Targeted Debt: Give the Stockholders What They Want

Too much leverage can be risky, but sometimes it's just what the doctor ordered.

One of the reasons that stockholders in Columbia Gas survived a Chapter XI proceeding more nearly intact than owners of other bankrupt utility enterprises was that the parent holding company was a secured creditor of its operating subsidiaries at the time of the filing. This status gave priority to Columbia Gas stockholders over the unsecured creditors of the operating companies, including the "take or pay" gas suppliers who represented the major problem that provoked the bankruptcy filing. Although in retrospect the filing proved costly and troublesome for Columbia Gas, the creation of a secured position helped the Columbia stockholders once the company found itself in bankruptcy. The stock held steady throughout the proceedings, once the initial shock had passed and analysts understood the basic legal and economic implications of Chapter XI.

In fact, electric utilities learn from the fortuitous example of Columbia Gas.

Symptom: Growing Risk, Falling Stock Price

Today, risk can be seen on the upswing in the electric utility industry. Nevertheless, this growth in risk remains difficult to quantify, because we cannot yet say that we fully understand the true competitive positions of many vertically integrated electric utilities. Where are the real transmission constraints? What cost structures would utility managers accept if they were really obliged to deal with all-out competition? What are the true costs of nuclear power? What is the real political resistance to forcing retail customers to pay higher rates in order to give those with bargaining power the rates they can bargain for?

We can only guess.

Nevertheless, we can assume with a fair degree of confidence that, as the traditional, integrated electric utility comes face to face with competition, its common stock will begin trading below book. while the common stock dividend may be cut or even eliminated. Moreover, the utility's bank creditors would demand assurance that they remain protected.

The reasons will sound familiar enough: too much nuclear or old fossil plants; high labor costs; an unsupportive state public utility commission (PUC); a PUC determined to force deregulation at a rapid pace; slow-to-nonexistent economic growth in the service territory; good transmission ties to lower-cost sources of supply. Some or all of these reasons may apply.

The bond indenture and charter provisions and state and federal law will also come into play. These structures, based on accounting concepts from the '30's and '40's or even earlier, assumed that "cost of service" ratemaking would last forever. They never anticipated the current talk of deregulation, price cap models, or incentive-based regulation.

Along the way, bondholder and trustee fears will grow with the perceived difference between book value of assets and fair market value, where fair market assumes deregulation of generation and continued regulation of transmission and distribution (T&D). These fears relate to nuclear generation, but also to older fossil plants, and in an indirect way to labor costs compared with staffing levels and nonunion labor at independent power producers with modern, gas-fired, combined-cycle generation.

Early Treatments: Restructuring, Unbundling

To counteract these forces, the company or it regulators may consider restructuring scenarios that involve creation of a holding company and two separate subsidiaries (em a Genco and a "wires" (T&D) company (em or perhaps a third sub that takes the form of an energy service company (ESCO or SuperESCO) to conduct unregulated activities. However, many senior officers of utilities continue to preach the model wherein the same management controls all three basic types of utility assets, whether they are only functionally separated or separated into different corporate entities. If this model is in fact sustainable, the difference in the business climate for utilities going forward is likely to permit or require a different approach to the classic three-layer capital structure (debt, equity, and preferred) that has served the industry well for decades but is now seen going forward as a source of problems.

Nevertheless, the utility managers themselves may pose a major obstacle to disaggregation. In short, many managers prefer not to lose control of any assets.

This desire arises partly from the basic instinct to hold onto what you've got (em be it assets, market power, reliability of supply, or control over sources of supply. It also stems from a lack of comfort level in knowing what will be best in a future deregulated market. When in doubt, hold on to equity. That path always appears easier than to recognize that rates are prices, or equity can be replaced (substituted for) by a more cost-efficient source of capital.

A Proposed Cure: Targeted Debt

Utility stockholders tend to focus on yield, showing only a very secondary interest in capital gains. As such, they are atypical as equity investors. These investors have no other investment vehicle which suits their goals of high income and minimal risk.

Utility managements, protected by the Public Utility Holding Company Act and state laws dating from the same era, remain much more isolated from common stockholders (less likely to feel pressure) than their counterparts at public companies in the deregulated sector.

These two observations suggest a disarmingly simply strategy (em issue more debt. In essence, simply convert stockholders into bond investors with more secure expectations. Increasing debt leverage offers a way of counteracting financial pressures from threats of restructuring, deregulation, and divestiture. It should pay dividends all around.

A targeted debt strategy would involve three basic proposals:

1. The Debt Issue. Offer subordinated secured debt (the "target debt") in exchange for common stock for up to 60-80 percent of outstanding shares. This idea assumes the typical utility structure of senior first mortgage bonds plus a limit in the corporate charter on unsecured debt. This targeted debt would take the form of either a 30-40 year bullet maturity or otherwise be structured as a long-term obligation that would be refunded, or have some rollover or remarketing feature akin to adjustable rate preferred stock. Meaningful equity would still remain, given the size of most utilities, to serve as a buffer with respect to the fraudulent conveyance issues that could be raised by creditors.

As for tax 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, the deductibility of the interest payment and the lack of need for an income tax component for return on common equity has a multiplier effect that very few other elements of the corporate equation offer, so this exchange would provide meaningful savings for very little trouble.

In short, management serves common stockholders by giving them 1) more assured cash flow and 2) priority against independent power producers and other potential or existing creditors who might have been living off of utility balance sheets. The transaction also preserves seniority and cushion for existing debt holders; it simply converts the form

of the junior investment and makes it more tax-efficient, which in turn helps rates get lowered to enhance the company's competitive position.

Some portion of preferred stock and common would remain as a cushion for debt holders. Bondholders are unaffected, however, and management's duty to preferred holders is defined by contract and generally does not reach the fiduciary level, except in cases of fraud of violation of law or express terms of contract. Nevertheless, some preferred consents may need to be obtained where dividend restrictions include repurchase of common shares as well as dividends on common, or where state law does not differentiate, as to the nature of distributions, between dividends and other payments. Healthier companies (em as long as they are still not under Financial Accounting Standard 101 or 121 (em should find no difficulty in this area. It may also be possible to obtain preferred consents by offering them a pro rata exchange of subordinated debt at the next level senior to the debt for which common shares are to be exchanged.

Presumably, the offer would be made on a first-come, first- served basis. Many utility shareholders are simply non-responsive; some will believe that they are better off holding on to their common (em which will, after all, constitute a bigger stake in the recapitalized entity. The impact on deferred taxes under this scenario will also need to be examined, but preliminary analysis does not suggest problems here. t

J. Michael Parish, Richard S. Green and Stephen H. Kinney are partners with the law firm of Reid & Priest.