Something About Coorporate Finance: Cardready International

example is that the initial creditor will realize a lower rate of return because it will not be fully paid of the project fails. Of course, the new creditor with guaranty will be paid in full, regardless of what happens with the project. The increased value of the project allows shareholders to realize a bigger upside if the project succeeds, increasing their rate of return. This represents the classic shift from debtholders to shareholders.

Conclusion: You can’t say definitely one way or the other whether the old debt holders will favor the new bondholders’ investment, but guarantees are not innocuous.

Conversion: Conversion serves as a check on equity. If the shareholders loot, the bondholders can simply convert their debt to stock. This is a protective incentive characteristic.

Flexibility: How does the company get out of the protective provisions? The debtor must renegotiate with the bondholders, but there is the problem of numerous bondholders and the fact that such negotiations would become administratively cumbersome. The indenture is a way of collectivizing these costs. Section 1014 allows the bondholders to waive restrictive covenants by majority vote.

Call Provisions: Another way to get out of protective provisions is to call the bonds. See § 1101. What is the difference between redemption and a tender offer for the bonds?

The redemption provision provides some price protection for the issuer. Also, the redemption provision allows the company to force the bondholders to put their bonds at a specified price. This takes care of holdout problems. Note that the bondholders do get a premium for allowing the redemption of their bonds.

Enforcement Provisions: Article 6 of the indenture sets up the enforcement mechanism.

The trustee is a contractual device for surmounting the collective action problem of the bondholders. The trustee can bring suit in the event of a default (§ 501 sets out the default provisions) and declare the principal due and immediately begin collection (§ 502 has the acceleration clause).

Violation of Ratios: What happens when one of the ratios is violated? The bondholders don’t want to push the company into bankruptcy if the default can be cured. The trustee doesn’t even have to notify the bondholders immediately of an event of default. This makes the identity of the trustee fairly important.

The trustee is often the bank of the issuer who has loans outstanding to the issuer, which creates an interesting situation. Suppose that there is an event of default and the trustee refuses to bring suit. The bondholders have to get together (25% of the bondholders) to pursue the debtor. This makes some intuitive sense, because you don’t want to allow one small bondholder to be able to pursue the debtor and crash the entire thing for the everyone.

Boilerplate: The trustee’s conflicts of interest are listed, almost directly out of the Trust Indenture Act (TIA). The TIA regulates by requiring the inclusion of certain language in the contract.

USX Hypothetical: This problem was not in the materials but was presented in class. See Slides 25-26. U.S. Steel purchased Marathon Oil and later U.S. Steel was pressured to spin off Marathon. Eventually, U.S. Steel issued a tracking stock keyed to the oil company and a tracking stock keyed to the steel company. The issue in this hypothetical, though, is what would have happened if U.S. Steel had spun off Marathon. Suppose that U.S. Steel and Marathon split up, each with the same amount of debt, expected returns, and risk (although with uncorrelated outcomes). Should the creditors complain?