Activist distressed debtholders: the new barbarians at the gate?

• Author: Harner, Michelle M.

The term "corporate raiders" previously struck fear in the hearts of corporate boards and management teams. It generally refers to investors who target undervalued, cash-flush or mismanaged companies and initiate a hostile takeover of the company. Corporate raiders earned their name in part because of their focus on value extraction, which could entail dismantling a company and selling off its crown jewels. Today, the term often conjures up images of Michael Milken, Henry Kravis, or the movie character Gordon Gekko, but the alleged threat posed to companies by corporate raiders is less prevalent--at least with respect to the traditional use of equity to facilitate a hostile takeover.

The growing use of debt rather than equity to cause a change of control at target companies raises new concerns for corporate boards and management teams and new policy considerations for commentators and legislators. Are activist debtholders who employ this investment strategy akin to the corporate raiders of the past? This Article explores these issues by, among other things, presenting in-depth case studies and critically evaluating the value implications of traditional takeover activity and regulation. It compares and contrasts the use of equity and debt in control contests and identifies similarities that suggest some regulation of strategic debt acquisitions is warranted. The Article proposes a proactive approach that better equips corporate boards and management teams to negotiate with activist debtholders while preserving investment opportunities for debtholders and the governance efficiencies that often flow from activism for the corporate target's other stakeholders.

Table of Contents Introduction I. The Emerging Role of Debt-Based Takeovers A. Examples of Loan-to-Own Investments B. Potential Issues with Loan-to-Own Investments II. The Evolution of Takeover Strategies A. From Proxy Contests to Tender Offers 1. Corporate Raiders and Hostile Takeovers 2. The Mechanics of a Hostile Takeover B. Regulation of Equity-Based Takeovers 1. The Williams Act 2. Anti-Takeover Legislation and Defensive Tactics. III. The Mechanics of Debt-Based Takeovers A. A Case Study of Industry-Specific Debt Opportunities. 1. American Media, Inc. 2. Freedom Communications, Inc. and the "Star Tribune" 3. Tribune Co. 4. Philadelphia Newspapers 5. The Makings of a Media Conglomerate B. Observations Regarding Loan-to-Own Strategies. IV. Policy Analysis and Recommendations for Regulation of Debt-Based Takeovers A. Disclosure of Debt Acquisitions B. Parameters of Disclosure Obligations. C. Application in Bankruptcy. D. Potential Critiques. E. Potential Value to Proposed Disclosures Conclusion INTRODUCTION

The theme of Barbarians at the Gate is greed and the dehumanizing effect of the acquisitions mania. No concern is shown for the people who will be hurt by the takeover, for tradition, for preserving a company that has meant so many things to so many people. Making more money is the fix that gets the junk bond junkies through their day. (1)

Barbarians at the Gate referred to the activities of equity investors who earned the name "corporate raiders" in the 1980s. (2) This term also reflects a common characterization of activist distressed-debt investors--investors who use a company's debt (rather than equity) to facilitate a change of control at the company. (3) Activist distressed-debt investors typically extend credit to, or purchase the debt of, financially troubled companies and then exploit the leverage associated with the underlying debt instruments to acquire ownership of the company through a debt-for-equity exchange or credit bid in a sale of the company's assets.

Whether accomplished using debt or equity, takeover activity might impose discipline and much-needed monitoring. (4) on the other hand, such activity can also be disruptive and produce significant profits for the new owner at the expense of the other stakeholders, leaving the impression the investor raided the corporate coffers. (5) That impression is particularly acute in the distressed debt context, where shareholders and junior creditors generally are wiped out and any value created by the investment strategy flows primarily to the activist investor and perhaps the restructured company to a limited extent.

This Article examines the takeover activity of distressed debtholders against the backdrop of traditional corporate raiders and their use of equity to acquire corporate control. Traditional corporate raiders target undervalued, cash-flushed or mismanaged corporations. They seek to unlock value that is underutilized or overlooked by existing management. Several studies suggest that hostile takeovers increase corporate value, which generally flows to existing shareholders through a stock price premium. (6) That value may also benefit the corporation and other corporate constituents (including creditors) to the extent that the acquirer continues the business and improves management or operations. (7) The changes imposed by the acquirer, however, may oust existing management, add leverage, strip core assets or otherwise impede long-term value. The latter possibilities lend to the sometimes questionable reputations of traditional corporate raiders.

To address these undesirable possibilities, Congress and state legislatures enacted a variety of takeover-related legislation, starting with the Williams Act in (1968). (8) The Williams Act requires that entities make certain disclosures when intending to pursue a tender offer, or upon acquiring five percent or more of a public company's stock. (9) The Williams Act does not necessarily endorse or condemn hostile takeovers. Rather, its purpose is to provide information to parties involved in the potential transaction to foster better-informed decisions. (10) In contrast, most states enacted "anti-takeover" legislation--measures generally designed to create more protection for management and more obstacles for potential acquirers in the takeover process. (11)

Commentators debate the pros and cons of anti-takeover legislation. Proponents of takeovers point to the governance benefits generated by an active market for corporate control. (12) The actual or even potential threat of a hostile takeover can discipline corporate managers and improve accountability. For these reasons, many institutional shareholders have pressed corporate boards to remove defensive measures, such as shareholder rights plans from companies' governance documents. (13)

Despite increased regulation, equity-based takeover activity continues. Recent hostile or uninvited takeover activity includes Air Products & Chemicals' bid for Airgas, Sanofi-Aventis' bid for Genzyme Corp., and Carl Icahn's bid for Lions Gate Entertainment. (14) That activity, however, often is less contentious than in the past and may take different forms. Among other things, potential acquirers may work with or seek allies among the target's shareholders, and "takeover targets are borrowing tactics from the (1980) s, but avoiding such a scorched-earth approach." (15)

In addition, an investor who seeks control of a company may forego an equity investment and instead acquire a significant position in the company's debt. A debt investment is not subject to the disclosure requirements of the Williams Act. (16) Likewise, it does not trigger anti takeover defensive measures facilitated by state law. In fact, relatively little regulation governs the activities of investors acquiring debt in the secondary loan and bond markets. (17)

This lack of regulation provides a significant advantage to an investor making a control play. Among other things, it reinstitutes the element of surprise once prevalent and advantageous to acquirers in the hostile takeover process. (18) Investors generally have no obligation to disclose when they purchase a company's debt. Consequently, management often does not know who holds the company's debt until an investor is already positioned to make its move. Moreover, the investor faces little downside risk because, if the takeover attempt fails, the investor is still likely to receive some return (perhaps even a significant profit) when the company repays the debt.

A debt-based takeover is not feasible, however, in every situation. This strategy works primarily in the distressed company context. specifically, the investor attempts to identify and purchase the distressed company's "fulcrum security"--i.e., the tranche of debt in the company's capital structure that effectively captures the company's enterprise value. (19) The fulcrum security is similar to equity in that its holders arguably are the residual owners of the company. The distressed debtholder then uses the company's debt restructuring efforts as a takeover opportunity. (20)

Debtholders invoke this control strategy in both out-of-court workouts and in-court reorganizations under Chapter 11 of the Bankruptcy Code. (21) Recent examples include CIT Group, Lear Corp., Reader's Digest, and Trump Entertainment. (22) Notably, some investors pursue both traditional takeover strategies and debt-based takeovers. (23)

similar to traditional takeovers, the value of debt-based takeovers is subject to debate. (24) For example, on the one hand, distressed debtholders may represent a source of liquidity for distressed companies that otherwise may be unavailable. These investors frequently offer debtor-in-possession financing or post-reorganization capital infusions that allow the company to continue operations. On the other hand, the debtholder's investment may facilitate a restructuring that undervalues the company to the direct detriment of junior creditors and shareholders. Accordingly, the challenge is to preserve the liquidity, discipline, and accountability attributes of debt-based takeovers and to protect the company and its stakeholders against potential raids.

This Article presents the first extensive analysis of...