Lawyers

I like lawyers. Most people kindly think of them as a necessary evil, but I think better of them. It probably helps their cause that I have several lawyer friends, and that one day soon, Rockett Girlfriend will be joining their ranks (and thus accelerating my retirement plans... yesssss).

But there are times when you see a glimpse of the seedy underbelly of billable hours, the whoring of legal expertise to the highest bidder, just past the thin veneer of "client relationships" which is nothing but blatant conflicts of interest. Lawyers receive several streams of work from several (and often competing) corporates. In a market that is several notches short of perfect competition (like, oh I don't know, the Australian financial institutions industry), no lawyer can survive by faithfully acting for one player only; they must act for several (and the best ones act for all).

Sure, it is impossible for one lawyer to act for more than one side in one transaction; but there is nothing stopping them from acting for one bank in one transaction, then act against the same bank (but a different division, perhaps) in another transaction. For all the talk of "Chinese walls" and "managing conflicts of interest", is it really possible for a lawyer to disregard the idea that, by negotiating well for one client in one transaction, that he or she might be jeopardising future income from the other side (who is, perhaps, a much better-paying client)?

For the past two months we had been advising one of our debt teams on a leveraged transaction. The borrower is an infrastructure fund, being advised by an investment bank fondly known in the small-pond Aussie industry as "a bunch of douchebags". Said investment bank has a lot of fingers in a lot of pies, which is a lawyer's wet dream because it means a never-ending stream of deals... if you are on their good books.

I was on a conference call last week with two colleagues, discussing and refining the terms and conditions on a draft agreement to line up with our negotiating position. On the other line is our external lawyer, a partner at a top Sydney corporate law firm. The idea was that we would discuss what points we want reflected in the agreement, our lawyer will draft the document as such, then send the document back to the borrower's advisers and lawyers (a different firm - there is at least the appearance of objectivity) so they can tweak it with their negotiation points.

Amongst other points, we were negotiating the definition of "Distributions", which is important because it basically defines how cash can leave the business. In highly leveraged transactions, cash is definitely king. Lenders want it to stay in the business, to support spending, service the debt and generally act as buffer against a downturn. Financial sponsors want it out of the business and into their pockets, because the longer it stays in the business, the greater the risk of losing it, and the lower the IRR on their investment becomes. Typical of highly leveraged transactions is the presence of different tranches of debt; in basic structures, Senior Debt and Subordinated Debt. As the names imply, Senior Debt get priority over the cash flows of the business - its interest and principal get paid first (in return for this relative safety, it charges a lower interest). Subordinated Debt ranks behind Senior in the cash flow priority - in fact, in some cases Sub Debt interest is not paid, it is accumulated instead (oh the boom years, how I miss thy funky structures). In all cases, Sub Debt principal is only paid after Senior Debt principal has been completely paid out.

For some strange reason, the original deal had allowed "Distributions" to include prepayment of principal in Sub Debt... i.e. if the borrower chose to, it could have prepaid Sub Debt principal ahead of Senior Debt (the reasons why this was allowed in the first place is unknown, and for my own sake, I would rather not know). This would be utterly disastrous for Senior Debt, because if things go pear-shaped, there is no cash or Sub Debt to take the first loss. We pick up the conference call at this point:

[Us - Rockett Fuel, CS, BJ] [Lawyer: GR]

Us: "I think we are OK with the rest of the "Distributions" definition, just take out the reference to "principal" in Sub Debt and send it through."

Lawyer: "Really? It doesn't make a difference does it?"

(Quizzical look around the table.)

Us: "Uh... yes it does. We don't want to get paid out after Sub."

Lawyer: "Hang on, let's think this through. I'll tell you what they'll say (NB: "they" being the advisers)... they'll say that a dollar out is a dollar out, no matter if it is paid out as interest, principal, equity dividends or share buybacks. I'm not a banker so maybe I'm missing something, but to me it doesn't seem to make a difference."

(During that little lesson on Capital Structure Theory To Suit You, the mute button was pressed and the phrase "WTF" may or may not have been expressed. We checked to make sure we were, in fact, the ones paying for this billable hour - we were. Un-mute.)

Us: "That is exactly why we don't want Sub principal getting paid out, because we have already allowed them the ability to reduce their capital base by allowing share buybacks."

Lawyer: "OK let's think this through. Let's say you have $20 in earnings and $100 in Sub Debt, and there is $10 of Sub interest due via Distributions. But let's say instead of the company paying $10 out of earnings, it pays it via prepayment of Sub Debt. You still have $110 of capital left over, so on cash basis you are in the same position."

Us: "However we now have only $90 of Sub Debt as buffer, so we have $10 less protection."

Lawyer: "Yes but the same cash went out the door."

(Unknown speaker): "Just delete it, you backstabbing lowlife whore!"

(Pause.)

Lawyer: "OK. By the way, in clause 5 I inserted that you have 2 Business Days to respond to a Clause 5 Notice."

Us: "We didn't ask for that! Why the hell did you do that?"

Lawyer: "Because I know they will ask for it."

I kid you not.