It is alleged that the date of options granted to executives was manipulated so that they appeared to have been granted at an earlier date when the price was more favourable. As a result, corporates have delayed filing their earnings in order to remain compliant with the Sarbanes Oxley Act of 2002, which requires executives to attest personally to the accuracy of these statements.
The delay in providing this information to bondholders has caused many of these companies to technically breach their bond covenants. Hedge funds are having a field day.
Technical breach
Rating agencies such as Standard & Poor’s are not overly concerned about whether or not there is a breach of covenant in these cases as it considers them to be technical defaults, where the company is likely to meet the requirements in a timely fashion. Hedge funds, however, have been quick to take advantage of any such technical breach.
A breach enables bondholders either to negotiate a fee to allow the waiver of the covenant or force the company to repay the debt at par. For example, if the bondholder had bought the bonds at 80 cents he could now demand a $1, or par, repayment.
In addition to going long the debt of these companies, some hedge funds are also shorting the equity to profit from any drop in the share price.
One hedge fund manager says it would make sense technically to short the equity as well as go long the debt to profit from early redemption as well as a fall in the stock. “If debt is redeemed it costs the company money, which is intuitively negative for the stock as the company would be forced to refinance at disadvantageous terms.”
Forced default
Another, more drastic, option for aggressive players is to force the company to default on its debt, with the possibility that this might cause some companies to file for bankruptcy.
Some companies that have delayed announcing earnings because of the investigations are concerned that some hedge funds might be buying their debt and shorting the equity with the deliberate aim of causing the company to default, and perhaps go bankrupt, thereby profiting from short positions in the stock market.
“There have been allegations that in some cases hedge funds have been so aggressive that they have employed a strategy that may cause the company to default,” says Sol Samson, managing director and chief rating officer for corporates at Standard & Poor’s. “We have heard [this concern] directly from at least a couple of companies.”
Offset gain
But, is it worth forcing a company to default and face the risk of bankruptcy? “Even if the investors in the bond lost money on the bonds, even if they became worthless, the gain on the short position could more than offset that loss, depending on the relative size of the positions taken,” says Solomon.
Not even companies with highly rated debt are safe from default in this situation. “Even solid companies can be put at risk, as it could be very difficult to finance debt in default, especially if there are no [up-to-date] financials and the company is featured in the media negatively,” says Solomon. However, aggressors are likely to “selectively focus on companies that might have such difficulties”, he says.
S&P does not at present have any of the companies being probed for alleged option back-dating on credit watch.
