Bill: Company that defaults on debt can't borrow for 10 years

Israel's MKs are setting out to protect savers from businessmen who stiff their lenders one day, only to borrow again the next.

Financial institutions managing long-term savings will be prohibited from lending to companies controlled by anybody who defaulted on debt any time in the preceding ten years, under a new "Financial Turpitude" bill that will be presented to the Knesset today.

And that's not all. Defaulters will have to forgo control over their companies, under the bill sponsored by Carmel Shama-Hacohen (Likud ), who is also the chairman of the Knesset Economic Affairs Committee, together with Meir Sheetrit (Kadima ), a former finance minister, and Aryeh Eldad (National Union ). Also, they will forfeit dividends disbursed from other companies they own: The money will be taken to repay bondholders.

The law's sponsors wrote the law with the help of the Movement for Quality Government in Israel, out of concern for the future of Israel's pension savers. About 20% of the total public savings for pensions has been lent to corporate Israel.

As of year-end 2011, no less than NIS 240 billion of the public's savings had been used, by institutional investors managing the public's money, to buy corporate bonds - or to extend "private" loans to the controlling shareholders of big companies. (Private loans may be made with the public's money, but as a "personal" transaction between the finance institution and the borrower. )

To put things into proportion, that sum is equivalent to two-thirds of the state budget.

The companies use the borrowed money to develop their businesses, pay interest payment to bondholders and repay old debt.

But just as the public's lending to companies ramped up, so did the number of companies defaulting on debt - meaning not repaying it in full, and sometimes, not repaying it at all.

Buying a bond is equivalent to lending the company money. Unlike a share, it doesn't confer any ownership. The company is a borrower and the bondholder is a lender. When a publicly-traded company listed on the stock exchange cannot honor its debt to bondholders, it reaches an agreement with them. Typically the bondholders agree to settle for a portion of the principal they lent, in exchange for shares in the company, higher interest on the debt or other forms of compensation.

Sometimes that portion of debt they get back is a small fraction.

This practice of defaulting and reaching a debt settlement with bondholders is called a "haircut" in market argot.

The thing irking Knesset members was the absence of constraints that deter defaulters, especially ones who had other choices rather than leave their creditors dangling.

"Haircuts hurt savers, first and foremost," said a Quality Government source yesterday. People are required by law to set aside money for their retirement, only to see chunks of it vanish. "Since the market forces have not penalized defaulters, the pension savings of Israeli citizens need protection through legislation."

Some 600 companies are listed on the Tel Aviv Stock Exchange. During the last three years, 90 of them entered into debt settlement arrangements. In 2011 alone, 20 debt settlements were signed.

How much did bondholders lose? That remains to be seen, but conservative estimates place the loss in 2011 at NIS 7 billion. Less conservative estimates are NIS 10 billion.

Deutsche Bank recently predicted that from 2015 to 2017, companies owing some NIS 40 billion to bondholders will default to some degree.

The reason for legislative action is that the institutional investors have failed to curb the practice.

Institutional investors are firms that manage pension savings. They include insurance companies such as Migdal, Phoenix and Harel, investment houses such as Psagot, Menora and Excellence-Nessuah. Each month they receive hundreds of millions of shekels from savers and route them to investments. Their purpose is to maximize profits for savers, in exchange for which they charge management fees that can be as much as 2% of the managed assets each year.

Yet they seem unable to represent the public adequately when a corporate borrower defaults. Many settlements have involved the institutionals selling the loans at a loss to avoid taking on powerful interests. The upshot is the same: the bondholders get a haircut. In the case of Tao Tsuot, belonging to Ilan Ben-Dov, and Delek Real Estate, belonging to Yitzhak Tshuva, the fight was left to minority shareholders who wouldn't capitulate.

The biggest barbers in town are the tycoons, claims Quality Government. "In the tiny, concentrated Israeli economy, it seems there is nobody to stand up to them and impose effective pressure," claims the movement's source.

"We as legislators have to change the rules of the game," said Carmel Shama-Hacohen, one of the law's parents. "We cannot stand by idly and watch the tycoons deliver haircuts to investors."

Failure to act is one thing. Even more egregious to the minds of the legislators is that having cringed at haircuts and done nothing, the institutional investors then go and lend the same tycoons more money.

There is nothing in law at present to stop a company owner from borrowing from bondholders again right after defaulting, observes Quality Movement. In allowing that, the institutional investors are being egregiously irresponsible, in its view.

To drive home the point, the movement notes the case of Yitzhak Tshuva and Delek Real Estate, one of his many companies. It began with Delek Real Estate announcing that it couldn't meet NIS 2.2 billion in bond payments. Tshuva's representatives spent months hammering out a debt settlement for that enormously over-leveraged company. Bondholders stand to lose 25% to 30% of their principal, if not more. Yet last week, two other Tshuva vehicles, the gas exploration companies Delek Drilling and Avner, tapped the market for a billion shekels. Tshuva's insurance company Phoenix raised NIS 360 million in a bond offering of its own.

How to avoid one hand defaulting and the other borrowing more? The parliamentarians propose that, for one thing, a defaulter will be declared in a state of financial turpitude and none of his companies may borrow from bondholders again for ten years. The Finance Ministry would be empowered to fine any institutional investors breaking the rule by as much as NIS 2.25 million.

If a company defaults on more than 20% of its debt, the creditors will assume control, they propose.

The ultimate purpose is to alarm the controlling shareholders into forgoing more of their own money - injecting it into their companies to repay debt. They do not have to do that, under the laws governing limited liability companies. But if they don't, they will be stamped with the mark of financial turpitude.

Not only may they not borrow from the market for ten years, and not only may they lose the controlling interest in their companies: they lose the dividend flow.

The legislators caviled at the situation of controlling shareholders ignoring debt to bondholders on the one hand, while receiving dividends from other companies they control. A section of the proposal does away with that.

Any dividends distributed by the company delivering the haircut, and any other companies the controlling shareholder owns, will be forfeit. The money will be used to repay the bondholders.

For instance, in September 2009 a debt settlement was reached at Zim Integrated Shipping Services, which belongs to the Ofer family. The company put off repaying money from 2012 to 2016 in exchange for some debt conversion into stock and higher interest. Yet in 2010 Zim's parent company, Israel Corporation, paid $70 million in dividends to shareholders, and another of the group companies, Israel Chemicals, paid $680 million in dividends.

Note, however, that all this is a proposal. It remains to be seen how the other Knesset members vote.