FINANCING FOR NEW private equity-backed acquisitions has all but dried up as a result of the ongoing credit crisis. However, for those companies already in the portfolio, market events have, in many cases, created an opportunity to reduce leverage by repurchasing outstanding bonds at a deep discount.
Open-market purchases are the simplest way for an issuer to repurchase its debt securities. They often can be completed quickly and require minimal or no documentation, resulting in modest transaction costs.
However, before engaging in open-market bond repurchases, an issuer must be sensitive to a number of potential legal landmines.
Avoiding Insider Trading Claims
The anti-fraud rules under the federal securities laws prohibit an issuer from repurchasing its securities while in possession of material nonpublic information. Under case law, information is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in deciding whether to sell its securities. Whether particular information is material is determined by the particular facts and circumstances; there is no bright line test. Examples of information that may be considered material include the following: (1) historical financial information for the most recently completed financial period; (2) projected financial results or changes in business outlook; (3) acquisitions, dispositions and other significant transactions; (4) new material contracts or other business relationships; and (5) restructuring or refinancing plans.
To mitigate insider trading risk, an issuer often will repurchase bonds only during a prescribed window period, beginning after the issuer releases earnings and ending before it has visibility as to the next quarter’s earnings. If, during the window period, the issuer comes into possession of material non-public information, it must cease further open-market repurchases of its bonds.
An issuer also must evaluate whether the decision to repurchase its debt securities is itself material information that needs to be disclosed to investors prior to commencing repurchases. In most cases, a plan to repurchase debt in open-market transactions is unlikely to constitute material non-public information. However, because there is no bright line materiality standard and the analysis is fact-specific, some issuers first opt to issue a press release, file a Form 8-K or make disclosure in a Form 10-Q or Form 10-K indicating their intent to engage in openmarket bond purchases.
Complying with Regulation FD
If an issuer concludes that the intent to engage in openmarket repurchases is, in and of itself, material non-public information, it also must be sensitive to compliance with Regulation FD. Regulation FD generally prohibits selective disclosure of material non-public information to investors, analysts and other market professionals unless the recipient agrees to keep the information confidential. Absent a written or verbal agreement by a recipient to keep information confidential, Regulation FD requires broad-based disclosure of the information before it can be shared with the recipient.
Navigating the Tender Offer Rules
A bond tender offer is required to comply with the Exchange Act’s tender offer rules. The tender offer rules generally require that a bond tender remain open for at least 20 business days and 10 business days following a change in the offering price or the percentage of securities being sought. In addition, in the equity context, the SEC has indicated that an offer must remain open for at least 5 business days following any other material change in the terms of the offer. Convertible debt securities are subject to additional requirements, which are not discussed in this article, since those securities are treated as equity securities under the tender offer rules.
The federal securities laws do not define what constitutes a “tender offer.” Therefore, there is no bright line division between open-market purchases and a tender offer. The issuer must instead apply an eight-factor test derived from case law, which looks at whether:
- there is active and widespread solicitation of security holders;
- the solicitation is made for a substantial percentage of the issuer’s securities;
- the offer to purchase is made at a premium over the market price;
- the terms of the offer are firm rather than negotiable;
- the offer is contingent on the tender of a fixed amount of securities or subject to a fixed maximum amount to be purchased;
- the offer is open only for a limited period of time;
- the offeree is subject to pressure to sell its securities; and
- public announcement of a purchase program precedes or accompanies rapid accumulation of large amounts of securities.
No single factor is dispositive in determining whether a repurchase transaction constitutes a tender offer, and the conclusion always depends on the facts and circumstances. However, most open-market repurchase transactions are unlikely to implicate the tender offer rules, even if a fairly significant percentage of bonds is acquired, since repurchases tend to occur over time, involve a small number of sellers, are at prevailing market prices and for available quantities, and are not coercive. Nevertheless, given the lack of clarity in this area, it is prudent for an issuer to consult with counsel regarding the parameters of its repurchase program before commencing purchases.
Complying with Debt Covenants
Open-market bond repurchases must navigate restrictive covenants contained in the issuer’s other debt instruments, including credit facilities and indentures of more senior series of bonds.
For example, a bond repurchase may constitute an “investment” or “restricted payment” under a credit agreement. Similarly, where the issuer has issued bonds at different levels in the capital structure—such as senior notes and senior subordinated notes—the senior notes indenture may limit the amount of subordinated notes that may be repurchased without violating the restricted payments covenant. The restricted payments covenant may require the issuer to either rely on the covenant’s net income buildup or utilize a catch-all basket to repurchase subordinated notes.
Although an issuer can seek a waiver of a covenant, this often is expensive and time-consuming. In addition, if the issuer has bank debt or privately placed notes that are widely held, a waiver might not be practical.
Taking Tax into Account
Open-market purchases of debt usually result in cancellation of indebtedness (“COD”) income, which arises when an issuer purchases debt in exchange for consideration that is less than the adjusted issue price of the debt. The amount of taxable income generated is equal to the difference between the amount paid to repurchase the debt and its face amount (in the case of debt issued without original issue discount (“OID”)) or its adjusted issue price (i.e., its issue price plus any accrued OID, in the case of debt issued with OID).
The issuer also will have COD income to the extent that bonds are purchased by a person related to the issuer. The determination of who is related to the issuer for this purpose is highly technical. In many cases, the person that desires to purchase the issuer’s debt is the fund that sponsored the acquisition of the issuer (or any entity created by that fund). The sponsoring fund (or the entity created by it) will generally be “related” for purposes of the COD rules. Under the tax code, related-party purchases are treated as if they were a repurchase by the issuer coupled with the issuance of new debt at the purchase price paid by the related person. This “deemed reissuance” of the debt generally results in the “new” debt being treated as issued with OID. Accordingly, following the deemed reissuance, the issuer is generally entitled to OID deductions, but the related person must include accrued OID in its income for tax purposes.
During February 2009, however, new legislation was adopted as part of Congress’s fiscal stimulus plan that allows borrowers to defer taxes on COD income for five years following the date of repurchase for debt cancelled in 2009, and for four years for debt repurchased in 2010. Following the end of the deferral period, the COD income must be included ratably in income over the subsequent five years.
Being Mindful of Affiliate Issues
As discussed above, a sponsor may wish to make openmarket purchases through an up- the-chain affiliate of the issuer. If so, in addition to the considerations discussedearlier, the sponsor will need to navigate potential conflicts of interest if issuer debt is purchased through a different fund than that which holds the equity investment. The sponsor will need to be sensitive to divergent interests between debt and equity holders, resolving any conflicts of interest in accordance with each fund’s limited partnership agreement. Up-the-chain debt ownership also may raise additional fiduciary duty considerations at the portfolio company level, such as when the portfolio company has publicly traded minority equity or is in the zone of insolvency.
The affiliated purchaser also must be sensitive to the possibility of attempts to equitably subordinate its claims. In bankruptcy, a court may subordinate an affiliate’s claims to those of other debtholders or invalidate any liens securing notes held by the affiliate if the court concludes that the affiliate used its relationship with the debtor to obtain an unfair advantage or benefit that resulted in a cognizable harm to other creditors.
Finally, if the affiliate intends to resell bonds prior to maturity, it needs to be sensitive to restrictions on its ability to do so. It may not engage in resales while in possession of material non-public information. In addition, absent registration for resale of the bonds under the Securities Act, the affiliate also may be subject to a holding period of as long as one year and resales will be subject to volume limitations under Rule 144, which limit the affiliate to resales in any three-month period equal to not more than 10% of the total series.
Considering Alternatives to Open-Market Repurchases
Notwithstanding their ease of completion, open-market repurchases may not enable the issuer to repurchase the desired amount of bonds or to accomplish its other financing goals. The issuer may instead opt to conduct a cash tender offer or an exchange offer.
A cash tender offer may be effected as part of a refinancing in parallel with a new issuance or on a stand-alone basis as a deleveraging transaction. As discussed above, a debt tender must be held open for a minimum time period. The tender offer can be either at a fixed price or a price based on a formula, such as a spread over treasuries. In connection with a debt tender, an issuer prepares and distributes an offer to purchase; however, unlike in the equity context, the offer to purchase is not required to be filed with the SEC.
Alternatively, as part of a refinancing transaction, the issuer may seek to exchange existing bonds for new securities, such as debt with a later maturity date or equity securities.
Exchange offers raise a number of additional considerations not presented by cash tender offers. First, because an exchange offer involves a new issuance of securities, it may need to be analyzed under, among other things, the debt incurrence and lien restrictions contained in the issuer’s existing debt instruments to the extent that the covenants in those instruments will remain in place following the exchange offer.
An exchange offer also is subject to the requirements of the Securities Act, since it involves the offer and sale of a new security. The securities to be issued must either be registered with the SEC on a Form S-4 or issued pursuant to an exemption from registration. Issuers often shy away from registered exchange offers, which can be expensive and typically require significant lead time to launch.
There are two applicable Securities Act exemptions. Section 3(a)(9) provides an exemption from registration for an issuer making an exchange offer exclusively to its existing securityholders where no compensation is paid for the purpose of soliciting holders to exchange their securities.
In many cases, an issuer will need the assistance of a paid solicitation agent to complete an exchange offer, either because of the number of bondholders or the complexity of the restructuring transaction. Although a Section 3(a) (9) exchange offer does not prohibit all advisory fees, the limitation on paying compensation for soliciting bondholders often makes the Section 3(a)(9) exemption impractical.
Alternatively, an exchange offer may be able to be structured as a private exchange—i.e., a transaction not involving a public offering—since, following their issuance, high yield bonds continue to be held overwhelmingly by qualified institutional buyers. The disclosure in a private exchange offer is similar to what would be included in a Form S-4, although the timetable is shortened because no SEC filing is required. The issuer also is not subject to the restrictions of Section 3(a)(9).
Both tender offers and exchange offers often are structured to include a consent solicitation. Indentures typically allow most covenants to be stripped out by a vote of a majority in interest of the bondholders. In connection with tendering bonds, the holder agrees, for an extra consent payment, to vote those bonds to remove the covenants relating to the tendered series. This incentivizes holders to tender and often facilitates other pieces of a broader refinancing transaction.