Finance: What happens if you own bonds casually through a brokerage & the debtor wants to negotiate?

Factual Questions
1

So, let’s say that I use e-trade, scottrade, or one of those other discount brokerages and buy me some of them juicy Bonds, say, from Podunk Lumber, Inc. Eventually, Podunk Lumber gets into financial trouble and wants to see if it can negotiate a better rate to avoid default.

  1. Can corporate bonds generally (in law and/or in practice) be renegotiated in the same sense that a consumer may be able to talk a bank into reducing credit card interest rates? Is it common? E.g., Podunk Lumber had sold some 8% bonds, but now says, “We’re in trouble. If you won’t accept 5% we’re going to file for Bankruptcy and then you might not even get your principal back. Your pick.”
  2. If I held some of these bonds casually with E-Trade, Scottrade, etc., and Podunk Lumber wanted to negotiate, would I get something like an alert message with a poll, e.g. “Podunk Lumber says it may have no choice but to file for bankruptcy and wants to avoid this (click here for the full financial disclosure document), will you accept a reduction of 3 percentage points on the coupon rate? Please click Accept or Decline.”
2

The short answer is that yes, sometimes corporations try to renegotiate their debt in order to avoid defaulting. How they might try to renegotiate, what sort of leverage they have/you have, and why they get in trouble in the first place depends upon the specific circumstances of the company and what type of debt it is.

First, understand that there are numerous types of corporate bonds. Generally, from lowest risk to highest risk, corporate debt looks something like the following.

  1. Revolver - Shorter term debt with a low, variable interest rate that acts sort of like a big credit card. There is not usually required principal payments except at maturity. It is provided by banks and gets first call on assets of the company in a bankruptcy.
  2. 2nd Lien / Term Loan A / Term Loan B - Riskier debt with higher interest rate than revolver that is secured by collateral of the company has a longer maturity date than the revolver and is structured as a term loan. There is usually some amortization required. May be variable or fixed rate.
  3. Senior Notes / Subordinated Debt - Longer term maturity, higher fixed interest rate, minimal amortization, usually unsecured.
  4. Mezzanine Debt - Very risky debt that usually provides not only interest but also “equity kickers” as part of the payment.
  5. Preferred Stock - This is sort of like a hybrid of debt and equity. You get paid back after all the debt in a bankruptcy, but you have a claim ahead of the common stock. There is usually a fixed dividend (just like interest) but not really a penalty if it doesn’t get paid.

Now, a company may have one or all of these types of debt. There are also other types of debt that I ignored such as commercial paper, 364 day lines, and some others.

Next, it matters how they are going to default. A default doesn’t just mean payment default. It could mean something like they didn’t turn their financial statements in on time, or they didn’t meet a certain financial ratio test, or they did something they weren’t supposed to do like sell a certain asset or any number of random things. Different types of debt place different restrictions on a company.

Now if you are talking about a payment default, is it an issue that they just need more time to pay? If so, it makes sense for everyone to just extend the maturity date. You’d probably charge them a fee to do that.

Is it an issue where it is a good company but circumstances beyond their control have worsened? Maybe you force them to hire a consulting firm to help them try to work their way out of the problem. You probably tighten things up on them and charge them a fee that is due after they get the situation under control.

If it is a hopeless situation and you don’t trust the management, then you might want to force them into bankruptcy. Rather than let the management destroy any more value that might be left in the company, it makes sense to have a bankruptcy judge in charge.

If it is a hopeless scenario but you do trust management, you might try to work things out with them outside of bankruptcy in order to avoid legal fees. Usually the options here are either have the company do an orderly liquidation (sell their assets and pay back as much of their debt as they can) or try to wipe out the existing stockholders and convert the debt into equity. Now the debt holders own the company.

The basic answer now is that depending upon the circumstances, you could do all sorts of different things. Here is a recent example where a company was in a hopeless situation and in order to avoid bankruptcy and save everyone the legal fees, they put it up for a vote to allow the debt to be converted to equity. This means that the people who used to own the company don’t any more and the people that loaned them money now own them.

Dune Energy debt restructuring

The situation you described where a company just can’t really pay and asks for a reduction in their interest rate doesn’t really happen. You would instead probably offer to lower their cash interest expense and add a new PIK (payment in kind) interest expense, which basically means that the interest they didn’t pay just gets added as principal they owe.

3

From the perspective of you as the individual holder of public debt, the institution is likely not going to try and come to you directly unless you happen to own a siginificant % of their debt. The debt indenture agreement should have call provisions etc. that say if the debt is being called early that you should be paid X or X+Z, or what is required for the debt to be amended, ususally it will require a majority approval of all lenders based upon their $ holdings.

Also, most public debt instruments have an administrative agent, usually the bank or investment bank that helped the company arrange the debt in the first place. The company will negotiate with the administrative agent, who will in turn seek to get approval from the large holders of the debt. The biggest investors of debt are usually institutional investors like insurance companies, pension plans, etc. Once they have the necessary amount of approval the debt modification will take place. Many times holders are paid a fee for agreeing to the changes in terms.

In some situations it is easier to pay-off the existing debt with newly issued debt that has better terms that the company can handle. Again bankers get lots of fees to help companies do this.

4

Also, IIRC there are laws that prevent a company from offering a sweetheart deal to one debt-holder to the detriment of others during its financial problems. Ultimately if the offer is not aceptable to most debt holders, any one can refuse to accept and demand full payment - wichshould push the company into bankruptcy, at which point a trustee makes impartial decisions for them.

5

I’m not sure I agree with you that there are laws that individual debt holders have an option to be be paid off if they don’t like the deal. Please provide cite. In my experience, I’ve seen numerous deals where a majority of lenders can agree to terms of debt amendments and the dissenting minority holders have to live with it. Those types of terms for amendments are spelled out in the loan agreements or indentures…so holders of the debt should know what they are getting into before they invest.

6

That’s what I meant too. The debtors’ group has to agree to the deal. Usually this is in concert with some agency/trustee/whatever trying to negotiate a settlement.

My understanding of the situation:
-the bond issuer obviously cannot unilaterally change the terms of the bond; thus, they need consent.
-the bond issuer cannot make a sweetheart deal with only one debtor or set of debtors. (Transactions made in anticipation of bankruptcy can be reversed by the bankruptcy judge… up to 6 months prior… at least in Canada; I assume something smilar applies in the USA)

-usually, if one or more bondholders or other debtors refuse to go along, then the situation goes to some legal resettlement deal through bankruptcy court. (What, Chapeter 11 or Chapter 7 in the USA?)

Once the law and the bankruptcy trustee gets involved, then you get the famous “settlement and reorganization plans” that figure in the news. I forget which company recently went through all this, and some small debtors thought they were getting the shaft and took the settlement to court to see if they could change or amend the deal. But basically, the bankruptcy trustee can set terms for reorganization and get some majority of debtors to agree. However, this is not a private deal between the bond-holder(s) and the company, it’s for all debtors.

To answer the OP - I suspect it’s the same as any major corproate transaction; you’d probably get a letter forwarded from your broker explaining the deal and giving you a ballot to submit; same as if you owned shares and there was a takeover offer or merger bid.