Debt or Equity: How the Classification of Hybrid Securities Can Turn a Good Company Bad
by John E. Moose and Patrick M. Jones March/April 2007
A company that appears to be flying high in the black might actually be neck deep in the red if its financing relies heavily on “hybrid” securities. Issuances of hybrid securities — financial instruments that have qualities of both debt and equity — are on the rise. This article reviews three cases that may guide individuals charged with directing a company’s operations to determine whether hybrid securities should be treated as debt or equity.
In 2006, companies issued hybrid securities in an amount of more than $40 billion. That amount is certain to increase with each successive year as companies and professionals become more familiar with hybrids and the advantages they offer. As described in this article, however, hybrid securities can play tricks on a company’s balance sheet.
The issuance of hybrid securities has little relevance to a company or investors unless the company’s financial condition becomes stressed. At that point, the characterization of the hybrid as debt or equity is critical because of the impact that characterizing an issuance as debt can have on a company’s solvency. Characterize it as equity, and everything is fine. Characterize it as debt, and the net value of the company will decrease an amount equal to the value of the securities, which may render an apparently solvent company insolvent.
A company is typically deemed “insolvent” when its debts exceed the fair value of its assets. This analysis is relatively straightforward when the company’s assets and liabilities are easily classified. A challenge arises, however, when the company has issued significant amounts of hybrid securities, which may be characterized as debt and included among the company’s liabilities, or as equity and, for all intents and purposes, disregarded.
Knowing whether a company is solvent, insolvent or within the zone of insolvency at any given time is essential for individuals charged with directing the company’s operations, including directors, officers, controlling shareholders and, in rate cases, lenders. Those parties ordinarily owe fiduciary duties to the company and its shareholders, but those duties may expand to include the company’s creditors upon insolvency. Further, insolvency may expose certain transactions to subsequent avoidance, and even render certain transactions, including stock dividend payments, illegal in some cases.
This article briefly describes hybrid securities and reviews three cases that may guide individuals charged with directing a company’s operations, as well as the professionals they employ, in determining whether these securities should be treated as debt or equity.
What are Hybrid Securities?
Hybrid securities can be spotted by their labels, such as “preferred,” “convertible” or “redeemable.” The name placed on a security, however, is a minor factor in determining whether it should be treated as debt or equity. The most important factor is the financial operation of the security. The table below presents typical features of financial instruments, which can be deemed as pure debt and pure equity:
Hybrid securities have features of both debt and equity. A typical hybrid security, such as cumulative preferred stock, may have one or more of the following features associated with a debt instrument: 1.) cash flows through maturity similar to interest, 2.) a set maturity date and 3.) an expected return of amount borrowed. The same security may also have one or more of the following features associated with an equity instrument: 1.) it represents a residual interest in the assets of the firm, 2.) there are no covenants and 3.) the issuer retains the authority over whether to distribute dividend payments. A more accurate way to think about the financial instruments of a corporation is through a continuum where the characteristics of the financial instrument range from pure debt to pure equity.
Companies gravitate toward hybrid securities because they allow flexibility. Generally, a hybrid security will include enough equity-like features for the securities to be equity in the eyes of accountants and rating agencies, which may improve the issuing company’s financial ratios and leverage. A hybrid also will include enough debt-like features to achieve tax-deductible distributions and a favorable cost of capital. A company may choose to emphasize the equity features or the debt features of the security depending on its financial strength, industry practice and the current market environment.
Most credit rating agencies, including Standard & Poor’s and Moody’s Investors Service, and financial reporting agencies, such as the Financial Accounting Standards Board and the Securities and Exchange Commission, recognize that hybrid securities lie between the two extremes of debt and equity. In fact, these agencies have devoted substantial effort to assisting stakeholders in analyzing and classifying hybrid securities. For example, rating agencies typically assess the characteristics of the instrument and the business prospects of the corporation and, based on those factors, will consider some portion of the instrument as equity and some as debt. This pragmatic process is referred to as “assigning equity credit.”
State and federal judges, however, are rarely as practical and often completely ignore the opinions of the financial agencies when examining hybrid securities. The existing case law suggests that hybrid securities must be treated as either debt or equity, at least for purposes of determining a company’s solvency in the context of bankruptcy-related litigation.
The Relevant Cases
In the three cases discussed, the court was tasked with determining whether hybrid securities should be treated as debt or equity for purposes of solvency analyses. In each case, the court examined the financial characteristics of the hybrid security and the circumstances in which the financial security was issued. Although the hybrid securities were roughly similar, the courts characterized two of the hybrid security as debt, and the third as equity.
The case of Brown v. Shell Canada, Ltd.,2 an adversary proceeding, which arose out of the In re Tennessee Chemical Co. bankruptcy case, may be the first case to address question of whether a hybrid security should be treated as debt or equity. In that case, Tennessee Chemical secured a debt to Shell Canada by granting Shell Canada a security interest in Tennessee Chemical’s property shortly before filing its Chapter 11 bankruptcy petition. The bankruptcy trustee sought to avoid the transfer of the security interest as a preferential transfer. One of the elements of the trustee’s case was that Tennessee Chemical was insolvent on the date of the transfer.
The court noted that Tennessee Chemical’s schedules filed as part of its bankruptcy petition indicated that it was solvent by about $1.6 million on the date of the transfer.3 In an attempt to demonstrate that the debtor was insolvent on the date of the transfer, the trustee argued that Tennessee Chemical’s redeemable preferred stock should be treated as debt, rather than equity. The court noted that the stock had many characteristics that made it appear as debt, including a mandatory redemption date, required dividend payments, and additional dividend payments and interest on any unpaid dividends.4
The court was not persuaded that the stock should be treated as debt, however, because the trustee “did not attempt to prove the effect of state law on the stockholders’ right to payment or Tennessee Chemical’s right to make the payments if it was insolvent.”5 The applicable state law in the Tennessee Chemical case, like the state law in most jurisdictions, prohibited a company from making a dividend payment while it was insolvent. Therefore, the court concluded the mandatory preferred stock could not be treated as a debt because the “mandatory” dividend payments, which were so similar to interest payments, were not mandatory at all. Thus, for purposes of the debtor’s solvency analysis, the mandatory preferred stock was treated as equity and not counted against the fair value of the company.
In the case, In re Color Tile, Inc. (Official Committee of Unsecured Creditors of Color Tile, Inc. v. Blackstone Family Inv. P’ship, L.P.), the court engaged in a similar analysis of a hybrid security, but reached the opposite outcome. In Color Tile, the trustee sought to avoid and recover as fraudulent transfers payments to purchasers of the debtor’s preferred stock made during the year prior to the debtor’s bankruptcy.6 The defendants argued the hybrid security was a debt instrument and the payments were in the form of interest, not dividends made on account of equity. The court disagreed.
The Color Tile court noted that while the labels that parties to a transaction may offer some direction, whether a security constitutes debt or equity depends on the economic substance of the issuance and the interpretation of the contract between the corporation and the security holders.7 To determine whether the security in this case constituted debt or equity, the court applied the factors traditionally employed to contract interpretation, including the following: 1.) the name given to the instrument, 2.) the intent of the parties, 3.) the presence or absence of a fixed maturity date, 4.) the right to enforce payment of principal and interest, 5.) the presence or absence of voting rights, 6.) the status of the contribution in relation to regular corporate contributions and 7.) the certainty of payment in the event of the corporation’s insolvency or liquidation.8
Based on these factors, the Color Tile court determined that the parties had intended the redeemable preferred stock to be an equity interest even though, as was the case in Tennessee Chemical, dividend and redemption dates were projected. Contrary to the Tennessee Chemical court’s reasoning, the Color Tile court found the state law prohibiting dividend payments by an insolvent corporation to be evidence that the instrument was intended to be equity, not debt, because it provided evidence the parties did not intend that the payments were mandatory, like interest. The court reasoned the state law limited the debtor’s ability to pay dividends to “funds legally available therefore.” Further, the stock agreement restricted the shareholders’ right to redeem the stock if the debtor was in a substantially leveraged financial position.9 Finally, in the event of a liquidation, the payment of accrued dividends and the redemption price were subordinated to creditors in a liquidation.10 The court further noted, “where such certainty of payment is missing, the security is equity, not debt.”11 Because the payments were made on account of equity, they were not made on “account of an antecedent debt” and could be avoided and recovered as fraudulent transfers.
In the case, In re Trace Int’l Holdings Inc. (Pereira v. Dow Chemical Co.), the court again analyzed whether a company’s preferred stock issuance should be characterized as a debt instrument.12 Like the Color Tile case, the bankruptcy trustee in Trace Int’l Holdings sought to recover a purported stock dividend payment made to the stockholder while the company was insolvent. One of the requirements of the trustee’s case was the payment was made on account of an antecedent debt, which did not exist if the preferred stock could be characterized as equity.
The Trace Int’l Holdings court followed the Color Tile court’s analysis by focusing on the stock agreement and whether the dividend payments were intended to be made regardless of the issuer’s financial condition, as one would expect from an interest payment on a debt, or whether they were restricted, as one might expect from equity. The court initially noted that a provision in the preferred stock prospectus prohibited redemption of the stock if the company was deemed insolvent. The court disregarded this provision, however, because the parties intended the payments to be made, regardless of the financial condition of Trace. The court relied on the following evidence of the parties’ intent: 1.) the sole holder of the preferred stock was Trace’s primary supplier, 2.) Trace acknowledged that the supplier expected redemption regardless of Trace’s financial condition and 3.) the agreement provided a substantial increase in the dividend rate if the stock was not redeemed. The close relationship between the issuer and the sole stockholder in this case was clearly a unique and overriding factor in the court’s decision.
When viewed together, the decisions indicate that a hybrid security will be treated as equity if the issuer retains control over whether to make dividend payments, and as debt if the dividend payments are more similar to interest payments, which will be made regardless of the issuer’s financial condition. Whether the existence of a state law prohibiting dividend payments by an insolvent company is evidence the hybrid security should be characterized as debt or equity is less clear. That question should become clearer as more opinions examine the issue in the typical issuer/stockholder relationship, like Color Tile, and contrary to the unique facts of Trace Int’l Holdings.
Why It Matters
From a transactional standpoint, directors, officers and controlling shareholders need to inform themselves regarding how subsequent judicial review may characterize a company’s hybrid securities in order to fully vet the interests of their fiduciaries. For example, if the company is planning to divest a business unit, and its financial advisor concludes that its hybrid securities are likely to be characterized as equity rendering the company solvent, then the company can proceed with the sale in reliance on the financial advisor’s advice. On the other hand, if the financial advisor determines that the company’s hybrid securities are likely to be characterized as debt rendering the company insolvent or within the “zone of insolvency,” then the company also would be prudent to seek the consent of its key creditors — to whom they may now owe fiduciary duties — prior to entering into the transaction.
From a litigation standpoint, representatives of a debtor’s bankruptcy estate should determine whether hybrid securities are likely to be characterized as debt or equity prior to prosecuting claims, which might hinge on conflicting conclusions. Failure to take one position or the other at the outset can compromise some claims of the debtor’s estate. This caution was illustrated in a separate adversary proceeding related to Trace Int’l Holdings.
In addition to the preference action discussed above, the bankruptcy trustee in Trace Int’l Holdings also filed claims against the debtor’s former directors and officers for breach of fiduciary duty in connection with the company’s payments of certain dividends.13 The trustee alleged that the defendants owed fiduciary duties to the company’s creditors at the time of the transaction because the debtor was in the zone of insolvency. In order to prove the company was in the zone of insolvency, the trustee contended that the company’s hybrid securities must be characterized as debt.
In a separate adversary related to Trace Int’l Holdings, the trustee filed claims against the recipients of the dividends to avoid and recover the payments as fraudulent transfers. In order to prevail on these claims, the trustee contended that the payments were made on account of equity and therefore not made in exchange for reasonably equivalent value. The court dismissed the fiduciary duty adversary because once the court ruled the hybrid securities were equity in the fraudulent transfer adversary, the trustee was precluded from arguing the hybrid securities were debt for purposes of the breach of fiduciary duty claims against the directors and officers.
The classification of a hybrid security as debt or equity is unpredictable and can have far-reaching effects. Corporate principals should be cognizant of the impact on the solvency of their company if its hybrid securities are deemed debt and manage the affairs of the company accordingly.
1 Standard & Poor’s defines equity as a financial instrument that: 1.) requires no ongoing payments that could lead to default, 2.) has no maturity or repayment requirement, 3.) provides a cushion for creditors in the case of bankruptcy and 4.) is expected to remain as a permanent feature of the enterprise’s capital structure. In addition to these factors, Standard & Poor’s considers how likely the financial instrument is to convert into equity, the likelihood of the company’s retaining the equity as permanent capital and how soon the conversion is likely to occur.
2 143 B.R. 468, 471 (Bankr. E.D. Tenn. 1992).
3 Id. at 473.
6 2000 WL 152159 (D. Del. Feb. 9, 2000).
7 Id. at *4.
10 Id. at *5.
12 287 B.R. 98 (Bankr. S.D.N.Y. 2002) (emphasizing that hybrid securities must be characterized as either debt or equity — they cannot be both).
13 301 B.R. 801 (Bankr. S.D.N.Y. 2003).
John E. Moose is a director at Huron Consulting Group specializing in providing valuation and financial analyses for litigation, financial reporting, tax, and transaction related purposes. He has provided more than three dozen valuations of public and private Chapter C and Sub-Chapter S corporations in a variety of industries and has determined the value of many types of intangible assets, including trademarks, developed technology, in-process research and development, non-compete agreements, and assembled workforce. Moose also has extensive experience in financial issues surrounding bankruptcy related litigation, including establishing solvency/insolvency, calculating damages, and determining expenses potentially recoverable under section 506(c) of the U.S. Bankruptcy Code.
Patrick M. Jones is an attorney with Lord Bissell & Brook LLP in its Chicago office. His practice focuses on commercial bankruptcy and related litigation, including the prosecution and defense of avoidance actions and claims for breach of fiduciary duty.
This article first appeared in the March 2007 issue of the ABI Journal, Vol. XXVI, No. 2. Reprinted with permission from the American Bankruptcy Institute (www.abiworld.org).
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