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Tim Short is author and a former investment banker at Credit Suisse First Boston, where he specialized in whole-of-business securitization.
Thames Water is struggling with a heavy debt burden and an uncomfortable regulatory settlement. Now it seems that a solution is in sight, which is good news. However, the nature of the solution raises some questions about corporate governance. Since the regulated water company has 16 million customers, these issues are of some importance.
The proposed solution, swapping debt for equity, has a long and storied history in the City and should work here as well. The idea is that since the equity has no current value, the debt holders are next in line and they will become the new equity holders. This leads to the somewhat tricky nature of the current position, which may continue for several months until the replacement is completed.
Current stockholders wrote off their investments, and in at least one case they did their director resigned. This does not mean that, at least in a technical sense, there are no shareholders. The question is whether its shareholders are motivated to act according to the current scenario. They stated that they have no interest in investing additional capital in the company. They have no skin in the game.
To the extent that they were also involved in debt, some of which will survive restructuring, they have mostly been replaced by vulture funds and various distress specialists. Therefore, they have no financial motivation to act as shareholders in the current circumstances.
This is important because under English company law, shareholders have a number of potential actions that only they can take.
It would be said that the short period of uncertainty is not a concern, and new shareholders are already waiting. They are, but this is a company that provides a critical function, and the standard cumbersome mechanisms of company law may be delayed. In addition, the Thames debt problems are it is not unique. We don’t know if sector peers will follow a similar slide, but if they do, they will all face the same vicious interregnum.
One obvious point to note is that shareholders appoint the board. Imagine a president stepping down for non-business reasons. Who would oversee the process of replacing him?
Shareholders usually work to constrain and control the board where necessary. There is no suggestion that the directors, for example, awarded themselves exorbitant salaries. However, if there was such a proposal, what containment mechanism would be applied?
The Thames Water board’s most pressing task is to choose between two competing refinancing offers. It is one of the holders of class A bonds and one of the holders of class B bonds. The holders of class B bonds stated with some justification that their offer is cheaper. The board said it preferred the Class A option, known as Plan A.
A key term to consider when comparing Plan A and Plan B is the interest rate. Plan B provides for new financing of 8 percent. Finance Plan A carries a rate of 9.75 per cent and includes £200 million in fees. Both of these rates are much higher than the allowable interest rate on debt taken by regulator Ofwat, which is a measure of the level of current financial distress.
Because Ofwat assumes a different and much lower cost of debt, it suggested that “no more interest is added directly to customers’ bills”. However, this actually acknowledges that such costs exist indirectly added to customers’ accounts. It’s not hard to see why this has to happen. However, Thames has only one source of income: customer payments. If money goes to pay higher interest rates, it can only come from those customer payments.
But while Plan B might raise more money under less onerous conditions, Plan A has the advantage of reducing execution risk. By that term I mean the risk of the company running out of money before the debt-for-equity swap is concluded. The quicker Thames Water reduces the risk of going into temporary nationalization through a special administrative regime, the more likely the slab will stay in place. Plan A is the best option for them, but is it the best option for customers?
There is no suggestion that management is in any conflict of interest here, but if such an appearance were to arise, who, in the absence of effective and active equity owners, would act to remove that appearance?
It would probably take some thought at a regulatory and government level about how clients can be protected in the absence of both a dedicated trustee and anyone performing fairness duties. Switching to plan B saves clients money, but it would be nice to be sure management is weighing those prospects equally against their own survival. This is the crux around which perceptions of a potential conflict of interest revolve.
