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The faltering dialogue over structural versus contractual subordination in European junk bond contracts is one that banking lawyers cannot escape from just now. Poor recovery rates for bondholders in Europe's high-yield market - 16-17 per cent compared with 30-40 per cent in the US - prompted last December's so-called boycott letter. The bondholders asked nicely, but essentially they were demanding that the investment banks fix the structures.
While the bondholders would do well to remember that you cannot structure a bad credit into a good credit, they do have a point.
The debate is hardly new, but by finally digging their heels in, high-yield investors are making the banks gulp very hard. As we speak, teams at Clifford Chance and Latham & Watkins are scrambling around trying to help the investment banks resolve structural issues on the Brake Bros and Focus Wickes deals, all too aware that their competitors are at the ready to advise the senior lenders on the downsides of any such proposals. Both deals are floundering at counter and counter proposal stage, but the pressure is on to get them out of the door as soon as possible and before a war in the Gulf switches from prospect to reality. The hunt is on for the perfect solution and the likelihood is that it will involve some step from structural towards contractual subordination.
It was hoped that Legrand's bond deal would crack some of the issues, but the bank lenders would not give up their privileged position. So rather than face further delay and risk letting its financial statements for the bond issue reach their expiry date, Legrand has pressed ahead with a more conventional structure for its €600m (£392.3m) euro/dollar dual tranche, 10-year bond - a structural, rather than contractual subordination. As a result, the expectation is that it will sell less successfully in Europe.
Legrand leaves the smaller bond issues for UK companies Brake Bros and Focus Wickes as the deals with the potential to come to market as the first with new structures. Both were expected to come out in early January.
Credit Suisse First Boston and JP Morgan faced immense difficulty in getting the Brake Bros deal out of the door last year. By December, it appeared that a restructured £175m sterling/euro dual tranche 10-year non-call bond was back on the cards. The key structural enhancement was a move towards a contractual subordination. But the amended guarantee was subject to sign-off by two-thirds of the company's banks. They knocked it back before it even reached a formal vote, leaving the lead managers bruised by the rejection.
You may well have heard the story doing the rounds: that a Clifford Chance partner wrote a no prejudice memorandum on behalf of the lead managers, effectively telling the senior banks that, in the context of this deal, their position would not be affected by the concession. A bold statement indeed. Well, in case you haven't seen a copy, the memo really does exist. Not surprisingly, it has caused a few raised eyebrows among Clifford Chance competitors. The memo has a point - in a limited sense, the bank's rights are the same even if the junior creditor suddenly has better rights than before. The memo was also very deal-specific and stopped well short of saying that there is no difference between contractual and structural subordination.
But the senior lenders were clearly unhappy. The proposal was pulled, and they are still trying to get a solution that will satisfy both the senior banks and European in-vestors. The same goes for Focus Wickes' £225m deal, with Latham scooping the role advising the underwriters ING Barings and Goldman Sachs.
There seems to be some optimism about the creativity of the investment banks on this deal, but while the UK DIY retailer would obviously like to reduce its costs, it doesn't have to do another bond deal and could rely on the bridge that has just gone into place if a structural solution for the issue cannot be reached.
In reality, neither Brake Bros nor Focus Wickes may prove to be the best precedents for lawyers or their clients. One senior capital markets lawyer predicts that both bond issues will end up full of fine tweaks and heavily negotiated pieces that later deals will not have. Their fundamental problem is that both businesses were acquired before bondholder discontent came to a head, making it virtually impossible to ask the senior banks to make concessions now. Future deals should come with the advantage that this will have been considered much earlier in the cycle.
The thinking caps are definitely on. One problem is the Securities and Exchange Commission regulations that inevitably come into play because most deals must contemplate selling into the US market as a last resort. This, in turn, brings the Trust Indenture Act into the picture. A post-Wall Street Crash piece of Federal legislation, the act prevents the bondholders from fettering their right to recover money owed to them. That's fine if you're reaping the rewards of the Chapter 11 bankruptcy regime, but the act prevents the contractual subordination that European high-yield investors so desperately want. Some major players in the LBO market are known to be actively considering alterative structures to avoid the effect of the act to allow some form of intercreditor agreement. But still more creative thinking and flexibility on all sides will be needed to get through the impasse.