Ethics Case 14–8 Debt for equity swaps; have your cake and eat it too LO14–5 The

Question

Ethics Case 14–8 Debt for equity swaps; have your cake and eat it too

LO14–5

The cloudy afternoon mirrored the mood of the conference of division managers. Claude Meyer, assistant to the controller for Hunt Manufacturing, wore one of the gloomy faces that were just emerging from the conference room. “Wow, I knew it was bad, but not that bad,” Claude thought to himself. “I don’t look forward to sharing those numbers with shareholders.”

The numbers he discussed with himself were fourth-quarter losses which more than offset the profits of the first three quarters. Everyone had known for some time that poor sales forecasts and production delays had wreaked havoc on the bottom line, but most were caught off guard by the severity of damage.

Later that night he sat alone in his office, scanning and rescanning the preliminary financial statements on his computer monitor. Suddenly his mood brightened. “This may work,” he said aloud, though no one could hear. Fifteen minutes later he congratulated himself, “Yes!”

The next day he eagerly explained his plan to Susan Barr, controller of Hunt for the last six years. The plan involved $300 million in convertible bonds issued three years earlier.

Meyer: By swapping stock for the bonds, we can eliminate a substantial liability from the balance sheet, wipe out most of our interest expense, and reduce our loss. In fact, the book value of the bonds is significantly more than the market value of the stock we’d issue. I think we can produce a profit.

Barr: But Claude, our bondholders are not inclined to convert the bonds.

Meyer: Right. But, the bonds are callable. As of this year, we can call the bonds at a call premium of 1%. Given the choice of accepting that redemption price or converting to stock, they’ll all convert. We won’t have to pay a cent. And, since no cash will be paid, we won’t pay taxes either.

Required:

Do you perceive an ethical dilemma? What would be the impact of following up on Claude’s plan? Who would benefit? Who would be injured?

Explanation / Answer

Answer:

Yes, definitely there is ethical dilemma. Mr. Meyer is being unethical by converting bonds to stock at this point of time. Basically convertible bond means to give the holder the option of converting the bond to stock. Here, the basic problem is that Claude Meyer wants to offer a very low premium so that the bond holders will not even think of cashing out and instead convert them to stock. Actually, even if Meyer wants to swap, he should offer the bondholders a good premium so that they can have a fair deal.

The impact of Claud’s plan will be that the financial statements of the company will now show profits instead of losses. Thus, Meyer wants the books to look good and the 4th quarter losses would be wiped from financial statements. But, this will not be accurate because it is only a temporary solution and also unethical. Here, Meyer is trying to cover up his profits through a capital profit, which is non-recurring. His ideas should actually be in how can they increase sales and productivity in the long run and not in how to change the numbers to make them look good.

Only the company Hunt Manufacturing would benefit from the conversion as its books will now show profits and look attractive for investors. But, in the long run even the company will be injured as it may become bankrupt.

The bondholders and other investors will be injured with this action. However, if the bondholders are an option to cash out their bonds at a high premium, they would be saved from losses.

Also, the company Hunt Manufacturing will be injured by this action because they will think that they are doing a lot better than they actually are. Once they see the numbers and compare them to previous periods they will believe that they did much better than they did and that sales went up when in reality they went down. Thus, Meyer is anticipating this situation from a completely wrong angle.

Thus, the company should not go for conversion and instead work for increasing its sales and earning profits in long run.

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