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Distressed debt transactions: soup to nuts

A central feature of the ongoing credit crisis has been the decline in prices across all types of debt as the market has undertaken a radical repricing of risk. In response, a significant amount of capital is being raised by funds with a view to investing in debt. At the end of the first quarter of 2008, and in the midst of gloomy forecasts about how long the current market malaise will last, funds formed to purchase and manage distressed debt had raised over $24.6 billion. (1)Only a fraction of the funds raised have been invested to date, suggesting an imminent boom in distressed debt transactions.

J Bradley Boericke

Michael H Friedman

Shirley R Kuhlmann

From a variety of perspectives, and particularly in a climate where other alternative investment strategies are short-circuited by a lack of attractive financing and significant uncertainty, investments in distressed debt may have great appeal. But appeal does not come without risk, and purchasers of debt and their advisers need to be aware of the legal and practical pitfalls associated with distressed debt transactions. We examine the legal implications of transactions involving the sale and purchase of debt securities or syndicated bank debt. We use the generic "purchaser" throughout—but in some instances, we focus on issues that private equity funds in particular might encounter in the distressed debt arena.

Preliminary Considerations

Purchasers of debt in this environment may be acting with a variety of motivations and exit strategies. Is the purchaser seeking to purchase distressed debt for resale after the debt has been revalued? Or is the distressed debt purchase intended to be a variation on a loan-to-own transaction, whereby the purchaser anticipates becoming an active or controlling equity holder following an imminent bankruptcy or restructuring period?(2) Sometimes, the purchaser's strategy will be a hybrid of these two approaches, with different dominant strategies. The issues discussed in this article need to be reviewed in light of the particular objectives of the purchaser. It also is important to keep in mind some distinctions relating to different kinds of debt. Generally, this article addresses both debt securities, which may have been publicly issued or privately placed (including so-called "144A for life" issuances), and syndicated "bank" debt, which is generally not treated as a security under the federal securities laws. We flag in the discussion below a number of areas where the differences in securities law treatment, and common practice relating to debt terms, may have a significant impact.

Finally, there are different ways in which distressed debt can be purchased, including open market purchases of publicly-traded debt or other debt securities for which there is a liquid market (including many "144A-for-life" issues, traded in QIB markets); privately negotiated purchases of debt securities; standard purchases of bank debt in the secondary trading market; or negotiated portfolio acquisitions. Certain legal issues may be implicated by

some forms of transactions and not others.

Getting Started: Issues for Funds Planning to Invest in Debt

In addition to all the conventional issues associated with formation of a new fund, there are certain issues that are particular to funds formed with a view to making investments in debt.

The distressed debt investment, because it often reflects a hybrid of trading and loan-to-own strategies, raises some issues regarding the types of entities eligible to participate. ERISA investors, and funds that include ERISA investors, need to assess whether there is likely to be sufficient control over the target —i.e., the issuer of the acquired debt securities—for the fund to qualify under the venture capital operating company (VCOC) exception to the ERISA "plan assets" regulations.

The VCOC exemption is available to funds that retain certain management rights over a minimum percentage of their portfolio investments.(3) In the case of funds raised exclusively to invest in distressed debt, the VCOC exemption may be available only if specific management rights are negotiated into an amended indenture; alternatively, these funds could avoid ERISA requirements by limiting their ERISA investors' aggregate investment to 25 percent of the fund.

While foreign investors do not pose the same eligibility issues as ERISA investors, tax treatment of investment returns may make certain distressed debt investments unattractive to foreign investors. A foreign fund, or a U.S. fund with foreign investors, will need to determine whether income from the debt instrument will be subject to U.S. tax. Interest will be exempt if it qualifies as "portfolio interest," provided that proper documentation is provided. Tax due diligence should include verifying that the debt instrument to be acquired meets the "registered form" requirements of applicable tax regulations and whether the debt provides for contingent payments. Certain contingent payments (such as payments contingent on the income or profits of the issuer) can disqualify a debt from the portfolio interest exception. Further, the portfolio interest exception is not available to persons who own, directly or by attribution, 10 percent or more of the issuer. If the fund is acquiring equity or warrants of the issuer (in addition to debt securities), the impact of the 10 percent ownership rule must be assessed. If the portfolio interest exception does not apply, then the interest paid by the U.S. issuer will be subject to 30 percent U.S. tax, unless an applicable tax treaty provides an exemption or a lower rate.

On July 1, 2008, the SEC issued proposed rules regarding the deletion of references to nationally recognized statistical ratings organizations (NRSROs) in Regulation M, among other rules.(4) Rule 102 of Regulation M (which limits the ability of security holders who have an interest in the success of a particular offering to trade in issuer securities and thereby unfairly "condition" the market in anticipation of the offering) currently includes an exception for trading investment grade non-convertible securities.(5) Because the definition of "investment grade" securities is based on NRSRO ratings,(6) and because the SEC wants to "reduce undue reliance" on such ratings, the proposed rule eliminates the exception for investment grade non-convertible securities in Rule 102(d)(2) and replaces it with an exception for all non-convertible securities issued by well-known seasoned issuers (WKSIs).(7)

The use of the well-known seasoned issuer as a proxy for investment quality is particularly relevant in this market, in which the debt of many WKSIs is rated (belatedly) by the NRSROs as below investment grade. Should the proposed rule be adopted in substantially the form in the proposing release, the new rule may benefit investors with resale strategies that liberalize restrictions on their ability to trade non-investment grade securities.

Due Diligence Review

In connection with any purchase of debt, the purchaser will want to perform a due diligence review of the terms governing the debt, paying particular attention to the following.

A key characteristic of any debt is the identity of the obligor—who has the obligation to repay the debt. Often there will be multiple obligors, either as co-borrowers or as guarantors. In some cases, there also may be third party credit support (such as letters of credit or insurance) to take into account in evaluating the risks of nonpayment.

Consideration also should be given to how the target debt fits with other indebtedness of those obligors and related parties. For example, structural subordination can exist for debt issued by a holding company, where other debt is incurred by a subsidiary that holds assets or operations. Since the claims of the holding company to the assets of the subsidiary exist by virtue of the holding company's equity ownership, the claims of debt holders of the subsidiary will have priority over claims of the holding company (and its creditors) with respect to the assets of that subsidiary.

In addition, cross default and cross acceleration provisions should be evaluated in light of the overall debt structure of the issuer to ensure that the holders of the debt to be purchased will not be substantially disadvantaged relative to other classes of debt.

The Trust Indenture Act of 1939 (the TIA) requires the issuer of public bonds to file with the indenture trustee all annual reports and other reports that the issuer is required to file with the SEC pursuant to Sections 13 or 15(d) of the Securities Exchange Act of 1934 (the '34 Act). As an overlay to the requirements of the TIA, financial reporting covenants in the indentures that govern these bonds generally come in one of two variations, which might be termed the "restrictive" and "flexible" forms.(8) The restrictive form of the reporting covenant requires the issuer to deliver the same information (i.e., periodic reports on Forms 10-Q and 10-K), and within the same time frames, as would be required by the '34 Act, while the flexible form of the covenant requires delivery of SEC filings promptly after making such filings with the SEC.

Recent case law has generally confirmed (with an exception(9)) that the flexible version requires delivery of the information only as and when it is actually filed under the '34 Act—thus, under the flexible version, if an issuer is delinquent in its '34 Act reporting (e.g., because of a restatement of financials), and belatedly delivers the delinquent report to the SEC and the trustee, there is no breach under the indenture so long as the delivery to the trustee closely follows the filing of the report with SEC.(10) However, the issue is not closed, as evidenced by the recent Finisar litigation. The Finisar litigation, now in the summary judgment phase, poses the same issue, but takes the inquiry a step further: after the litigation commenced, the delinquent SEC filings were made and subsequently furnished to the trustee, albeit after the 60-day period to cure a default under the indenture had lapsed. One of the questions presented to the court is whether such action by the issuer cures the event of default (assuming such an event has occurred).(11)

Debt documentation will almost always include a set of covenants imposing restrictions on various aspects of the operations of the issuer, but the nature and scope of these protections can vary significantly.

Historically, there has been a significant divide between debt securities and bank debt, with bank debt covenants set more restrictively (and waivers and amendments correspondingly commonplace). Bond covenants are usually focused on the issuer's prospective ability to incur debt and liens, and are "incurrence" covenants—financial ratio tests set criteria for determining the permissibility of additional debt or liens at a discrete point in time (the time of incurrence), and if those criteria are met at that time, then such debt and liens are permitted.

Covenants under bank loan documents are usually more concrete, imposing absolute financial maintenance covenants (e.g., a requirement that the leverage ratio of debt to EBITDA not exceed a specified level at any time) and allowing only for set "baskets" of additional debt and/or liens. The "covenant lite" loans that surfaced in 2006 and into the first half of 2007 sought to import bond style incurrence-based covenants into bank loans. Though relatively few deals were completed under this model, the response of rating agencies clearly reflected their view that this represented a significant change in the risk profile of such debt.(12)

Broadly speaking, covenants provide protections against the issuer changing its risk profile as well as "early warning" triggers allowing a creditor to take steps before there are actual payment defaults. How much protection the covenants provide is an element to be evaluated before purchasing any particular debt issue. Where the covenants are less restrictive, the equity holders have much more freedom to operate the company with a view to maximizing equity value. If equity value has in effect been eliminated, this can amount to gambling the debt holder's money on a turn-around. In one report, S&P estimated that where there was no significant layer of debt that included meaningful maintenance covenants, the delay in lenders' ability to force an issuer to the table translated into recovery estimates that were an average of 8 percent to 14 percent lower as compared to equivalent borrowers with full maintenance covenants.(13)

Mandatory and optional prepayment terms should be evaluated for their potential effect on the return on an investment in debt. Debt purchasers should consider the degree to which certain material events will trigger mandatory prepayments—such as changes of control, equity issuances or material dispositions of assets. At the same time, debt purchasers should be mindful of the loss of yield that can result if prepayments (whether mandatory or optional) may be made without premiums or penalties.

The purchaser should identify whether any debt instruments, including the instrument relating to the debt being purchased, have issuer friendly features, such as payment-in-kind, or PIK toggles. PIK toggles, which were a familiar part of the financing landscape just a few years ago, allow issuers to choose to pay interest on their debt by issuing more debt instead of making cash payments. Issuers are still subject to certain financial covenants that prevent them from taking on too much debt without lender consent, but those covenants did not stop seven companies from "flipping the switch" recently on their PIK toggle bonds worth $2.4 billion.(14)

In bank loan documents that include financial ratio maintenance covenants, financial sponsors frequently bargain for an "equity cure" right—the ability to put additional equity into the debt issuer in a manner that would cure the covenant breach. In some cases, the equity cure right would be effected by an equity contribution that would be used to pay down debt, thereby adjusting the leverage ratio or other covenant measured against the issuer's debt levels. In other cases, the equity cure right was taken a step further; the lender's equity infusion was treated as the equivalent of earnings (increasing EBITDA).

While the infusion of additional equity is generally a positive event for debt holders, it bears mention that the allowance of an equity cure can delay the point at which the debt holders can bring the issuer to the table as discussed above in the context of "covenant lite" loans.

Assignability and transfer restrictions should be reviewed and understood, not only for their impact on the proposed purchase but also as they affect the marketability of the debt in the event the purchaser desires to sell the purchased debt in the future.

Publicly traded debt securities will generally be unrestricted. In the case of debt securities issued though a private placement, including "144A-for-life" issuances, there will be limitations on the types of buyers and manner of sale.

Transfers of bank debt often require borrower consent to the assignment in the absence of any defaults under the loan documents.

Insider Trading Rules

Federal 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, joins a creditors' committee as part of a bankruptcy proceeding, 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.(15)

Technically, the insider trading rules do not apply to trading in bank debt since bank debt is not treated as a "security" under the federal 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 the '34 Act 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.(16) 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 recharacterized as tender offers.(17)

Issuer Bankruptcy

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.(18)

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

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.(19)

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.

Tax Issues

If a debt security is purchased at a discount from its face value, the purchaser will be subject to the tax rules concerning "market discount."(20) In general, the market discount rules require that the difference between the face amount of the debt and the purchase price be recognized as ordinary income, taxable at the highest applicable tax rates. Unlike the tax rules governing original issue discount, the market discount rules do not generally require that accrued market discount be taken into income currently.

Instead, market discount is taken into account as principal payments are made, or when the debt is sold, to the extent of the accrued market discount on the date of the sale or payment. In the case of a private equity fund purchaser, individual investors in the fund will recognize ordinary income taxable at maximum rates of 35 percent (rather than capital gain, taxable at a 15 percent maximum rate) with respect to the market discount on debt instruments acquired by the purchaser.(21)

In general, market discount accrues using a ratable method. However, taxpayers can elect, on a bond-by-bond basis, to accrue interest using a constant interest method). Funds should consider the potential benefits of electing the constant interest method, which may reduce front-loading the market discount accrual. Funds also should be aware that a portion of the fund's interest deductions may be deferred if the purchase of market discount bonds is leveraged. The interest deduction deferral rules do not apply to taxpayers who elect to accrue market discount currently.

The modification of a debt (for instance, a change in the interest rate, extension of the maturity date or change in security) may result in a "deemed exchange" for federal income tax purposes. Under some circumstances, the modification of a debt instrument purchased at a discount may result in the purchaser recognizing a taxable gain equal to the difference between the principal of the debt and the discounted purchase price. Deemed exchanges also may have adverse consequences for issuers of debt, including the potential to recognize income from the cancellation of indebtedness (COD income). In general, purchasers will be in a better position to avoid unintended adverse tax consequences if any debt modifications or workouts are completed prior to the acquisition of the debt instrument.

If the purchaser is (or becomes) a related party to the issuer, the purchase of the debt instrument at a discount may result in the issuer realizing cancellation of indebtedness income. In general, the threshold for related parties is 50 percent ownership or control. Distressed debt purchasers and issuers should consult their tax advisors if the purchase will, or may, result in the purchaser's acquisition of a greater than 50 percent interest in the issuer.

Conclusion

Warren Buffet compares taking on debt to driving with a spike sticking out of your steering wheel: All is well until you hit a bump in the road. Hitting a bump in the road, while no doubt painful for the impaled issuer in Buffet's analogy, can create great opportunities for purchasers to infuse cash and greater discipline into a struggling, or at least devalued, business while relieving debt holders who lack the resources to turn the business around. The challenge in investigating and structuring distressed debt transactions is dealing with multiple dynamic variables including investment strategy, market forces, and unknown and unpredictable co-creditors, but careful consideration and even more careful diligence—including investigation of the points described above—can help reap the rewards of a wise investment in distressed debt.

ENDNOTES

1 See, e.g., Matthew Sheahan, "Investors Warming Distressed Bench," High Yield Rep., May 5, 2008.

2 See, e.g., Kelly DuPonte, "An Overview of the Private Equity Distressed Debt and Restructuring Markets," The Guide to Distressed Debt and Turnaround Investing, 15.

3 An advisory opinion issued by the Department of Labor in March of 2002 categorizes these requisite management rights into three groups: (1) delivery rights, which ensure the delivery of financial statements and other financial information to the investor (including a consolidated balance sheet within 120 days of the end of a fiscal year); (2) inspection and access rights, which include the right to receive copies of all documents, reports, financial data and other information reasonably requested; and (3) consultation and advisory rights, which entitle the investor to advise and consult with management relating all business affairs. Dep’t. of Labor Advisory Opinion 2002-1A (Mar. 26, 2002).

4 References to Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 34-58070 (July 1, 2008) (hereinafter, the NRSRO Release).

5 17 CFR 242.102(d)(2).

6 17 CFR 240.15c3-1.

7 NRSRO Release, supra note 4, at 31-33.

8 See Bruce C. Bennett, "Reflections on Indenture Remedies and Investor Protection," 22 Insights 11, 15 (Feb. 2008).

9 See Bank of New York v. BearingPoint, Inc., 824 N.Y.S. 2d 752 (N.Y. Sup. Ct. 2006) (holding that the issuer was in default due to its failure to perform the reporting covenant in the indenture).

10 UnitedHealth Group, Inc. v. Cede & Co., No. 06-cv-4307 (D. Minn. Mar. 10, 2008); Affiliated Computer Services, Inc. v. Wilmington Trust Co., No. 06-cv-1770, 2008 WL 373162 (N.D. Tex. Feb. 12, 2008); Cyberonics, Inc. v. Wells Fargo Bank National Ass’n, No. H-07-121, 2007 WL 1729977 (S.D. Tex June 13, 2007). See also Bennett, supra note 3, at 16—18.

11 Motion for Summary Judgment at 5, Finisar Corp. v. U.S. Bank Trust, No. 507-cv-04052 (N.D. Cal. Apr. 24, 2008).

12 See e.g., Standard & Poor’s Ratings Direct CDO Spotlight (June 12, 2007), "The Covenant-Lite Juggernaut is Raising CLO Risks—And Standard & Poor’s is Responding," http://www2.standardandpoors.com/spf/pdf/fixedincome/CovenantLite_Juggernaut.pdf.

13 See, e.g., Recovery Chances Lower for Covenant-Lite Loans-S&P, July 18, 2008, available at http://uk.reuters.com/article/marketsNewsUS/idUKN1831469820070718 (citing the S&P report).

14 Serena Ng, "PIK and Roll: Companies Seize on Perks of Loose Lending Terms," Wall St. J., May 19, 2008, C-1 (citing a Standard & Poor’s Leveraged Commentary & Data report, premium over market price; (iv) terms of offer are firm and nonnegotiable; (v) offers to purchase contingent upon the purchase of a minimum amount; (vi) offer was open for a limited time ; (vii) offerees were pressured to respond; and (viii) public announcements of a purchase program is followed by a rapid accumulation of the issuer’s securities); Hanson Trust PLC v. SMC Corporation, 774 F.2d 47 (2d. Cir. 1985) (noting certain factors whose presence would indicate the absence of a tender offer, including, inter alia, (i) sophistication of the purchasers; (ii) no time limit within which to accept the offer to purchaser; and (iii) limited or nor advance solicitation or publicity of purchase program).

15 See Glenn E. Siegel & Davin J. Hall, "Confidentiality and Disclosure in Distressed Investing," 24 Rev. of Banking & Fin. Serv. 1 (Jan. 2008).

16 See Wellman v. Dickinson, 475 F. Supp 783 (S.D.N.Y. 1979) (describing eight factors indicating the presence of a tender offer, including (i) widespread solicitation of offers; (ii) solicitation representing a "substantial percentage" of securities; (iii) significant premium over market price; (iv) terms of offer are firm and nonnegotiable; (v) offers to purchase contingent upon the purchase of a minimum amount; (vi) offer was open for a limited time ; (vii) offerees were pressured to respond; and (viii) public announcements of a purchase program is followed by a rapid accumulation of the issuer’s securities); Hanson Trust PLC v. SMC Corporation, 774 F.2d 47 (2d. Cir. 1985) (noting certain factors whose presence would indicate the absence of a tender offer, including, inter alia, (i) sophistication of the purchasers; (ii) no time limit within which to accept the offer to purchaser; and (iii) limited or nor advance solicitation or publicity of purchase program).

17 See, e.g., Client Alert: Navigating Debt Repurchases—Issues and Answers, Latham & Watkins, March 31, 2008, available at http://www.lw.com/upload/pubContent/_pdf/pub2141_1.pdf.

18 See Siegel & Hall, supra note 15.

19 Henry v. Lehman Commercial Paper, Inc. (In re First Alliance Mortgage Co.), 471 F.3d 977 (9th Cir. 2006).

20 An exception to this rule may exist in the case of deeply discounted bonds. Several cases support the view that if a recovery of a deeply discounted obligation is sufficiently speculative, principal payments on the bond should be treated first as a nontaxable return of basis.

21 An illustration: Corp X issued bonds in the amount of $1,000 on January 1, 2005. The bonds pay interest only at the rate of six percent and mature on December 31, 2011. On January 1, 2008, Fund acquires the bonds for $800. The Corp X bond has market discount of $200. Under the ratable method of accrual, approximately $50 of market discount will accrue each year through the maturity date of the bond. Assume that Fund sells the bonds after two years on December 31, 2009, for $950. Fund's gain of $150 is treated as ordinary income to the extent of the $100 accrued market discount and as long term capital gain for the remaining $50.

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