In a financial environment averse to surprises and unexpected variations, the phenomenon known as "The Credit Cliff Dynamic" has attracted the spotlight over the last few quarters. A credit cliff (or ratings cliff) is reached when a certain risk scenario materializes that carries with it immediate consequences. A rating change in this situation is, by definition, very substantial. The credit cliff dynamic figured prominently into several recent severe credit downgrades including Xerox Corp., Pacific Gas and Electric Co. (PG&E), Southern California Edison (SCE) and Enron Corp. In addition, credit agencies have increasingly warned investors of its potential impact on some of their rated issuers.

Historically, the credit cliff dynamic occurred in situations where a major event significantly impacted the issuer's economics, such as:

• a perceived government backing that did not materialize. (Railtrack PLC ratings were lowered to "CC" from "A" when the British government chose to put the company into administration.)
• a potential acquirer of a distressed company that unexpectedly withdrew its offer. (Enron Corp.'s rating dropped rapidly from "BBB-" to "B-" to "CC" and to "D" when Dynegy withdrew its merge offer.)
• an eroded confidence in a financial institution that led to a downward spiral of lost business or liquidities (the classic "run on the bank" cases affecting banks, insurance companies or trading companies).
• an issue from a low rated-entity formerly believed to be financially guaranteed that suddenly turned out to be stripped of that insurance. (Hollywood Funding No. 5 and No. 6 "AAA" ratings were downgraded to "CCC-" in February 2001 when the insurer, a subsidiary of AIG Inc., contested the coverage.)

However, recent highly publicized cases involving credit cliffs resulted from more insidious situations in which companies had tied their fate to maintaining a certain credit rating by incorporating rating triggers into some of their financial instruments. The rating triggers resulted in a downward rating pressure that materially eroded their cash positions and, in the cases of PG&E and Enron Corp., precipitated their bankruptcy filing. In most instances, rating triggers probably defeated their purpose of protecting investors by causing or accelerating a bankruptcy filing that adversely affected all creditors.

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Today, the criteria used by rating agencies to establish or revise their ratings are widely known, and therefore most rating triggers can, to a large extent, be anticipated.

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Rating Triggers 101, or "The Road to Hell is Paved with Good Intentions."

Traditionally, rating triggers had mainly been used to step-up loan pricing in the event that the perceived financial risk attached to the debt instrument increased. Under market pressure, however, their use has become widespread, and their severity has increased from a harmless means to reset pricing to a deadly default or acceleration-related rating trigger. Such ratings can severely limit a company's flexibility and substantially amplify the seriousness of credit quality deterioration. Lenders and borrowers should always understand the trigger's potential consequences before requesting or accepting triggers in negotiated contracts.

The most commonly used rating triggers include:

• Credit agreement pricing triggers: According to an agreed-upon rate matrix, downgrading or upgrading the borrower causes an increase or a decrease in the cost of borrowing. When a company faces tougher economic conditions, a downgrade puts additional pressure on its cash flows by increasing its financing charges. A recent example is when Standard & Poor's (S&P) downgraded Lucent Technologies' debt to junk status ("BB+") in June 2001, triggering a clause that increased the interest rate paid on an existing $6.5 billion facility. The cash-flow impact in this situation can prove debilitating to highly leveraged entities that are in structured finance deals.
• Springing liens: Certain triggers require a borrower to provide creditors with new or additional collateral in the event of a downgrade. Assuming the borrower has executed security documents and met the collateral perfection period, the value of the assets put as collateral may have already eroded. If not, the borrower may be faced with increased challenges if asset-backed financing is needed down the road to weather the very same cash-flow weakness that may have triggered the downgrade in the first place.
• Escape Clauses: Incorporating rating triggers in purchase agreements is becoming more and more frequent. They can either specify that a downgrade during the due-diligence process is a cause for calling off the deal, or that the acquisition would only be consummated if the pro forma of the new consolidated group receives investment grade ratings. If the financial situation of an already distressed target worsened during the due-diligence process, a downgrade by a major rating agency would therefore trigger the termination of the deal and potentially lead to a further downgrading due to the increased uncertainty faced by the target after the loss of its "white knight."
• Poison pills: High-yield indenture contracts sometimes include rating triggers that enable creditors to "put" the notes back to the issuer under scenarios where an ownership change results in a downgrade due, for example, to an increase in the leverage of the company. In situations where ownership changes would benefit all parties (which probably sounds familiar to most bankruptcy professionals), this could discourage potential acquirers faced with the prospect of needing to execute more expensive replacement refinancing.
• Default or acceleration triggers: These triggers enable lenders to terminate their funding obligations to fund or to accelerate the repayment of credit in the event certain rating requirements are no longer met by the issuer. Such triggers proved deadly to the commercial paper programs of PG&E and, in Enron Corp.'s case, accelerated a $690 million note and required the company to repay, refinance or cash-collateralize additional facilities for $3.9 billion.
• Collateral release, release of guarantees and covenant fall-aways: Unlike most of the previously described triggers, this category describes triggers that come into effect when an upgrade occurs. They present a significant risk for lenders who may, paradoxically, see their exposure increase in the event of an upgrade, but this is unlikely to result in a credit cliff. At worst, the triggers will constrain ratings to their pre-existing levels.

Market Reaction

The top three U.S. credit rating agencies responded recently to the increased focus on the rating trigger issue. In early December 2001, they announced that they were more likely to downgrade the debt of companies with contractual obligations that could lead to harmful events such as default if their credit ratings were ever to fall. The markets welcomed the closer scrutiny of the rating triggers by Moody's Investors Service, S&P and Fitch. As stated by Pamela Stumpp, chief credit officer in Moody's corporate finance group, "the presence of rating triggers may result in downward rating pressure depending on the severity of the triggers, the underlying facts and circumstances surrounding the credit, and rating level of the issuer."² Such a downward pressure could in turn result in increased borrowing cost, depending on the impact's extent.

In a report released on Jan. 22, 2002, Moody's discussed the enhancements intended to improve the flow of timely credit opinions to financial markets. These include a more thorough rating triggers analysis. According to the report, Moody's "launched a comprehensive rating trigger survey in all financial and operating contracts of rated issuers. Since rating triggers are sometimes not disclosed in financial filings, this project requires dialogue with issuers, and we may not be at liberty to disclose non-public information. However, the results of this research will be reflected in our ratings and will be especially relevant to our forthcoming research on liquidity risk."³

S&P, in turn, announced in a Jan. 25, 2002, report that it had "initiated a review of ratings, equity price triggers, other contingent financial and operating commitments embedded in companies' borrowing, counterparty and structured financing arrangements. S&P believes companies should publicly disclose these contingent risks, as they can present material incremental risks when performance is under pressure. The use of triggers has increased substantially in recent years and contributed significantly to Enron's default.... S&P has also polled its investment-grade issuers to determine how many triggers are in use."⁴

The measures taken by the two major rating agencies should further increase market awareness of the risks embedded in rating triggers, and the S&P proposal to require the public disclosure of such risks will certainly find a lot of support among a financial community increasingly eager for transparency.

Issuers are also starting to pay more attention to the time bombs that may hide within their numerous financial contracts. Some have publicly disclosed that they had already started the process of negotiating to remove rating triggers from existing debt. Williams made such an announcement in December 2001 as part of a set of balance-sheet strengthening measures.⁵ To respond to creditor concerns arising from Enron's bankruptcy, El Paso Corp. announced on Dec. 12, 2001, that it planned to eliminate or renegotiate certain financings that had rating triggers.⁶ Moody's further underlined this move in its rating confirmation report that followed the announcement.⁷

Conclusion

The financial markets' awareness of the potential pitfalls of rating triggers has significantly increased over recent months. Lenders and borrowers alike will probably more carefully consider their use while negotiating future financial contracts. Bankruptcy and restructuring professionals need to ensure that their clients have a comprehensive and thorough understanding of all triggers embedded in financial arrangements to avoid any unpleasant surprises, especially when out-of-court restructuring is considered. Today, the criteria used by rating agencies to establish or revise their ratings are widely known, and therefore most rating triggers can, to a large extent, be anticipated. Such anticipation would give time for the various parties to fully understand the potential impact of these triggers, and, in cases where they would be detrimental to the parties in interest, negotiations could remove them or limit their impact. Debtors, creditors and their respective advisors now have one more reason to keep the communication lines open during challenging times.

Footnotes

¹ The author is on secondment to the San Francisco office of Andersen from Paris. The views expressed are solely those of the author and not necessarily his firm. Return to article

² See "The Unintended Consequences of Rating Triggers" by Moody's Investors Service Global Credit Research (December 2001). Return to article

³ See "The Bond Rating Process in a Changing Environment" by Moody's Investors Service Global Credit Research (Jan. 22, 2002). Return to article

⁴ See "Credit Policy Update: Changes to Ratings Process Address Economic Conditions and Market Needs" by Standard and Poor's (Jan. 25, 2002). Return to article

⁵ See "Williams Addressing Potential WCG Obligation; More Asset Sales Planned," press release (Feb. 4, 2002). Return to article

⁶ See "El Paso Corporation Announces Balance Sheet Enhancement Plan," press release (Dec. 12, 2001). Return to article

⁷ See "Moody's confirms El Paso Corp.'s debt ratings (Baa2 Sr. Uns.) in response to debt reduction plan that includes elimination of rating triggers" credit rating report by Moody's (Dec. 12, 2001). Return to article