Predicting Bondholder Activism

Market observers know that two important general characteristics of today's financial markets are relatively low returns and an unprecedented level of liquidity throughout the capital structure. The position that public debt normally occupies is also important to understand in this context. Bond debt typically falls somewhere in the middle to lower-middle of the capital structure and as such, frequently is at the crucial fulcrum position on the balance sheet if the issuer becomes financially distressed, such that bond debt typically benefits from at least partial asset coverage and bondholders often have an opportunity to convert their debt into reorganized equity. One other important characteristic in this regard is that bond debt normally has a fixed maturity ' which typically leaves bondholders with less leverage over, and in many case less concern for, management than is normally the case with working capital lenders. That said, it also vital to remember that, while many bondholders think of themselves as 'investors,' in many fundamental respects they actually are 'lenders', even when they have purchased their claims at a significant discount.

In past business cycles, issuers who were having disputes with their bondholders generally also had far more serious underlying problems, and it was the collective response to those underlying problems by all creditors that normally determined the company's fate. In the current business cycle, however, the prevailing dynamic of low yields and high liquidity enables most issuers to refinance their way out of trouble with their bondholders if they so choose, notwithstanding poor management or business performance or even, in a surprising number of cases, actual malfeasance.

How Bondholders Work Together

One now needs to understand two more dynamics in order to predict how bondholder activism will play out in a particular case. The first is whether or not the members of a particular bondholder group have a dominant investment philosophy or style and, if so, what that is and the second is the manner in which bondholders must organize and work together.

Most bond debt is held by financial institutions; even where retail investors do allocate their investment capital to bonds, they generally do so through the medium of a fund and not by direct purchase. Moreover, diversification of risk is a fundamental principle of investment management that applies to most such institutions, regardless of their investment style. The net effect of these two factors is that the preponderance of most bond issues is held by anywhere from a few to a few dozen institutional holders in a universe of only a few hundred such holders in total.

In turn, however, the range of investment strategies and styles among these financial institutions covers a wide spectrum. That spectrum spreads over at least three ranges of behavior, including: 1) caution versus assertiveness; 2) long term holders with diversified investment activities who are concerned with how their institutions are perceived generally in the financial markets as compared to active traders who may seek to profit from short term volatility; and 3) the fact that while all investors are concerned with their returns in today's low yield environment, there still is a wide range of approaches to achieving yield, which runs from a greater emphasis on short term profits to pursuit more predictable long term yields.

This latter consideration is especially important. A market in which triple B rated notes yield 6% per annum or less puts significant pressure on an institution which may have a 6% high water mark that it must return to investors before it can recognize any profits for itself. By contrast, some large public asset managers with extensive families of mutual funds and other heavily marketed investment products may be far more concerned with their relative performance among their peers than with any specific goal for their actual rate of return. That said, even the most conservative institutions take a dim view of developments that unexpectedly increases that risk in a particular credit and normally seek to be compensated for any such increased risks.

While discerning institutional investment strategies may seem opaque, the style in which many bondholders have exercised their rights in the past has created a track record of experience that can be analyzed over time. This is because all bond indentures provide that the holders of a majority of the outstanding issue in question collectively have the right to determine how to exercise whatever contractual rights the bondholders collectively may have. However, the holders of only 25% of an issue can, in the first instance, call an event of default and accelerate the maturity of all of the notes, and their action can only be undone if holders of a majority of the issue then votes otherwise.

The practical mechanism for organizing and mobilizing these necessary blocks of holdings is an ad hoc committee of bondholders for each issuer or, in some cases, multiple committees for the same issuer. Many experienced professionals at institutions who hold any significant amount public debt have become adept at organizing and working through such committees and, in many cases these individuals have developed working relationships with each other which they utilize from one matter to the next. Finally, the single most important dynamic to understand about ad hoc bondholder committees is that, unlike creditor committees in bankruptcy, bondholders vote and determine the group outcome directly in accordance with the size of their holdings.

CSK Automotive and Georgia Pacific

Analysis of the forgoing considerations of investment philosophy, return strategy, committee style, and the size of holdings of a particular issue can enable one to predict what might happen in a particular case. A relatively small issue of, say, $200 million, which trades at a discount to par, very easily could come under the control of a small group of holders with aggressive investment objectives. A good example of that was CSK Auto, Inc., where a small number of holders controlled a majority of the notes that were subject to a financial reporting default. The holders accelerated and were repaid at par out of the proceeds of a new financing facility that CSK was able to place within the default grace period provided for in the note indenture.

Georgia Pacific presented the opposite extreme for bondholders when it unexpectedly announced that it would be acquired Koch Industries on terms that would leave $3 billion of GP's bond debt outstanding with far more leverage risk than anyone had anticipated. Even though they suffered a sudden decline of more than $500 million in aggregate market value, the GP noteholder group did not take concerted group action because, with more than 80 institutions involved, it was too fragmented to agree on a collective strategy.

Conclusion

The idea that bondholder activism somehow is distorting the public debt markets not only is inaccurate but also reflects a fundamental lack of understanding of the importance and effect of the unprecedentedly high liquidity prevalent in today's capital markets. For the balance of the present business cycle, and particularly, so long as issuers can freely refinance their way out of trouble, investors would be well advised to look carefully at who the bondholders are in each particular credit in order to predict how bondholder activism may play out in that case.

J. Andrew Rahl, Jr. is a shareholder and chair of the Bankruptcy & Restructuring Practice of Anderson Kill & Olick, P.C. He recently has led Anderson Kill engagements on a number of bondholder committee representations, including Georgia Pacific, Key Energy, Inc., Medquest, Inc., United Rentals, Inc., Navistar International Corporation, CSK Auto, Inc., PHH Corporation and Novelis, Inc., among others.

Concerted action by public bondholders can be counted upon to attract attention in both the financial markets and the financial press. A current topical example is the wave of public debt refinancings, consent solicitations and conversion price resets that has ensued from enforcement of bondholder remedies for financial reporting covenant defaults (e.g., Peter Lattman and Karen Richardson, Hedge Funds Playing Hardball with Firms Filing Late Financials. The Wall Street Journal, Aug. 29, 2006, at A1). As the title of that article suggests, the image of bondholder activism in many quarters is one of rapacious bondholders aggressively pursuing a ruthless quest for returns. The reality is far more complex, but the outcome of particular cases may be surprisingly predictable for the astute analyst.

Bondholders unquestionably have become progressively more active and assertive over the course of the last three business cycles. That said, the course of many bondholder induced refinancings and restructurings it is possible to predict with some success in light of the considerations discussed in this article. These include: the current highly liquid market environment, the investment strategies of the particular holders of a given bond or note issue, the amount of it which is outstanding, and the dynamics of the bondholder committee process.

Market Environment and Capital Structure

Market observers know that two important general characteristics of today's financial markets are relatively low returns and an unprecedented level of liquidity throughout the capital structure. The position that public debt normally occupies is also important to understand in this context. Bond debt typically falls somewhere in the middle to lower-middle of the capital structure and as such, frequently is at the crucial fulcrum position on the balance sheet if the issuer becomes financially distressed, such that bond debt typically benefits from at least partial asset coverage and bondholders often have an opportunity to convert their debt into reorganized equity. One other important characteristic in this regard is that bond debt normally has a fixed maturity ' which typically leaves bondholders with less leverage over, and in many case less concern for, management than is normally the case with working capital lenders. That said, it also vital to remember that, while many bondholders think of themselves as 'investors,' in many fundamental respects they actually are 'lenders', even when they have purchased their claims at a significant discount.

In past business cycles, issuers who were having disputes with their bondholders generally also had far more serious underlying problems, and it was the collective response to those underlying problems by all creditors that normally determined the company's fate. In the current business cycle, however, the prevailing dynamic of low yields and high liquidity enables most issuers to refinance their way out of trouble with their bondholders if they so choose, notwithstanding poor management or business performance or even, in a surprising number of cases, actual malfeasance.

How Bondholders Work Together

One now needs to understand two more dynamics in order to predict how bondholder activism will play out in a particular case. The first is whether or not the members of a particular bondholder group have a dominant investment philosophy or style and, if so, what that is and the second is the manner in which bondholders must organize and work together.

Most bond debt is held by financial institutions; even where retail investors do allocate their investment capital to bonds, they generally do so through the medium of a fund and not by direct purchase. Moreover, diversification of risk is a fundamental principle of investment management that applies to most such institutions, regardless of their investment style. The net effect of these two factors is that the preponderance of most bond issues is held by anywhere from a few to a few dozen institutional holders in a universe of only a few hundred such holders in total.

In turn, however, the range of investment strategies and styles among these financial institutions covers a wide spectrum. That spectrum spreads over at least three ranges of behavior, including: 1) caution versus assertiveness; 2) long term holders with diversified investment activities who are concerned with how their institutions are perceived generally in the financial markets as compared to active traders who may seek to profit from short term volatility; and 3) the fact that while all investors are concerned with their returns in today's low yield environment, there still is a wide range of approaches to achieving yield, which runs from a greater emphasis on short term profits to pursuit more predictable long term yields.

This latter consideration is especially important. A market in which triple B rated notes yield 6% per annum or less puts significant pressure on an institution which may have a 6% high water mark that it must return to investors before it can recognize any profits for itself. By contrast, some large public asset managers with extensive families of mutual funds and other heavily marketed investment products may be far more concerned with their relative performance among their peers than with any specific goal for their actual rate of return. That said, even the most conservative institutions take a dim view of developments that unexpectedly increases that risk in a particular credit and normally seek to be compensated for any such increased risks.

While discerning institutional investment strategies may seem opaque, the style in which many bondholders have exercised their rights in the past has created a track record of experience that can be analyzed over time. This is because all bond indentures provide that the holders of a majority of the outstanding issue in question collectively have the right to determine how to exercise whatever contractual rights the bondholders collectively may have. However, the holders of only 25% of an issue can, in the first instance, call an event of default and accelerate the maturity of all of the notes, and their action can only be undone if holders of a majority of the issue then votes otherwise.

The practical mechanism for organizing and mobilizing these necessary blocks of holdings is an ad hoc committee of bondholders for each issuer or, in some cases, multiple committees for the same issuer. Many experienced professionals at institutions who hold any significant amount public debt have become adept at organizing and working through such committees and, in many cases these individuals have developed working relationships with each other which they utilize from one matter to the next. Finally, the single most important dynamic to understand about ad hoc bondholder committees is that, unlike creditor committees in bankruptcy, bondholders vote and determine the group outcome directly in accordance with the size of their holdings.

CSK Automotive and Georgia Pacific

Analysis of the forgoing considerations of investment philosophy, return strategy, committee style, and the size of holdings of a particular issue can enable one to predict what might happen in a particular case. A relatively small issue of, say, $200 million, which trades at a discount to par, very easily could come under the control of a small group of holders with aggressive investment objectives. A good example of that was CSK Auto, Inc., where a small number of holders controlled a majority of the notes that were subject to a financial reporting default. The holders accelerated and were repaid at par out of the proceeds of a new financing facility that CSK was able to place within the default grace period provided for in the note indenture.

Georgia Pacific presented the opposite extreme for bondholders when it unexpectedly announced that it would be acquired Koch Industries on terms that would leave $3 billion of GP's bond debt outstanding with far more leverage risk than anyone had anticipated. Even though they suffered a sudden decline of more than $500 million in aggregate market value, the GP noteholder group did not take concerted group action because, with more than 80 institutions involved, it was too fragmented to agree on a collective strategy.

Conclusion

The idea that bondholder activism somehow is distorting the public debt markets not only is inaccurate but also reflects a fundamental lack of understanding of the importance and effect of the unprecedentedly high liquidity prevalent in today's capital markets. For the balance of the present business cycle, and particularly, so long as issuers can freely refinance their way out of trouble, investors would be well advised to look carefully at who the bondholders are in each particular credit in order to predict how bondholder activism may play out in that case.

J. Andrew Rahl, Jr. is a shareholder and chair of the Bankruptcy & Restructuring Practice of Anderson Kill & Olick, P.C. He recently has led Anderson Kill engagements on a number of bondholder committee representations, including Georgia Pacific, Key Energy, Inc., Medquest, Inc., United Rentals, Inc., Navistar International Corporation, CSK Auto, Inc., PHH Corporation and Novelis, Inc., among others.