Buyer beware

Caveat emptor (buyer beware) is a term often used in connection with the high yield market. It is likely to be ever more appropriate if current economic conditions continue. This is not going to be a discussion about credit quality though. Rather, it concerns one of the often overlooked details that distinguish the European market from its US cousin. It concerns jurisdiction and governing law and the impact this may have on returns following default.

Many European high yield investors simply have never taken the time to understand such details. In fairness, if everything goes swimmingly, then no one needs to bother too much. But what if it doesn't? Let's look at a recent issue to illustrate the point.

In December 2001, CIBC World Markets put an end to the dearth of new issues by bringing GAL Finance to market. (To restate the earlier point, no opinion is being expressed on the credit matters surrounding this issue – the fact is that the deal got done.) GAL Finance was a special purpose finance vehicle used by an automotive sector logistics and transportation group that was sold by Renault to a consortium of industrial investors in a highly leveraged transaction.

GAL Finance is incorporated in Luxembourg. The high yield issue, as is standard in the market, is governed by New York State law. GAL Finance is owned by, and has a senior subordinated guarantee from, Global Automotive Logistics SAS (GAL), a French company. It is also the borrower under the senior credit facilities that partially funded the acquisition and, via an Intercompany Bond (governed by Luxembourg law), the creditor of the on-lent proceeds of the high yield issue. Finally, GAL is the holding company of the group, although it has no operations of its own. The principal operating company is Compagnie d'Affrètement et de Transport SA (CAT), a direct subsidiary and sister company of GAL Finance which is incorporated in France.

This sort of structure is neither particularly complicated nor unusual. But, in the event of financial difficulties, it is likely that CAT, as the principal operating company, would be the first to be put into some form of administration. This would not necessarily affect the senior banks so much because of their security and limited guarantee from CAT. But bondholders don't have any direct claim to CAT. Though GAL and GAL Finance could follow CAT into bankruptcy, this would only happen at the direction of the banks and bondholders respectively, and only after actual default following grace periods.

The bondholders would hold the subordinated claim under the guarantee, governed by New York law, as well as a direct claim under the Intercompany Bond, governed by Luxembourg law, against a French company. The first step in any legal proceedings would be to establish competency. It is likely that New York law could be upheld as competent and hence bondholders would be able to use all their rights under the US bankruptcy codes. However, the problem is that to actually enforce any eventual findings, the Luxembourg courts would need to be petitioned.

Meanwhile the banks would in all likelihood try to get the French court administrator to sell CAT to extract some cash. Unfortunately, French courts don't play ball very often and are within their rights to permit CAT to continue to operate in order to preserve jobs. This would force the banks to defer their claim ? and indirectly make it difficult for GAL to meet its obligations under the subordinated guarantee.

So in the event of trouble the likely outcome would be a long and messy process at the end of which the banks may hope to extract some return. But the bondholders would be way behind – in reality, the present value of their claim could be pretty close to zero. Clearly, this is quite a different outcome from a typical US issue where the issuer and senior borrower are commonly the same entity and the majority of the business is domestic. History has shown that here, so-called ?recovery rates? have been around 40 per cent.

This of course does not mean that European high yield deals are all bad. But what it demonstrates is that as an investor, you not only have to be ever so clear as to the credit quality of a deal before investing. You must also recognise where in the queue you would be in the event of default. Caveat emptor ?