The trading rules and conventions of the loan market are well known to its participants. Similarly, the laws and practices governing equity securities trading in the U.S. are quite familiar to securities market professionals. The opportunity for confusion may arise, however, when these two markets quickly converge—for example, when the loans of a reorganized borrower are converted into or satisfied by the issuance of equity securities.
Today, because “exit financing” or other capital for distressed borrowers is scarce, the reorganization and restructuring of borrowers often result in the issuance of equity securities to their lenders. As loan market participants receive equity distributions for their loans and subsequently trade “reorganization equity” on a stand-alone basis, they will be well-advised to understand the rules of engagement applicable to the securities market and trading in the equity portion of the capital structure.
This memorandum briefly frames the key securities law and related issues that can arise before and after reorganization equity is traded, and describes the advisable documentation conventions applicable to those trades.
WHAT IS REORGANIZATION EQUITY?
“Reorganization equity” refers to equity securities that are issued in connection with a reorganization or restructuring of a borrower, but are not registered as a class of securities under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) and therefore are not traded on an exchange or inter-dealer quotation system. Accordingly, this memorandum focuses on securities that do not trade publicly.
If the borrower has gone through a bankruptcy, reorganization equity is often issued pursuant to Section 1145 of the Bankruptcy Code when the borrower emerges from the Chapter 11 proceeding. Section 1145(a)(1) provides an exemption from the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”) for the issuance of securities by a debtor, or an affiliate or successor, in exchange for (or primarily in the exchange for) claims against the debtor.1
However, not all securities issued in a reorganization are necessarily issued under Section 1145. In some cases, securities might be issued pursuant to a Chapter 11 plan of reorganization but not under Section 1145 because they do not satisfy Section 1145’s “in exchange for a claim” requirement. A typical example is the sale of securities in a rights offering under a Chapter 11 plan for the purpose of raising fresh equity capital. More fundamentally, Section 1145 only comes into play when the reorganizing debtor is actually in bankruptcy. This means securities issued in an out-of-court restructuring by definition are not issued under the Section 1145 registration exemption.
Securities that a reorganizing borrower issues outside the realm of Section 1145 are often issued pursuant to the “private placement” exemption from the Securities Act registration requirements. A private placement typically relies on the registration exemption provided by Section 4(2) of the Securities Act or the “safe harbor” thereunder expressed in Regulation D under the Securities Act. Securities issued in reliance on Section 4 (2) or Regulation D are considered “restricted securities” within the meaning of Rule 144 under the Securities Act.2
BEFORE YOU TRADE REORGANIZATION EQUITY
A thoughtful approach to trading reorganization equity will require marshalling relevant facts about the securities and your trading counterparty, determining the applicable securities laws and other regulatory regime and preparing appropriate documentation.
Consider Information Parity
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit fraudulent, deceptive or manipulative practices in connection with the purchase and sale of securities. Rule 10b-5 has been interpreted to impose on a party who possesses material non-public information about an issuer, its business or its securities (“MNPI”)3 a duty to disclose the information or abstain from the trade.4 If the party in possession of MNPI chooses to disclose the information, it must heed the requirements of any relevant confidentiality undertaking, including the obligation to ensure that any recipient of the information is informed of, and agrees to maintain, the confidential nature of the information.
For an intermediary, such as a dealer, the information parity issue may become more complex. For example, the intermediary may buy the security from a party that possesses MNPI and simultaneously sell the security to a party that does not. Can the intermediary assume that since it does not possess the information, it can transact with seller without obtaining the MNPI, and also with buyer without delivering the information that seller possesses? While every case should be examined on its unique facts, where the intermediary has bought or sold from an insider, depending on the insider’s position and access to information, the identity of the counterparty alone may be deemed material non-public information. Caution is therefore advisable given the potential consequences of insider trading violations.
Many institutions rely on information walls to separate the business unit or desk of the firm that trades securities from another unit or desk that may come into possession of MNPI. While institutional management of information is outside the scope of this memorandum, when setting up the trading infrastructure for reorganization equity, due regard should be given to the effectiveness and verification of barriers that channel the flow of information within the institution. It is particularly important to put in place policies and procedures that create certainty with respect to how and when MPNI will be received and safeguarded.
Know Your Exemption from Securities Act Registration Requirements
Any offer or sale of a security is subject to the registration requirements of Section 5 of the Securities Act, unless an exemption from registration is available. It is therefore important to ascertain the exemptions available for a proposed resale of reorganization equity. This analysis forms the basis for some of the essential trading concerns we will discuss below.
Resales of Unrestricted Reorganization Equity
Reorganization equity issued in a transaction satisfying the requirements of Section 1145(a)(1) is deemed to be offered and sold in a “public offering.” This means the securities are not restricted, which in turn means the securities may be resold without registration in reliance on the exemption provided by Section 4(1) of the Securities Act (exempting transactions by any person other than an issuer, underwriter or dealer). If relying on the combination of Section 1145 and Section 4(1) in the resale of reorganization equity, parties will need to ensure that the relevant requirements are satisfied. A threshold issue to consider is whether the reorganization equity being traded was indeed issued under Section 1145, particularly if the plan of reorganization also provided for the issuance of certain other securities outside of Section 1145. In addition, since an affiliate5 of the issuer is an “underwriter” within the meaning of Section 1145, securities issued to the affiliate are not freely tradable under Section 4(1), even if issued in compliance with Section 1145(a)(1).
Resales of Restricted Reorganization Equity
Two registration exemptions are often used for resales of reorganization equity constituting restricted securities. Each method perpetuates the securities’ restricted status in the buyer’s hands, and must be conducted on a private basis.
The first exemption for the private resale of restricted securities is provided by Rule 144A under the Securities Act. Rule 144A generally states that a security that is not fungible with any class of securities listed on a national securities exchange or quoted on a U.S. automated inter -dealer quotation system may be offered or sold to “qualified institutional buyers”6 that have access to certain prescribed information about the issuer, if seller takes reasonable steps to make buyer aware that seller may be relying on Rule 144A as a registration exemption for the resale.
The alternative private resale exemption for restricted securities is known as “Section 4(1-½).” This is not a formal statutory registration exemption. It is a technique for transferring restricted securities, developed by the securities bar and recognized by the SEC as not requiring registration under the Securities Act. In essence, a Section 4(1-½) resale involves the selling security holder adopting the practices that an issuer itself would use to sell securities in a Section 4(2) private placement. This generally means limiting resale offers to “accredited investors;” making sure that the offer is made without any publicity or other “general solicitation;” and obtaining a representation from the purchaser that it understands the securities are restricted and will not resell them other than in compliance with the Securities Act.
Know Your Underlying Reorganization Equity Documents
Holders of reorganization equity often enter into a governing contract with the issuer, such as a shareholders agreement or limited liability company agreement. Such an agreement often imposes procedural or substantive requirements and restrictions on resales that have nothing to do with Securities Act registration exemptions. Substantive transfer restrictions may be driven, among other things, by other securities law concerns (e.g., “no transfer may result in the issuer becoming an Exchange Act reporting company”), by the issuer’s desire to limit transfers to certain types of investors (e.g., “no transfers to competitors”), or by the equity holders’ desire to have a preferential right with respect to each other’s shares (e.g., a right of first refusal with respect to a selling equity holder’s shares). Transfer restrictions also may be designed to protect the issuer’s tax or citizenship status.
An equity holders agreement may also prescribe procedural requirements for transfers. These might include, for example, advance notice of proposed transfers; a requirement that the seller provide an opinion of counsel that the transfer complies with the securities laws; or a requirement that the buyer execute an instrument of joinder to become bound by the terms of the equity holders agreement.
Confidentiality provisions may present another set of transfer-related issues under an equity holders agreement, in particular by limiting a holder’s freedom to share with a potential purchaser the periodic financial or management information delivered by the issuer under the agreement. Even if disclosure is permitted, the prospective transferee may be required to enter into its own confidentiality agreement with the issuer before gaining access to the information.
Finally, when investigating possible transfer restrictions, it is important to review the issuer’s certificate of incorporation or other organizational documents. A certificate of incorporation may limit transfers, for example, to preserve the issuer’s use of net operating loss carry-forwards or other tax attributes, or to ensure compliance with regulated industry rules that limit foreign ownership.
Know Whether You’re Subject to a Non-Securities Regulatory Regime
If the issuer of reorganization equity operates in a regulated industry, there is a separate set of pre-trade diligence issues. Frequently ownership restrictions apply, and foreign owners may be disfavored, resulting in particularly harsh trading conditions for entities that are formed offshore or unable to certify as to their U.S. ownership, due to their ownership structure and the relevant regulatory ownership attribution requirements.
These industries include, but are by no means limited to, aviation, banking, broadcasting, communication, gaming, insurance, transportation and utilities.
Under the Hart-Scott-Rodino Antitrust Improvements Act, acquisitions of voting securities in a U.S. company may require a buyer to file premerger notification reports with the Federal Trade Commission (the “FTC”) and the Department of Justice (the “DoJ”) if the transaction will result in a substantial holding by buyer of the issuer’s voting securities (the “size of the transaction” test) and the parties to the transaction are of a substantial size (the “size of the person” test). If reported, a substantial filing fee is required to be paid, and the transaction may be reviewed by the FTC and the DoJ, and cannot be consummated until the expiration or early termination of a statutory waiting period.7 It is therefore desirable to avoid entering into a transaction that requires premerger notification. Since the size of the person test is likely met in a transaction between financial institutions trading reorganization equity, parties should consider refraining from an acquisition that would meet the size of transaction test, or take precautions aimed at ensuring an exemption from the review is available.
Many states have anti-takeover statutes designed to impede unsolicited acquisitions of significant equity positions in companies formed in the state. While some statutes apply only to ownership stakes in public companies, others apply to private companies as well. These statutes may nullify the voting rights of shares held by an investor that has exceeded a certain ownership limit, unless the company’s other stockholders vote to restore the investor’s right. It is therefore desirable to confirm that any transaction in reorganization equity is under the relevant state-law threshold.
Be Aware of Potential Tax Issues
If the reorganization equity is stock in a corporation (or equity in an entity taxed as a corporation for U.S. income tax purposes) offshore investors will be subject to a 30% withholding tax (absent tax treaty protection) on any dividends paid on the reorganization equity. If the issuer of the reorganization equity is a U.S. real property holding corporation (generally a corporation that has more than 50% of the value of its assets attributable to U.S. real property interests), an offshore investor will also be subject to U.S. income tax on any capital gains from the sale of the reorganization equity.
On the other hand, if the issuer of the reorganization entity is not a corporation for U.S. tax purposes, the underlying income of the issuer will pass through to the equity holders, potentially creating income effectively connected with a U.S. trade or business for offshore investors, unrelated business taxable income for U.S. tax-exempt investors, and burdensome state tax filing requirements for U.S. taxable investors.
AFTER YOU ENTER INTO A TRADE
Most trades of reorganization equity will require straightforward, but tailored, transactional documentation negotiated between buyer and seller. This documentation often takes the form of a “securities transfer agreement” or similarly-styled document. The agreement serves several functions, including confirming information parity, establishing an exemption from Securities Act registration and verifying compliance with the provisions of the equity holders agreement in connection with the transfer.
As discussed above, information parity is an essential concern under the securities laws. The parties therefore would want to confirm in their trade documentation that each party has access to the same information that the other does, and each has the sophistication to understand the information and risks associated with trading reorganization equity. This confirmation takes the form of representations and acknowledgements from each party, and should apply to all trades in reorganization equity.
Since different trades of reorganization equity may rely on different exemptions from Securities Act registration, the securities transfer agreement should be tailored to reflect the specific exemption being used. For example, if the transfer is made in reliance on the combination of Section 1145 and Section 4(1), buyer would want to confirm that seller is not an affiliate of the issuer. If the transfer is made under Rule 144A, buyer would need to acknowledge that the transfer is in reliance on Rule 144A and that it has access to the issuer information prescribed by Rule 144A, and represent that it is a “qualified institutional buyer.” If the transfer is effected under Section (4-½), buyer would need to represent, among other things, that it is an “accredited investor,” and it is purchasing the securities for investment purpose and not with a view toward distribution in violation of the securities laws, and seller will represent that it has not engaged in general solicitation or advertising.
In addition to any agreement between buyer and seller in which issues under the securities laws are dealt with, the parties will need to take any transfer-related steps required by the equity holders agreement or otherwise imposed by the issuer. As noted above, these requirements may entail, among other things, delivery of notices, certificates or representation letters to the issuer, the buyer’s execution of a joinder agreement, delivery of a legal opinion or compliance with right-of-first refusal procedures.
Settlement of a securities trade between a securities intermediary (such as a broker-dealer) and its counterparty is also subject to the regulatory framework pertaining to extension of credit by securities intermediaries. Specifically, the Federal Reserve Board’s Regulation T requires that a broker-dealer obtain payment for the securities that it sells to a customer in a cash account within one payment period, i.e., five business days, from the trade date. In a delivery versus payment transaction, however, a broker-dealer is permitted to obtain payment within 35 calendar days, if “delivery of the security is delayed due to the mechanics of the transaction and is not related to the customer's willingness or ability to pay.” If settlement of a reorganization equity trade does not occur within the applicable time period, the broker-dealer will need to apply for an extension of the settlement period from its examining authority, the Financial Industry Regulatory Authority.
A trade of reorganization equity is a securities transaction. It therefore requires consideration of the legal and regulatory framework governing the purchase and sale of securities and the consequences of maintaining an equity position in the issuer. Appropriate legal due diligence should be conducted to ascertain the precise scope of permitted trading activities in connection with each issuer, giving due regard to the securities laws, other applicable regulatory regimes and the documents governing the terms of the reorganization equity. Negotiation of the trade documentation should be guided by each party’s need to comply with the securities laws. Even the settlement timeframe is subject to regulatory scrutiny, something unfamiliar to participants in the loan market or other unregulated trading markets.
While these issues may initially be unfamiliar to loan market participants, when considered within a well-developed and thoughtful transactional and compliance framework, the issues can be resolved in a way that should achieve a high degree of liquidity. As the historical development of other trading markets shows, given a certain legal framework and tailored transactional documentation, market participants can create a robust and liquid trading market in reorganization equity. This, in turn, will serve as a true “exit” for the loan positions held by loan market participants.