The Toxic Avenger

Collaterized debt obligations raise capital for junk-rated borrowers. Plus: how former CFO Andrew Fastow helped sink Enron; the IRS clears up confusion on multistep mergers; do happier employees make more-profitable companies; and more.


Things could be worse. Despite a dismal economy, companies with solid credit have had little trouble raising capital. And although borrowing is tougher for companies with a double-B rating or lower, capital markets are more diverse than they were back in July 1991, when default rates caused by the last recession peaked.

"There was no material source of nonbank capital in the loan market then," notes Dan Gates, senior vice president of Moody's Investors Service. "This time around, the leveraged loan market looks to be stronger, because you have an additional class of lenders." Gates is talking about collateralized debt obligations (CDOs), an investment vehicle invented about five years ago that slices up corporate loans or other assets into tranches with varying levels of risk. The investment-grade top tranches, which pay off earlier, have much higher credit ratings than the borrowers themselves, making them attractive to investors. "CDOs are one of the keys to providing capital to noninvestment-grade borrowers," says Gates.

Of course, some investors must also hold the lower tranches, including the unrated bottom, or "equity," tranche--often called the "toxic waste." American Express Financial Advisors, Conseco, and other institutional investors have all been burned recently by toxic waste from CDOs written four to five years ago. "Certainly some investors have already been shying away from CDOs," admits Jerry Gluck, managing director of Moody's CDO-rating team. "We have downgraded a lot of them this year."

Observers also say downgrades of CDOs lag behind downgrades of the underlying corporate debt--another worry for investors. "The good news," counters Gluck, is that sharp increases in spreads over Treasuries have increased the potential arbitrage for equity holders.

Can investors overcome the toxic fallout? "I think we are still seeing the CDO track record evolve," says Julie Burke, a managing director of Fitch IBC's Insurance Group. --Tim Reason

Wrong Numbers

Roger Oustecky, chief operating officer of Tenet International, a company that audits corporate telecommunications bills, claims that 80 percent of phone-company bills are wrong, accounting for customer overpayments of 7 percent on average. Spokespersons for phone giants Verizon Communications Inc. and BellSouth Corp. make a counterclaim of greater than 98 percent bill accuracy. Whichever number is closer to the truth, the fact remains that telecommunications costs still rank as one of the top four budget items for companies.

With that in mind, Russell Lipari, vice president, telecommunications, at Greenpoint Bank, in Lake Success, N.Y., decided to let Castle Rock, Colo.-based Tenet examine the bank's phone statements as part of an outsourcing agreement that pays Tenet based on the number of bills processed. Tenet cut the bank's telecom bill by between 5 percent and 10 percent during the first year, says Lipari, adding that so far, Greenpoint has "saved so much money that the first two years of outsourcing were essentially free." -- Joan Urdang

What Andy Knew

Regardless of his lawyer's insistence that former Enron Corp. CFO Andrew Fastow bears no responsibility for the company's collapse, the largest in corporate history, Fastow's own comments suggest that he does.

More than two years ago, as part of an interview with CFO, Fastow boasted that he had helped keep almost $1 billion in debt off Enron's balance sheet through the use of a complex and innovative arrangement.

"It's not consolidated and it's nonrecourse," he told this magazine. Maybe it depends on how you define "nonrecourse." In fact, the 10-Q that Enron filed on November 19, 2001, states plainly that the debt ultimately was Enron's responsibility. According to the filing, the $915 million debt was backed by Enron's obligation to extinguish it, if necessary with cash.

That obligation, as reported in the 10-Q, would fall to Enron if the company experienced a downgrade below investment grade by any of the three major credit rating agencies. Sure enough, that downgrade took place shortly after the disclosure of the $915 million obligation, along with another $3 billion in similar off-balance-sheet liabilities. And that downgrading, in turn, prompted Enron's bankruptcy filing.

Partnerships Within Partnerships

The debt that Fastow discussed with CFO was needed for a partnership called Marlin, which helped finance the Atlantic Water Trust, Enron's unconsolidated subsidiary. The Atlantic Water Trust in turn invested in Azurix, a subsidiary that owned a majority of the water facilities of a U.K. company known as Wessex.

"What we did," Fastow told CFO, "is we set up a trust, issued Enron Corp. shares into the trust, and then the trust went to the capital markets and raised debt against the shares in the trust, using the shares in the trust as collateral."

During the 1999 interview, Fastow boasted that the Atlantic Water Trust was so effective at minimizing Enron's balance-sheet exposure that several banks that had not been involved in the transaction later "came back and marketed it to us" as their own invention.

Fastow was flattered. "We like to see our ideas get marketed back to us every once in a while," said Enron's ex­finance chief. Neither Fastow nor his lawyers were willing or able to comment for this article.

Credit analysts insist that they did not know the full extent of arrangements such as Marlin before the 10-Q filing on November 19. But earlier, in his comments to CFO, Fastow had argued that the company had supplied enough information, if only in supplemental form, to keep analysts informed. "We have disclosures about it in footnotes," he told CFO in the spring of 1999, "which help our investors and the rating agencies understand all of this."

Dancing In The Dark

In hindsight, of course, analyst understanding turned out to be woefully inadequate. Perhaps, in the case of the rating agencies, analysts felt constrained in their research by the fact that Enron, like other issuers, paid their employers for their opinions.

Analysts at agencies that rated Enron securities scoff at the suggestion of conflicting interests, pointing out that they knew about most of Enron's debt guarantees for off-balance-sheet partnerships and took them into account in their reports. Yet, at least one off-balance-sheet obligation, a $690 million note, took these analysts by complete surprise. Moody's Investors Service, for one, announced that in the future it would look harder at arrangements like those that brought down Enron.

At this point, at least one thing is clear: Footnote disclosures were not enough to figure out what Enron was really doing. Indeed, only analysts whose firms were paid by Enron seem to have had enough leverage to demand the additional information needed to fully clarify the nature and implications of the partnerships. "I wasn't in any position to demand certain information," says Michael Rao, an analyst for Dominion Bond Rating Service in Toronto. "And I couldn't follow it from the outside." -- Ronald Fink

Come Together

Sometimes the Internal Revenue Service is on your side. Just look what it's done for mergers lately. In the past year, so-called forward triangular mergers have become very popular. In these multistep transactions, the acquiring company creates a new subsidiary by merging the target with an existing subsidiary, thereby avoiding paying a capital gains tax.

According to tax experts, the IRS grants this exemption because it considers the new company's stock to represent a continuation of an old investment, with no gain or loss on the investment until the stock is sold.

Some clever souls have been experimenting with a variant on the triangular merger that involves one more step. In this variation, once the initial merger has been completed and the new subsidiary created, the parent company merges its assets with those of an existing subsidiary. Now it looks as if these transactions will also enjoy the tax advantages of triangular mergers.

For a while, says Glen A. Kohl, an M&A tax attorney in Cooley Godward LLP's Palo Alto, Calif., office, there was some question and confusion about the tax treatment of this second merger. The IRS was not clear on whether the first merger would still qualify for tax-free treatment if its assets were transferred to an existing subsidiary.

Revenue Ruling 2001-46 cleared things up by de-fining the purpose and scope of the tax exemption as it pertains to these multistep transactions. First of all, the rule states that the acquiring company must establish the business purpose for the mergers, as well as the continuity of the business enterprise and continuity of income.

The rule gives companies the opportunity to realize additional strategic and operational benefits, says Mark French, a KPMG tax partner based in Washington, D.C. In particular, the acquiring company may be able to merge its acquisition into a subsidiary located in a low-tax state, or one that shares similar distribution or manufacturing channels.

But this isn't the only good news. In a related development, the IRS is expected to finalize a proposed rule later this year that will loosen restrictions on tax-free mergers between corporations and non-corporate entities, such as limited liability companies. --Marie Leone

Contingency Plans

Contingent convertible bonds (cocos) have their advantages. But they also carry a risk that has become much more evident since the bull market ground to a halt.

The problem with cocos is that during a recession, jittery investors are more likely to force issuers to pay them off before maturity. The issuing companies must then scramble to raise new capital to cover the redemption.

Why the run to redeem? If the underlying stock price of cocos falls with the market, bondholders may try to cash out by exercising the bond's put option, says Tom Marshella, co-head of Moody's Investors Service's leveraged finance team. And the lower the credit rating of the issuer, the more likely the investor is to sell the bonds back, he adds.

The experience of Tyco International Ltd., an investment-grade company, puts the put theory to the test. In November 2000, Tyco issued $3.5 billion worth of zero-coupon notes, the first coco issue in the United States. The bonds reached their first put date on November 17, 2001, about a month after the company announced its intent to use cash to pay off bondholders that chose to put back the notes to the company. In that year's time, Tyco's stock price dipped below 40 before climbing to its current 58.

The cash wasn't at risk for long, as only $10 million worth of the notes were redeemed. What's more, Standard & Poor's analyst Cynthia Werneth comments that S&P believed in the conglomerate's ability to raise capital quickly, even if it had been forced to buy back all of the convertibles. "The real issue is that the convertibles afforded Tyco little financial flexibility, other than to react to the bondholders' decision," says Tom Marthaler, senior managing director at ABN Amro's Chicago Capital Management. -- M.L.

Put It Here

Coco issues as of November 2001.

  • Number of issues: 64
  • Total proceeds: $39.3 billion
  • Convertible issues that are cocos: 45%

Guard Up, Hacking Down

A welcome byproduct of increased national security is that the frequency and cost of computer-code viruses has dropped, says a new report from Computer Economics Inc. With cyberspace patrolled more heavily since September 11, "virus activity has been extremely low compared with prior months and years," says Michael Erbschloe, vice president of research at the Carlsbad, Calif.-based research firm, primarily because "typical virus- writers and run-of-the-mill hackers are concerned about getting caught." As of late November, the economic impact of viruses stood at $12.3 billion, compared with $17.1 billion in 2000.

Even the viruses that are unleashed appear to be wreaking less financial havoc, says Erbschloe, thanks largely to upgraded antivirus software that now automatically cleans and updates company servers after an attack. For example, the Nimda virus, launched on September 18, "was incredibly rampant," but cost companies a total of only $590 million, compared with the $8.75 billion price tag associated with the Love Bug virus in 2000, which hit before such automated cleanup was available. Goner, in early December, tallied losses of only about $5 million.

The respite from hackers could last for several years, or at least as long as terrorism stays in the headlines, predicts Erbschloe. Still, vendors continue to build stronger armor. More companies are layering their firewalls and implementing more sophisticated intrusion-detection systems that identify combinations of "seemingly innocent events that may indicate a coordinated multipoint attack," says James Goldman, professor of computer technology at Purdue University. Others are considering such extra defenses as Argus Systems Group's Pitbull, software that creates a moat around highly sensitive data. Up next, experts say, are devices that can heal themselves after an attack, such as servers IBM is developing within its Project eLiza initiative. --Alix Nyberg

Closing the Gap?

It's a line employees and union leaders have touted for years: Happy employees make for more profitable companies. Now there seems to be more data to back it up.

Watson Wyatt Worldwide, the benefits consulting firm, says it has evidence to support the idea that improvements in human-capital practices (in which it includes both compensation and traditional human-resources concerns such as employee recruiting and retention) can boost a company's financial performance. What's more, after comparing the human-capital practices and financial results of 51 companies for 1999 and 2001, the consultants claim that the practices are a leading, rather than a lagging, indicator of financial performance.

If a company makes a "significant improvement" in 16 pay and benefits practices, for instance, its market value should jump 16.5 percent, according to the study. Practices yielding the biggest gains included linking pay to performance and using the lure of stellar health benefits as a recruiting tool.

Brian Becker, a professor at the State University of New York at Buffalo's School of Management, says the Wyatt findings confirm similar discoveries he and colleague Mark Huselid of Rutgers University made in the 1990s. In five surveys that polled a total of 3,000 companies between 1992 and 1997, the research team found that significant jumps in an index of human-capital improvements tend to lift shareholder value 20 percent.

Such findings may cause finance executives to pause before they opt for cutbacks in the current downturn. "If human-capital practices drive financial results, then it behooves you to make the investment even in a down market," argues Bruce Pfau, a Watson Wyatt consultant and author of the study. And rash reductions in benefits packages or pay-for performance incentives made in response to the recession may have unintended financial consequences, says Becker. --David M. Katz

Missing Links

Human-capital and shareholder-value links.
Source: Watson Wyatt Worldwide


Market-value impact (%)

Total rewards16.5
Flexible workplace9.0
Recruiting, retention7.9
Communications integrity7.1

Union Busts Wall Street

For the past year, Wall Street firms have been under the gun for long- standing conflicts of interest between their sell-side analysts and investment bankers. Regulators, Congress, and irate investors have all expressed concern that purportedly objective research reports merely serve to further lucrative banking relationships.

Well, now add the AFL-CIO to that list. The umbrella group for some of the nation's largest unions, with 13 million members and $400 billion invested in union-sponsored pension plans, has filed a shareholder resolution with Goldman Sachs Group Inc. aimed at rebuilding the so-called Chinese wall between analyst and banking operations. J.P. Morgan Chase & Co. may also be targeted by the union for a shareholder vote in the spring.

"It is clear that investors are not being well served by the [Securities Industry Association] guidelines on analyst independence," says Damon Silvers, associate general counsel of the AFL-CIO. "Our philosophy is that long-term value is created by firms that behave ethically. Conflicted analysis is not good for a business whose credibility is its core asset."

The AFL-CIO resolution calls for Goldman to bar its analysts from participating in the sales efforts of underwriters, and to stop linking analysts' pay to the performance of the investment-banking group. It also recommends that the securities firm prevent its analysts from owning stock in the companies it covers.

The AFL-CIO opted not to file a similar resolution against Merrill Lynch & Co. after a series of high-level meetings about the firm's current efforts to address the union's concerns. Silvers, who took part in the meetings with Merrill executives, says the firm is "not perfect, but at the vanguard" on the issue. For instance, the head of research reports directly to the CEO, not through the banking department or some other intermediary; the bonus pool for analysts is drawn from the overall corporate performance; and analysts are prohibited from acquiring pre­initial public offering shares.

The AFL-CIO has decided not to pursue two other Wall Street firms that have also been the focus of intense scrutiny. One, Morgan Stanley, didn't get the chance to file a shareholder resolution to address the conflict, because its deadline for filing predated the union's decision to act. And Credit Suisse First Boston, which has a foreign parent, is not subject to the same kind of shareholder activism. --Stephen Barr

Give Me Credit

Looking to boost your company's credit rating? Try issuing equity, and then use the proceeds to redeem or refinance debt.

Moody's Investors Service reports that 24 companies saw upgrades at least partly stemming from the injection of common equity capital as of Q4 2001. In 2000, only 15 companies witnessed the trend. And expect to see the correlation between equity issues and credit upgrades strengthen in 2002, particularly after equity market firms buy enough to spur a broad-based recovery by initial public offerings, notes John Lonski, Moody's chief economist.

In theory, the strategy indicates that these companies are favoring debt holders over equity holders, a practice that doesn't sit well with Wall Street. But CFOs who have engineered the move say the promise of a stronger balance sheet has swayed even growth-oriented equity investors.

"To say the two constituencies are in direct conflict is an overstatement," says Richard Navarre, CFO of Peabody Energy, one of the world's largest coal providers. "They both want a strong, healthy company." Peabody's $452 million IPO in May was 20 times oversubscribed and priced $10 above its initial range, even though investors knew all proceeds would go to pay down debt. Purchased through a leveraged buyout three years ago, Peabody shrank its debt-to-equity ratio from 80 percent to 47 percent within two years with the IPO. However, mindful of growth, Navarre emphasizes that Peabody invested $124 million in capital projects during the first six months of 2001.

For non-LBO companies, a bald request for cash to pay off debt may not fly, say some pundits, but equity investors are not unsympathetic to such plans if they're coupled with the right growth prospects, notes J.P.Morgan equity analyst Corey Davis. --A.N.


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