There is theory and then there is actual practice. The Chapter 11 bankruptcy case of USEC, which processes uranium for power plants, provides a nice reminder.
Academics, in both the business and legal worlds, spend a lot of timing worrying about the “absolute priority rule.†This is the idea that secured creditors are paid in full before unsecured ones, and the unsecured creditors are paid in full before shareholders receive anything.
Academics have long argued that failure to heed the absolute priority rule with great rigor results in higher debt costs for all borrowers in the economy. It’s the basis for many academic criticisms of Chapter 11.
But now we have the USEC reorganization plan, which creditors and preferred shareholders have agreed to support. It would give the holders of existing convertible notes cash for their accrued but unpaid interest, as well as new notes and just more than 79 percent of the stock of the reorganized company.
The preferred shareholders â€" Toshiba and Babcock & Wilcox â€" would receive just more than $40 million in notes and not quite 16 percent of the new equity. The old shareholders would retain a 5 percent interest in the company.
All other claims would ride through the bankruptcy unaffected.
Of real interest is what’s happening to the preferred shares â€" especially relative to the convertible debt. The preferred shareholders are upgrading their place in the capital structure â€" becoming creditors instead of mere shareholders â€" while also retaining a nice piece of the potential upside.
But the holders of convertible debt are not being paid in full. USEC, which is based in Bethesda, Md., estimates they are recovering a bit less than 70 percent, but Bloomberg News reports that the bonds are trading at about 40 percent to face value. Even allowing for some discount for the possibility the plan will fall through, this suggests USEC’s estimate is a bit on the optimistic side.
In short, the plan contains a rather obvious violation of the absolute priority rule.
Nonetheless, USEC reports that about 65 percent of its bondholders support the deal. Based on a quick look at the known holders â€" again via Bloomberg â€" this does not look like an unsophisticated bunch. It includes Highbridge Capital, J. Goldman & Company, GLG Partners and the like.
So they have agreed to a deal that gives the preferred shareholders money that the bondholders would normally be entitled to demand.
Maybe, just maybe, this suggests that the academics need to think a bit more about the subtleties of the absolute priority rule.
Sometimes continuing the business as a going concern means realizing the soft power of those that would normally have lower-ranked claims. In this case, it’s probably not a coincidence that the two preferred shareholders are big players in the power industry.
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
