Qwest Noteholders Fail to Stop Coercive Exchange Offer
Written by Glenn E. Siegel ¹

On Nov. 20, 2002, in the wake of serious cash flow problems and accounting irregularities, Qwest Communications International Inc. (QCII) announced a private exchange offer to holders of $12.9 billion of Qwest Capital Funding (QCF) Notes. The offer was to exchange QCF Notes for new notes with a lesser face value (but higher interest rate) of up to $4 billion, but with a junior security interest on the assets of Qwest Services Corporation (QSC). The offer had no minimum tender requirement but did make provision, in the event the exchange offer was over subscribed, for a QCII security that would be structurally senior to the QCF Notes but junior to the QSC Notes. It was due to expire on Dec. 20, 2002.

QCF Noteholders had an impossible choice. If they did not tender, noteholders would likely receive a diminished (or no) distribution in a bankruptcy of Qwest, while tendering holders would capture the remaining value through their new junior security interest. On the other hand, if they did tender, it was likely that the company would avert bankruptcy and a windfall of value would inure to the benefit of shareholders. In addition, it was virtually impossible to assess the likelihood of a filing since there was no reliable financial information. Indeed, the offering memorandum said holders could not rely on previous audited company financial statements in evaluating the condition of the company.

Given this choice, a group of noteholders formed an ad hoc committee and commenced an action against the company and certain of its directors in the U.S. District Court for the Southern District of New York (02 Civ. 9660) alleging violations of the securities laws and breach of fiduciary duty. The amended complaint, dated Dec. 9, 2002, suggested that the company and its directors were engaging in illegal trading in the companies' securities because they possessed information about the companies' operations that were not possessed by the public. Additionally, because the company was in the "zone of insolvency" and the effect of the exchange offer, in their view, was to benefit the shareholders at the expense of creditors, the noteholders sought damages for breach of fiduciary duty.

On Dec. 12, 2002, the defendants moved to dismiss the complaint for failure to allege fraud with particularity and to state a claim upon which relief could be granted.

In response, on Dec. 14, 2002, plaintiffs moved for a preliminary injunction forbidding and restraining defendants from consummation of the exchange offer pending "(1) issuance … of audited financial statements; (2) meaningful board consideration of the [e]xchange [o]ffer; and (3) removal of the coercive aspects of the [e]xchange [o]ffer, including the subordination feature, the overallotment feature and the releases."

On Dec. 18, after extensive oral argument, Hon. Denny Chin, U.S. District Court Judge, denied the motion for a preliminary injunction on the grounds that the plaintiff had failed to demonstrate irreparable injury since

this is a case where the egg can be scrambled …. It seems to me that if the plaintiffs are in it for the long haul that makes it even easier to calculate their damages if indeed fraud is proven. You just undo the transaction if they indeed tender, and if they did not tender you provide them with new notes. There is the ability to fashion a monetary remedy. Of course there is the risk of insolvency, but that risk exists anyway, whether or not there is an exchange offer. So I don't think that it creates irreparable harm.

The court was also not concerned with the subordination feature since the existing indenture allowed for the issuance of additional senior debt. Accordingly, the debt exchange offer was completed with the company announcing the tender of approximately $5.2 billion of QCF Notes, which resulted in the reduction of outstanding indebtedness by more than $1.9 billion. Shortly thereafter, the ad hoc committee dismissed their lawsuit.

Was this much ado about nothing? Rating agencies were unimpressed with the result assigning speculative ratings to Qwest securities. In early February 2003, the company reduced its reported revenue by another $357 million to bring the total restated reduction for that period to $2.21 billion. In late February, the Justice Department filed a 12-count indictment against four former Qwest executives, charging them with illegally boosting revenue in 2001.

On March 10, 2003, The Wall Street Journal reported that Qwest had spent more than $75 million for outside lawyers to defend the company and its executives under investigation for accounting fraud.

Noteholders continue to hold debt of questionable value. Those who did not tender run the risk that their distribution has been diluted in a potential bankruptcy. Those who did tender will receive less principal for repayment of their notes in the event they are repaid at all. But what is most striking is the inability of our legal system to provide a pre-bankruptcy forum in which the merits of the proposal could be fairly evaluated.

Sources for this article include court papers, Wall Street Journal articles and company press releases.

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