Sunday, August 23, 2020

Arrgh, Faulty Memory Leads To Embarrassing Correction

In one of yesterday's posts I wrote:
Regarding the first transformation I remember reading about a fund manager who discovered there were some still-outstanding bonds issued by one of the larger railroads, long past their maturation date that were payable in gold. He began to quietly accumulate a position and when he had purchased pretty much the entire float he went to the railroad and asked for his, now greatly appreciated, gold.

The railroad demurred, saying the actions of President Roosevelt in 1933 and 1934 had made any contracts that called for settlement in gold null & void and would he please go away.
The manager was persistent and eventually the railroad agreed to settle for an amount much smaller than the ounces of gold specified but still much larger than his investment.
The lesson here? Kids, read those indentures.
The problem is, one of the key points of this homely little vignette is wrong.
I conflated one of the Gold clause cases* with this, from the Financial Management Association, 1992, here via The Free Library:

Bond covenants and forgone opportunities: the case of Burlington Northern Railroad Company.
Late in 1987, a federal court approved a settlement between Burlington Northern Railroad Company (BNRR) and holders of two series of bonds issued by Northern Pacific Railroad, one of the companies merged to form BNRR. The settlement agreement provided for payments of $35.5 million to the bondholders, in return for changes in important covenants in the bond indentures.

This agreement can be regarded as the concluding chapter in a story that illustrates vividly one of the agency costs of bond covenants -- foregone opportunities, or loss of managerial discretion (see Wakeman [25]). Almost three years earlier, BNRR had started what turned out to be a long and expensive process of modifying indenture provisions on bonds issued in 1896 by Northern Pacific Railroad as it was being reorganized. Covenants in the indentures placed severe restrictions on management's use of valuable assets. Those restrictions were the result of the deliberate efforts of J.P. Morgan, as he attempted to assure investors who were being asked to commit capital to the reorganization.

Attempts by management to relax the indenture provisions nearly 90 years later were blocked by bondholders until they received "hold-up" payments that amounted to about 30% of the face value of the outstanding bonds. Notwithstanding the rather large payments to bondholders, however, the stock market reacted very favorably to the settlement. Common shareholders of Burlington Northern, Inc. (BNI), the holding-company parent of BNRR, experienced abnormal returns that amounted to at least 9.5%. 

BNRR's experience with the tight indenture provisions of its Northern Pacific bonds is an interesting example of the agency-cost tradeoffs in bond indentures. Although tight covenants reduce bondholder uncertainty about future actions of managers -- and therefore increase proceeds from the sale of debt -- the cost of the indenture restraints is a loss of managerial discretion. While these tradeoffs are recognized in the finance literature, there is little evidence on their effects.

Although the BNRR case involves bonds that were issued many years ago, it nonetheless contains lessons that are quite relevant today: the case illustrates that bond covenants indeed can work and can survive the attacks of bond lawyers seeking to avoid constraints, notwithstanding contemporary views to the contrary (see McDaniel [17]). It further shows that the absence of a call provision and a sinking fund, combined with restrictions on the use of cash, can impose constraints on managers that have substantial opportunity costs. Since recent debt issues often lack call options and sinking funds and can contain tight constraints on cash flows,(1) The BNRR case involves conditions that continue to be relevant to managers.

This paper examines the BNRR experience with restrictions covenants on the Northern Pacific Railroad bonds and the stock market reaction to a relaxation of those restraints. It begins, in Section I, with a description of the bonds and a brief review of the history surrounding them. Section II examines events leading up to the settlement with the bondholders in late 1987. As noted in that discussion, the indentures were sufficiently tightly written to allow the bondholders to frustrate the firm's attempts to avoid constraints on investment opportunities. Section III of the paper analyzes abnormal returns associated with four announcements related to two events: The first event contained two announcements, and stemmed from a tender offer and defeasance proposal in 1985; the second event was a settlement with bondholders in 1987, and had announcements for the initial agreement and the court approval of the agreement. The final section of the paper contains a summary.

I. The Bonds
The 1987 settlement agreement relaxed covenants on two series of Northern Pacific Railroad bonds. At the time of the settlement, the outstanding principal amount of the bonds totalled $117.7 million: $69.9 million of 4% prior lien bonds, due in 1997; and $47.8 million of 3% general lien bonds, due in 2047. Both were issued in 1896, in connection with a reorganization of the Northern Pacific Railroad, which had gone bankrupt in 1873, was reorganized in 1879, and then later fell into financial difficulties again. The prior lien bonds had a first mortgage and the general lien bonds a second mortgage on millions of acres of land and mineral rights. The essence of the agreement was to release some of the properties -- particularly oil, gas, timber, and coal properties -- from the liens of the mortgages. Railroad properties continued to be subject to the liens [2]. 

The reorganization of 1896 merged the Northern Pacific and the Great Northern to form the Northern Pacific Railroad. Worked out by J.P. Morgan and the Deutsche Bank (since many Northern Pacific bonds had been sold in Germany [7, p. 206]), the organization plan included the issuance of $121.6 million of the 4% prior lien bonds and $60.0 million of the 3% general lien bonds.(2) Adjusted to 1987 dollars using the CPI, these amounts total about $2.5 billion, a large issue even by today's capital market standards.

The indenture provisions of the bonds were quite constraining on the company. The bonds could not be called, they did not contain a sinking fund, and there was no provision for amending the mortgages.(3) Placement of prior liens on the properties securing the bonds was prevented by a negative pledge provision, although mergers were allowed, provided the security of the bondholders was not impaired [2].(4)

A feature of the indentures that generated particular concern for BNRR related to proceeds from the sale of properties. Such proceeds could be used only to redeem bonds up to a maximum $500,000 a year, or to make extensions or improvements to railroad property (see [2], [26]). Such proceds could be viewed as form of restriction on production/investment decisions and dividend payout decisions, as described by Smith and Warner [23, pp. 130, 131]. Unless BNRR faced substantial capital requirements for railroads operations, use of revenues from the sale of properties or the development of the natural resources on such properties would be constrained by the requirement that such cash flows be reinvested in railroad plant.(5) This requirement could produce investments with low returns. As quoted by Business Week [4], one financial analyst (presumably with tongue in cheek) suggested that the company might have to "gold-plate the rails." While the covenants in the Northern Pacific bonds seem very severe, the indentures were written at a time when railroad finances were facing extreme conditions. In his classic work on corporate finance, Dewing [8, p. 1247] labelled the period after 1893 as a fourth period of railroad finance, characterized by failures of completed railroads. He described the period as one in which bondholders' rights were no longer regarded "as inviolable" [8, p. 1250], and one of weakening court support of bondholder positions.

J.P. Morgan's attitude toward tight indentures apparently had been affected by the widespread railroad failures around 1873. In his recent book, House of Morgan, Chernow [6, p. 37] quotes Morgan as saying,

"The kind of Bonds which I want to be connected with are those which can be recommended without a shadow of doubt, and without the least subsequent anxiety, as to payment of interest, as it matures."

Chernow [6, p. 68] goes on to refer to the 1987 court settlement as Morgan standing up "foursquare for creditors from beyond the grave."

II. Toward the Settlement

Public attention first focused on the Northern Pacific bonds in 1981, when BNRR announced its plans to form a holding company. The Wall Street Journal [12] claimed that rumor had it that the bond covenants would prohibit that step. While BNRR insisted that the bond indentures had no bearing on the company's ability to form the holding company, bondholders were described as convinced that the company would have to pay a preminum or redeem the bonds at face value in order to proceed. The company went on to form Burlington Northern, Inc. (BNI), a holding company.

In early 1982, Business Week [1] referred to speculative interest in the Northern Pacific bonds. That article described a "strong commitment of BNI's new management to build the nontransportation side of the company," and pointed out that the indenture restrictions on cash flows might force the firm to buy back the bonds at full face value. Given the coupons, of course, the bonds were selling at deep discounts, despite the speculative interest. The article also noted, however, that the indenture restrictions had not hampered the company to date, and cited company estimates that it could take ten or more years before the cash flow from the resource properties would exceed capital expenditures on the railroad. The treasurer of BNI was reported [1] as saying, "It's a deferred problem, but it is a problem." Even though the prior lien bonds would mature in 1997, the same restrictions in the general lien bonds would continue.

Information released during a subsequent bondholder suit revealed that the company had become concerned about the covenants earlier. In one of its rulings in the case, the court referred to an attempt by BNRR in 1959 to release the resource properties from the liens. The trustees objected [21], and the attempt was dropped. The court went on to observe that, in 1973, two law firms consulted by BNRR concluded that "the mortgages barred all means of substituting collateral"[21].

The first public step by BNRR to get out from under the indentures came in April 1985. The company got the agreement of the bond trustees to eliminate the covenant restrictions on cash flows from the resource properties by placing U.S. Treasury securities in trust to cover interest and principal payments on the bonds. In essence, BNRR was defeasing the Northern Pacific bonds. In addition, the company made a tender offer of 53.5 for the 4% prior lien bonds and 39.0 for the 3% general lien bonds [22]. Based on Moody's yield to maturity on A-rated railroad bonds (the Northern Pacific bonds were A-rated) in March 1985, the 4% bonds would have sold for about 48.6 and the 3% bonds for about 23.9.....
*From the U.S. Supreme Court via Justia:
Norman v. Baltimore & Ohio Railroad Co., 294 U.S. 240 (1935)
1. A bond for the future payment of a stated number of dollars in gold coin of the United States "of or equivalent to the standard of weight and fineness existing" on the date of the bond, or for payment in gold coin of the United States "of the standard of weight and fineness prevailing" on the date of the bond, is not a contract for payment in gold coin as a commodity, or in bullion (cf. Bronson v. Rodes, 7 Wall. at p. 74 U. S. 250), but is a contract for payment in money. Pp. 294 U. S. 298-302.
2. Such "gold clauses" are intended to afford a definite standard or measure of value, and thus to protect against depreciation of the currency and discharge of the obligations by payment of a lesser value than that prescribed. P. 294 U. S. 302.

Apologies, I was working from a sometimes faulty memory.
The lesson here? Kids, read those indentures. double check your remembrances.