Companies that have issued or plan to issue debt securities are facing an unusual confluence of circumstances: a severely discounted secondary debt market combined with an increasing level of internal corporate investigation activity resulting from, among other things, requirements imposed by the Sarbanes-Oxley Act. Internal investigations may force bond issuers to delay their SEC filings and reports to bondholders because the issuers are unable to certify their financial statements until full investigations are concluded. This delay poses the risk of default under the reporting covenant in indentures which requires issuers to make SEC filings available to bondholders within specified time frames. The potentially drastic consequences for defaulting issuers include acceleration of the bonds and cross-defaults to other debt. Such circumstances, together with the discounted pricing currently available in the secondary debt markets, may provide an attractive investment opportunity where there is a potential covenant default which allows for acceleration at par value or requires a costly waiver or forbearance to avoid such default.
A recent decision by the United States Court of Appeals for the Eighth Circuit makes it more challenging for bondholders to assert such defaults in some cases. As the first federal appeals court to consider the issue, the Eighth Circuit ruled in UnitedHealth Group v. Wilmington Trust Co. that a company’s delay in filing an SEC report did not constitute a default of a reporting covenant. The covenant at issue in the case required the company to furnish to bondholders its SEC filings within a certain time frame, but did not specify that reports needed to be filed with the SEC. The decision is consistent with a number of lower federal court decisions interpreting the same covenant language.
Background of the Case
The case involved an indenture under which Wilmington Trust served as trustee and pursuant to which UnitedHealth Group (UHG) issued US$850 million of bonds. The indenture contained the following reporting requirement:1
So long as any of the Securities remain Outstanding, the Company shall cause copies of all [SEC reports] which the Company is then required to file with the [SEC] pursuant to Section 13 or 15(d) of the Exchange Act to be filed with the Trustee and mailed to the Holders of such series of Securities…within 15 days of filing with the [SEC]. The Company shall also comply with the provisions of the [Trust Indenture Act] ss. 314(a).
Because of an ongoing stock option back-dating investigation, UHG delayed filing its quarterly report on Form 10-Q for the second quarter of 2006. UHG did, however, file a Form 12b-25 notification of late filing on a timely basis in which it explained the reasons for the delay accompanied by a 44-page appendix containing substantially the same information as UHG would have included in a timely Form 10-Q. Subsequently, bondholders who collectively owned more than 25 percent of the bonds sought to accelerate the maturity of the bonds by asserting that UHG had defaulted on the bonds because it breached an affirmative duty under the indenture to file its SEC reports on a timely basis.
The Court’s Decision
The Eighth Circuit agreed with the reasoning of the lower court decision (and three other federal district courts that had considered the same issue in different cases) that the indenture’s unambiguous language imposed on UHG only the obligation to forward SEC reports that had been filed and not an independent obligation to file reports with the SEC on a timely basis. The Court noted that the parties were sophisticated and represented by counsel and that they could have drafted the indenture to require that SEC filings be made on a timely basis. The Court cited readily available language from the 1967 American Bar Foundation model indenture which requires that an issuer “will…file with the Trustee, within 15 days after the Company is required to file the same, copies of the [SEC reports].” Because the indenture did not include this or similar language specifically requiring UHG to timely file reports with the SEC, the Court ruled that UHG had not defaulted on its bonds.
The Court also discussed the requirements of Section 314(a) of the Trust Indenture Act (TIA) which was referenced in the indenture provision and found those requirements to be even less burdensome than the indenture’s requirements. The Court noted that the TIA contained nearly identical language as the reporting obligation in the indenture, but without the 15-day timing requirement. Consequently, the Eighth Circuit concluded that TIA Section 314(a) requires only that debt issuers forward to their trustees copies of such reports as are actually filed with the SEC.
Finally, the Eighth Circuit rejected the argument that the implied duty of good faith and fair dealing under New York law (which governed the indenture) imposed an affirmative obligation on UHG to file its reports with the SEC on a timely basis. The Court noted both that UHG continued to make payments on the bonds while its filings were delayed and that by filing preliminary financial data with its notification of late filing and updates on the back-dating investigation through Form 8-K filings, UHG provided bondholders with as much information as was possible during the internal investigation. The Court concluded that UHG acted prudently and responsibly in those respects and that its failure to file SEC reports on a timely basis breached no express or implied duty of good faith and fair dealing.
Although the UHG decision is the first by a federal appeals court involving the alleged breach of a reporting covenant due to belated SEC filings, it is consistent with several other federal district court cases addressing the same issue. In each of Cyberonics, Inc. v. Wells Fargo Bank N.A., Affiliated Computer Services Inc. v. Wilmington Trust Co., and Finisar Corp. v. US Bank Trust N.A., federal district courts came to the same conclusions based on essentially identical analyses as that applied in the UHG decision. There is, however, an unpublished 2006 decision by a New York State triallevel court, Bank of New York v. Bearingpoint, Inc., that considered the very same issue and came to the opposite conclusion. The federal court decisions have largely dismissed the Bearingpoint decision as poorly-reasoned because the New York court simply ignored the critical language of the covenant requiring that the issuer forward to the trustee SEC reports “…within 15 days of filing with the [SEC]”. Moreover, in the Bearingpoint case, the issuer provided no financial information to the bondholders until it ultimately filed its tardy SEC reports.
The UHG decision and similar lower court decisions highlight how important it is for bond issuers to provide as much financial information as possible if such issuers are forced to delay filing SEC reports. The availability of current information was an important consideration in several of the federal cases that ruled in favor of the bond issuers and a distinguishing factor in the one case that interpreted the indenture in favor of the bondholders.
Unlike the UHG indenture, indentures that contain language requiring issuers to “timely file” SEC reports create a contractual obligation that is separate from the requirements of the federal securities laws. This is a risky situation for any issuer that becomes unable to certify its financial reports because of an investigation or other accounting issue. The potential default can result in acceleration of the debt at par value or, alternatively, require a costly waiver or forbearance to avoid such default—a potentially attractive situation to investors when debt is trading at a discount.
Bond issuers and trustees who are currently negotiating indentures should consider how to balance the bondholder’s need for current information with the issuer’s desire to avoid defaulting on its bonds (and cross-defaulting other debt) because of a delay in filing SEC reports. Issuers could consider specifying alternative information that must be provided in such situations such as uncertified financial information with appropriate caveats or limiting remedies, such as providing that penalty interest is the sole remedy for such a default. Alternatively, this provision could be subject to a lengthier cure period before certain remedies could be exercised. In any case, it is clear that issuers and bondholders must carefully consider the requirements of the reporting covenant to avoid unintended consequences.