO, such plans may involve considerable dilution of a shareholder's ownership interest. This consequence must be weighed against the benefit to shareholders of a significant debt reduction which would allow the company to retain more of its future earnings for reinvestment or dividends.

Wrap Plans

Similar to prepackaged bankruptcy plans, this method of restructuring and refinancing a troubled company involves "wrapping" a restructuring plan around an exchange offer. The exchange offer document describes a restructuring plan and indicates that the company will file for bankruptcy if the terms are not accepted. These plans may or may not involve the issuance of common stock.

Other plans may result in dilution of shareholders' equity positions in a company on a going-forward basis through the use of "fulcrum securities"-subordinated debentures or preferred stock which creditors can convert to equity once a company has restructured or reorganized. Again, shareholders must weigh the disadvantages of a reduction in their ownership interest and equity value against the opportunity to avoid bankruptcy.

Shareholders should examine the proxy statements that present these transactions for a number of items to assure they are being treated fairly. Like most significant corporate transactions, the proxy statement or consent solicitation for debt restructurings contains a fairness opinion prepared by an investment banker. (Fairness opinions are discussed in more depth in Chapter 12, "Mergers and Corporate Restructurings.") At a minimum, these opinions should compare the treatment of shareholders in a given transaction to that afforded to similarly situated shareholders, if any. The opinion should also discuss the company's prospects for survival if the transaction is not consummated. Also included in the opinion should be a comment on the tax implications of the transaction. For example, if the restructuring involves too great a change in stock ownership, a company may lose the use of valuable net operating loss carryforwards which are critical to restoring profitability and enhancing shareholder value.