Debt buybacks: selected legal issues

1. Given current market conditions, private equity sponsors and their portfolio companies (each, a "Buyer")[1] are considering buybacks of debt owing by those portfolio companies[2]. This is a brief list of selected issues.

2. Potential issues under debt documentation

(a) Transfer prohibitions: are there any assignment or transfer provisions that prohibit buybacks of loans or bonds by (i) the borrower or issuer or (ii) any affiliate thereof? Is there any other provision in the debt documentation that would make the Buyer a disqualified assignee or transferee? If the Buyer is not the borrower or issuer, does the Buyer own any competing business that could make the Buyer a prohibited transferee by reason of being a "Competitor"? Are there specific procedures that must be followed (e.g. a Dutch auction or other similar process)?

(b) Holding restrictions: is there any limitation on the amount that the Buyer is permitted to purchase? Is the borrower or issuer required immediately to extinguish the debt bought back?

(c) Breach: if the Buyer were to become the registered owner of the loan or bond, and the debt documentation does not require the loan or bond to be extinguished immediately, would such purchase by the Buyer result in a violation or breach by the borrower or issuer of, or otherwise contravene, the debt documentation (except for any requirement relating to a consent required to be obtained from the borrower of a loan)? Consider in particular the following covenants:

(i) Line of business covenant

(ii) Investments covenant

(iii) Restricted payments covenant that prohibits payments on certain types of debt instruments to affiliates

(iv) Transactions with affiliates covenant

(v) Etc.

(d) Disenfranchisement: if the Buyer were to become the registered owner of the loan or bond, would voting or other similar consensual rights allocable to the loan or bond be adversely affected? Typically, indentures provide that bonds owned by an "affiliate" of the issuer cannot be voted and are not deemed to be outstanding for purposes of determining if holders of the requisite principal amount of notes have consented to particular actions.[3]

(e) Pro rata sharing: if the buyback is deemed to be a payment or prepayment of a loan, would the seller be required to share the benefit of the payment or prepayment with other members of the lending syndicate by reason of pro rata sharing provisions commonly found in credit agreements?

3. The borrower or issuer will need to consider the accounting consequences of a loan or bond buyback to determine if the debt has been extinguished (e.g. in substance versus legal defeasance). In addition, if the borrower or issuer is an SEC reporting company, financial statements will need to accurately present whether debt has been extinguished. This can have important consequences for financial reporting and covenant compliance.

4. Would the loan or bond being purchased be a security and, if so, are the US Federal tender offer laws applicable to the buyback? A buyback of bonds will usually be structured to avoid the US Federal tender offer rules.

(a) The test for whether or not a tender offer has been made is based on a number of factors, taking all the facts and circumstances into consideration, including: (i) whether there is active and widespread solicitation, (ii) whether solicitation has been made for a substantial percentage of the class of the issuer’s securities, (iii) whether the offer to purchase has been made at a premium over the prevailing market price, (iv) whether the terms of the offer are firm rather than negotiable, (v) whether the offer is contingent on the tender of a fixed amount of securities, (vi) whether the offer is open only for a limited period of time and (vii) whether offerees have been subjected to pressure to sell securities.

(b) In addition, a buyback should be structured to avoid being considered a "creeping" tender offer. If a potential tender offer to all holders is contemplated, open market purchases should be planned carefully to avoid being "integrated" with the tender offer.

5. Will the debt buyback need to be disclosed to the market either before the buyback commences or when it is completed?

6. Would the Buyer (other than the borrower or issuer) lose the availability of the portfolio interest exemption from US withholding tax if the Buyer were the beneficial owner of the loan or bond for US federal income tax purposes? This would be problematic if:

(a) The Buyer is a 10-percent shareholder (within the meaning of Section 871(h)(3)(B) of the Internal Revenue Code) with respect to such borrower or issuer;[4] or

(b) The Buyer is a controlled foreign corporation as to which such borrower or issuer is a related person (within the meaning of Section 864(d)(4) of the Internal Revenue Code)—generally where there is at least 50 percent overlapping ownership by value in the case of two entities

The Buyer would need to rely on a tax treaty or other exemption in order to avoid withholding.

7. Would the borrower or issuer recognize any cancellation of indebtedness income under Section 108 of the Internal Revenue Code, including by reason of a relationship between the Buyer (if not the borrower or issuer) and such borrower or issuer described in Section 108(e)(4) of the Internal Revenue Code?

(a) For these purposes, a related person will generally include persons who are related by more than 50% actual or constructive ownership.

(b) A person will also be considered related for purposes of the cancellation of indebtedness rules if they are treated as under "common control", which is a less defined standard but is broadly intended to test indirect common control and ownership.

8. Would the borrower or issuer be unable to deduct original issue discount and interest for US Federal income tax purposes if the Buyer is a related foreign person until the original issue discount or interest is actually paid?

9. Is the Buyer in possession of any material non-public information ("MNPI") concerning the borrower or issuer? If the debt obligation being purchased is a security[5], then the Buyer has a duty to disclose the MNPI or refrain from trading.

(a) Is the fact of the purchase of the loan or bond, in itself, MNPI?

(b) If the debt obligation is a loan, the Buyer (if it is the borrower) should consult the credit agreement to see whether the Buyer has an obligation to disclose MNPI in connection with the purchase.

(c) If the Buyer is in possession of MNPI under either (a) or (b) above, is such MNPI either:

(i) information that can be disclosed to a prospective assignee or transferee of the security without violation of any confidentiality obligations (without implicating any selective disclosure concerns); or

(ii) if the Buyer is not the borrower or issuer, held by employees of the investment adviser to the private equity sponsor that are separated by an information wall from the investment professionals that render advice to the Buyer?

(d) If the Buyer is an entity other than the borrower or issuer:

(i) Are the personnel responsible for rendering investment advice to the Buyer (e.g., employees of a debt fund under the same umbrella as a private equity owner) walled off from the personnel responsible for rendering investment advice to the private equity sponsor?

(ii) Is the legal entity responsible for rendering investment advice to the Buyer different from the legal entity responsible for rendering investment advice to the private equity sponsor?

(e) Is the Buyer willing to rely on a non-reliance (so-called "big boy") letter in a sale to a highly sophisticated investor?[6]

(f) Insider trading policies (including with respect to trading windows) of the private equity sponsor/borrower or issuer would need to be considered and followed.

10. Corporate governance concerns

(a) The opportunity to purchase debt at a discount may be viewed as a corporate opportunity that belongs to the borrower or issuer and should not be wrongly taken by the private equity sponsor. Unless the borrower or issuer's charter formally waives the application of this doctrine, it may be prudent to have the borrower or issuer first consider the debt buyback opportunity and formally decline to pursue it. The decision to formally decline to pursue such an opportunity would best be made by directors who are independent of the private equity sponsor (if there are such persons).

(i) Are any preemptive rights of investors in the private equity sponsor triggered?

(ii) Various private equity fund partnership agreements restrict (either entirely or by establishing a basket) the amount of capital that can be used to effect open market purchases of securities of portfolio companies.

(b) If the Buyer is the private equity sponsor, the Buyer may be conflicted as a result of being both a significant creditor of the borrower or issuer and also its equity holder. Directors that are not independent from the private equity sponsor may be required to recuse themselves from board decisions related to the borrower or issuer's capital structure or any future restructuring involving the borrower or issuer. This could result in control of future material decisions being made by board members who are independent of the private equity sponsor.

(c) If the Buyer is an affiliated debt fund of the private equity sponsor, issues may arise under the Investment Advisers Act of 1940.

11. Would inequitable conduct of the Buyer (if not the borrower or issuer) toward creditors of the borrower or issuer cause the loan or bond to be equitably subordinated under Section 510(c) of the Bankruptcy Code following the commencement of a bankruptcy proceeding relating to the borrower or issuer? The Buyer must be mindful that harmful conduct may cause the acquired loan or bond to be subordinated.

12. Would payments of the debt made by the borrower or issuer to the Buyer (if the Buyer is an affiliate under the Bankruptcy Code) be subject to clawback as a preference under Section 547 of the Bankruptcy Code for a period of one year (as opposed to 90 days) prior to the bankruptcy of the borrower or issuer?

13. If the Buyer is the private equity sponsor, will the Buyer’s vote be considered when determining whether a class of creditors has accepted a plan of reorganization under the Bankruptcy Code? Under Section 1129(a)(10) of the Bankruptcy Code, one of requirement to obtain confirmation (i.e. approval) of a plan is that at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider. Under most circumstances, the private equity sponsor will be considered an insider. Therefore, careful consideration of the creditor base will be key to determining whether chapter 11 is a viable option for the borrower.

14. How would answers to the foregoing questions/issues change if the Buyer acquired economic exposure to the loan or bond through a funded or unfunded participation, credit default swap, total return swap or other derivative financial instrument?

(a) Many swap dealers take a dim view of total return swap or other similar instruments that would permit the Buyer to gain exposure to a loan or bond in order to avoid a negative consequence that would otherwise arise in the case of record ownership.

(b) Section 510(b) of the Bankruptcy Code creates a risk to the swap dealer that would not exist if the Buyer had purchased the loan or bond directly. Under that Section, a claim under a total return swap against the Buyer for capital depreciation arising from the swap dealer’s purchase of debt as a hedge (because the Buyer is an affiliate of the borrower or issuer) is subject to subordination to all claims or interests that are senior to or equal the claim or interest represented by such security.

[1] As well as mainstream corporates. This list of issues focuses on private equity, but many of the issues apply as well to corporates.

[2] Of course, buybacks do not make good business sense if they would result in insufficient liquidity.

[3] If the Buyer is an debt fund that is an affiliate of the private equity sponsor by reason of common management, such a Buyer of loans is typically able to vote to approve amendments or consents (but often with the prohibition on these loans constituting more than 49.9 percent of the loans approving any amendment or consent).

[4] If the Buyer (not the borrower or issuer) is an entity taxed as a partnership for US Federal income tax purposes, (a) the 10 percent ownership threshold will be tested at the level of the Buyer's partners, using a partner-by-partner analysis, and (b) the Buyer will need to present an IRS Form W-8IMY to claim either the portfolio interest exemption or treaty relief. This would require the Buyer to compile and attach the US withholding forms (IRS W-8s for non-US persons or W-9s for US persons) for its underlying partners, together with a withholding statement which allocates to each partner their share of the Buyer's income.

[5] Although bank loans are traditionally not considered to be securities, borrowers and private equity sponsors frequently adopt similar policies which prohibit the purchase of bank loans while in possession of MNPI.

[6] For loans: LSTA guidelines provide that market participants should generally not trade while in possession of MNPI (other than confidential information that is made available to all current and prospective members of the lending syndicate), unless the market participant has obtained the MNPI without a breach of any duty owed by the market participant to the borrower, and the market participant reasonably believes that the counterparty is in possession of or has access to such MNPI. Any exceptions should be subject to the internal policies of the market participant and consistent with the LSTA Code of Conduct. Where an exception is being made, market participants may consider using enhanced disclosure language and explicit acknowledgement of non-reliance. The LMA has published similar principles.