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NEWS & INSIGHTS
Publications
27 APR 2009
Exchange Offers Of Capital Markets Debt: New Guidance From Rating Agencies
DEBT RESTRUCTURING ALERT
Both debtors and creditors are increasingly receptive to pursuing voluntary, out-of-court restructurings of outstanding debt through various types of exchange offers. A summary of capital market debt restructurings appeared in our Alert of March 24, Restructuring Capital Markets Debt: Opportunities and Strategies. Now, in response to this trend, the three leading credit rating agencies, Moody's Investors Service, Standard & Poor's and Fitch Ratings, have issued guidance regarding the ways they expect to evaluate these exchange offers in relation to an issuer's existing credit rating, as well as the rating of the outstanding securities involved in the attempted exchange.1 When some issuers attempt exchange offers, these rating agencies may categorize the exchange offer as distressed. The effect of this characterization generally will be to trigger a temporary downgrade of the issuer's credit rating to a selective default. In addition to the temporary issuer downgrade, the attempted exchange offer may also cause the rating agencies to downgrade the rating of the outstanding securities to a defaulted rating, although the rating of a stub portion of the outstanding securities may be revised upward after the completion of the exchange. The rating agencies' new guidance outlines how they determine whether a particular exchange offer is to be considered distressed. Even a temporary designation of selective default could conceivably produce an adverse impact on that issuer's relationships with its regulators, lenders, suppliers and customers. Depending on the terms of its instruments and agreements, such a downgrade could represent an event of default under certain of the issuer's other debt. It could also allow lenders under a credit facility to refuse drawings. On the other hand, completion of an opportunistic exchange could improve an issuer's credit rating due to a strengthening of its financial position. Issuers should consider approaching the lenders under their credit facility and other creditors to discuss the potential benefits of the contemplated exchange and, where
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indicated, waivers of potential technical defaults. Difference between a Distressed and an Opportunistic Exchange Offer In evaluating whether a particular exchange is distressed, the rating agencies will consider two primary factors: (1) whether the terms of the exchange offer represent an impairment to the value of the outstanding securities and (2) whether the effect of the exchange offer is to avoid bankruptcy or payment default. If Offer Impairs Value An exchange offer will be categorized as distressed2 if the value of the outstanding securities will be materially impaired as a result of the offer. In determining whether an exchange offer will be categorized as distressed, each rating agency utilizes slightly different criteria. Moody's will look to whether creditors will incur an economic loss "relative to the original promise to pay," measured against par value of the outstanding securities.3 S&P considers whether the "original obligation is . . . being fulfilled in accordance with its terms."4 Finally, Fitch looks to whether the holder receives "anything other than an equal amount of straight debt and/or cash (e.g., receipt of equity, warrants, in place of debt issues)."5 In reaching their determination as to whether the terms of the proposed exchange offer materially decrease the value of the issued securities, the rating agencies each look to a variety of factors, including: the size of the offer relative to issuer's total debt; the severity of the loss being incurred by participating holders of the securities; an interest rate under the new securities that is lower than the original yield; subordination of the new debt in the issuer’s consolidated capital structure; a maturity date for the new securities which exceeds the maturity date of the outstanding securities; a reduction in aggregate principal amount between the outstanding securities and the new securities; a change from cash payment to payment-in-kind (PIK); and swapping of debt for equity, hybrid securities, or other instruments. If Offer Intends to Avoid Bankruptcy or Payment Default All three rating agencies agree that only an exchange offer which is intended to avoid bankruptcy or payment default will be considered as potentially distressed, while other exchange offers will be considered "opportunistic." S&P states that an offer in which "the issuer does not face insolvency or bankruptcy if the offer was not accepted will be viewed as opportunistic."6 All three agencies analogize a distressed exchange offer to an out-of-court restructuring of the issuer's debt structure, reinforcing the background theme of bankruptcy. There is a clear subjective component involved in determining whether bankruptcy avoidance is the intent of a given exchange offer. All three agencies acknowledge this subjective difficulty in evaluating an issuer's intent. However, despite the lack of precision, the agencies do not elaborate regarding how the outlined criteria and procedures will be applied in their review of an exchange offer. Both Moody's and S&P point to an issuer's general credit rating as a broad indicator for whether an offer is opportunistic or distressed. Both agencies are inclined to view exchange offers by issuers with a credit rating of B1 or BB-, respectively, or better as opportunistic. Conversely, there is a likely presumption that
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exchange offers from issuers rated Caa1 or B- are distressed. In the thin middle ground between those ratings lies the greatest scope for discretion for Moody’s and S&P. Timing and Effects on Credit Ratings All three rating agencies will downgrade an issuer's credit rating upon, or shortly after, the announcement of a distressed exchange offer. An issuer’s rating will be downgraded to a selective or restricted default, representing the issuer's de facto default on the outstanding securities in the exchange. As noted, these downgrades may be temporary, because an issuer's financial picture often improves after a successful debt exchange. Upon completion of the exchange, the agencies will reevaluate the issuer’s post-exchange position and may issue a new, higher credit rating. The rating agencies are largely silent on the criteria they will use to evaluate an issuer’s post-exchange position, stating only that they will use a "look forward,"7 "forward-looking"8 or "going-forward"9 perspective. In addition to the temporary issuer downgrade, the rating of the outstanding securities will also be downgraded. The process is similar to that related to the downgrade of the issuer described above. The securities' rating will drop to default, and the stub portion of the securities, if one remains, could be upgraded upon completion of the exchange. Which Exchange Offers May Trigger Review? Moody's casts a wide net when deciding what types of exchange offer may be classified as distressed exchanges. All formal debt exchanges, tender offers, open market, and bilateral purchases of debt are potentially distressed. S&P is less inclusive, taking the view that an open market transaction would not be considered a distressed exchange. The guidance from Fitch does not specifically differentiate between various types of exchange offers. All three rating agencies may classify a modified bank loan as a distressed exchange. The agencies will evaluate the modification of a bank loan using the same criteria detailed above. Both S&P and Fitch take a qualified position on bank loan modification, leaving the door open to characterizing some modifications as a distressed exchange, depending on the circumstances. Moody's uses stronger language regarding modifications and seems more willing than S&P and Fitch to classify a bank loan modification as a distressed exchange. Coercive Terms in Exchange Offers There is some variation in how the agencies view the presence of "coercive" terms in an exchange offer. A coercive exchange offer is one in which creditors' interests are used against each other or in which holdouts to the exchange offer are faced with reduced protection after debt covenants in the outstanding securities are removed.10 Moody's and S&P present different approaches to the presence of coercion in determining whether an exchange is distressed. Moody's regards coercive components of an exchange as potential indicators of distress in an issuer. The coercive components would weigh for or against the issuer in Moody’s analysis. S&P discounts the presence of coercive elements in an exchange offer. S&P focuses on whether the original obligation is being fulfilled through the offer, rather than the means through which the offer may be completed. S&P is less likely than Moody’s to look to coercion as a factor in the distressed-offer analysis. Before Pursuing an Exchange Offer
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Issuers and their advisers are urged to meet with the applicable rating agencies when structuring an exchange offer or other debt restructuring so that they are fully informed of the consequences of any potential action by the rating agencies before pursuing such transaction. If you have any questions regarding the matters summarized in this alert, please contact one of the lawyers named below or your DLA Piper relationship partner. Christopher Paci Jonathan Klein Jack Kantrowitz Steven D. Pidgeon Daniel Goldberg Thomas R. Califano Timothy W. Walsh Karol Denniston
1 Moody’s Investors Service, Approach to Evaluating Distressed Exchanges, March 2009; Standard & Poor’s, Ratings Implications of Exchange Offers and Similar Restructurings, January 28, 2009; Fitch Ratings, Coercive Debt Exchange Criteria, March 3, 2009. 2 In the case of Fitch, the term “coercive” is used in place of “distressed”. 3 Moody’s, Evaluating Distressed Exchanges at p. 4. 4 S&P, Ratings Implications at p. 3. 5 Fitch, Coercive Debt Exchange Criteria at p. 3. 6 S&P Ratings Implications at p. 4. 7 Moody’s, Evaluating Distressed Exchanges at p. 6. 8 S&P, Ratings Implications at p. 5. 9 Fitch, Coercive Debt Exchange Criteria at p. 1. 10 Fitch uses the term “coercive” as a substitute for “distressed”. In regards to coercive exchange offers as described in this section, Fitch offers no guidance.
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