Can Europe's lawyers save the junk bond market?

"If we can't come up with a structure, the future of high yield in Europe is under threat." The concern of Clifford Chance securities lawyer John Connolly is justified. There were just 14 high-yield deals in Europe in the first four months of this year, compared with 134 in the US, according to investment banking research firm Dealogic. European high yield isn't working, and only the region's lawyers can rescue it.

An investor in junk bonds in the US can expect to get about a third of the money invested back from a borrower that defaults. But differences in the way deals are structured in Europe mean investors are likely to lose as much as nine-tenths of their initial outlay. With default levels for 2002 double those of the previous 17 years put together, a group of institutional buyers, including the asset management arms of Aberdeen, AXA and ING, have even written to the industry saying that they will avoid high-yield bonds unless these are structured more favourably.

As high-yield bond deals stand in Europe, a troubled company's bankers can in theory sell its assets and take back their money without so much as a phone call to bondholders. This is because deals are structured so that a holding company issues the bonds, but the banks lend to an operating company lower in the corporate structure. The banks also demand guarantees from the borrower's subsidiaries, creating a claim against the assets of those subsidiaries if the company defaults.

High-yield investors are happy to line up behind the senior banks in the queue to get paid. But they resent their lack of influence in workout negotiations.

Stuart Stanley, senior fund manager at AXA Investment Managers, which buys as much as e25 million of high-yield bonds a month, says: "Investors are wary of structurally subordinated bonds, especially after Energis, as banks are able to take control and potentially liquidate a company without consulting or taking into account the interests of high-yield bondholders." When Energis restructured in July 2002, over $1 billion of bank debt stayed on the balance sheet. But bond debt worth over $900 million was converted into shares.

To change this, high-yield investors want the company that borrows money from the banks to be the same as the one that issues bonds. And they also want subordinated versions of the same guarantees that the banks get. This means the banks have to include bondholders in discussions. And, if investors dislike a deal, they can either sue for liquidation of the borrower or claim against subsidiaries under the terms of their guarantees. Cecil Quillen, a partner with Linklaters specializing in US securities law, says: "It is a potential whip hand, a limited power to trigger a meltdown."

Of course, banks are not going to give up such guarantees to their junk bond peers without careful qualifications. Europe's senior lenders are used to working out difficulties with debtors among themselves. They claim this is better for borrowers because they get to talk to banks that know them, have invested heavily in their past and believe in their future. Bondholders, especially of the vulture investor variety, have less to lose and can be less forgiving. Late last year vulture investors who had bought cheap bonds in UK company Colt Telecom tried to force it into administration even though it hadn't yet defaulted.

A key step towards reviving high yield in Europe is to protect the banks from such hardball tactics.

Protection comes in three forms. The first is to write a standstill into the bonds to buy the banks time if a borrower defaults. Either the lawyers write the guarantees to bond investors so they are inoperable for six months following a default or they amend the terms of the notes so the holder cannot declare a default until 180 days after the issuer misses payment. Connolly says: "For 180 days the bondholders can call, but the senior lenders don't have to pick up the phone."

A second approach is for the banks to insist that bondholders waive their rights under the guarantees if the bank can sell company assets at a fair price. The tricky part is determining that fair price. Either you look to an expert third party such as an investment bank to judge whether a proposed sale is fair or not, or you rely on local law. In Germany, for example, banks can only enforce security over a bankrupt company's assets by going through a court-sanctioned sale. In the UK, banks have a common law duty to act reasonably towards other creditors.

High-yield investors favour the first method because it is less risky. Banks prefer the second because fairness opinions can be difficult to get in practice.

A third option is to steal an idea from the market in rated Eurobonds and include collective action clauses in high-yield deals. These oblige bondholders to accept a restructuring if a specified majority - usually 75% - will go along with the proposed workout. Such clauses replicate the position under US law, where a super-majority of bondholders can impose its will on those that try to hold out for a better deal. Recent sovereign issues by Brazil and Uruguay have shown that deals with collective action clauses can sell well. Adding them to high-yield deals would be controversial. But it is an option that lawyers should consider.Senior lenders have had things their own way for too long, but new structures for high yield in Europe must find a lasting compromise.