"Newbies"

Humor

Themes & Topics

Glossary

Lecture Notes

Trivia & Factoids

Kmart Finalizes Financial Pact

"Kmart Corp. finalized a financial agreement that removed, at least for now, a threat to the company’s survival. The accord will result in a quarterly loss for the discount retailer.

Kmart said creditors agreed to remove a provision requiring it to pay back $548 million in real-estate related bonds as a result of its junk-bond credit rating. In addition, the deal postpones payment on $3.1 billion that Kmart, based in Troy, Mich., owes on its bank lines of credit." (WSJ, 2/4/96, p. B4)

I using this news as an application of the potential conflict of interest between shareholders and creditors.

Creditors need to protect themselves against shareholders taking "excessive" risk at their expense. For example, shareholders can borrow money to finance a risky project. Since the borrowed money is not coming out of their pockets, they would not incur any monetary loss if the project goes bad. The creditors, on the other hand, take all the risk without being able to participate in the any potential windfall profits from such projects. Thus, creditors need to protect themselves through bond covenants that are aimed at reducing such risk. A typical covenant is a ceiling on the maximum amount of debt the company can issue.

The problem with these covenants, however, is that they can be too restrictive, i.e., might hinder optimal company performance, as measured by shareholder value creation. Overly stringent covenant requirements might have the opposite effect and drive the company to bankruptcy - a scenario that is not necessarily in the best interest of bondholders either. Thus, both sides need to write bond contracts (covenants) that are win-win.

In this particular situation, Kmart’s bondholders presumably intended to discourage "excessive" risk taking by the company’s managers. They included a covenant requiring that Kmart immediately pay back $548 million in real-estate bonds if the company’s debt rating lowered to junk bond (i.e., below BBB).

The new agreement was important in that it saved the company from bankruptcy, at least for now, but could not prevent the lowering of its bond rating.

By Alex Tajirian