A group of more than 50 fixed income investment managers, The Credit Roundtable, has just proposed a set of model covenants for investment grade bonds. The proposed model covenants are contained in a “White Paper” (available at www.creditroundtable.org), that addresses perceived shortcomings in current protections in investment grade bond deals which, in the view of the investment managers, have eroded over time. Investment firms supporting the White Paper include AIG Investments, Aetna, Allstate Investments, Brock Rock Financial Management, Dodge & Cox, PIMCO, TIAA-CREF and The Vanguard Group.
The White Paper contains model covenants relating to:
- Step-up Coupons,
- Limitations on Liens and Priority Debt,
- Reporting Obligations, and
- Voting by Series.
In addition, the White Paper calls for “verbatim disclosure of indenture provisions in offering documents.” The White Paper explicitly rejects “plain English” descriptions of covenants. Nothing in the White Paper suggests that The Credit Roundtable has received any SEC support for the assault on “plain English” disclosure, and it is unclear how The Credit Roundtable intends to implement its position in the face of SEC requirements.
Change-of-Control. Change-of-control covenants permit bond holders to “put” their bonds to the issuer in the event of a change-of-control. The White Paper indicates that investors believe that many existing forms of these covenants do not permit “puts” in all appropriate circumstances. The model change-of-control covenant adopts a standard definition of change-of-control which includes (i) any stock-for-stock merger, unless the issuer’s stockholders end up with more than 50% of the voting stock of the surviving company, and (ii) a sale of all or substantially all the assets of the issuer. The White Paper’s preferred approach is to eliminate “double-trigger” change-of-control covenants that require both a change-of-control and a ratings downgrade below investment grade before the change-of-control put is triggered. The White Paper, however, does offer a model double trigger covenant that requires only “a temporal link between the change-of-control and the rating decline.” In other words, the rating agencies would not be required to state that the change-of-control caused the downgrade in order for the put to become exercisable.
Step-up Coupons. Step-up covenants are designed to increase the interest rate on bonds if the issuer’s credit deteriorates as evidenced by a downgrade or the discontinuation of rating by the rating agencies. The model covenant proposes to modify step-up coupons in two ways. First, issuers would face an increased interest rate if more than one out of three identified ratings agencies cease to rate the bonds. Issuers would not be permitted to replace rating agencies in an attempt to avoid a ratings downgrade. Second, “fall-away” provisions, which eliminate the step-up terms if the bonds are upgraded to a higher rating, would be eliminated. In that way, investors would continue to be protected against future downgrades.
Limitations on Liens and Priority Debt. The White Paper proposes a model lien covenant restricting many prevalent exceptions and carve-outs currently enabling issuers to incur additional debt that is effectively senior to outstanding bonds. The model covenant would:
- limit borrowings by non-guarantor subsidiaries to limit structural subordination;
- apply the covenant to each of an issuer’s subsidiaries and eliminate the concept of “unrestricted subsidiaries” also to limit structural subordination;
- eliminate the ability of issuers to place liens on assets that fall outside the definition of “Principal Property;” and
- remove the “equal and ratable” clause that currently permits additional secured debt to be incurred so long as the outstanding debt is also secured.
Reporting Obligations. Under the White Paper, issuers that terminate their obligation to make SEC filings would continue to be required to provide note holders with unaudited quarterly and audited annual financial statements, together with an MD&A and to make these reports available on a public-access website.
Voting by Series. Some indentures currently permit certain amendments and waivers to be adopted by a majority of the aggregate principal amount of bonds outstanding under the indenture regardless of the different interests of different series. The model provision would require voting on indenture amendments or waivers by individual series of bonds.
Future of the Model Covenants. Although current credit market conditions have improved the market power of investors, the ability of fixed income investment managers to implement the model covenants will be determined over time as new issuances of investment grade debt come to the market. As the White Paper acknowledges, the model provisions will need to be tailored to “the circumstances of particular issues and particular market conditions.” In addition, further discussions by issuers and investors will be required to overturn the SEC’s position on “plain English” disclosure for note terms.