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Bondholders Rights vs. Shareholders Rights

Posted by admin on June 3, 2008 in General Information

BCE still could be the largest private-equity privatization in history but it is stuck in legal and financing molasses (one of the most concise summaries of BCE’s privatization woes was made by Michael James on Money). The point of this post is not to address BCE per se. Others have discussed this topic to death. Instead, the legal decision stopping the privatization substantially on the basis that a company has a legal duty to look after both the shareholders and bondholders rights, and it failure to look after the latter, raises the larger question what the two largest stakeholders in any business should expect.

As a side-note, the BCE decision has profound implications beyond the business itself. If the Supreme Court of Canada upholds the Quebec Court of Appeal decision, the result will be it will make it harder for private-equity, mostly international financiers, to take Canadian companies private. One wonders if this is judicial economic nationalism at work (remember that BCE is nominally a Quebec company and Quebec economic interests are often intertwined with Quebec political aspirations).

Paradoxically, under the law of unintended consequences, you could also see the watering-down of bondholder rights substantially to avoid another BCE situation (some would argue this is already occurring). Rather than embolden bondholders, companies may simply beat them into submission with restrictive covenants and dare the bondholders to fund an expensive and time-consuming litigation to enforce their common (judge made) law rights.

Back to the topic at hand though…what rights do bondholders and shareholders get? Bondholders buy the corporate debt of a business. If you own a bond mutual fund, you may indirectly be a corporate bondholder. Traditionally, a bondholder’s right is confined by contract to certain obligations of the business in connection with your bond: mainly, how much interest you are paid, for how long, when does the company have to redeem (i.e. buyback) your bond etc. A bondholder’s rights, in other words, are traditionally set out in contract and not common law. The trade off is simple: in return for a certainty of payment, you forgo the upside of the company. Even if the company takes off, you continue, in most cases, to only get the interest rate set out. Think of a bondholder as an accountant- they always know they will make money doing your taxes. They may never get rich doing it but there’s a certainty of income year after year.

To continue the analogy, a shareholder is a poker player (which is a career choice now just like being an accountant- Mothers close your eyes and shudder). It is playing the odds that it has a good hand (i.e. the business is strong) and it can win the pot which could be potentially huge. Rather than seek the certainty of payment of an accountant, you are going all in thinking (hoping?) for the upside. A shareholders rights are not set out in contract instead investing in stock is an exercise in risk management; you are hedging that the company will do well. Therefore, the government and the Courts pass laws and make decisions to make sure that the house isn’t stacked against you and your risk insulated somewhat from shady dealers/board of directors and shifting rules (shareholder have to consent to a wide variety of fundamental changes to how the business is run). A shareholder’s play is upside in lieu of certainty of payment which is enforced by law and common law.

Who gets paid first? A bondholder’s interest payment gets paid before a shareholder’s dividend (hence the term “debt before equity”). Who reaps the reward of a take-over or acquisition? The shareholder by a rise in the share price.

How does this affect you?

1. The rights of bondholders and shareholders form the cornerstone of asset allocation. You can’t have a portfolio of all poker players or all accountants. The former is too risky and the latter is B-O-R-I-N-G! You need both to maintain balance.
2. Remember why you invest in a stock- the promise of future performance- and why you invest in bonds- the certainty of now. Depending on your life cycle, the future may be a much better place to invest in than now or vice versa. This is why my parents will not a biotech company- there is no certainty of a now.
3. Short of extraordinary situations, bondholders are given little to no say in the company as long as it is paid interest. Shareholders do have a vote on the future direction of the company. It becomes a preference of ownership (however small) over being a lender.

As for BCE…the Court decision is really a side-show to a larger problem. Even if BCE wins on appeal or settles with the bondholders, the banks won’t fund a deal as is. Even if the banks get sued, a Court will be hard-pressed to force specific performance (a type of legal remedy) of the financing term if the banks show that it doesn’t have the liquidity to fund the deal (can’t get blood from a stone). I would consider the gap between financing demand and supply to be the much larger problem for not only BCE but the entire market and, while BCE makes for some great headlines, there’s a much larger issue coming our way from the fallout of businesses not having readily available supplies of money to expand- an issue which wouldn’t fully be felt until the 2nd half of this year and into 2009.