A trade-for-debt equity swap offered by a debtor to a large creditor can provide a viable alternative to liquidation while offering that creditor potential more value on its debt and a role in the company’s future growth. Specifically, where a failing business is in need of capital, it can offer a trade creditor to convert its existing debt into equity in the company – i.e., the creditors will forgive the debt owed to them by the failing business in exchange for a share in the business. This might pose the question – why would a creditor want a share in a failing business? In fact, such a swap can work to the advantage of both the creditor and the business. If the creditor does not make the trade, the Debtor may become insolvent and forced to liquidate and the creditor in turn may get pennies on the dollar for its debt. If however the trade debt is reduced, the failing business can pull itself up and the value of its equity can grow.
A debt for equity swap may be appropriate where a company is having solvency issues but is still ultimately viable, is over geared and/or is unable to obtain finance. One example of where this proved to be a success was in the furniture retailer, Jennifer Convertibles, Inc., bankruptcy cases. Prior to filing for bankruptcy, the company owed almost half of its total unsecured debt to a foreign furniture supplier. This foreign furniture supplier was the debtor’s sole supplier for many of its products. The supplier entered into an agreement with the Debtor prior to the filing of the bankruptcy agreeing to convert the debt into a controlling stake (90%)in the reorganized debtor’s new common stock. Significantly, the Supplier also recovered more than 87% of its claim. See, ABI Journal, July/August 2011, “Converting Trade Debt to a Controlling Stake: The Pragmatic Path to Jennifer Convertibles’ Unique Reorganization”, Neiger, Edward E.
Obviously, the debt for equity swap works best when dealing with parties who are otherwise indispensable to a debtor’s reorganization. An equity interest may be used such as ordinary shares, fixed coupon ordinary shares, preference shares and equity warrants. It is important to recognize this swap also helps the debtor by reducing corporate debt, which in turn strengthens the balance sheet improving their borrowing position and status with customers, suppliers and other investors. The swap however also is based on an inherent risk- that the reorganized business will be successful. In the event the business cannot become solvent or the reorganization is impractical (and results in a liquidation), the creditor would lose its investment. If successful however, this allows the debtor to substantially de-lever its balance sheet and significantly reduce its debt. In sum, the pre-arranged swap for debt to equity prior to a business filing for bankruptcy can provide a creditor with potential for great recovery and opportunity if they are willing to take that risk.