Monday, October 10, 2005

Second Anniversary of "Why the Secrecy About Financial Covenants?"

It's been two years since The New York Times published my idea about debt covenant compliance reporting (see below). But the proposal has been ignored -- harming equity investors in recently bankrupt companies like auto parts maker, Delphi.

Debt covenants are not some weird religious ritual -- they're contract terms between a lender and a borrower. When companies borrow money from banks, they negotiate many contract terms -- including the conditions under which the bank can demand immediate repayment of the loan.

Such convenants might include maintaining a specific debt/equity ratio, having ample cash flow to cover interest expense and other bank charges, filing financial statements on time, or getting an audit opinion that is free of suggestion that the company might not survive as a "going concern."

In 2001 many investors were surprised that debt-laden companies -- such as Williams Communications Group -- went bankrupt when they tripped a convenant. In this case, WCG got a "going concern" letter from its auditor. This violated a covenant that led WCG's nervous banks to demand immediate repayment of billions in loans -- and WCG filed for bankruptcy.

My basic idea was that companies should be required to warn investors if they are in danger of violating these bank covenants. I suggesed that publicly traded borrowers should be required to include in their quarterly reports the specifics of their covenants, their standing on each measure and the risks of noncompliance.

This proposal would have helped investors in Delphi, which filed for bankruptcy on October 8th. A review of its June 30, 2005 quarterly financial report -- the one preceeding its bankruptcy filing -- was pretty sanguine about Delphi's ability to stay compliant with its debt covenants. The quarterly statement presented Delphi's level of compliance with some of the covenants but failed to analyze the ones that it might be in most danger of violating. My reading was that Delphi was trying to avoid alarming investors by putting its situation in the best possible light.

But three months later, Delphi filed for bankruptcy and its stock plummeted from $5 in April 2005 when I raised the possibility of a bankruptcy to 33 cents today. We really don't know exactly why Delphi filed for bankruptcy -- an October 17th deadline loomed for a new, less borrower friendly bankruptcy law, Delphi was trying to get the unions to accept wage concessions, and its customer, GM, was not selling enough of its gas guzzling SUVs and trucks to keep Delphi's revenues from plummeting.

Debt covenant compliance may not have been on the radar of this bankruptcy. However, if my proposal had been implemented, I believe investors may have been in a better position to salvage their investment in Delphi stock before it was too late. If, for example, Delphi had been required to include an exhibit in its financial reports listing each covenant, its state of compliance, the chances of falling out of compliance, and the reasons for the estimate, then investors would have been in a far better position to conclude that it was time to sell.

Here's the original article.

Why the Secrecy About Financial Covenants?
By Gretchen Morgenson
12 October 2003
The New York Times


MANY companies have increased their financial disclosure recently, responding to shareholders' cries for greater details about their operations.

But most corporations still refuse to lay open a set of financial statistics that are central to their ability to survive. They're called financial covenants, or restrictions a company has set with lenders in exchange for loans.

Financial covenants vary, but they can involve a company agreeing to maintain its net worth at a certain level or keep its cash flow high enough compared with its interest payments. Covenants protect lenders by allowing them to call loans if a company fails to meet its requirements.

Violating covenants can set in motion events that lead to bankruptcy. Enron's devastating spiral into Chapter 11, for example, was related to violations of financial covenants. Still, the details of most covenants are kept between a company and its bank.

''How many investors are out there who have no idea about these debt covenants and how important they are?'' asked Peter S. Cohan, a management consultant in Marlborough, Mass., and author of ''Value Leadership: The 7 Principles That Drive Corporate Value in Any Economy'' (Jossey-Bass, 2003). ''Anyone investing in a heavily indebted company is likely to be surprised by covenant violations because there is no systematic way of reporting them.''

Carol Levenson, director of research at Gimme Credit, an independent research firm, said, ''Many companies don't disclose these covenants or where they stand with regard to them, which can be tricky to calculate, until it's too late and they're in danger of violating them.''

One solution, Mr. Cohan said, would be requiring companies to include in their quarterly reports the specifics of their covenants, their standing on each measure and the risks of noncompliance. Filings could also be required if a material change took place in a company's operations that put it in violation of a covenant.


Ms. Levenson said she would like to see disclosure of any amendments to existing agreements or waivers that a company has requested from its bank. To be sure, many banks grant waivers to companies that are in violation of their covenants, so noncompliance does not always spell doom.

''It's very difficult to understand a company's liquidity position from reading the financial statements,'' said Pamela W. Stumpp, a managing director at Moody's Investors Service. ''Although steps have been made to make it more transparent, it doesn't go far enough.''

Some companies are already increasing disclosure. EDS, the computer-services company, described its covenants in its most recent quarterly statement, spelling out what its minimum net worth must be, how the figure is calculated and what would occur if the covenant were violated. Sean Healy, a spokesman, said the disclosure was a strategy of new management ''to give investors a better understanding of our business and to build confidence.''

Other companies should follow. Corporate defaults are down but remain high. Moody's said 66 companies defaulted on $30.3 billion in bonds in the first nine months of 2003 compared with 118 defaults totaling $135 billion during the same period last year. If a company does default, increased disclosure on covenants would keep investors from ugly surprises.

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