debt-to-equity swaps

"...A contribution to the capital of a company has no purpose for the contributing company unless the entity making the contribution is getting or has an interest in the company it is contributing to. The easy solution would be to transfer some shares in the company to the contributing companies or to issue shares in the company to the contributing companies when contributions are made. This way any contribution would bring value to the company making the contribution because the value of the company receiving the contribution and in which the contributor owns shares, would increase..."

It is amazing how lawyers can render even the simplest statement opaque and incomprehensible. The situation is as follows:

Company X holds the debt of company Y which is currently in a distress. Having secured the consent of company Y, Company X will now be swapping some of this debt into equity. The corporate lawyer Mr.W (who is quoted above) claims that a debt-to-equity swap will be rational from the point of view of Company X only if Company X already has partial equity stake in Company Y.

Here is my take on the issue:

Please correct me if I am wrong, but the argument is false for the following two reasons:

1) In a distressed situation, it can be rational from the point of view of a creditor with no equity stake to even unconditionally forgive a part of the debt. Myers’ classic paper “Determinants of Corporate Borrowing” (1977) explains this point in detail. Here is the heart of his argument: “Most firms are valued as going concerns and this value reflects an expectation of continued future investment by the firm. However, the investment is discretionary... The firm financed with risky debt will, in some states of nature, pass up valuable investment opportunities – opportunities which could make a positive net contribution to the market value of the firm... If creditors and shareholders find themselves in a position where the net present value of an investment project is positive, but less than the payment promised to creditors, then it is in both sides’ interest to renegotiate the debt contract.”

2) As pointed out above, in some distressed situations (such as today), conducting a debt-equity swap (or even forgiving debt) can enrich the creditors. However this does not necessarily mean that such a move will increase the expected income of the already existing shareholders. The resulting lower leverage will decrease the return on equity and an enlargement of the shareholder base will dilute the incumbent shareholders’ claims. That is why, in practice, one sometimes sees cases where an opportunity to increase the market value of a firm is by-passed due to the stiff opposition by incumbent shareholders.

Here is the response from Mr.W:

Many thanks for your message this afternoon. I had just proposed an alternative solution to Mr.Z, but it does not seem it would work in these circumstances either. Since everyone involved seem also aware of the possible repercussions of bankruptcy and findings of fraudulent conveyances by trustees in bankruptcy, I could take out the problematic assumption if shareholder resolutions of the two contributors are provided, and would then just direct everyone's attention to the bankruptcy exception which is already in the opinion.

... and the amazing message that Mr.Z sent to my uncle:

I have just drafted the shareholder resolutions and sent to Mr.W for his approval. I will then send it to you for signature. I note your nephew’s input. With the greatest of respect to his knowledge, he should keep the business of MBA discrete with the knowledge of the law. I will revert shortly with Mr.W’s comments on the draft resolution.

Perhaps corporate laws do not need to make any economic sense. I do not know... (Note that I do not have a MBA degree.)

P.S. If interested, you can read the linked VoxEU article which contains another example where forgiving debt can enrich both the creditor and the debtor.