This article first appeared in PEI Manager, January 2009. Copying without permission from PEI Manager is unlawful. It is reprinted here with permission.
In the first in a two-part series on debt buybacks, the authors explore the legal implications a private equity firm must consider when structuring the debt purchase. In the February 2009 issue, they examined the tax implications.
Debt instruments used to fund private equity transactions currently are trading at significant discounts. These market conditions have caused private equity firms to consider purchasing the debt of their acquisition companies (ACs). The purchase by a fund of a debt instrument issued by one of its ACs can be economically lucrative, but there are a number of legal issues that must be considered in structuring the debt purchase.
Restrictions Under Debt Documents
Generally, the fund must consider (1) whether the proposed purchaser is a permitted transferee under the debt documents, and (2) whether the transaction will trigger requirements of pro rata sharing or other similar considerations.
In the context of syndicated loans, transfers are often limited to particular classes of transferees and often specifically prohibit transfers to the borrower or any of its affiliates. Consideration should be given to whether the proposed transaction is permitted under these provisions.
Assuming that the proposed transfer is permitted under the relevant assignment provisions, a further issue may arise under the pro rata sharing provisions of the credit documents, particularly if the repurchased debt will be cancelled as a result of the transaction. Again, the particular terms of the governing documents must be reviewed (including repayment and pro rata sharing provisions) but the risk is that either the purchaser of the debt, as beneficiary of the cancellation, or the seller of the debt, as recipient of the purchase price, is required to make payments to the other lenders as a consequence of the transaction.
In order to avoid these issues, an alternative may be to formally approach the bank group to negotiate a repurchase. Depending on the overall circumstances, the bank group may be willing to accept a negotiated repurchase arrangement. For example, Citadel Broadcasting negotiated the ability to repurchase its term debt at a discount under a tender-offer type structure in which Citadel indicated a range within which it was willing to repurchase and holders of the debt indicated the price within that range at which they would be willing to accept prepayment, with the settlement price then set at the lowest price that cleared the offer.
Bonds and private placement notes generally would be more flexible, though the particular documentation should be reviewed.
Securities Law Issues
Syndicated bank debt has historically been treated as not subject to the U.S. securities laws. However, if the debt to be repurchased constitutes bonds or private placement notes, then there may be securities law considerations that come into play in the context of a debt repurchase. (If the intent is to purchase the debt and hold it for future sale, there also will be securities law issues in the context of such re-sale.)
Insider Trading Rules
U.S. securities laws generally prohibit trading in securities while in possession of material non-public information relevant to those securities. This type of information might be acquired if the purchaser acquires a seat on the board of the issuer, exercises consulting or advisory rights with respect to the issuer, or simply through the communication of information by the issuer under conditions of confidentiality. In any of these circumstances, the purchaser may find itself subject to trading restrictions with respect to the purchased debt or other securities of the issuer.
In most syndicated bank facilities for companies with publicly traded securities, debt holders will often be given an opportunity to indicate whether they are public side or private side. If they wish to preserve their ability to trade in securities issued by the borrower or its affiliates, holders of the bank debt will indicate that they are public side holders and information otherwise required to be delivered under the loan documents but designated by the issuer as non-public will not be delivered to such public-side holders.
Some debt holders have sought to circumvent the restriction on trading by securing “big boy letters” from the parties to which they intend to sell their debt securities. A big boy letter amounts to an acknowledgement by the purchasing party that it is aware of the information asymmetry between itself and the seller, and waivers of future claims based on such asymmetry; the purchaser, despite being at an informational disadvantage, is willing and able to purchase the subject securities. However, recent cases – particularly the litigation between R2 Investments and Salomon Smith Barney and the SEC action against Barclays and one of its traders, Steven Landzberg – suggests that big boy letters are not panaceas for insider trading restrictions.
Technically, the insider trading rules do not apply to trading in bank debt since bank debt is not treated as a “security” under the U.S. securities laws. Nonetheless, many active participants in the secondary loan market apply similar principals as a matter of good practice and consideration should be given to the reputational and other risks that would be entailed in trading on material non-public information.
Tender Offer Rules
The tender offer rules under U.S. law impose certain disclosure and timing obligations on offers to purchase outstanding publicly traded securities; each of the parties to a distressed debt transaction may have incentives to structure the purchase of distressed debt to ensure that it is not subject to these obligations. Generally speaking, a debt purchase program will not be susceptible to categorization as a tender offer if it has a limited target audience, the purchase price does not represent a significant premium over the market price of the securities, and the target purchasers are sophisticated investors. Although the jurisprudence relating to tender offers focuses on the offering of equity securities, it can provide meaningful comfort for parties involved in debt transactions: purchase programs relating to securities that involve fewer and more sophisticated holders – common characteristics of debt securities – are less likely to be recharacterised as tender offers.
When an issuer of debt slips into bankruptcy, a debt holder will have to make a significant strategic decision about whether it will be closely involved in the bankruptcy proceedings.
If a debt holder takes a role as part of a creditors’ committee it will become an “insider,” thereby subjecting it to trading restrictions with respect to the debt securities as discussed above. Participation on an official creditors’ committee under the Bankruptcy Code necessarily entails responsibilities that would make the participant an insider. Where there is an ad hoc committee of holders, the bar to trading may be avoided for a while through the delegation of workout negotiations to attorneys and financial advisors and/or the designation of a steering committee of holders which will become restricted while the other holders remain free to trade. All of the holders will become restricted and receive confidential information when terms of a workout deal are ripe for consideration.
For larger market participants, who might hold the debt through one group but have other groups involved in trading of other securities, it is possible to structure a Chinese wall. In this context it is crucial to abide by a set of specific criteria established by the court in connection with the bankruptcy of Federated Department Stores. These safeguards included: (1) requiring execution of a letter by employees with access to non-public information acknowledging their awareness that the information they receive may be material and non-public through their participation in or involvement with a creditors’ committee, and that they are aware of ethical screen procedures; (2) establishing procedures to prohibit the dissemination (oral and written) of non-public information to employees not involved in the bankruptcy proceeding; (3) excluding employees that were privy to non-public information from communications that discuss imminent trading activity; and (4) maintaining compliance procedures to ensure that all trades comply with the above restrictions. These safeguards are similar to the requirements subsequently adopted in relation to more generally applicable insider trading policies under Rule 10b5-1(c) of the ’34 Act.
Equitable subordination, while not a remedy that is often approved by bankruptcy courts, has the ability to so undermine a creditor’s investment that its specter continues to affect creditor behavior. To the extent that purchasers of distressed debt do not become fiduciaries of the issuer – by taking positions on the board or otherwise creating a protected relationship with the issuer – they can take comfort in a 2006 ruling by the U.S. Court of Appeals for the Ninth Circuit noting that a much higher burden of proof applies when claimants seek an equitable subordination remedy with respect to a non-insider creditor.
However, if the terms of the distressed debt transaction create a fiduciary relationship, the purchaser must pay careful attention to preventing even the appearance of impropriety, keeping in mind that disgruntled creditors or shareholders of the issuer in bankruptcy will only have to prove “substantial impropriety” to win their claim for equitable subordination in the absence of demonstrations of good faith and fair dealing on the part of the purchaser.
The economic benefits afforded to a private equity fund upon its purchase of debt issued by an AC at a discount can be significant, and, given the current state of the market, many funds may be increasingly considering this transaction. To ensure the realization of these benefits, funds must ensure that their structure for the debt acquisition is within the confines of the legal and regulatory requirements applicable to the debt instrument.
Steven D. Bortnick , J. Bradley Boericke and Timothy J. Leska
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.