By Michael Chernick, Harald Halbhuber, Merritt Johnson, Lona Nallengara and Alan Rockwell

Law360 (April 16, 2020, 6:08 PM EDT )

Michael Chernick

Harald Halbhuber

Merritt Johnson

Lona Nallengara

Alan Rockwell

As the markets continue to react to the COVID-19 pandemic, the trading prices of many corporate loans and bonds have fallen dramatically. As a result, many companies, or their private equity sponsors, are looking at repurchasing their debt at a discount.

In addition, many companies are concerned that the impact of the COVID-19 pandemic will result in covenant breaches or other defaults (e.g., a failure to deliver annual or quarterly financial statements within the required time period or, in certain credit agreements, the inclusion of a so-called going concern qualification in an audit opinion) and engaging in discussions with their lenders and investors to obtain needed modifications to their debt agreements.

This article highlights certain key issues companies should consider when evaluating potential debt buybacks and amendment/liability management exercises.

Contractual Restrictions

As always, it is imperative that companies consult their legal counsel and review their debt agreements to determine whether the contemplated transaction is permitted. Credit facilities will often limit the ability of a company to buy back or otherwise prepay junior debt, which could include junior lien, unsecured and/or subordinated debt depending on the particular terms of such credit facility.

Likewise, high-yield indentures restrict an issuer's ability to prepay subordinated debt. Any new debt or liens incurred must comply with any existing limitations unless amendments or waivers are obtained.

Debt Securities

Open-Market Purchases and Privately Negotiated Transactions

Companies looking to repurchase their bonds in the open market must abide by applicable U.S. securities laws, including the anti-fraud provisions and the tender offer rules. Generally, market practice dictates that companies and their affiliates should not repurchase their bonds when in possession of material nonpublic information.

Among other things, companies should consult their insider trading policies and associated trading blackout periods when considering a bond repurchase.

Public companies should also consider whether the repurchase itself gives rise to any disclosure obligations, including whether the repurchase in and of itself or the source of funds for the repurchase is material nonpublic information that needs to be publicly disclosed.

Furthermore, companies must evaluate whether the repurchase constitutes a tender offer under the federal securities laws. Depending on the circumstances, open-market repurchases may be found to constitute a tender offer and, since such purchases would not have complied with the tender offer rules, may expose a company to monetary damages, injunctive relief and U.S. Securities and Exchange Commission sanctions.

Factors to consider include: the amount of bonds being repurchased; the number of holders solicited; the manner by which the holders are solicited and the terms of the repurchase. Unfortunately, there are no bright line rules; however, generally speaking, open-market purchases of up to 20% of the aggregate principal amount of a series of notes during any quarter should not be considered a tender offer absent other countervailing factors.

A company may be able to repurchase a greater percentage of outstanding securities (up to 80%) without triggering the tender offer rules, if such repurchases are not executed on the open market, but instead privately negotiated with a very limited number of sophisticated holders.

Debt Tender and Exchange Offers

Debt tender and exchange offers allow issuers to buy back or exchange all or a portion of a series of debt securities subject to compliance with U.S. securities laws. Debt tender and exchange offers may be coupled with a consent solicitation to incentivize participation in the offer and obtain covenant relief.

Debt Tender Offers

Cash tender offers for nonconvertible debt securities do not require the filing of a registration statement or SEC review, but are subject to certain SEC rules. Generally, the offer must be open for at least 20 business days, and holders must be paid promptly (i.e., within two business days absent special circumstances) following the expiration of the offer.

Certain changes to the terms of the offer (e.g., the percentage of securities being sought or the price being offered) will require a ten-business day extension and corresponding public announcement. The SEC has also permitted abbreviated five-business-day tender offers for nonconvertible debt securities so long as certain conditions are met.

Such conditions include: that the offer is for "any and all" of the securities of the relevant series, the consideration consists solely of cash, qualified debt securities (i.e., securities that are basically identical to the securities subject to the offer), or a combination of both, there is no concurrent consent solicitation asking to amend the terms of the subject securities, and that the tender offer is not financed with senior debt.

Companies have a great deal of flexibility in structuring the terms of a debt tender offer, including offering an early tender premium, offering to purchase multiple series of notes in a single tender offer using a waterfall structure, Dutch auction-style pricing and variations in the amount of notes sought and the price being paid.

Tender offers require limited documentation, and companies can typically be in the market quickly.

Debt Exchange Offers

Exchange offers may involve a debt-for-equity exchange or debt-for-debt exchange. Unlike cash tender offers, exchange offers involve a new issue of securities and, thus, will require either SEC registration of the new securities or an exemption from registration.

Public companies wishing to exchange debt for freely tradable shares of common stock or new registered debt securities will need to go through the SEC registration process, which may be lengthy and unpredictable. Note that the SEC has expressed a desire to be flexible in response to requests for accelerated review processes during the current COVID-19 crisis.

Well-known seasoned issuers, or WKSIs, will not be able to utilize an existing shelf registration statement or take advantage of the automatically effective registration rules because those cannot be used for exchange offers; however WKSIs and certain other public companies will be able to incorporate their public filings by reference.

As a result, exchange offers are typically limited to institutional investors and non-U.S. persons that qualify for exemption from SEC registration; however, this limitation may not be practical if a significant portion of the relevant debt securities is held by retail investors.

If the exchange offer includes a consent solicitation to amend the terms of the old debt securities, it may also make limiting the exchange offer to certain classes of the existing investors more complicated.

Companies may also be able to take advantage of Sections 3(a)(9) and 3(a)(10) of the Securities Act of 1933, which permit exchanges without registration in limited circumstances. In addition, exchange offers are subject to the same SEC tender offer rules as cash debt tender offers, including a minimum 20-business day offer period (with the ability to execute a five-business day exchange offer subject to certain conditions), and have similar flexibility in terms of pricing and structure.

Companies looking to launch an exchange offer should allow for additional time even if the offer does not require SEC registration and review as the offer will require a disclosure document (similar to an offering memorandum for a 144A bond offering) and, if a bank is engaged to act as a dealer manager to help with the exchange, additional due diligence, law firm opinions and negative assurance letters, and auditor comfort letters.

Consent Solicitations

A consent solicitation is the customary method for obtaining the approval of holders for waivers and amendments to the terms of their debt securities.

Most covenants can be amended with the consent of the holders of a majority of the outstanding notes, but changes to economic or other fundamental obligations (e.g., principal amount, interest rate, interest payment dates and maturity, among others) typically require the consent of all affected holders.

Furthermore, if amendments are significant so as to substantially affect the rights of the debt security holders, the changes may constitute the issuance of a new security, raising tax and other concerns.

Indentures often disregard bonds held by the issuer or its affiliates when determining whether the requisite principal amount of bonds to effect an amendment have been received. To maximize holder participation, holders are often offered a consent fee in exchange for agreeing to the proposed modification.

Consent solicitations on a stand-alone basis may be completed quickly and with few requirements (e.g., there is no SEC-mandated minimum offer period). In many cases, however, a consent solicitation is combined with a tender or exchange offer in which consenting holders also agree to sell back their securities to the company — a so-called exit consent.

In such event, the SEC tender offer rules will, as a practical matter, dictate the timing of the solicitation, and the amendment to the terms of the bonds that remain outstanding will only become operative once the associated tender or exchange offer has closed.

Convertible Bonds

Convertible bonds are treated as equity securities under SEC tender offer rules. Tender offers for convertible bonds therefore require filing of a Schedule TO that is subject to SEC review and comment.

Tender offers for convertible bonds must also comply with the all holders/best price rule, and issuers therefore cannot offer an early tender premium or exclude retail holders, as in certain exchange offers.

Typically, convertible bonds are held by a relatively small number of institutional investors, and issuers may be able to structure cash repurchases or exchanges as privately negotiated transactions to avoid SEC registration and review — although care must be given to avoid triggering a tender offer, as noted above.

Companies should consider the impact of short covering purchases by holders of convertible bonds in connection with repurchase of their bonds, and any bond hedge and related warrant transactions may have to be partially unwound to account for any reduction in the amount of outstanding convertible bonds.

Term Loans

Loan buybacks arose in the syndicated loan market as a result of the financial crisis of 2008/2009. Prior to the crisis, most credit agreements did not contemplate borrower buybacks and, in fact, many credit agreements specifically provided that the borrower and its affiliates were not eligible assignees of the loans.

After that financial crisis, many credit agreements specifically contemplated the ability of the borrower and/or its affiliates to purchase loans, typically limited to the term loans, either through non-pro rata open-market purchases or through a Dutch auction process that in many cases is required to be open to all lenders of the class of loans being purchased on a pro rata basis.

Open-Market Purchases

Open-market purchases allow the borrower to repurchase the loans on a one-off, non-pro rata basis on a simpler, faster and more cost efficient basis.

Credit agreements usually will require that the principal amount of the loans purchased by the borrower (including accrued and unpaid interest thereon) will be automatically cancelled and extinguished as of the date of the purchase (but such point should be confirmed for each particular credit agreement).

Credit agreements typically will also condition the ability of the borrower to purchase its loans on (1) there being no default or event of default or, in certain cases, no payment or bankruptcy event of default, and (2) a liquidity test, which in most cases requires that no proceeds of the borrower's revolving credit facility are used to fund the purchase of term loans.

In addition, a review of the applicable credit agreement will be required to determine whether the borrower or its affiliate is required to make a representation that it is not in possession of material nonpublic information with respect to itself and its business that has not been disclosed to the lenders generally or state that it cannot make such representation.

Also, credit agreements may provide that in the case of a purchase of loans by the borrower (or its affiliates) that the lenders have agreed to certain nonreliance or so-called big-boy provisions in connection therewith or otherwise require such lender to execute a big-boy letter.

Dutch Auctions

Many credit agreements currently contain provisions allowing the borrower to voluntary prepay the term loans at a discount to par pursuant to enumerated Dutch auction procedures set forth in such agreements. A borrower may decide to engage in a Dutch auction process if it desires to purchase a substantial portion of its loans that is in excess of the normal trading volume of such loans.

In its simplest form, these Dutch auction procedures allow the proposed buyer of the loans to submit an offer to purchase a specified amount of the term loans at a given price expressed as a discount to par. Lenders will then be given a period of time to accept such offer and the borrower would purchase the loans tendered in such offer (subject to pro rata reductions if the principal amount of loans tendered is greater than the principal amount of loans offered to be repurchased).

There are many credit agreements that allow the proposed buyer to offer to purchase the term loans based on a price range rather than a single specific purchase price and the borrower would repurchase loans at the lowest price offered by accepting lenders that would permit the borrower to repurchase the desired amount of loans. If the borrower is the purchaser of the loans in such offer, the provisions set forth above regarding cancellation of the loans and the related conditions will apply.

Purchases by Affiliates of the Borrower

Under certain circumstances, including where the borrower and its owners want to preserve the borrower's liquidity, affiliates of the borrower may desire to purchase the loans via open-market purchases. In general, credit agreements will restrict the ability of affiliates to purchase term loans and exercise rights as lenders.

These restrictions usually include: a cap on the principal amount of loans that may be purchased (typically around 25-30%), limitations on access to information and lender-only meetings, certain limitations on voting rights and waivers of certain rights in bankruptcy proceedings and, in certain circumstances, an affirmative undertaking not to challenge the lenders' legal privilege.

A number of credit agreements exclude debt fund affiliates from the limitations described in the preceding sentence but will ordinarily limit such debt fund affiliates' vote on required lender matters to an aggregate of 49.9% of such vote so that such debt fund affiliates would not constitute the required lenders by themselves.

Affiliates that have purchased these loans will be permitted, but not required, to contribute such loans to the borrower and, if so contributed, such loans would ordinarily be cancelled and extinguished. As described above for borrowers, a review of the credit agreement will be required to determine the scope of any representations that such purchasers will be required to make with respect to material nonpublic information in connection with such purchase.

Repurchase of loans by the borrower or its affiliates will likely impact certain other provisions of a credit agreement that will need to be reviewed. Such provisions include: the impact on the definition of EBITDA and leverage ratios, the calculation of excess cash flow and the ability to incur incremental debt.

Amendments

In general, the holders of a majority in principal amount of the loans and commitments — the required lenders — and the administrative agent will be required to approve any amendment or waiver of the covenants; except that in covenant-lite facilities where the financial covenant is for the benefit of the revolving lenders only, the consent of the holders of a majority of the revolving loans/commitments would be required instead of all loans.

Likewise, in most credit agreements, amendments to the mandatory prepayment provisions would also require approval of the required lenders and the agent. Deferrals of interest or principal and/or paying such amounts in kind would generally require an affirmative vote from all lenders or all affected lenders.

Tax Considerations

If debt is acquired for an amount less than its adjusted issue price (e.g., either through a repurchase or debt-for-debt exchange), the borrower may recognize cancellation of indebtedness, or COD, income, which can give rise to a cash tax liability. The amount of COD income generally is the difference between the principal amount of cancelled debt and the repurchase price

COD income can be triggered by the forgiveness of debt by its holder, modification of the debt, and the repurchase of the debt by the company at a discount. COD income may also arise if a related party (such as a private equity sponsor that owns the borrower) engages in the repurchase transaction. COD income typically is not recognized to the extent of the insolvency or bankruptcy of the issuer.

Companies should consider the tax issues involved with debt buybacks and liability management considerations with their tax advisers.

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Michael Chernick, Harald Halbhuber, Merritt Johnson and Lona Nallengara are partners at Shearman & Sterling LLP.

Alan Rockwell is a partner and global bank finance practice group leader at the firm.

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