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High-yield debt securities versus bank loans
Discuss the major differences between high-yield debt securities and bank loans in your jurisdiction. What are some of the critical advantages and disadvantages?
One of the key differences of high-yield debt securities compared with bank loans is the limited flexibility in approaching investors and soliciting required waivers or consents. While a borrower of a bank loan has the possibility to easily approach the limited number of lenders, either directly or through the lenders’ agent, and can agree with them on any waivers or consents within short lead times and without major effort, the issuer of a high-yield bond has to communicate with a broad investor base, via the clearing system, public announcements and the trustee or common representative of the bondholders, which it will only know in part, if at all, due to the tradability of the securities.
The solicitation of waivers or consents relating to high-yield bonds, including any amendment of the indenture (in the case of a bond governed by New York law) or the conditions of issue (equivalent to the indenture in an issuance governed by German law) requires a formal process that is time-consuming and costly for the issuer (see question 9). This is the main reason why high-yield covenants typically provide more flexibility than the covenants under a credit agreement, which are often designed to require a borrower to solicit consents or waivers from its lenders for particular actions deviating from its ordinary course of business. Accordingly, the solicitation process, with respect to a bank loan and the amendment of the credit agreement, is fairly common and less onerous.
Other key differences between high-yield debt securities and bank loans are the extensive disclosure of company-related information (including financials) to be prepared for the offering of a high-yield bond, which is in most cases very time-consuming and costly (see question 15), as well as the required public ratings (see also question 4). Furthermore, issuers of listed high-yield debt securities are subject to applicable statutory securities laws and stock exchange rules (see question 2).
From an investor’s or lender’s perspective, one of the differences between high-yield debt securities and bank loans is that, according to German law, a bank licence is required to grant a loan to a German company, while there is no statutory licensing requirement with respect to an investment in high-yield debt securities.
Are you seeing increased regulation regarding either high-yield debt securities or bank loans in your jurisdiction?
High-yield debt securities issued by German issuers are usually listed on a stock exchange-regulated unofficial market or another multilateral trading facility (MTF) within the meaning of the EU Directive on Markets in Financial Instruments (MiFID II) (Directive 2014/65/EU), for example, the Euro MTF Market of the Luxemburg Stock Exchange or the Global Exchange Market of the Irish Stock Exchange. Unlike under the previous market abuse regime, since 3 July 2016, the requirements set forth by Regulation (EU) No. 596/2014 (the European Market Abuse Regulation) apply to all issuers whose high-yield debt securities are listed on a stock exchange in the European Economic Area (EEA), irrespective of whether they are admitted to trading on a regulated market within the meaning of Directive 2014/65/EU or traded on an MTF.
The Market Abuse Regulation defines certain key areas of capital market law at European level and imposes, in particular, the following duties on issuers:
- keeping insider lists and making insiders aware of applicable prohibitions;
- disclosing inside information relating to the issuer or the listed securities and complying with documentation and notification obligations in the event of delayed disclosure of inside information and regarding market soundings; and
- disclosing transactions conducted by persons discharging managerial responsibilities at the issuer (managers’ transactions) or persons closely associated with these, keeping insider lists of persons affected and making them aware of what their duties are with regard to such transactions.
MiFID II, which took effect from 3 January 2018, introduced, among other things, new product governance rules which apply to investment firms that are established in the EEA and subject to MiFID II (MiFID firms) when, inter alia, advising corporate issuers on the launch of financial instruments (including high-yield debt securities) or when offering or recommending financial instruments to investors. MiFID firms must, inter alia, ensure that financial instruments they manufacture are consistent with the needs, characteristics and objectives of an identified target market of investors and that the strategy for distribution of the financial instruments is compatible with the identified target market. However, compliance with these rules should not be too onerous for MiFID firms acting as initial purchasers in a high-yield bond offering, given that high-yield bonds typically only target institutional investors. In addition, MiFID II requires MiFID firms to provide a justification for the final allocation of the offered securities if the order book is oversubscribed, as is usually the case in practice.
Current market activity
Describe the current market activity and trends in your jurisdiction relating to high-yield debt securities financings.
Activity in the German high-yield market was relatively low in 2017 and the first months of 2018 compared with other jurisdictions and the issuance levels of previous years, which, according to market observers, was partially due to greater availability of financings by covenant-lite loans.
While the majority of high-yield bonds issued in the German market are governed by New York law (the issuance procedure and documentation of these bonds follow the typical structure and provisions of New York law governed high-yield bonds), since 2009, there have also been some high-yield bond issuances under German law. However, given that there were only a few German laws governed high-yield bond issuances in the last couple of years, it will be interesting to see whether German law will be chosen as governing law by German high-yield bond issuers more frequently in the future.
In Germany, high-yield debt securities are typically exclusively offered to institutional investors; more precisely, ‘qualified investors’ within the meaning of section 2, No. 6 of the Securities Prospectus Act. To a certain extent, we are seeing overlaps between investors that invest in high-yield debt securities and loan financings.
In line with common practice, high-yield bonds of German issuers are usually guaranteed by all group companies that guarantee the credit facility and other material debt of the company.
Identify the main participants in a high-yield debt financing in your jurisdiction and outline their roles and fees.
The key parties, besides the issuer and the guarantors, the auditors and the legal counsel to the issuer and the initial purchasers, involved in the typical issuance of a German law governed high-yield bond are listed below:
- Initial purchasers: the role of the initial purchasers is to advise the issuer on the structure and timing of the offering and to coordinate and market the transaction. They purchase the securities from the issuer under the terms of the purchase agreement and resell them to investors.
- Common representative of the bondholders: unlike under a New York law governed high-yield debt financing, there is no noteholders’ trustee in the case of a German law governed high-yield bond. Instead, there is a common representative of the bondholders whose duties and rights are set forth in the conditions of issue of the bond and the Act on Debt Securities of 2009 (SchVG) and can be extended by majority resolution of the bondholders.
- Security agent: the security agent is party to the intercreditor agreement and the security documents. Its main role is to enforce the collateral securing the notes in an enforcement scenario.
- Paying agent: the paying agent is, in particular, responsible for routing payments of principal and interest through the clearing system to the bondholders.
- Book-entry registrar: the central securities depositary - typically, Clearstream Banking AG or Clearstream Banking, société anonyme and Euroclear Bank SA/NV - acts as book-entry registrar in respect of the notes. In this role, it keeps the global notes in custody and maintains records of them.
- Rating agencies: typically, ratings are issued by two of the big three rating agencies - Fitch, Moody’s and Standard & Poor’s.
The fees of the initial purchasers are typically calculated as an individually agreed percentage of the aggregate principal amount of the notes, while the other parties listed above receive market standard flat fees in connection with their engagement.
Describe any new trends as they relate to the covenant package, structure, regulatory review or other aspects of high-yield debt securities.
Generally, trends in the high-yield documentation are driven by the state of the market, with covenants getting looser and providing issuers with more flexibility, in particular with respect to the incurrence of debt and restricted payments, in times of increasing investor demand for high-yield debt securities, and covenants tightening up in times of lower investor demand.
How are high-yield debt securities issued in your jurisdiction? Are there particular precedents or models that companies and investors tend to review prior to issuing the securities?
Prior to issuing a high-yield bond, the deal team will review the main transaction documents prepared in connection with relevant recent precedents, including, in particular, the offering document, the indenture (in the case of a bond governed by New York law), the conditions of issue (in the case of a bond governed by German law) and the purchase agreement. Relevant precedents include previous issuances by the same issuer, if not a debut issuer, issuances by other companies operating in the same industry sector as the issuer and precedents for companies with a similar credit profile. Often, it is agreed that the documentation of a certain precedent will serve as a basis for drafting. The lead bank’s (and, in a sponsor deal, also the sponsor’s) standard covenant form typically also plays an important role in negotiating the covenants.
Maturity and call structure
What is the typical maturity and call structure of a high-yield debt security? Are high-yield securities frequently issued with original issue discount? Describe any yield protection provisions typically included in the high-yield debt securities documentation.
The maturity of high-yield bonds issued so far under German law has ranged from four to 10 years, with most of these bonds having a maturity of seven years (the average life for European high-yield bonds) or five years.
For a certain period after the issuance date (non-call period), issuers can typically redeem all or a part of the notes at a redemption price equal to 100 per cent of the principal, plus accrued interest and a make-whole premium. In addition, during the non-call period, the issuer is usually permitted to redeem a portion of the notes, typically up to 35 per cent or 40 per cent of the aggregate original principal amount - at a specified redemption price plus accrued interest with the net proceeds of an equity offering (equity clawback). At any time after the expiration of the non-call period, the issuer may redeem all or a part of the notes at specified redemption prices (declining rateably to par).
How are high-yield debt securities offerings launched, priced and closed? How are coupons determined? Do you typically see fixed or floating rates?
The process of launching, pricing and closing high-yield debt securities offerings of a German issuer follows the steps and mechanics of a typical high-yield offering. The offering is launched by distributing the preliminary offering memorandum (also referred to as ‘Red’) to investors (sometimes there is a pre-marketing on the basis of a draft preliminary offering memorandum (also referred to as ‘Pink’)). Following a roadshow, which can vary between two days and two weeks, and the completion of book-building, the terms of the deal (ie, the coupon, issue price, maturity, etc) are agreed between the banks and the issuer on a pricing call. Immediately after pricing, the purchase agreement is signed according to which the initial purchasers agree to purchase the notes. Typically, high-yield debt securities offerings close three business days after pricing (T+3).
Most high-yield bonds have a fixed coupon. The coupon is determined based on investor demand, which in turn depends on several factors, including, among others, general market developments, the financial condition of the issuer, the covenant package and the prospects for the industry in which the issuer is operating.
Describe the main covenants restricting the operation of the debtor’s business in a typical high-yield debt securities transaction. Have you been seeing a convergence of covenants between the high-yield and bank markets?
The covenants always seek to strike a balance between protection of the bondholders’ investment (eg, by preventing the issuer from undertaking new obligations that could divert the issuer’s cash flows and disposing of assets for less than their equivalent value) and the legitimate needs of an issuer to be able to run its business without undue restrictions and to have the flexibility to grow and execute its business plan.
The typical high-yield covenant package of a German issuer does not materially differ from the covenant package of other European or US issuers and includes the typical set of incurrence-based covenants. Such covenants are tested at the time of taking a certain action, as opposed to maintenance covenants that require compliance with specified terms on an ongoing basis and are typically included in credit agreements, and include issuer-specific (and, to the extent customary, industry-specific) modifications and individually negotiated baskets and exceptions. Covenants restricting the business operations of the restricted group, consisting of the issuer and its restricted subsidiaries, include, among others, limitations on:
- restricted payments and investments;
- asset sales;
- transactions with affiliates; and
- mergers and consolidations.
The covenants and related provisions, such as termination rights, included in the conditions of issue of high-yield bonds governed by German law largely correspond to the covenants and other provisions typically included in indentures of bonds governed by New York law. However, there are certain distinctions reflecting the rules and legal concepts set forth in the SchVG - for example, the concept of majority resolutions to be passed by the bondholders in a meeting in person or in a vote without a meeting (ie, through a written or electronic process) with binding effect for all bondholders, irrespective of how they voted or whether they participated in the vote. While high-yield bonds governed by New York law typically have consent thresholds as percentages of the aggregate outstanding principal amount of the notes, high-yield bonds governed by German law have consent thresholds based on percentages of the votes cast by bondholders. As a general rule, for any resolution that significantly affects the interests of the bondholders - including, for example, any amendments or waivers to restrictive covenants a majority requirement of 75 per cent of the bondholders voting on the matter needs to be met under the SchVG (save for a higher majority requirement set forth in the conditions of issue for a certain matter).
According to the SchVG, any other amendments and waivers to the conditions of issue that do not significantly affect the interests of the bondholders can be passed with a majority of at least 50 per cent. In addition, any resolution of the bondholders requires that a quorum of 50 per cent of the aggregate outstanding principal amount of the notes participate in the vote. If such quorum is not met, a second meeting can be convened, which only requires a reduced quorum of 25 per cent.
In line with the typical termination concept provided for in indentures governed by New York law, the conditions of issue of several German law governed high-yield bonds issued in recent years contained a provision according to which bondholders representing at least 25 per cent of the principal amount of outstanding notes may terminate the notes with effect for all bondholders, whereby such acceleration can be rescinded by simple majority resolution of the bondholders. However, the concept of whether an acceleration by a minimum quorum of bondholders with effect for all outstanding notes is possible at all under the rules of the SchVG and, assuming this is the case, whether a simple majority vote would be sufficient for the rescission of a termination declared by the minimum quorum of bondholders is subject to discussions in German legal literature and has not yet been tested by German courts.
Against this background, it cannot be excluded that a German court will conclude that an acceleration declared by bondholders representing at least 25 per cent of the principal amount of all outstanding notes will only affect the notes held by the bondholders having declared a termination and will have no effect on the bondholders not having accelerated their notes, or that the rescission of a termination declared by a minimum quorum of bondholders requires a qualified (instead of a simple) majority vote of the bondholders.
In line with the typical payments for consent provisions contained in indentures governed by New York law, the conditions of issue of a couple of German law governed high-yield bonds issued in recent years provided for a covenant according to which the issuer, if paying a consent fee, shall pay such fee to all bondholders that consent to certain amendments or waivers proposed by the issuer in a consent solicitation. However, paying a fee only to the consenting bondholders would violate the legal principle set forth in section 6, paragraph 3 of the SchVG, which prohibits making any payment to a bondholder as consideration for voting in a certain way. If a fee is paid by the issuer in connection with a consent solicitation, it has therefore to be paid to all bondholders participating in the vote. This should be reflected when drafting the language of the relevant covenant.
Another notable difference between New York law and German law governed high-yield bonds is that the solicitation process for high-yield bonds governed by German law follows the formal rules set forth in the SchVG (including specific procedures for voting to be complied with by bondholders), which provide less flexibility than the typical procedures for solicitation processes with respect to high-yield bonds governed by New York law.
As regards a convergence of covenants between the high-yield and bank loan markets, we have recently noticed some German law governed promissory notes (a promissory note is legally a loan) that were issued by borrowers with lower credit ratings and whose documentation contained typical high-yield elements.
Are you seeing any tightening of covenants or are you seeing investor protections being eroded? Are terms of covenants often changed between the launch and pricing of an offering?
The individual design of covenants depends on the specific issuer and also tracks the general development of the high-yield market (with covenants tending to be tighter if demand is low and investors becoming more selective). It is not unusual for the terms of certain covenants to be changed (eg, by reducing a particular basket size or amending a particular definition) or even for new covenants to be introduced between the launch and pricing of an offering in reaction to particular requests or concerns raised by investors during the roadshow.
Are there particular covenants that are looser or tighter, based on a particular industry sector?
To the extent that business operations among market participants in the relevant industry sector are characterised by certain customary specifics (eg, the forming of joint ventures) which would only be permitted to a very limited scope under the typical high-yield covenant package and would therefore restrict the issuer in its ordinary business operations, the covenants will contain appropriately tailored exceptions to reflect such industry specifics.
Change of control
Do changes of control, asset sales or similar typically trigger any prepayment requirements?
In the case of a change of control, each bondholder typically has the right to require the issuer to repurchase such bondholders’ notes at a purchase price of 101 per cent of the principal amount of the notes.
Asset sales only trigger prepayment obligations if the issuer, within a specified time period, does not use the sale proceeds for paying off debt or a reinvesting in new assets. The issuer is typically required to make an offer to the bondholders to purchase their notes at par plus accrued interest to the extent any (excess) proceeds are not applied in the manner permitted by the asset sales covenant.
Do you see the inclusion of ‘double trigger’ change of control provisions tied to a ratings downgrade?
In the case of high-yield issuers that are on the verge of being investment grade, the change of control put is often tied to a rating downgrade from one or more rating agencies within a specified period following the announcement of a change of control.
Is there the concept of a ‘crossover’ covenant package in your jurisdiction for issuers who are on the verge of being investment grade? And if so, what are some of the key covenant differences?
Yes, a ‘crossover’ covenant package is common for German issuers that are on the verge of being investment grade. The main difference from a typical high-yield covenant package is that there is usually no restricted payments covenant. In addition, some of the covenants are typically less strict. For example, the limitations on indebtedness covenant may only apply to secured debt.
Describe the disclosure requirements applicable to high-yield debt securities financings. Is there a particular regulatory body that reviews or approves such disclosure requirements?
As a general rule, any disclosure materials - in particular, the offering memorandum or prospectus - prepared in connection with the offering of securities, including high-yield debt securities, must, to avoid any liability risks for the issuer, contain all information necessary to enable investors to make an informed assessment of the issuer’s assets and liabilities, financial condition, profits, losses and future prospects and the rights attached to the securities.
If, as is typically the case, high-yield debt securities are offered to investors in Germany by way of a private placement, there are no specific statutory disclosure requirements to be complied with (ie, in practice, the disclosure follows the standards applied in a typical high-yield debt offering) and the private placement offering memorandum does not need to be reviewed and approved by the German Financial Supervisory Authority (BaFin).
On the contrary, a public offering of high-yield debt securities in Germany would require the publication of a securities prospectus drawn up in accordance with the requirements set forth by the EU Prospectus Directive 2003/71/EC as implemented by Commisson Regulation (EC) No. 809/2004 (such requirements would have an impact on, for example, the structure and contents of the upfront summary section, commonly referred to as the ‘box’) and approved by BaFin or passported to Germany after approval by the competent regulatory authority of another member state of the EEA.
On 5 April 2017, the European Parliament adopted a new Prospectus Regulation, which will be applicable from the third quarter of 2019. In addition, in case of an offering of high-yield debt securities that does not exclude retail investors, since 1 January 2018, a ‘key information document’ might have to be prepared in accordance with Regulation (EU) No 1286/2014 (PRIIPs Regulation) if the offered high-yield debt securities qualify as packaged retail investment products within the meaning of the PRIIPs Regulation (which may in particular be the case if the notes provide for a make-whole provision). Against this background, since the beginning of 2018, offering memoranda for high-yield bonds typically contain legends and selling restrictions to the effect that the notes are not to be offered, sold or otherwise made available to retail investors.
Use of proceeds
Are there any limitations on the use of proceeds from an issuance of high-yield securities by an issuer?
Apart from anti-money laundering or similar laws limiting the possible use of proceeds from an issuance of high-yield securities, the financial assistance rules set forth in section 71a of the Stock Corporation Act need to be complied with if the proceeds shall be used for the acquisition of own shares of a German stock corporation.
Restrictions on investment
On what grounds, if any, could an investor be precluded from investing in high-yield securities?
If, as is usually the case, high-yield securities are offered by way of a private placement, the offer in Germany is typically limited to qualified investors within the meaning of section 2, No. 6 of the Securities Prospectus Act. In such case, retail investors are not permitted to acquire any high-yield securities from the initial purchasers.
However, there is no statutory rule under German law that would preclude a certain type of investor from investing in high-yield securities either directly nor indirectly via any funds investing in high-yield securities. Accordingly, any investors, including retail investors, may acquire high-yield securities on the secondary market.
Are there any particular closing mechanics in your jurisdiction that an issuer of high-yield debt securities should be aware of?
There are no particular closing mechanics that have to be observed in the case of the issuance of a high-yield bond by a German issuer. Generally, as part of the closing, the global notes have to be deposited with the central securities depositary - typically, either Clearstream Banking AG or Clearstream Banking, société anonyme and Euroclear Bank SA/NV - which acts as book-entry registrar in respect of the notes. Clearstream Banking AG requires physical delivery of the global notes which will then be kept in their custody.
Guarantees and security
Outline how guarantees among companies in a group typically operate in a high-yield deal in your jurisdiction. Are there limitations on guarantees?
In a typical high-yield deal, guarantees are granted by material subsidiaries of the issuer (upstream guarantees) and, in cases where the issuer is not the top company, often also by its parent company (downstream guarantee) and any material sister companies (cross-stream guarantees). Usually, the group of note guarantors mirrors the guarantor structure under the credit facility.
German corporate law provides for certain limitations applicable to upstream and cross-stream guarantees granted by companies in the legal form of a German limited liability company (GmbH), a German limited partnership with a German limited liability company as general partner (GmbH & Co KG) or a German stock corporation (AG).
Any grant of a guarantee, and any payment thereunder, by a subsidiary incorporated in the legal form of a GmbH or a GmbH & Co KG is subject to certain capital maintenance rules set forth in the Act regarding Companies with Limited Liability (GmbHG). As a general rule, sections 30 and 31 of the GmbHG prohibit a GmbH from distributing to its shareholders to the extent that the amount of the GmbH’s net assets (ie, assets minus liabilities and liability reserves) - or, in the case of a GmbH & Co KG, its general partner’s net assets - is or would fall below the amount of its stated share capital. Guarantees granted by a GmbH or a GmbH & Co KG to guarantee liabilities of a direct or indirect parent or sister company and any payments thereunder are considered to constitute distributions within the meaning of sections 30 and 31 of the GmbHG.
The capital maintenance rules do not apply by operation of law to the beneficiary of an upstream or cross-stream guarantee; they address the managing directors and shareholders only. The managing directors of a company granting such guarantee could incur personal or criminal liability.
Therefore, to enable German subsidiaries to grant guarantees to secure liabilities of a direct or indirect parent or sister company without the risk of violating sections 30 and 31 of the GmbHG, and to limit any potential liability of management, it is standard market practice for indentures and guarantee agreements to contain limitation language in relation to the enforceability of upstream or cross-stream guarantees granted by companies incorporated in Germany in the legal form of a GmbH or a GmbH & Co KG. Pursuant to such limitation language, the beneficiaries of the guarantees contractually agree to enforce the guarantees against the relevant subsidiary only if, and to the extent that, such enforcement does not result in the subsidiary’s - or, in the case of a GmbH & Co KG, its general partner’s - net assets falling below, or increasing an existing shortfall of, its share capital.
For the purpose of ascertaining the net assets available for an enforcement of a guarantee granted by a subsidiary guarantor, the limitation language typically provides for adjustments of certain balance sheet items, which are usually highly negotiated. As a result of these adjustments, the net assets available for enforcement could potentially be increased beyond the amount allowed to be taken into account in accordance with the capital maintenance rules.
Any grant of a guarantee, and a payment thereunder, by a subsidiary incorporated in the legal form of an AG is generally subject to the strict capital maintenance rules set forth in section 57 of the Stock Corporation Act, according to which any repayment of shareholders’ contribution is generally prohibited. As a result, an AG is generally only allowed to guarantee its own liabilities or the liabilities of its direct or indirect subsidiaries.
However, the capital maintenance rules set forth in the GmbHG and the Stock Corporation Act do not apply if the subsidiary guarantor is subject to a domination or profit-and-loss-transfer agreement, if a valid reimbursement claim exists against the shareholder or if a shareholder or comparable loan is repaid. From a deal structuring and marketing perspective, it should therefore always be evaluated whether it is desirable and practically feasible for the issuer to enter into domination or profit and loss transfer agreements with the relevant subsidiary guarantors.
In addition to the aforementioned limitations based on capital maintenance rules, limitations in respect of the ability of a GmbH, a GmbH & Co KG and an AG to grant upstream or cross-stream guarantees may result from the case law of the German Federal Supreme Court regarding ‘destructive interference’ (ie, a situation where a shareholder deprives the relevant company of the liquidity necessary for it to meet its own payment obligations), in cases where the enforcement of the guarantee may impair the continued existence of the subsidiary guarantor. In such case, the amount of proceeds to be realised in an enforcement process may be reduced, even to zero.
It is currently unclear whether and to what extent the principles of the recent decision of the German Federal Supreme Court dated 21 March 2017 (file no. II ZR 93-16) regarding the granting of upstream security (see question 21) are also applicable to the granting of upstream guarantees.
What is the typical collateral package for high-yield debt securities in your jurisdiction?
The typical collateral package granted by German entities in connection with high-yield debt securities comprises, subject to reasonable analysis of availability and value:
- pledges over the issued share capital (or partnership interests, as applicable);
- land charges on real property;
- security assignments of receivables (usually including trade, insurance and intercompany receivables);
- bank account pledges;
- security transfers of movable assets (including plant, machinery, inventory and equipment); and
- security assignments or pledges of intellectual property rights.
In Germany, security is taken over each asset category separately. There is no concept of a floating charge or general security agreement.
Under German law, certain security interests such as pledges are of a strict accessory nature and are therefore dependent on the corresponding secured claims and require the security holder and the creditor of the secured claims to be identical. Given that the security interests are granted to the security agent, which is not a creditor under the notes or the note guarantees, and to allow the bondholders to benefit from accessory security interests, these will secure a parallel debt obligation created under the intercreditor agreement in favour of the security agent, rather than securing the bondholders’ claims under the notes and the note guarantees directly.
Are there any limitations on security that can be granted to secure high-yield securities in your jurisdiction? Are there any limitations on types of assets that can be pledged as collateral? Are there any limitations on which entities can provide security?
The limitations outlined above with respect to guarantees (see question 19) apply mutatis mutandis to upstream and cross-stream security granted by German entities in the legal form of a GmbH, GmbH & Co KG or AG (in cases of share pledges with the modification that, if and to the extent that an enforcement of the pledge would cause the GmbH’s net assets to be reduced below the amount of its stated share capital, the GmbH has a claim for surrender of the enforcement proceeds against the pledgee in an amount that is necessary to avoid the GmbH’s net assets being reduced below the amount of its stated share capital).
According to a recent decision of the German Federal Supreme Court dated 21 March 2017 (file no. II ZR 93-16), a GmbH may (only) grant upstream security if there are enough free net assets equal to the value of the security to be granted or the company has a valuable recourse claim against the shareholder or its affiliates benefiting from that upstream security (it is still somewhat unclear whether and to what extent the above principles apply to the granting of revolving security interests and upstream guarantees). Therefore, the management of the GmbH has to assess at the time of granting of the security as to whether the recourse claim is fully valuable. According to the above mentioned court decision, this is the case if the shareholder or the affiliate benefiting from the upstream security will most likely be able to repay the loan or notes being secured. Further, the managing directors of the GmbH remain obliged - as long as the upstream security remains outstanding - to monitor the financial condition of the shareholder/affiliate and to request security or indemnity if the financial situation of the shareholder/affiliate deteriorates, which may be difficult in practice. Against this backdrop, the court decision did not result in a significant change to market practice and documentation standards (in terms of limitation language) in high-yield bond transactions so far.
In addition, the taking of security can be void pursuant to section 138 of the Civil Code if it infringes the principle of good faith. This could be the case if the anticipated realisation value of the security taken is, from the outset, disproportionately higher than the value of the secured claims (initial over-collateralisation), whereby taking of such disproportionate collateral is considered to constitute egregious conduct from the perspective of a creditor. Alternatively, in cases where over-collateralisation occurs later (eg, after a partial repayment of the bond), the collateral may have to be released to the extent that its value significantly exceeds the value of the secured claims.
Describe the typical collateral structure in your jurisdiction. For example, is it common to see crossing lien deals between high-yield debt securities and bank agreements?
There is no single typical collateral structure in Germany. The individual collateral structure is mainly driven by the capital and financial structure of the company. Crossing lien structures (with lenders taking a first lien and bondholders a second lien on certain assets and bondholders taking a first lien and lenders a second lien on certain other assets) are not a common concept in Germany and, from a legal perspective, only possible in respect of pledges with such lien subordination structure solely accomplished by way of timing of perfection of the respective liens.
However, from a practical perspective, we do not see any need for such crossing lien structures, given that the desired economic result can be achieved by way of contractual agreement on the provisions with respect to the payment waterfalls and distributions of enforcement proceeds among the lenders and bondholders contained in the intercreditor agreement.
Who typically bears the costs of legal expenses related to security interests?
In a German deal, the issuer typically bears the costs of legal expenses related to the transaction, including the fees to be paid by the initial purchasers to its legal counsel (often a certain fee cap is agreed). This includes any legal expenses related to security interests.
How are security interests recorded? Is there a public register?
In Germany, land charges and mortgages on real property are registered in the relevant land register. In the case of an assignment or pledge of any intellectual property rights of a German company, the parties to the relevant security agreement may agree that the assignee or pledgee is registered in the relevant patent or trademark register or domain register (registration of such assignment or pledge may not be compulsory but is common market practice). Any ship mortgage is registered in the relevant shipping register. The other types of security interests are not recorded in public registers. In addition, land charges and mortgages on real property as well as share pledges need to be notarised before a German notary who will charge fees under the applicable statutory provisions.
How are security interests typically enforced in the high-yield context?
The security interests are enforced by the security agent in accordance with the provisions of the indenture or conditions of issue, the intercreditor agreement and the relevant security agreement, including any agreed enforcement principles, upon the occurrence of an enforcement event and an instruction by the bondholders, lenders and any other relevant creditors. There is no common enforcement regime in Germany applying to the different types of security interests and secured assets in the same way. In fact, each of the security types is subject to its own particular enforcement rules.
Debt seniority and intercreditor arrangements
Ranking of high-yield debt
How does high-yield debt rank in relation to other creditor interests?
The ranking of high-yield debt securities in relation to other debt mainly depends on the capital and financial structure of the company. Typically, high-yield debt securities:
- rank equally in right of payment with all existing and future obligations that are not subordinated in right of payment;
- rank senior in right of payment to any existing or future subordinated indebtedness;
- effectively rank senior in right of payment to any existing or future unsecured obligations to the extent of the value of the collateral that is available to satisfy the obligations of the issuer under the high-yield debt securities; and
- are effectively subordinated to existing and future secured indebtedness that is secured by property or assets that do not secure the notes, to the extent of the value of such property and assets securing such indebtedness.
Regulation of voting and control
Describe how intercreditor arrangements entered into by companies in your jurisdiction typically regulate voting and control between holders of high-yield debt securities and bank lenders?
In general, the terms of the intercreditor agreement governing control of enforcement proceedings depend on the collateral structure and the ranking of high-yield debt in relation to bank debt. While recent issuances of German law governed high-yield bonds mainly involved super senior bank debt, with lenders being in the driver’s seat in terms of control of enforcement proceedings, the deals with pari passu structures provided for a right of the bondholders to participate in the control of enforcement proceedings by voting as a class.
Whether a true proportional voting of bondholders with other secured creditors (one euro, one vote) would work under the majority resolution concept set forth in the SchVG is currently not clear.
Offsetting of interest payments
May issuers set off interest payments on their securities against their tax liability? Are there any special considerations for the high-yield market?
Issuers of securities, including high-yield bonds, may generally set off their interest payments against their tax liability provided the interest payments do not exceed €3 million or 30 per cent of the earnings before interest, tax, depreciation and amortisation. Interest expense that cannot be deducted is carried forward to the following fiscal years. The interest barrier rule is not applicable if the issuer does not belong to a consolidated group or if its equity percentage at the end of the preceding fiscal year is equal to or greater than the equity percentage of the consolidated group.
Is it common for issuers to obtain a tax ruling from the competent authority in your jurisdiction in connection with the issuance of high-yield bonds?
No. It is uncommon for German issuers to obtain any tax rulings in connection with the issuance of securities, including high-yield bonds.
Update and trends
Update and trends
Updates and trends
The Association for Financial Markets in Europe (AFME) published ‘best practice’ disclosure guidelines for European high-yield bond issuers in April 2016 and updated these guidelines in March 2017. The AFME’s recommendations include the following:
- The issuers’ material debt and intercreditor documentation should be made publicly accessible.
- The offering memorandum should include key data about the terms of the group’s other material financings, including an illustration of such debt’s position in the group’s capital structure, related credit support and intercreditor terms. Investors should be afforded an opportunity to discuss the capital structure and covenants in each transaction during marketing.
- Ongoing disclosure: high-yield issuers should be required to disclose promptly material changes to the group’s major debt facilities and intercompany arrangements, the occurrence of default and cross-default events, and material changes to the group’s corporate structure (eg, reorganisations).
- Ongoing financial reporting obligations: issuers should be required to include in their regular financial reports the total amount of the group’s material debt obligations, as well as unused capacity or availability under committed credit facilities; the publication of financial reports should be followed by a conference call open to all market participants pursuant to an express obligation in the bond documentation; and financial reports should be made available on a publicly accessible website which is not password-protected.
So far, the European high-yield market has followed these recommendations only to a certain extent. However, the publication and disclosure requirements under the Market Abuse Regulation applicable to listed European high-yield bond issuers since July 2016 oblige such issuers to disclose certain types of information to the public, thereby generally improving transparency for investors during the term of the notes.