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Financial News

Fortnightly Magazine - January 1 1997

issues concerning the ratio of debt to equity, this plan would qualify under President Clinton's proposal, as long as the targeted debt would not have a weighted average maturity of more than 40 years (or 20 years for securities issued by the subsidiaries but not shown on the parent's balance sheet). Tax experts believe that targeted debt would pass tax scrutiny at the Internal Revenue Service and create tax efficiencies if sufficient cash flow coverage exists. The exchange would be completed on an exempt basis under Section 3(a)(9) of the Securities Act or as a registered exchange offer (which might be preferable in terms of comfort levels on disclosure issues relating to the newly recapitalized company).

The idea would be to set the exchange rate based on the market price of common stock, (or a market-based measure, provided in an investment banker fairness opinion, as to what realistic price level the stock might trade at, given the issues facing the company in question). Built into the pricing of the security to be exchanged for the common stock (em the targeted debt (em would be the value to the holders of a fixed and prior claim on their investment versus the vulnerabilities of a dividend. Any such exchange would be taxable for the shareholder (em a fact that should also reduce the number of shareholders who will exchange. The benefit to shareholders who do exchange will come in the form of enhance certainty of the income stream. Also, in the likely event under this scenario that their investment is worth less than their cost, stockholders will be able to recognize the loss for tax purposes without incurring any brokerage commissions.

2. The Discount Rate. Set the coupon at a sustainable payout rate; create a "collar" or formula like a money market adjustable rate preferred stock. The issuer could also create a pay-in-kind (PIK) feature (or a deferrable interest feature such as rating agencies have blessed in the past) or some other form of deferral under a set of defined circumstances. Default provisions and covenants would stay loose, recognizing that whatever rights the holders have are superior to what they would have had as holders of common stock.

3. Utility Rates. Reset rates to customers (charging lower prices but no loss of profit margin), based on this new capital structure. Simply stated, a lower equity component equals a lower cost of capital. Debt is cheaper than equity.

Why It Should Work: The Rationale

For most utilities, common equity is the same as highly subordinated debt. Thus, the sort of swap proposed here should prove appealing to stockholders because of higher assurance of payout and improved competitive position of their company. Even adjustable debt with some sort of "collar" would still provide more certainty and security than now exists for many utility shareholders.

In addition, rating agencies shouldn't care about rating the new debt, since the issue is retail and represents subordinated debt that could go unrated. The market would decide on valuation issues, as it now does on common stock.

From a tax angle,