Debt For Equity: Is It Time To Rethink The Paradigm?
By Michael J. Venditto¹

Predicting trends, particularly in unsettled times, is a perilous enterprise. But nothing is more risky than slavish adherence to outmoded concepts. Prudence requires that even the most basic principles be reviewed periodically to ensure that they are still valid. This article challenges bankruptcy professionals to reevaluate one of the touchstones of plan formulation in light of some recent business trends: the debt for equity exchange.

Conventional wisdom holds that exchanging debt for equity in a public company enables creditors to participate in the upside potential of a reorganized business. This is a time-tested, fundamental assumption of many restructurings and chapter 11 reorganizations. Of course, it does not always work. TWA is the archetypical example of when, and why, exchanging debt for equity does not work. By the time it filed its third chapter 11 case in January 2001,² TWA had suffered through a dozen profitless years. Optimists might argue that TWA’s non-profitability resulted from undercapitalization due to the reluctance of the bondholders in the first two cases to accept more equity and reduce the debt load on the reorganized company. The bondholders, however, were fearful of what would happen to their equity if the airline had to file yet again. In hindsight, those fears were well-founded. But those decisions were made in a simpler economic environment. Things have changed since 2001.

The current investment climate, dominated by the aftermath of Enron, Sarbanes-Oxley and the seemingly continuous television images of corporate executives doing the “perp walk” adds a new dimension to the analysis of the debt for equity exchange as a fundamental component of a company’s successful emergence from bankruptcy. Bankruptcy professionals should be asking the question: does the paradigm remain valid; or, should it be replaced?

The Criminal Side of Things

The infamy befalling executives such as John Rigas, Dennis Kozlowski and Jeffrey Skilling has affected widely held attitudes about the benefits of publicly traded securities. After years in which virtually any business with the potential for generating a profit (and many with little more than the hope of doing so) seemed anxious to offer shares to the public, managers are increasingly concerned about the cost, inefficiencies and possible liability of running a public company. For example, a recent survey reported that 80 percent of the public-company executives polled said they would prefer to manage a private company rather than a public one.³ With executive compensation under a microscope, that sentiment is not likely to change in the near future, and creates a challenge to a reorganization premised on new and improved management leading the debtor out of bankruptcy. Management’s concerns are paralleled by a new skepticism that has taken hold among investors and shaken the capital markets.

Those Dirty Rotten Numbers

The collapse of Enron was precipitated by revelations about accounting practices that hid corporate liabilities and artificially increased its revenues. Enron’s management would have been well advised to heed the advice offered in the film Dirty Rotten Scoundrels, where Sir Michael Caine’s character warns that “a poacher who shoots at rabbits may scare big game away.” Enron’s machinations may have had the temporary effect of boasting Enron’s equity value; but once investors understood the consequences of the manipulations, that equity evaporated. This loss of investor confidence ignited a firestorm that engulfed the capital markets and burned many investors.

In the ensuing months, the media was filled with reports about phony earnings, inflated revenues and concealed liabilities; these mushroomed into chronicles involving conflicted analysts, compromised auditors and directors who were either complicit or asleep at the switch. Almost every one of the supposed checks on corporate behavior that underlay the equity markets seemed to have been consumed in a conflagration of greed. These factors combined to create a crisis of investor confidence that was unparalleled by anything since the Great Depression. Some observers have characterized this as a systemic breakdown that demanded a fundamental re-evaluation of the way the equity markets operated, their fundamental hypothesis being that capital markets cannot function without investor confidence.

Into this real or imagined void stepped the prosecutors, politicians and regulators. Each of them was determined, in their own way, to create a brave new world in which investors could rely on the “voluntary disclosures” we mandate from corporate America.

Sarboxing

The new landscape of the post-Enron business environment is typified by a legislative solution concocted by the politicians. The Sarbanes-Oxley Act⁴ imposed new obligations,⁵ with the attendant costs, on publicly held companies. The legislation, together with the numerous implementing rules promulgated by the Securities and Exchange Commission, establishes new or increased regulations in four areas that directly affect public companies, their officers and directors: (i) corporate governance; (ii) corporate disclosure; (iii) audit practices; and, (iv) enforcement and penalties, including criminal liability⁶ for directors and officers who file certain mandated certifications containing financial statements that are untrue.

Its impact on corporate existence is so pervasive that lawyers and accountants have fashioned a new word “Sarbox” – which is apparently both noun and verb – to describe the new compliance processes applicable to companies that have registered equity or debt securities. For law firms and accounting firms, the business of Sarbox advising is mushrooming. For companies, the direct economic costs of compliance are the subject of much discussion.

The extent of regulation is so pervasive that these reforms also will almost certainly have indirect consequences, constructive and other destructive, on companies, their investors and the markets in general. One of the anticipated benefits is greater market confidence. The implicit assumption underlying the reforms was that any erosion of investor confidence would diminish the marketability of securities. If Sarboxing boosts confidence, then the market will value businesses more efficiently. For creditors exchanging their claims for equity, this market efficiency is — at least theoretically — a positive development.

In addition, to keep auditors from getting too close to their clients, the Sarbanes-Oxley Act also polices the relationships between public companies and their auditors. For example, it prohibits audit firms from providing other professional services to their clients, potentially increasing the costs of these services to companies that must now contract with multiple professionals where in the past one sufficed. And, to avoid allowing the prospect of future employment to influence an audit, an accounting firm is prohibited from auditing a public company if any of the company's executive officers were employed by the accounting firm and worked on the company's previous audit. These restrictions are bad news for the accounting industry, but are probably good news for shareholders and investors. Therefore, their consequences should also be classified as salutary for creditors exchanging their claims for equity. Indeed, any reforms that strengthen the independence of audit firms or increase corporate responsibility and financial disclosure would suggest that the accepted wisdom about debt-equity swaps remains unchanged.

A brave, new world?

But the news is not all good. With executive compensation under attack, it will be harder for newly reorganized companies to attract the talented managers needed to resurrect a fragile business. The potential exposure to personal liability and criminal liability for the actions taken as directors and officers will be a further disincentive for qualified executives to take on the responsibilities of these offices. Meanwhile, the plaintiffs' bar is as active and aggressive as ever in pursuit of claims sounding in negligence, gross misconduct and fraud, with the result that insurance companies are boosting premiums for director and officer liability coverage. Beyond the cost of defending suits is the indirect and incalculable cost of the defensive management style they engender. Until the environment improves, managers may eschew creative or daring solutions, embracing an accepted and mundane management style that avoids criticism.

In this new world, the decision to accept equity for debt may not necessarily be different than it would have been three or four years ago. In the decision-making process, however, bankruptcy professionals need to be more focused and detailed in analyzing the prospects for a newly reorganized business. In other words, pay attention to the bottom line and the team it will take to get there.

No bankruptcy professional wants to be associated with a failure, particularly when creditors who have swapped their debt into equity get wiped-out in a subsequent case. The reluctance to do a debt-equity swap in appropriate situations may also convert fears about a future bankruptcy into a reality. When creditors, particularly holders of large amounts of bond debt, refuse to accept equity in a reorganized business, they may doom the reorganization. Then again, these sophisticated investors may understand something about the future prospects for the business.

TWA’s eventual demise highlights the obvious risk of being too optimistic about what a reorganized company might accomplish in the future. The lessons of Enron, WorldCom, Adelphia, and other recent filings, together with the current business environment, suggest that adding a few more items to the mental checklist could avoid making a premature and ill-conceived decision to swap debt for equity.

¹ Michael J. Venditto is a shareholder in the New York office of Anderson Kill & Olick, P.C. and a member of the firm’s bankruptcy and Restructuring Group.
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² See generally, In re Trans World Airlines, Inc., Chapter 11 petition filed Jan. 10. 2001 in the U.S. Bankruptcy Court for the District of Delaware (Case No. 01-00056); In re Trans World Airlines, Inc., Chapter 11 petition filed June 30, 1995 in the U.S. Bankruptcy Court for the Eastern District of Missouri (St. Louis division) (Case No. 95-43748); In re Trans World Airlines, Inc., Chapter 11 petition filed Jan. 31, 1992 in the U.S. Bankruptcy Court for the District of Delaware (Case No. 92-00115).
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³In a national survey conducted in August 2003 by executive compensation firm Clark Consulting, 80 percent of 209 executives said they would rather head a private versus a public company. See, James Bernstein, “New York Executives Formerly at Publicly Traded Firms Prefer Private Sector.” (Knight Ridder Tribune Business News, September 21, 2003).
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⁴ Corporate and Auditing and Accountability, Responsibility, and Transparency Act of 2002, Pub.L. No. 107-204, 116 Stat. 745 (July 30, 2002)(referred to herein as the “Sarbanes-Oxley Act”).
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⁵ The Sarbanes-Oxley Act was passed by a nearly unanimous Congress (the votes were (423-3 in the House of Representatives and 99-0 in the Senate) as a reaction to several high profile corporate accounting scandals. It targeted the transgressions that had spawned five of the largest bankruptcies in U.S. history.
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⁶ The certification requirement of Section 906 of the Sarbanes-Oxley Act requires the chief executive officer and chief financial officer of each company that is required to file reports under either Section 13(a) or 15(d) of the Exchange Act to make the certification with respect to any report containing financial statements. The penalty for a knowingly false certification is up to a $1 million fine and up to 10 years in prison. For a willfully false certification, the penalty is up to a $5 million fine and up to 20 years in prison.
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