World Turned Upside Down

1 May 2009:

The economy has weakened most companies, but it has strengthened the hand of one group: creditors. Marginalized somewhat the past few years, banks are once again imposing stiff covenants and pricing risk profitably. Bondholders, determined not to bear the brunt of restructurings, are beating back offers to exchange their notes at a discount. Commercial lenders are extracting highly prized collateral from companies needing working capital.

In short, creditors have their groove back. They're peering over the shoulders of CFOs to make sure that company assets, many of which are at risk, are preserved. With good reason: Moody's Investors Service projects that the recovery rate for senior unsecured bonds will average 33% in 2009, the lowest rate since 2002 (see "Slim Pickings" below). "If there are fewer funds to pay out to creditors, they always look for ways to increase their recovery," says Sam Alberts, a partner in restructuring at law firm White & Case.

The revival of the creditor class presents a major challenge for CFOs of financially stressed companies — particularly those approaching the "zone of insolvency," a legal term for when a company is in imminent danger of going bankrupt. Since 1991, the Delaware courts have found that when companies are in the zone of insolvency, management and boards are not just the agents of shareholders. They have a fiduciary obligation to a wider community of interests, particularly creditors. Delaware case law has evolved over the past two years to shelter directors and officers from direct creditor claims, but the zone-of-insolvency issue is far from resolved.