Law and Valuation
To:
Professor Alan Palmiter
From: Stacy Gomes and Adam Vore
Subject: Analysis of the RJR-Nabisco Bondholder Litigation
Date: April 4, 2005
Yield, Credit Spreads, and its Inverse Relationship to Price
A bond’s price moves inversely to discount rate applied to it. The discount rate is
simply the expected yield an investor requires to participate in an investment.
This rate is constructed of two major parts. The first being the risk free rate in the
market of a security with a similar maturity. This is normally calculated by looking
at “on the run” Treasuries with the same maturity of the issue being considered
(i.e., the underlying risk free rate for a five year corporate bond would be a five
year U.S. Treasury bond). The second part of the required yield is the credit
spread required by investors to invest in the securities of a given company. This
spread is usually quoted in bps (pronounce “bips”) with one bp representing
1/100 of a percent. Thus, if the credit spread for a company’s five year bond was
120bps and the U.S. five year Treasury was yielding 5.5%, the company’s bond
would issue at 6.70%. The coupon rate is almost always set as close as possible
to the required yield and is fixed for the life of bond. It is this fixed rate that
causes the inverse relationship to exist between the required yield and the price
of the bond. An example would be a company issues a bond such as the one
described above with a coupon of 6.70% and a face value (par) of $1000. If, say
a year passes, and the market has decided the company is more risky then the
credit spread for this company increases to, say, 220 bps. The coupon payment
was fixed at issuance and there the extra 100 bps the market is now requiring will
be taken out of the price the bond is trading for, thus placing this additional
compensation for more risk at redemption when the bond is tendered for face
value, in this case $1000.
Capital Structure and the Probability of Bankruptcy (Default)
The RJR Nabisco bonds price fell because the market viewed that the risks
associated with payment of interest and principle had increased significantly
therefore increasing the required yield. In this case, before the leveraged buyout
had occurred, RJR Nabisco had a low debt to equity ratio, strong free cash flow,
a high free cash flow to interest expense ratio, and a very steady, consistent
history of generating free cash flow. All of these factors resulted in the
marketplace viewing RJR Nabisco’s credit rating as high, resulting in an
investment grade credit rating of A, and thus a low yield was required on the
issue. This low yield allowed RJR to set the coupon payment at a relatively low
level, presumably the coupon was set at or very near the required yield, and RJR
received face value, or very close to it, at issuance. When the leveraged buyout
had been completed the company had drastically changed its capital structure.
This new capital structure had dramatically increased the probability of default (or
bankruptcy). (See Exhibit 1) This increase in default risk (and the accompanying
blowing out of credit spreads) is part of a larger group of risks normally referred
to as Event Risk. This increased risk was reflected in the company’s credit
spread by a large increase. This large increase in its credit spread was
exacerbated by the fact that the company had fallen from investment grade to
junk status. It is important to note that most of the institutions that hold
investment grade debt are required by either law or corporate governance not to
hold junk bonds. This meant that when the RJR bonds fell to junk status most of
the holders were required to sell by the end of the trading day. The junk bond
traders are well aware of this fact and usually force the holders to sell at lower
than expected market prices. The most recent example of this event was the
downgrade of AT&T bonds to junk in the summer of 2004.
Exhibit 1: Effects of Capital Structure on Bankruptcy Risk
EPS
$2.00
$1.00
Company X
has a Capital
Structure That
Places the
Company in
Bankruptcy if
Revenues Fall
Below $100
Million
Both Debt and
Equity Onwers
Worse Off Under
New Capital
Structure
Company X
has a Capital
Structure that
is 50% Debt
and 50%
Equity
Level of Revenue Where the
Company Would be
Indifferent to Either Capital
This Represents
the Increased
Level of Bankrupcy
Risk Inccured by the Increased
Leverage
Revenue
$500 Million
$300 Million
$100 Million
$0.00
Company X Leverages Up its Capital
Structure Which Allows for Higher
EPS but It has a Higher Level of
Minimum Revenue not Fall into
Bankruptcy
Bondholders Rights, the Indenture, and Event Risk Protective Covenants
The court makes a correct distinction between bondholders and stockholders
when discussing the applicability of fiduciary duties. Companies owe fiduciary
duties, such as loyalty and care to stockholders because they are involved in
managerial decisions and they are unable to put their demands into a contract.
In contrast bondholders are sophisticated players in the market who are able to
carefully analyze the provisions in their contract with companies as a check
against potential abuse.
The court also correctly noticed the difference between the contract in this case
as opposed to basic adhesion or boilerplate contracts. Not only is the
sophistication of Met Life and Jefferson Pilot highly significant, but originally,
MetLife included protection provisions against LBOs in the contract and later
waived them. Therefore, MetLife was fully aware of the possible ramifications of
takeovers like the one in this case, but made a conscious decision to take out
their protection mechanisms. This is perhaps one of the major reasons why the
court refused to look at parol evidence. Also, courts in general typically do not
like to get involved with provisions outside of the four corners of a contract unless
the contract is ambiguous, one party had a clear disadvantage in bargaining
power, or one of the major defenses apply, such as fraud or duress. In this case
the contract was clear and the court was correct in stating that they should be
concerned with the intent of the contract, but only to the extent that what they
intended is evidenced by what is written in the contract.
In addition to the basic parol evidence rules cited in the Restatement, there is
much common law precedent to this court’s decision as well. In Sabetav.
Sterling the NY Court of Appeals stated, “In other words, the implied covenant
will only aid and further the explicit terms of the agreement and will never impose
an obligation "'which would be inconsistent with other terms of the contractual
relationship.” In addition to this provision there are an abundance of cases that
state. Similarly the district court in this case stated, ”These plaintiffs do not
invoke an implied covenant of good faith to protect a legitimate, mutually
contemplated benefit of the indentures; rather, they seek to have this Court
create an additional benefit for which they did not bargain.”
The two plaintiffs in this case, Met Life and Jefferson-Pilot Insurance, were two
large and active participants in the fixed income market. The insurance industry
represents the heart of what is referred to as FIG (Financial Institutions Group) in
the Debt Capital Markets, and represents the source of the largest volume in
both acquisition and issuance. An expert level of understanding of fixed income
(and the risks associated with it) is paramount in the insurance business. They
must constantly assess how to invest unneeded premiums paid in, and when and
how much capital will be needed to cover expected liabilities from claims. The
courts found that because these investors were of the “expert level,” the court
would not step in and rewrite the indenture. Further evidence of the plaintiffs’
expert level of sophistication in the Debt Capital Markets is the fact that Met Life
has total assets of $88 billion with $49 billion located in the fixed income market
and Jefferson-Pilot has total assets of $3 billion with 1.5 billion located in the
fixed income market. The plaintiffs were aware of the risk and chose not to
include any protection from event risk.
The indenture should have contained event risk protective covenants. These
covenants protect bondholders from a sudden decline in credit rating because a
takeover related event has occurred. These events include recapitalization, a
hostile takeover, the purchase of a large block of shares, or an excessively large
dividend payout. A common form of an event risk protective covenant is the
“poison put”. The “poison put” allows bondholders to force the company to buy
back the bonds at par should a certain event take place (i.e., a leveraged
buyout). This makes actually perpetrating the event so unattractive that the
likelihood of the event actually occurring is very low, and should the event
actually occur the bondholders are indemnified from any drop in their bond’s
price because the company must buy them back at par. (The term “poison” is
used because it effectively kills the deal. The right to sell at a predetermined
price is called a “put” because you have the right to “put” or force to take at a
certain price; thus the convention “poison put”) There are also “ super poison
puts” which force the company to buy the bonds back at some multiple of par,
usually 1.5x. It is interesting to note that company’s that employee anti takeover
protection (even protection that is designed to protect the shareholders) do have
a lower cost of debt, but evidence has shown that stockholders to value this anti
takeover protection.
The Evolution of the Indenture
As a result of this case the indenture as grown from about five pages to fifty
pages. Investors now require that every remotely possible event be spelled out
and the protection that the company will provide explicitly detailed. The
indenture will have hundreds of activities that the company can not engage in or
they risk violating the indenture. The activities range from how much, if any,
additional debt the company can raise to what sort of business opportunities the
company can pursue. A whole list of financial ratios and what range they must
stay within will be detailed in the indenture. All of this is done in an effort to lock
in the risk level of the company so as to fairly compensate the bondholder for the
level of risk they are taking. Often indenture now include “step up” clauses that
protect bondholders if credit spreads widen even though the company is in
complete compliance with the indenture. These “step up “clauses state that the
coupon of the issue is increased, say 50 bps, for every level the company is
downgraded. This is a further attempt by the bondholders to ensure that they are
properly compensated for the level of risk they are incurring.