The significance of corporate default

In the abstract, the financial default of a company may appear like a doomsday scenario. But in everyday business, financial default can occur whenever a company fails to meet any kind of financial obligation. For a shareholder, the consequences of a default depend on the type of default and the magnitude of the financial event. The mildest forms of default can be cured with little lasting investment significance. The most severe forms can lead to the forced reorganization of a company or its liquidation in bankruptcy court.

Signs that might indicate default

Here's an overview of major financial events that might be considered “default” or could be considered harbingers for significant financial issues leading to default.

  • Missed payments for supplies, raw materials, royalties, and similar unsecured operating liabilities. In some cases, these defaults may be the result of contract disputes or other commercial issues, and they often remain on the books only until the underlying issue is resolved or adjudicated. Such disputes may involve immaterial amounts of money and may be cured with an eventual settlement or renegotiation of the obligation. Sometimes, however, late or missed payments might be early signs of deepening financial stress. When material sums are involved and repayment can seem uncertain, creditors can initiate legal action that could force the company into a bankruptcy proceeding. A company subject to involuntary bankruptcy cedes control of its finances to an independent trustee who has the general authority to redeploy or liquidate assets and to distribute cash in order to satisfy verified creditors.

  • Failure to make timely principal or interest payments on secured debt. Companies, like individuals, may be responsible for mortgages on company property and installment debt on company vehicles and equipment. When a company defaults on this kind of debt, the lender can take possession of the property or equipment offered as security for the debt. In some cases, the lender is limited to the secured assets, and if the obligation is greater than the secured value, the lender must take the loss. But in some lending deals, the lender was also given some kind of recourse to seek additional cash if the secured property’s value were to be insufficient. Secured creditors with recourse loans can pursue their claims in bankruptcy court, like unsecured creditors.

    Keep in mind that when a creditor takes loan security in lieu of payment, the action may involve court or public records, even when the activity does not occur in bankruptcy court. Also, in addition to property and equipment, business loans can be secured by accounts receivable and other operating cash flows or by intellectual property and other soft assets. From a reporting perspective, financially material security agreements should be disclosed in company reports.

  • Violations of indenture agreements. The basic commitment of any bond is timely payment of principal and interest. Sometimes, to reinforce that commitment, a bond issuer also includes a list of written promises to bondholders. Known as a trust indenture, this supplementary commitment may require the borrowing company to maintain specified levels of liquidity or equity capital, or to remain within specified financial performance objectives. Typically, the indenture spells out the process for assuring compliance and for resolving conflicting interpretations. It also typically describes the consequences for transgression.

    From the shareholders’ perspective, these consequences may include significant financial penalties or even a mandatory change of control, even if all principal and interest payments are otherwise current.

  • Failure to make timely payments on unsecured bonds and notes. An explicit failure to make timely payments on general obligation debt securities may have the most immediately dire consequences of any default. Aggrieved holders of securities on which the borrower defaults may seek immediate bankruptcy court intervention, or they may use the threat of filing to force the company to renegotiate the terms of the debt.

    In the wake of a default and liquidation, different categories of debt will have different priorities for repayment and thus different potential recovery values. Generally, secured debt holders would be repaid first, receiving their collateral or its current cash equivalent and any potential recourse payments. Senior unsecured debt holders would then normally receive their shares from whatever assets might remain after secured debt holders were repaid. When those commitments are satisfied, subordinated (or junior) debt holders typically would come next, then preferred shareholders, and then common shareholders.

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Assessing default potential

No single factor can predict default. Credit ratings represent an overall assessment of many important factors that can help predict future financial performance. Analysts typically consider the demonstrated financial capacity of the borrower to meet its obligations. They also consider the willingness of the borrower to meet its financial commitments and the specific details of the obligation being rated. Other factors include the value of any financial guarantees or collateral, the position of the obligation in the borrower’s overall debt hierarchy, and the potential applications of bankruptcy law.

As with other investing risks, there may be no way to precisely predict default. But with accurate research and analysis, default risk can be managed effectively.

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© 2013 by DST Systems, Inc. Reprinted with permission from DST Systems, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

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