Rise in out-of-bankruptcy restructurings prompts Fitch to issue new default report

By Sara Rosenberg

New York, Dec. 12 - The increasing number of debt restructurings outside of bankruptcy prompted Fitch Ratings to issue a new detailed definition of what it considers a default.

Noting the line has grown hazy as to what is a default, Fitch said its new report is an attempt to clarify this issue in the current market environment.

Defaulted volumes in the U.S. through October 2002 exceeded $100 billion, compared to $78 billion in 2001. Furthermore, rating downgrades have outpaced upgrades by a large margin this year. This distressed credit environment has led to record bankruptcy filings, skipped interest payments and corporate restructurings, some of which are considered distressed debt exchanges.

A distressed debt exchange, which typically imposes a direct loss or forgiveness on the investor and if unsuccessful would cause the issuer to seek bankruptcy protection or miss interest payments, causes the issuer to lose original principal. Although this is not a contractual default, the instrument affected by the exchange offer will be rated in the D category after the exchange is completed, assuming that the loss of principal is due to the terms of the exchange offer and not from market loss. Prior to the completion of the exchange offer, the debt will be rated in the C category, signaling that default is imminent.

Bank loans will be rated D when a "troubled debt restructuring occurs that requires such loans to be written down to their net present value," Fitch said. In a troubled debt restructuring there is some economic loss, forgiveness of future income or principal and financial benefit to the borrower.

In a situation in which a company files for bankruptcy, receivership or other similar reorganization, all ratings will be in the D category with DD and DDD ratings used to establish expected recovery values. The D rating will remain until the bankruptcy is resolved.

A subsidiary or an affiliate that has not filed for bankruptcy will be evaluated on a case-by-case basis. "Fitch will assess the financial incentives for the entity to file bankruptcy voluntarily or involuntarily; the direct impact of the bankruptcy on its corporate affiliate, own operations, and financial profile; contingencies related to litigation and taxes, among other things from the bankrupt affiliate; and other considerations that may be relevant to the situation," the report said.

If an instrument is expected to pay its debt service obligations despite the company's bankruptcy filing - for example, well-secured loans and mortgage bonds - then the rating will most likely be restricted to the CCC or B rating categories to show a link to the bankrupt parent company.

A skipped coupon payment after the expiration of the grace period is also considered an event of default. In this scenario, only the particular instrument would be rated in the D category.

Lastly, in the event that an issuer seeks a waiver of a current interest payment, a reduction in the payment, or a change in the payment terms and receives 100% approval by the holders of the outstanding securities, such consents would still be considered an event of default and ratings will be based on the recovery prospects of a D category rating. However, bank loan amendments, modifications and extensions do not represent an event of default.

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