Mozart's Requiem, Antoni Gaudi's Sagrada Familla, David Foster Wallace's Pale King, my story about the dispute between shareholders and debt investors at junior energy company Arcan Resources Ltd. While I'd like to say that the common thread between these four things is that they are all triumphant works, the real link between all of them is that they were unfinished.
Sadly, I need to remove myself from this rarified group as, on February 13, Arcan closed a transaction that converts much of its debt, including the debt held by the holdouts I described in my last article, into common shares of the company. For every $1,000 in debt, investors get 6,667 shares, worth about $333 at current market prices.
If my math is right (it is), that's a 66 per cent haircut over the face value of the debt. Wait, what?
This summer, a flock of debt investors, lead by Stornoway Portfolio Management, shut down a deal from Aspenleaf Financial that would have given them 82.5 per cent of their claim, on the grounds that such a deal would have unfairly transferred value from creditors to shareholders, who were not entitled to recover anything until debt is paid in full.
Formally, of course, that is correct; because they are higher in a company's capital structure than shareholders, creditors must get paid in full – or agree to receive less than face value on their claim – before shareholders can receive anything. But, so long as a company is solvent, shareholders get to vote on any plan. Thus, this summer, creditors and shareholders found themselves at an impasse. Shareholders wouldn't agree to a deal without a premium for their shares; creditors wouldn't agree to a transfer of value from their pockets to shareholders, even if they were still receiving a premium on the market price for their debt.
None of this solved Arcan's fundamental problem. To paraphrase, the debt was too damn high. Eventually, Arcan had to restructure itself one way or another. And this deal was that restructuring, but wow, from a financial perspective, it looks much worse for the creditors than Stornoway's $140-million proposal this summer. Like, about $83-million worse.
Much of this is path dependence. This summer, Arcan's enterprise value was greater than the value of its debt, hence the fight between equity and debt – creditors knew there was enough value to be paid in full on their claims but not enough to appease equity. Both wanted more and, with high oil prices, maybe there was another offer out there. As oil prices plummeted, however, something happened – Arcan's enterprise value slipped below the value of its debt. In other words, there was nothing left for shareholders, and the debentures had lurched closer to default.
The solution to this problem is obvious, if a little hard to take for everyone involved: creditors would give up their claims in exchange for equity in the company, shareholders would be diluted, and the company would free up the cash that had been servicing interest on the debt. So, creditors and shareholders took the deal. The creditors exchanged their debentures for 92.5 per cent of Arcan's equity, taking a large haircut in the process but making the company's capital structure healthier; shareholders took the deal, knowing that they would still end up with about 8 per cent of the company, far more than they would under a debt conversion on maturity, or bankruptcy.
To put it another way, the price that creditors paid wasn't a pure loss from their offer this summer; it was the price of control of the company. This summer, creditors would have walked away from the transaction with $140-million in cash. Now they walk away with $57-million in shares. For the difference of $83-million (a 59 per cent discount) – plus the missed opportunity cost – they get to call the shots. For shareholders, it was a gain over almost any other scenario, but still a massive dilution, albeit in a healthier company. Both sides lost as compared to the summer and probably gained over likely future outcomes without a deal. Will this work out for Arcan as a company?
I have no idea. The former creditors have already started to change the company, appointing prominent new directors. If new directors and new owners can find a way to make Arcan work, then the transaction is a winner. If they can't, then the inability to reach a compromise or find another offer this summer looks like a missed opportunity.
Last year, both parties wielded legal rights as a sword to try and extract concessions this summer. The fight was filled with haughty language about asserting creditor rights and shareholder approval. Those rights didn't change, circumstances did. With enterprise value greater than the debt, an exchange like this was appealing to neither creditors nor shareholders. With enterprise value lower than debt, asserting legal rights threatens oblivion for shareholders and default for creditors The Arcan saga serves as a reminder that, for all the bluster, all the uncertainty of the summer – will Stornoway raise its bid? Will high oil prices continue? – eventually collapses like a wave function – a package of uncertainties and probabilities eventually becomes an actual set of events that aren't necessarily what the parties anticipated when things began. And legal rights that seemed like they were tools for extracting concessions in one circumstance can start to look a little ominous in another.
This all sets the stage for the start of another story: whether they wanted it or not, we now know who has control over Arcan; the next story is whether they know what to do with it.
Adrian Myers is a lawyer at Torkin Manes LLP.