Recent declines in the trading prices of many companies' debt securities has created opportunities for those companies to reacquire a portion or all of that debt at substantial discounts through open market repurchases, privately negotiated transactions and tender offers. In some cases, the opportunities for discounted repurchases come to companies directly from investors seeking to sell the debt back in order to meet their own cash needs or otherwise obtain liquidity for thinly-traded securities.
Some companies, however, have been reluctant to take advantage of these opportunities because of the negative income tax consequences that usually accompany discounted debt repurchases. If your company is one of the reluctant ones, this week's enactment of The American Recovery and Reinvestment Act of 2009 ("Act") may encourage you to revisit the possibility of reducing your indebtedness through discounted debt repurchases, exchange offers or other debt restructuring techniques.
Tax Relief for Cancellation of Indebtedness Income Recognition
Companies repurchasing their outstanding debt at a discount typically must recognize cancellation of indebtedness ("COD") income based on the amount of the discount, which can serve to offset the positive effects of reducing indebtedness and doing so on attractive terms. Similarly, companies looking to restructure their existing debt through debt-for-debt or equity-for-debt exchanges usually must recognize COD income based on the difference between the amount owed on the outstanding debt and the fair market value of the new securities being issued. Significant modifications to outstanding debt, whether or not effected through an actual exchange, may be considered a "deemed exchange" and also can result in the company having to recognize COD income. These tax effects can act as a significant disincentive for companies that might otherwise try to reduce their debt using one or more of these techniques.
Tax relief provisions included in the Act encourage companies to repurchase or restructure their debt by allowing them to defer the recognition of COD income until a future date. Under these provisions, companies that complete repurchases and similar debt restructuring transactions in 2009 and 2010 that result in COD income may elect to defer recognition of that income for four or five years (depending on whether the transaction occurs in 2009 or 2010) and then begin to recognize the COD income ratably over the subsequent five year period (through 2018 or 2019, depending on whether the transaction occurs in 2009 or 2010).
This ability to choose to defer COD income recognition will apply to repurchases and restructurings taking the form of cash purchases by the company (including through negotiated purchases, open market purchases and tender offers), debt-for-debt exchanges (including a deemed exchange based on modifications to outstanding debt securities) and equity-for-debt exchanges. Entities organized as "C" corporations and pass-through entities ("S" corporations, LLCs and partnerships) that engage in qualifying repurchases and restructurings are eligible for this relief. Purchases by a "related person" of the company (such as a private equity/buyout sponsor) that result in COD income for the company also are eligible for this deferral.
Companies that choose to defer COD income also must defer any deductions for original issue discount relating to debt they issue in the restructuring transaction that gives rise to COD income (e.g., the replacement debt in a debt-for-debt exchange, or new debt issued for cash where the cash is then used to complete discounted repurchases of existing debt). These deferred deductions will get taken into account over the same period as the COD income is recognized.
Certain fundamental company events will accelerate the deferred COD income. Companies that choose to defer COD income will forego any ability to continue to defer recognition and must include all of the COD income in the tax year during which they wind-up, liquidate or sell all or substantially all of their assets.
Beyond The Stimulus - How To Do Repurchases and Restructurings
If the opportunity to defer COD income tax recognition might lead you to revisit the possibility of debt repurchases or some other form of restructuring, your next step should be to consult with your advisors, as debt repurchases and restructurings typically involve significant contract interpretation, securities law, tax law and accounting issues. Some of the important questions and topics for discussion with your advisors include:
- What is the nature of the debt to be repurchase or restructured? Straight debt or convertible? Senior or subordinated?
- How much of the outstanding debt will be targeted for repurchase? Can that amount be obtained from a small number of holders or only from a larger number?
- What will the purchase price be? A premium to market? Negotiated on a holder-by-holder basis?
- What are the legal issues relating to considering, implementing and completing a debt repurchase - relating to the company's contractual obligations, securities law compliance and disclosure rules and otherwise?
- What are the implications of exchanging new securities for the existing debt compared to purchasing the debt for cash?
The answers to these questions will be key drivers in your decision whether or not to pursue repurchases or restructurings and, if you do so, the preferred approach to effecting the repurchases or restructurings. While there are a variety of alternative approaches, the most common are:
- Cash purchases of the company's debt securities through privately-negotiated transactions;
- Cash purchases of the company's debt securities in open market transactions;
- Cash tender offers; and
- Offers to exchange a new debt or equity security for the existing outstanding debt securities.
Companies frequently combine privately-negotiated repurchases and open market repurchases, and these two alternatives are used primarily in situations where there are few holders of the debt and/or your goal is not to acquire a substantial portion or all of the outstanding debt securities. Cash tender offers are used primarily when circumstances make it likely or certain that the SEC's tender offer rules will apply, as would be the case in a broad-based offer for all of the outstanding securities of a particular debt issue on fixed/non-negotiable purchase terms. Cash tender offers also are used when you want to change terms of outstanding securities, as it is possible to tie the tender offer to the tendering holder's delivery of an "exit consent" to approve the desired changes (which will apply to any holders choosing not to tender).
Repurchases May Trigger Application Of The SEC's Tender Offer Rules
Certain of the SEC's tender offer rules apply to any form of security, whether equity, debt or convertible. Certain of those rules also apply whether or not the company's debt securities or any of its other outstanding securities are publicly traded. While the most stringent tender offer requirements apply to tender offers involving publicly traded equity securities (including securities convertible into publicly traded equity securities), tender offer rule requirements relating to tender offer timing, changes to the offer and anti-fraud protections will apply to repurchases of straight debt securities if the repurchases constitute a tender offer.
Determining whether or not your planned repurchases may constitute a tender offer is often a difficult task, as there is no statutory definition or "bright line" test for making the determination. Repurchases made for modest amounts of outstanding debt securities in the open market at market prices over a substantial period of time are not likely to trigger application of the tender offer rules, particularly if you are not actively soliciting repurchases and are not pressuring holders to sell. Privately-negotiated repurchases of modest amounts of your outstanding debt securities from a few holders also are not likely to trigger application of the tender offer rules, particularly if the terms of the repurchases vary among the holders based on your separate negotiations with them. The analysis becomes more complex, however, when some common variations are added. Adding to the amount targeted for repurchase, actively soliciting repurchases from a larger number of holders, setting a specific price and other repurchase terms applicable to all sellers and setting time constraints on holders agreeing or not agreeing to sell, either individually, or in combination, could lead to the conclusion that the repurchases are actually a tender offer. In addition, debt-for-debt or equity-for-debt exchange offers are more likely than not to be considered tender offers.
There may be circumstances in which the benefits of engaging in repurchases that are tender offers outweigh the related compliance burdens. The rules applicable to tender offers for straight debt securities are not as onerous as is the case for tender offers for widely-held, publicly traded stock, so you may determine that complying with the tender offer rules is justified in order to achieve your goal.
Repurchases Often Create Disclosure Issues
Repurchases and restructurings can create disclosure issues for both public and private companies. The anti-fraud provisions of Exchange Act Rule 10b-5 apply equally to public and private companies and apply to repurchases by an issuer of its debt securities just as they apply to other purchases and sales of securities. As a result, you will need to determine whether the company is in possession of any material non-public information that should be disclosed, either to the public generally (in connection with an open market repurchase plan or tender or exchange offer) or to individual potential sellers (in connection with privately-negotiated repurchases). Any necessary disclosure must be provided prior to making any repurchases or exchanging securities in a restructuring.
In view of the potential Rule 10b-5 liability exposure, some companies choose to engage in repurchases following their regular earnings releases. Others adopt repurchase plans under Exchange Act Rule 10b5-1 that are designed to operate automatically and can mitigate potential Rule 10b-5 liability exposure. Company affiliates (related persons) interested in engaging in repurchases also need to consider whether they must disclose material non-public information in their possession.
A common disclosure issue is whether the company's plan to repurchase its debt securities itself is sufficiently material as to require public disclosure prior to the company making any repurchases. In general, repurchases of modest amounts of outstanding debt using available cash should not trigger a requirement to disclose your plans to the public. The analysis becomes more complex, however, as more facts and circumstances are added -- for example, increasing the amounts to be repurchase, using a significant portion of the company's available cash, funding the repurchases by incurring other debt or issuing equity, and diverting funds away from announced strategic initiatives to complete the repurchases may, singly, or in combination, lead to the conclusion that disclosure is necessary. In addition, statements the company has made in the past or actions it has taken or not taken may make it necessary to update those prior public statements or provide new disclosure prior to engaging in repurchases -- for example, if the company has publicly stated in the past that it does not intend to engage in any repurchases, disclosure may be necessary.
Some companies attempt to address this disclosure issue generally by including statements in their Exchange Act reports as to their possible re-acquisition of outstanding debt through repurchases or other means. While this approach may be sufficient under many circumstances, each repurchase situation should be analyzed independently. And even if you determine that prior disclosure of planned repurchases is not necessary, you should consider the possible disclosure implications of any repurchases or restructuring when preparing the company's Form 10-K, Form 10-Q and other SEC filings.
Disclosure in the context of privately-negotiated repurchases can create additional issues for public companies. While disclosure of material non-public information to the potential seller may be necessary to protect the company from possible Rule 10b-5 claims, making that disclosure to the individual seller could cause issues under Regulation FD if that information is not disclosed generally to the market. The simplest approach to address this issue is for the company to obtain a potential seller's agreement to keep confidential any information disclosed to the potential seller.
Existing Agreements Can Include Repurchase Roadblocks
A thorough review of the company's key contracts is essential prior to pursuing repurchases or restructurings. These contracts may include prohibitions, limitations or conditions on repurchases or restructurings, and it is important to determine whether the adverse effects of those provisions can be avoided or mitigated by choosing a particular transaction structure or alternative funding approach. The indenture covering the debt you are targeting for repurchase or restructuring, indentures covering other company or affiliate indebtedness and agreements relating to your credit facilities often include provisions affecting the company's ability to repurchase or restructure debt. In addition, limitations and restrictions can show up in a variety of other places, including preferred stock designations, shareholder agreements, joint venture agreements and guarantees.
The restrictions can take the form of direct prohibitions or limitations on the amount of debt that may be repurchased, or be of a more indirect nature, as is the case where using existing cash resources for repurchases or funding repurchases through the incurrence of new debt may adversely affect covenants requiring the company to maintain certain ratios or available cash. In some cases, you may need to obtain waivers or consents prior to making any repurchases or undertaking a restructuring. Your existing indentures and other agreements also may require the company to provide notice of planned repurchases or restructurings. If so, the notice requirements need to be considered in the context of the company's plans to publicly disclose (or not disclose) its plans.