Debt-for-Equity Swaps in Out-of-Court Deals

Introduction

When a company's leverage is sustainably impaired (the existing debt cannot be supported by the projected post-restructuring cash flows even after extending maturities and lowering coupons) the workout typically requires converting debt to equity rather than just modifying the debt's terms. The debt-for-equity swap is the structural mechanism by which the converting creditors take ownership of the reorganized company in exchange for the impairment of their debt claims, the existing shareholders are diluted or wiped out entirely, and the balance sheet is reset to a sustainable level.

This article walks through the full mechanics: what a debt-for-equity swap actually is and how it differs from a distressed exchange, the governance and control implications when creditors take over the equity, the Section 108 tax framework that drives cancellation-of-debt income treatment in out-of-court swaps versus in Chapter 11, the dilution math that determines how much equity the converting creditors receive, the practical situations in which an out-of-court swap is achievable, the negotiating sequence that produces the swap, the listing-rule constraints for public companies, and the boundary conditions under which the engagement has to convert to a Chapter 11 plan instead. Recent precedents (Pluralsight August 2024, Audacy 2024, Petmate 2024, Sungard 2019) anchor the modern playbook with specific magnitudes and structural variations.

A debt-for-equity swap is a transaction in which a creditor accepts new equity in the company in lieu of cash repayment of all or part of its debt claim. The economic substance is that the creditor's debt claim is extinguished (canceled or partially canceled) in exchange for shares (or membership interests, or partnership units) representing ownership of the reorganized entity. After the swap, the creditor is no longer a debt holder; it is an equity holder, with all the rights and risks that come with that position.

Debt-for-Equity Swap

A transaction in which one or more creditors agree to extinguish all or a portion of their debt claims in exchange for newly issued equity in the borrower. The swap can be conducted out of court (with each creditor's consent) or in court through a Chapter 11 plan that converts impaired claim classes into the new equity. Out-of-court swaps require the company to issue equity (typically requiring shareholder approval if the dilution is material), produce a change of control if the creditors take a majority stake, and trigger Section 108 cancellation-of-debt income tax consequences for the company. The converting creditors typically take board seats and governance rights commensurate with their new ownership stake.

A distressed exchange offer modifies the form of debt: the bondholder ends up holding a different debt instrument with extended maturity, modified coupon, or reduced principal. The bondholder is still a creditor. A debt-for-equity swap changes the nature of the holding entirely: the creditor exits the debt position and enters the equity position, absorbing equity upside and downside in place of contractual debt rights.

The two tools coexist in the workout playbook. Lighter situations resolve through DEOs that maintain the debt structure with modified terms; heavier situations require swaps that fundamentally rework the capital structure. The dividing line is the debt capacity analysis: if the post-restructuring debt capacity is materially below the existing debt outstanding, equity conversion is required.

The 2024-2025 cycle produced four canonical debt-for-equity swap precedents that illustrate the range of structures and outcomes.

The four cases illustrate the spectrum. Pluralsight is a pure out-of-court swap: Vista Equity Partners accepted that its equity was worthless, and the private credit group (Blue Owl, Ares, Golub Capital, Oaktree, Benefit Street, Goldman Sachs, BlackRock) took 100% ownership without filing for bankruptcy. Audacy is a prepackaged Chapter 11 swap: filed January 2024, equitized $1.6 billion, emerged September 2024. Petmate is a fully consensual out-of-court reorganization in which lenders took 100% of the equity. Sungard combined a swap with a subsequent asset sale.

The recovery waterfall and fulcrum-security analysis (covered in the recovery waterfall article and the fulcrum security article) determines which creditor class converts to equity. The fulcrum is the most senior class that is impaired in the recovery analysis: senior secured creditors above the fulcrum receive cash or new debt at par; classes below the fulcrum are wiped out; the fulcrum class itself bears the impairment and typically converts to equity. In a typical 2025-vintage capital structure with first-lien term loan B, senior unsecured notes, and subordinated notes, the fulcrum often sits in the senior unsecured layer when the credit is moderately impaired (term loan recovers in cash; senior unsecured converts to a combination of new debt and equity; subordinated wipes out). When the credit is more severely impaired, the fulcrum can move up into the second-lien or even first-lien layer, with senior secured creditors taking the equity directly. The Pluralsight transaction is the canonical recent example of the fulcrum at the first-lien private credit layer: the lender group that held the term loan took 100% of the equity because the entire capital structure was impaired below them.

The implication is that out-of-court debt-for-equity swaps are typically negotiated with the fulcrum class. The senior secured creditors above the fulcrum want their cash recovery; the subordinated creditors below the fulcrum want any recovery at all. The fulcrum class is the negotiating counterparty: their conversion ratio (how much equity they receive in exchange for their debt) is the central economic term, and their willingness to take the equity (versus pursuing a Chapter 11 path that might produce different recoveries) determines whether the out-of-court swap closes.

Equity dilution in a debt-for-equity swap is calculated by valuing the post-restructuring equity at the post-emergence enterprise value minus the post-emergence debt, then dividing the existing shareholder portion by the new (existing plus issued) total. In practice, the math runs as follows.

Consider a hypothetical company with $2 billion of pre-restructuring debt, $1 billion of pre-restructuring equity value, $1.2 billion of post-restructuring sustainable debt, and $1.5 billion of post-restructuring enterprise value. The recovery analysis shows $2B $-$ $1.2B $=$ $800M of debt impairment that needs to be converted to equity. With $1.5 billion of post-emergence enterprise value and $1.2 billion of new debt, the post-emergence equity value is $1.5B $-$ $1.2B $=$ $300M. The converting creditors who took $800 million of impairment would expect to receive equity worth approximately $300 million in the new structure (recovering $300M $/$ $800M $= 37.5\%$ through equity ownership), and the existing shareholders would be diluted to a small minority position or wiped out entirely depending on negotiation and the new value doctrine.

The actual dilution outcome is heavily negotiated. Existing sponsor shareholders often argue for retention of a meaningful equity stake (10-30%) in exchange for management continuity and operational value. Converting creditors push back, arguing that the existing shareholders should be eliminated entirely under absolute priority principles. Out-of-court swaps typically settle somewhere in the middle: existing shareholders retain a smaller stake (often 5-15%) in exchange for governance concessions, with the converting creditors taking the controlling majority. The Pluralsight transaction skipped this negotiation entirely: Vista's equity was zero in the post-emergence structure, with the lender group taking 100%. The Petmate transaction ran similarly: the lender group took 100% of the equity, with no retained interest for the prior sponsor.

When converting creditors take a controlling equity stake (50%+), the swap produces a change of control with significant governance consequences.

The cancellation of debt in a debt-for-equity swap creates cancellation-of-debt income (CODI) under Internal Revenue Code Section 108, with materially different treatment depending on whether the swap occurs in or out of court.

Cancellation-of-Debt Income (CODI)

Income recognized for tax purposes when a debtor's debt is canceled, forgiven, or discharged for less than the amount owed. In a debt-for-equity swap, CODI equals the excess of the canceled debt over the fair market value of the equity issued in exchange. Section 108 of the Internal Revenue Code provides exclusions and exceptions: debtors in Chapter 11 can exclude all CODI from gross income (subject to attribute reduction of NOLs and other tax assets); insolvent debtors out of court can exclude CODI to the extent of their insolvency. Sponsor-owned companies often face material CODI consequences in out-of-court swaps that would have been avoided in Chapter 11.

The defining equation is:

In Chapter 11. CODI is excluded from gross income entirely under Section 108(a)(1)(A), regardless of solvency. The exclusion comes at the cost of attribute reduction: the debtor's tax attributes are reduced by the amount of excluded CODI in a defined order. The attribute reduction order is: NOL carryovers first, then general business credits, minimum tax credit, capital loss carryovers, basis in assets, passive activity losses, foreign tax credits. The trade-off is typically favorable for distressed companies because the attribute reduction is recovered over future years while the CODI exclusion is immediate. Audacy's prepackaged Chapter 11 cleanly used this exclusion to avoid taxation on the $1.6 billion of equitized debt.

Out of court. The exclusion is narrower. Under Section 108(a)(1)(B), an insolvent debtor can exclude CODI to the extent of insolvency at the time of the discharge (calculated as liabilities exceeding fair market value of assets, immediately before the discharge). A solvent out-of-court debtor faces full taxation of the CODI, which can produce significant tax bills exactly when the company is least able to pay them. A worked example: if Debtor Corp is insolvent by $75 million and realizes $100 million of CODI from a debt-for-equity swap, $25 million is taxable income and the remaining $75 million is excluded under Section 108(a)(1)(B). If Debtor Corp has $25 million of NOL carryforwards and $25 million of tax basis in its assets, both attributes are reduced to zero and the remaining $25 million is "black-hole" CODI that disappears without producing any cash tax.

Section 108(e)(6) capital contribution exception. Where a creditor owns all the equity of the debtor before the debt-for-equity exchange, Section 108(e)(6) allows the creditor to contribute its receivable to the debtor's capital without producing CODI. This is the structural reason sponsor-controlled debt-for-equity swaps are sometimes structured as capital contributions rather than as cancellations: when the same fund family owns both the debt and the equity, the contribution structure avoids the CODI altogether.

The tax differential is one of the meaningful structural reasons companies sometimes choose Chapter 11 over an otherwise-feasible out-of-court swap: the tax savings from excluding all CODI without an insolvency limitation can offset a meaningful portion of the Chapter 11 fee load.

Section 382 NOL limitation. Any debt-for-equity swap large enough to shift majority ownership triggers an "ownership change" under Section 382, capping the post-emergence usability of pre-change NOLs:

The long-term tax-exempt rate (published monthly by Treasury) typically runs around 3-4%, which means a debtor with $500M of NOLs and $300M of pre-change equity value can use only roughly $300M $\times 4\% =$12M of NOLs per year going forward. Section 382(l)(5) provides a critical bankruptcy exception that suspends the limitation entirely if qualified creditors and historic shareholders together hold at least 50% of post-emergence stock, but the exception applies only inside Chapter 11. Out-of-court swaps that flip control without satisfying 382(l)(5) typically produce dramatically less usable NOLs than the headline carryforward figure suggests.

The negotiation that produces a successful out-of-court debt-for-equity swap follows a defined sequence over three to six months.

Public companies undertaking debt-for-equity swaps face additional procedural friction. NYSE Rule 312 and Nasdaq Rule 5635 require shareholder approval for issuances above 20% of outstanding shares, introducing 60-90 days of timing risk through proxy filings. Some swaps structure as private placements under Section 4(a)(2) and Rule 506 to avoid the trigger; others accept the shareholder vote. Many recent large-cap transactions used the prepackaged Chapter 11 path specifically to avoid the listing-rule complications: the bankruptcy court's order authorizes the equity issuance and conversion to private status without the listing-rule framework.

Out-of-court debt-for-equity swaps work when five conditions hold simultaneously:

Pluralsight is the canonical case where all five conditions held: the credit was impaired (private credit group provided $250 million of new capital alongside the conversion to keep the business operating), the fulcrum class was concentrated (the same private credit group that had originally lent to the company), the existing equity (Vista) accepted that its position was worthless, the company was sufficiently insolvent to make the tax math work, and Vista cooperated with the transaction. The result: a clean out-of-court change of control completed in August 2024 without filing for bankruptcy, with Pluralsight's funded debt reduced by $1.3 billion and the lender group taking 100% ownership.

When any of these conditions fails, the engagement typically converts to a prepackaged Chapter 11 plan that uses cramdown mechanics to bind dissenting creditors and equity holders, preserves the favorable tax treatment under Section 108(a)(1)(A), and uses the court's confirmation process to validate the dilution and governance changes against legal challenge. The 2024-2025 cycle saw substantial debt-for-equity activity, with most large public-company swaps routed through prepackaged Chapter 11 cases (Audacy, Spirit Airlines, Cumulus's 2026 follow-on filing) rather than as standalone out-of-court swaps. Sponsor-owned middle-market private credit deals (Pluralsight, Petmate) more often resolved out of court because the fulcrum class was concentrated and the existing equity holders were willing to accept the wipeout.

Out-of-court debt-for-equity swaps are the right tool when the credit profile, the fulcrum-class concentration, the tax position, and the governance situation all align. Sponsor-controlled middle-market companies with concentrated lender groups, adequate insolvency-based tax exclusion, and willing existing equity holders are the typical candidates. Public companies with broadly distributed bondholders and existing public equity rarely succeed at standalone out-of-court swaps; the listing-rule shareholder vote, the holdout dynamics, and the difficulty of executing a clean change of control without court process push these into prepackaged Chapter 11.

The debt-for-equity swap is one of the more invasive tools in the workout playbook, second only to a Chapter 11 filing in the depth of restructuring it produces. The bankers who do this work well are the ones who can model the recovery economics, structure the governance, walk anchor creditors through the rationale for taking the equity in lieu of par recovery, and recognize the moment to push the engagement through court rather than continuing to negotiate out of court.