Debt Modification vs. Extinguishment: Pre-Insolvency Strategies for Distressed Capital Structures

The U.S. corporate debt market recorded a staggering $226 billion in amend-and-extend transactions during 2024, marking the highest annual volume on record. This extraordinary activity reflects a shift in how distressed companies address unsustainable capital structures.

Rather than seeking formal bankruptcy protection, businesses and their lenders are increasingly turning to private, negotiated solutions that restructure debt obligations without judicial oversight. 

For businesses facing covenant breaches, upcoming maturities, or deteriorating cash flows, understanding the strategic distinction between debt modification and debt extinguishment is critical.

These represent fundamentally different approaches to resolving financial distress. One preserves the lending relationship through adjusted terms; the other eliminates the debt obligation. 

Each path carries distinct legal, tax, and operational implications for all stakeholders involved.

Understanding the Fundamental Difference

Debt modification involves restructuring the terms of existing obligations while maintaining the fundamental debtor-creditor relationship. The debt continues to exist, but with altered terms such as extended maturity dates, reduced interest rates, or relaxed covenants.

Debt extinguishment, by contrast, represents the complete elimination of a debt obligation. The borrower's duty to repay is discharged, and the creditor's claim is satisfied or canceled. This typically occurs through bankruptcy proceedings, court-approved restructuring plans, or negotiated settlements that include debt forgiveness.

Why Modification Dominates the Market

The distinction matters enormously in practice. Data from 2023 shows that 85% of corporate defaults were resolved through out-of-court restructurings rather than formal bankruptcy proceedings. This dramatic shift from the historical 28% average reflects both the costs of bankruptcy and the strategic advantages of consensual modification.

For most distressed companies navigating pre-insolvency challenges, modification rather than extinguishment defines the realistic path forward. 

True debt discharge outside bankruptcy remains rare and legally complex, making it an option reserved for only the most distressed situations.

Amend & Extend: The Market's Main Tool

Amend-and-extend (A&E) transactions have become the dominant mechanism for corporate debt restructuring in the current cycle. 

These agreements allow borrowers to extend loan maturities in exchange for increased spreads, upfront fees, and often tightened operational covenants. Both parties avoid the expense and uncertainty of bankruptcy while giving the business additional time to improve operations or refinance under better conditions.

The scale of A&E activity in 2024 was unprecedented. Of the $1.4 trillion in total leveraged loan market activity, approximately 60% consisted of repricing and amendment transactions rather than new money issuance.

This represented a 250% increase in such activity compared to the prior year, driven by companies desperate to address the "maturity wall" of debt coming due in 2025 and 2026.

Key Components of A&E Transactions

The most fundamental element is the maturity extension itself, with 2 to 3 years representing the standard timeframe. 

Borrowers whose debt was scheduled to mature in 2025 or 2026 successfully pushed these obligations to 2027 or 2028, betting that interest rates will decline and refinancing conditions will improve.

In exchange for these extensions, lenders extract significant concessions:

• Amendment fees typically range from 7.5 to 25 basis points of the loan commitment amount

• Increased spreads over benchmark rates (a loan originally at SOFR + 350 bps might be amended to SOFR + 500 bps or higher)

• Covenant modifications that provide operational flexibility in exchange for enhanced lender monitoring

Payment-in-kind (PIK) toggle provisions have become increasingly common in these structures. 

Approximately 14% to 20% of private credit loans now include PIK optionality, allowing borrowers to defer cash interest payments by instead increasing the principal balance.

While this provides critical cash flow relief during distressed periods, it compounds the debt burden and signals severe liquidity constraints to the market.

Success Rates

While A&E transactions successfully defer immediate defaults, their long-term effectiveness remains limited.

According to restructuring professionals surveyed in 2024, 97% view A&E and liability management exercises as temporary solutions rather than permanent fixes. Only 3% of respondents believed these transactions definitively resolved the underlying financial distress.

The actual performance data validates this skepticism:

• 63% successfully avoided bankruptcy after completing A&E transactions

• However, only 14% maintained ratings above CCC+ and avoided subsequent defaults

• This suggests that while A&E prevents immediate insolvency, it rarely returns companies to full financial health

The Credit Quality Divide

The bifurcation in outcomes tracks closely with initial credit quality:

Strong Performers (B/BB Rated): Found receptive markets for extensions and often successfully turned around operations within the extended timeline.

Distressed Credits (CCC/C Rated): Experienced dramatically different results. For this cohort, 2026 maturities were reduced by only 19%, leaving a toxic concentration of distressed debt with limited refinancing options.

These companies face a hard maturity wall that A&E activity has merely shifted forward, not eliminated.

Forbearance: The Bridge Strategy

Forbearance agreements represent a more limited form of debt modification, providing temporary covenant relief or payment deferrals while lenders evaluate the borrower's turnaround prospects.

Unlike comprehensive A&E transactions, forbearance arrangements typically span only 30 to 180 days and come with stringent monitoring requirements:

• Explicit reservations of lender rights

• Enhanced reporting requirements (often weekly cash flow reports)

• Engagement of a chief restructuring officer or financial advisor at borrower expense

• Standstill fees of 50 to 100 basis points for each forbearance period

Forbearance serves as an interim step. It allows both parties to conduct diligence, explore strategic alternatives, and negotiate the terms of a more comprehensive modification.

For many distressed companies, forbearance agreements precede either a successful A&E transaction or, if the situation proves irreversible, an orderly bankruptcy filing or asset sale.

Debt-for-Equity Conversions: The Hybrid Approach

When a company's leverage becomes mathematically unsustainable, amend-and-extend strategies prove insufficient. 

A business carrying debt at 8x or 10x EBITDA with declining cash flows cannot merely extend maturities. It must reduce absolute debt levels.

This drives consideration of equitization, the conversion of debt into equity ownership.

How Equitization Works

Debt-for-equity swaps occupy a middle ground between pure modification and true extinguishment. The original debt obligation disappears, satisfying the technical definition of extinguishment. However, the creditor's economic interest continues through equity ownership rather than through a discharged claim.

The mechanism is straightforward. Lenders agree to exchange their debt claims for equity interests in the restructured company. A lender holding $100 million in debt might receive a 40% equity stake in exchange for canceling the obligation.

The company's balance sheet improves dramatically as debt converts to equity, while lenders trade their contractual claim for an ownership position with upside potential.

The Rise of Distressed Exchanges

Distressed debt exchanges have become the predominant form of default resolution in the current cycle.

In 2024, distressed exchanges comprised 64% of all corporate defaults, the highest annual share on record since tracking began in the 1980s. This represents a fundamental shift in how the market addresses insolvency.

Why Lenders Prefer This Path

The appeal lies in the recovery statistics:

• Lenders participating in distressed exchanges achieved average recovery rates of 82.6% (nominal value of securities received)

• Traditional defaults through formal bankruptcy yielded approximately 42% recovery

• This 40-percentage-point premium creates powerful incentives for consensual equitization over litigated outcomes

Important Caveats

These superior recovery rates come with significant limitations:

Valuation vs. Reality: The 82.6% figure reflects the face value of new securities and equity received, not their realizable market value. Many distressed exchanges involve illiquid securities in companies with uncertain futures.

Repeat Defaults: Approximately 46% of companies that completed distressed exchanges between 1984 and 2008 eventually filed for bankruptcy anyway, with a median time of two years between the exchange and the filing.

True Debt Extinguishment

True debt extinguishment, the complete and permanent elimination of debt obligations, occurs far less frequently than modification in the pre-bankruptcy context. 

While the term "extinguishment" is sometimes used loosely to describe any debt reduction, actual discharge of debt outside of bankruptcy is rare and legally complex.

Bankruptcy Discharge

The primary mechanism for debt extinguishment remains formal bankruptcy proceedings under Chapter 7 or Chapter 11 of the Bankruptcy Code. In Chapter 11, a confirmed plan of reorganization discharges all debts that arose before the confirmation date, except as otherwise provided in the plan.

This judicial discharge is absolute and provides the debtor with a clean slate, subject to the treatment specified for each class of creditors in the approved plan.

Out-of-Court Extinguishment

Outside bankruptcy, extinguishment requires negotiated settlements with creditors that include explicit debt forgiveness. These transactions are exceedingly difficult to execute because they need the consent of affected creditors who must voluntarily accept less than full repayment.

In a syndicated credit facility with dozens of lenders or a bond issuance with thousands of beneficial holders, obtaining unanimous or super-majority consent for outright forgiveness proves practically impossible.

Why Pre-Bankruptcy Extinguishment Remains Rare

Creditors have little reason to forgive debt outside bankruptcy when they can potentially recover more through:

• Foreclosure on collateral

• Litigation and judgment enforcement

• Waiting for a bankruptcy filing, where they may receive better treatment

If a company forgives debt while insolvent, that forgiveness may constitute a fraudulent transfer that can be unwound by a subsequently appointed bankruptcy trustee or other creditors. 

This risk makes lenders hesitant to participate in forgiveness transactions absent the safe harbor of a confirmed bankruptcy plan.

In a multi-tranche capital structure, senior lenders may have no interest in forgiving debt when they are over-secured, while junior creditors, desperate for forgiveness, lack leverage to compel it.

The coordination problem among creditor classes with conflicting interests typically requires either the bankruptcy court's authority or the coercive mechanisms of a liability management exercise.

Tax Consequences

Tax implications often determine whether companies pursue debt modification, equitization, or extinguishment. The treatment of cancellation-of-debt (COD) income under the Internal Revenue Code fundamentally shapes the economics of restructuring strategies.

This explains why many companies delay restructuring until they are deeply insolvent.

Under Section 108(e)(8) of the Internal Revenue Code, when a corporation issues stock to satisfy debt, it is treated as having paid the debt with an amount of money equal to the fair market value of that stock.

A Practical Example

Consider this scenario:

• The company owes $100 million to lenders

• The debt now trades at $40 million in the secondary market

• The company proposes to issue equity valued at $40 million in exchange for canceling the $100 million debt

Tax Result: The company has recognized $60 million in cancellation-of-debt income. The IRS treats this as ordinary income, potentially subjecting the company to an immediate tax liability of 21% of the COD amount.

For this example, the company would owe $12.6 million in taxes on the debt forgiveness, an obligation it almost certainly cannot pay given its distressed condition.

The Critical Insolvency Exception

Section 108(a)(1)(B) provides critical relief through the "insolvency exception." 

COD income is excluded from gross income if the taxpayer is insolvent immediately before the discharge, but only to the extent of that insolvency.

How It Works

Insolvency is defined as liabilities exceeding the fair market value of assets.

Returning to our example:

Scenario 1 (Full Exclusion): If the company has total liabilities of $150 million and assets with FMV of $80 million, it is insolvent by $70 million. The $60 million of COD income would be entirely excluded because it falls within the $70 million insolvency cushion.

Scenario 2 (Partial Exclusion): If the company had assets of $100 million against the same liabilities, it would be insolvent by only $50 million. In this case, $50 million of the COD income would be excluded, while $10 million would be taxable, resulting in a $2.1 million tax liability.

The Perverse Incentive

This rule creates a troubling dynamic. Companies with positive net worth or marginal insolvency face potentially catastrophic tax bills if they attempt equitization.

Rational behavior dictates waiting until insolvency deepens sufficiently to cover the anticipated COD income. This delay often destroys enterprise value as operations deteriorate during the waiting period, but tax law effectively compels it.

The excluded COD income does not disappear entirely. It requires a corresponding reduction in tax attributes:

• Net operating loss carryforwards

• Tax credit carryforwards

• Tax basis in assets

This defers rather than eliminates tax consequences, but the deferral is often sufficient to make restructuring viable.

Section 382: The NOL Limitation Problem

A second tax provision significantly impacts restructuring strategy: Section 382 of the Internal Revenue Code. 

This section limits the use of net operating loss (NOL) carryforwards when a company undergoes an "ownership change."

What Triggers Section 382

An ownership change is defined as a shift of 50 percentage points or more in ownership among 5% shareholders within three years. Most debt-for-equity conversions trigger Section 382 by definitionally creating massive ownership shifts.

When triggered, the annual limitation on NOL usage equals:

Company's equity value (immediately before ownership change) × Long-term tax-exempt rate (approximately 3.34% as of March 2024)

A Practical Example

For a company with a pre-restructuring equity value of $50 million:

• Annual NOL limitation would be approximately $1.67 million per year

• If the company has $200 million in NOL carryforwards, it would take 120 years to utilize them fully

• Most of the tax value is effectively lost

For companies whose primary asset is their NOL carryforward, Section 382 can make equitization economically irrational compared to alternative structures that preserve NOLs.

The Bankruptcy Exception

Section 382(l)(5) provides a limited exception for ownership changes occurring in bankruptcy, provided that qualified creditors held the debt for at least 18 months before the bankruptcy filing.

This bankruptcy exception is often the reason that companies ultimately choose Chapter 11 over an out-of-court equitization. It allows them to restructure while preserving valuable NOL carryforwards.

Partnership Structure Complications

The tax analysis differs substantially for borrowers organized as partnerships or LLCs taxed as partnerships.

Partnerships face fundamentally different and less favorable COD income treatment than corporations. While corporations have various mechanisms available to mitigate or defer COD income consequences, including the insolvency exception and subsequent attribute reduction under Section 108(b), partnerships operate under different flow-through rules.

In partnerships, COD income under Section 108(e)(8) flows through directly to the individual partners rather than being addressed at the entity level.

The Phantom Income Problem

This creates "phantom income" for the private equity sponsors or limited partners who hold the equity:

• They owe tax on the COD income that flows through to them

• They receive no cash distribution to pay that tax

• For a fund whose investment has already lost 80% of its value, an additional tax bill on phantom income is unacceptable

Example: A partnership completes a debt-for-equity swap, generating $60 million in COD income. This $60 million flows proportionally to all partners based on their ownership percentages. A limited partner with a 10% stake receives $6 million in taxable income reported on their K-1, potentially creating a tax liability exceeding $2 million, despite receiving no cash.

Strategic Implications

This tax friction explains why sponsors often resist consensual equitization and instead favor more aggressive liability management exercises that preserve equity value and avoid COD income recognition entirely.

For partnerships considering restructuring, the phantom income problem often makes Chapter 11 bankruptcy more attractive than out-of-court equitization, as bankruptcy proceedings may provide more favorable tax treatment and allow for better coordination of the restructuring with tax consequences.

Looking Ahead: The 2025 Landscape

The distinction between debt modification and debt extinguishment will remain central to corporate restructuring strategy throughout 2025 and beyond.

The 2028 Problem

The successful flattening of the 2025-2026 maturity wall through record amend-and-extend activity has provided temporary relief. However, it has simultaneously created a massive concentration of maturities now due in 2028.

If interest rates remain elevated and economic conditions fail to improve, the amend-and-extend playbook will be exhausted. Companies that have already extended twice will find lenders unwilling to extend again without significant principal reduction.

Intensifying Bifurcation

The bifurcation between credit qualities will intensify:

Strong Credits (B/BB Rated): Will continue to access modification transactions on reasonable terms.

Distressed Credits (CCC/C Rated): Face increasingly binary outcomes. For this lower tier, the question shifts from whether modification is preferable to whether equitization can be accomplished before value erodes to a point where only liquidation remains viable.

For businesses, lenders, and advisors navigating this environment, understanding the full spectrum from modification through equitization to true extinguishment is essential. 

Each approach serves different strategic objectives, carries distinct legal and tax consequences, and requires careful analysis of the specific facts and capital structure at issue.

Sources

• PitchBook LCD Leveraged Loan Market Update - https://pitchbook.com/news/articles/riskier-loan-issuers-push-back-maturity-wall-via-amend-and-extend-deals

• S&P Global Market Intelligence - Default and Recovery Studies - https://www.spglobal.com/ratings/en/research/articles/240314-are-prospects-for-global-debt-recoveries-bleak-13034374

• Moody's Investors Service - Monthly Default Report - https://www.moodys.com/web/en/us/insights/resources/us-report-july-2025.pdf

• AlixPartners Turnaround and Restructuring Survey 2024 - https://www.lexology.com/library/detail.aspx?g=853687da-c264-4679-91f6-7ea2565f733d

• NYU Stern - The Reemergence of Distressed Exchanges Study - https://pages.stern.nyu.edu/~igiddy/articles/distressed_exchanges.pdf

• Internal Revenue Code Section 108 (Cancellation of Debt) - https://www.law.cornell.edu/uscode/text/26/108

• Internal Revenue Code Section 382 (NOL Limitations) - https://www.law.cornell.edu/uscode/text/26/382

• IRS Publication 4681 - Canceled Debts and Repossessions - https://www.irs.gov/publications/p4681

• American Bankruptcy Institute - Bankruptcy Statistics - https://abi.org/newsroom/press-releases/bankruptcy-filings-increase-across-all-chapters-in-first-quarter-2024

• Cornerstone Research - Trends in Large Corporate Bankruptcy - https://www.cornerstone.com/insights/reports/trends-in-large-corporate-bankruptcy-and-financial-distress-midyear-2024-update/