Dealing with debtholders.

• Author: Vazza, Diane J.
• Position: Chairman's Agenda: Balancing Shareholder Interests

Dealing With Debtholders

The 1980s taught American corporate managers an important lesson: the importance of managing for public ownership. The combined forces of takeover mania, junk bond financing, institutional activism, and a stock market increasingly influenced by technical factors forced corporate boards and managers to recognize that they had long been neglecting an important part of their job. Programs to improve the management of public ownership began to emerge in the 1980s, initially as defensive tactics and then as programs to identify and communicate with beneficial owners.

The 1990s add a new dimension to the management of public ownership: debtholders. Largely because of the overleveraging policies of the '80s combined with the current recession, an increasing number of companies are being forced to recognize that relations with their debtholders, rather than just equityholders, have become a critical part of their responsibility. The statistics are revealing: * According to a recent Commerce Department report, in the third quarter of 1990 interest expense of American corporations was 25.4% of total cash flow vs. 15.1% in 1988. Unlike the 1980s, companies facing financial difficulties in the 1990s are generally those with fundamentally sound businesses. Because of business pressures created by the current economic slowdown, cash flows are falling short of aggressive growth projections (a legacy of the '80s) and are insufficient to service debt. * This trend is confirmed by a Moody's Investors Service Inc. report that in 1990, downgrades of corporate debt outpaced upgrades by 4.4 to 1. This record pace compares with a ratio of 3 to 1 during the 1982 recession - the previous record for the post-World War II period. In dollar terms, these downgrades amounted to $354 billion, or 38.7% of American companies' total outstanding bonds in the domestic and international markets. * Standard & Poor's Corp. reported that in 1990 the number of downgrades of corporate issues increased to 768 from 419 in 1989. These downgrades represent $510.1 billion (vs. $174.4 billion in 1989), of which $14 billion went into default. The default increase compares with a mere four companies with $217 million of public debt in 1980. Standard & Poor's expects defaults on corporate issues to rise to between $15 billion and $20 billion in 1991.

Faced with these problems and a cash flow squeeze, a corporation must address the problem of dealing with debtholders. For most companies, this presents a special set of challenges. Even when a company has been diligent in its relations with equityholders, it is likely to have neglected its debtholders. Because of historical differences in the nature of debt and equity and our tradition of corporate governance that gives voting rights to debtholders only under extraordinary circumstances, we have developed some bad habits. Most companies make no effort to communicate with their debtholders, or even to identify who they are, until the point of a crisis.

This approach puts companies at a severe disadvantage. They are automatically on the defensive...