As the world continues to adapt to the COVID-19 pandemic, many companies are assessing their liquidity position, general balance sheets, near-term interest payments and debt maturities. One way companies with outstanding debt securities are addressing these concerns is by evaluating possible liability management transactions. Benefits of undertaking liability management transactions include deleveraging, reduction of interest expense and delaying refinancing requirements by extending debt maturities.

Examples of transactions that companies might consider in response to COVID-19 include:

• Taking advantage of the ongoing market disruption to deleverage by repurchasing debt securities or loans;
• Utilizing a tender offer to refinance outstanding bonds at lower rates (and at a discount to the current applicable redemption price);
• Using a consent solicitation to increase flexibility in existing restrictive covenants (other than fundamental covenants such as payment of principal and interest); and
• Engaging in an exchange offer with holders to exchange existing bonds for a new series of bonds to forgo short-term interest payments or add payment-in-kind flexibility in exchange for improved long-term economics for the holder, such as a higher interest rate or amount due at maturity.

This client alert provides a summary of these types of liability management transactions as well as an overview of certain other important considerations, including disclosure obligations, contractual limitations and tax matters. 

Open-Market Repurchases of Debt Securities

Given current market conditions, many companies have outstanding debt securities that are trading at significant discounts. As a result, many companies (or their affiliates, such as private equity or other significant investors) are evaluating repurchasing debt at a discount by conducting open market or negotiated debt repurchases.

Avoiding Tender Offer Requirements

In structuring open market or privately negotiated debt repurchases, it is important to insure that such repurchases do not inadvertently become a tender offer for United States federal securities law purposes. If a purchase of securities is deemed to be a tender offer, compliance with certain SEC requirements will be necessary, including disclosure matters and requirements that the offer must be held open for a minimum number of days.

Because “tender offer” is not defined by statute, there is no bright-line rule as to whether an offer constitutes a tender offer. As a result, courts have applied an eight-factor test to determine whether a repurchase is a tender offer. This test considers factors such as whether there is an active and widespread solicitation, the percentage of securities to be purchased and whether the terms of the offer are firm or negotiable. As a result of these factors, repurchases that are not intended to be tender offers should be structured:

• For a limited amount of securities;
• To a limited number of holders (preferably sophisticated investors if not open market purchases);
• Over an extended period of time (with no pressure for holders to sell);
• At prices privately and individually negotiated; and
• With offers and acceptances independent from one another.

Disclosure Considerations

In evaluating whether to undertake a debt repurchase program, a number of important disclosure considerations may come into play. Because the company (or its affiliates) would be purchasing securities, disclosure obligations may arise at a time when the company would not otherwise be required to make such disclosure. These include:

• Disclosure of the repurchase program. Companies should consider whether the implementation of a securities repurchase program is itself material non-public information (MNPI) that should be disclosed in the context of a purchase of securities by the company. This can be a challenging analysis, driven in part by the expected size of the program, the company’s current liquidity and whether the company or an affiliate is purchasing the securities. However, many issuers historically have included disclosures in their periodic reports noting that the company or its affiliates may make open market or other repurchases of outstanding debt securities from time to time. Such disclosures can be helpful when determining that additional disclosures are not required and companies should consider including these types of disclosures in upcoming periodic reports if they have not done so previously. 
• Other MNPI. Depending on the timing of any debt repurchases (including tender offers and exchange offers as well as loan buybacks, as described below), the company or the affiliate making the purchase may be in possession of MNPI concerning the company, including unreleased earnings or potential changes to credit ratings. In times of significant market and economic uncertainty, companies should be especially cognizant of these types of issues. Any MNPI should be disclosed prior to making debt repurchases and consideration should be given to whether a debt repurchase transaction is best timed to occur, for example, shortly after the public release of earnings and the related filing of a quarterly or annual report.
• Regulation FD and EU Market Abuse Regulation (MAR). If negotiating private repurchases, companies should be aware of any disclosure obligations, including under Regulation FD and MAR, prohibiting them from making selective disclosures of MNPI that are not otherwise publicly disclosed to potential sellers.

Treatment of Repurchased Securities

Companies contemplating engaging in a repurchase program in anticipation of conducting other liability management transactions should be aware that repurchased debt securities held by the company or an affiliate of the company will typically be excluded from calculations under the related indenture in determining whether holders have approved an amendment or waiver to the terms of the securities. As a result, in some circumstances, repurchasing debt securities may make, for example, relaxing certain covenants more difficult if the remaining securities are held by a smaller group of less cooperative holders. 

Tender Offers

Engaging in a tender offer permits a company to make a broad solicitation to repurchase securities to all of its holders. Generally speaking, tender offers for non-convertible debt securities are subject to some but not all of the tender offer rules that apply to equity securities. In particular, tender offer documents for non-convertible debt securities are not required to be filed with the SEC and, therefore, debt tender offers can be commenced relatively quickly. Note, however, that convertible notes are considered to be equity securities under the federal securities laws and, as a result, tender offers for convertible securities must comply with the more cumbersome rules applicable to equity tender offers.

Generally, tender offers must be kept open for 20 business days. However, in most circumstances, debt tender offers can be structured to include a 10-business day early tender premium, which effectively shortens the period during which most holders will tender to the first 10 business days. Companies may also structure tender offers in a variety of other ways, including offering to purchase all or a portion of multiple series of debt securities, offering different prices between different series and Dutch auction pricing, as described below. 

In 2015, the staff of the SEC issued no-action letter guidance allowing for abbreviated five business day tender offers, if the transaction satisfies certain conditions. These conditions require that, among other things:

• The offer must be made to all holders of the debt securities and for all of the outstanding securities;
• The offer must be made by the issuer or a parent or subsidiary of the issuer;
• The offer must be made solely for cash or other so-called qualified debt securities;
• The consideration offered in the tender offer must be fixed or based on a benchmark spread; and
• The offer cannot be combined with an exit consent to amend or eliminate covenants or otherwise to amend the provisions of the debt securities. 

The no-action letter also limits the type of debt that may be used to finance an abbreviated tender offer and requires that the company must follow certain public announcement and Form 8-K filing requirements, as applicable, with respect to the tender offer. 

While the abbreviated tender offer no-action letter affords significant flexibility in some cases, that flexibility will not be available in most distressed or restructuring cases, especially where an exit consent to strip covenants is an important aspect of the transaction.

As noted above, in any event, companies should be aware of their disclosure obligations, particularly if they are in possession of MNPI that should be disclosed to the market prior to commencing a tender offer.

Exchange Offers

Rather than conducting a tender offer for cash, companies may also consider an exchange offer where outstanding debt securities are exchanged for new debt or equity securities. These types of transactions generally must comply with both the tender offer requirements described above  and the securities law requirements related to a sale of securities. In particular, the sale of new securities must either be registered with the SEC, which involves filing a new registration statement that is subject to review by the SEC, or issued under an exemption from registration (e.g., Section 4(a)(2), Regulation D and Regulation S). In any event, an exchange offer will require more detailed disclosures concerning the company (including recent material developments), the terms of the offer and a description of the new securities, than would be required in a tender offer. 

Because of the registration requirements applicable to exchange offers, most companies will limit exchange offers to accredited investors or will attempt to rely on Section 3(a)(9) of the Securities Act, which is a narrow exemption permitting companies to issue, in certain circumstances, securities solely in exchange for existing securities without registration. Depending on who owns the existing securities, a portion of the exchange offer may also be structured as an unregistered offshore offer, in accordance with Regulation S. 

In times of constrained liquidity, which many companies are facing as a result of COVID-19, exchange offers can be a particularly useful tool in managing interest payments or upcoming maturities. While credit agreements may permit companies to obtain, for example, a waiver of an interest payment relatively easily, such changes under outstanding debt securities would require consent of all holders. However, by offering to exchange existing securities for a new series of securities, a company may be able to forgo a near-term interest payment in exchange for a higher yield or otherwise-improved economic terms for participating holders.

In considering the various exchange offer structuring alternatives, companies should work with their advisors early in the process to identify existing holders and evaluate the optimal structure. Note, in particular, that excluding non-accredited investors from participating in an exchange offer may present potential issues if an exit consent (as described below) is also solicited. 

Consent Solicitations

Companies may also consider soliciting consents from holders of debt securities to amend the terms of the securities, either independently or in connection with a tender offer or exchange offer. Other than changes related to maturity date, interest rate, principal amount and other fundamental terms, most indentures permit the terms of debt securities to be modified with a simple majority approval of the holders of outstanding securities. 

Consent solicitations undertaken on a stand-alone basis will typically offer the holders a consent fee to incentivize participation and can typically be conducted on an accelerated timeline – in many cases as few as five business days from launch.

While some companies do undertake stand-alone consent solicitations, the more typical case is to combine a consent solicitation with a tender or exchange offer. Because holders provide their consent in connection with selling or exchanging their securities, these types of consent solicitations are referred to as “exit consents.” In most cases, companies seeking an exit consent will ask consenting holders to remove the majority of the restrictive covenants in the indenture, which would make the securities much less appealing to continuing holders and serve as an additional incentive for holders to participate in the offer. In addition to incentivizing participation in the offer, removing restrictive covenants can also have the benefit of increasing flexibility to conduct other transactions, such as incurring additional debt, because any remaining notes will not contain these limitations.

Loan Repurchases

Similar to the repurchase of debt securities, many companies (and their private equity sponsors) are considering the repurchase of their outstanding term loan debt to capture declining secondary market trading prices for bank loans. Many credit agreements specify mechanics for a borrower or its affiliates to purchase loans (generally limited to term loans).  Borrowers owned by private equity sponsors, in particular, negotiate credit agreements to include flexibility to buy back loans.

The advantage of such loan buybacks, in addition to purchasing debt at a discount that may later trade above the purchase price, is that the company (or its private equity sponsor) can reduce overall net leverage, reduce interest and amortization expenses, better manage liabilities on its balance sheet and improve financial covenant calculations. 

Loan buybacks are typically conducted through a Dutch auction procedure or open market process. In a Dutch auction, the borrower offers to purchase the debt at a specific price (or a price range), set as a discount to par, and makes the offer ratably to the entire lender syndicate. Typically, the borrower will have the option to purchase the debt at the lowest price offered by the participating lenders. In an open market buyback, the borrower can negotiate the buyback with individual lenders on a non-pro rata basis.

Loan buyback provisions in credit agreements vary and need to be reviewed carefully. If permitted, there are usually express conditions and terms set forth in the credit agreement. The provisions in a credit facility applicable to limitations on loan buybacks will depend on the entity conducting the loan buyback. There are generally three categories of purchasers:

• The borrower itself;
• A “bona fide debt fund” affiliate, which is an affiliate of the borrower that primarily extends credit and is not controlled by the borrower or its private equity sponsor; and
• Non-debt fund affiliates of the borrower.

Loan purchases by the borrower are often subject to conditions precedent that no event of default or unmatured default exists and drawings under the revolver are not used. Borrowers are often required to represent that it is has disclosed all nonpublic information that could be material to the buyback.  Following a borrower buyback, the loan is often automatically cancelled, ensuring that the borrower does not have any lender rights. 

Loan purchases by a borrower affiliate are often not subject to conditions precedent and, following purchase, loans can remain outstanding subject to ongoing limitations. For affiliates of the borrower who are not bona fide debt funds, the principal amount of the term loan that such affiliated lenders can hold at a time is often capped (typically 20-30% of the outstanding term loan facility). Additionally, certain rights of lenders generally are limited for such affiliated lenders. Such limited rights often include:

• Exclusion from voting decisions over amendments or company actions or consents (with certain exceptions for actions that adversely affect the affiliated lender);
• Exclusion from voting claims in bankruptcy;
• A power of attorney in favor of the administrative agent to vote claims in bankruptcy; and
• Exclusion from lender meetings and receipt of certain lender information. 

While these limitations are often not applicable to bona fide debt fund affiliates, credit agreements often limit voting rights of bona fide debt fund affiliate lenders to just under a majority of the voting power.

Contractual Limitations

Companies considering a liability management transaction should consider their contractual limitations that might limit flexibility. For example, companies should review credit agreements to determine if repayment of outstanding notes prior to maturity is restricted. In addition, if new debt is being incurred to finance repayment or in exchange for existing securities, debt incurrence capacity (and, if the new debt is secured, lien capacity) under existing credit agreements and indentures must be evaluated.[1] Loan buybacks are typically subject to restrictions in the applicable loan documentation (as set forth above), so the company should carefully review its existing loan documents to ensure compliance with such restrictions and determine whether any amendments to the loan documents are needed to permit a loan buyback or a repayment.

Tax Considerations

In connection with the various types of liability management transactions discussed above, tax planning is essential to prevent unexpected, and potentially adverse, tax consequences. For example, central to the tax considerations for a company restructuring its debt is the potential recognition of cancellation-of-indebtedness (COD) income. Under the Internal Revenue Code (the “Code”), taxpayers with outstanding debt are often subject to tax on COD income when all or a portion of such debt has been economically cancelled unless special exceptions apply (for example, in the event of bankruptcy or insolvency of the taxpayer). In addition, corporations that issue obligations with original issue discount (OID) as part of their restructuring must also consider potential limitations on the deductibility of such discount. For corporations that issue certain “applicable high-yield discount obligations” with “significant OID” (AHYDOs), a portion of such discount is treated as a nondeductible dividend under Section 163(e)(5) of the Code, while the remaining discount may not be deducted until actually paid. Companies considering a liability management transaction should consider the tax outcomes of their planned actions. What follows below is a brief overview of some of the basic tax considerations that should be evaluated.

Repurchases of Debt Securities, Loan Buybacks and Tender Offers

A company that repurchases its issued debt securities or buys back an outstanding loan at a discount to its adjusted issue price will generally recognize ordinary COD income in the amount of the discount. This occurs whether the company repurchases the debt securities or loan directly or repurchases the debt securities or loan through a related party, such as an intermediary.

A debt holder whose debt security is repurchased by the issuer will recognize gain or loss equal to the difference between the amount of cash received in the repurchase and the holder’s adjusted tax basis in the debt security. If the holder acquired the debt security with market discount, a portion of any gain may be characterized as ordinary income. Equivalently, a lender whose loan is repurchased by the borrower will recognize gain or loss equal to the difference between the amount of cash received in the buy back and the lender’s adjusted tax basis in the loan.

The tax issues in a repurchase apply similarly whether the company uses a tender offer to repurchase its debt securities or repurchases the debt securities without using a tender offer.

Exchange Offers and Consent Solicitations

A company that exchanges new debt for old debt, or that modifies old debt (and is therefore deemed to exchange old debt for new debt), may also potentially recognize ordinary COD income if it results in a taxable exchange. In the event of a taxable exchange, the company will recognize ordinary COD income in the transaction to the extent the adjusted issue price of the old debt exceeds the issue price of the new debt. A modification of existing debt or a debt-for-debt exchange will be treated as a taxable exchange if the modification to the old debt is determined to be “significant” under applicable Department of Treasury regulations. Generally, modifications are significant if, among other things:

• The yield changes by the greater of 25 basis points or 5% of the existing annual yield;
• Scheduled payments are materially deferred;
• Modified credit enhancements change payment expectations; or
• The nature of the security changes (for example, from debt to equity or from recourse to nonrecourse). 

By contrast, certain consent solicitations that seek to change “customary accounting or financial covenants” generally do not normally, by themselves, constitute significant modifications.

In each case, particular attention must be paid to terms of art like “issue price,” the meaning of which may vary depending on a number of factors. For example, if existing debt is publicly traded, the issue price of new debt issued (or constructively issued, in the case of a modification) in exchange for such debt is deemed the current market price. Depending on prevailing economic conditions, debt exchanges or modifications will result in COD income if the market prices of existing debt securities are discounted from their original or adjusted issue prices. Furthermore, even though a debt security or interest in a loan may not be traded on an established exchange, the debt may still be considered “publicly traded” and its fair market value may be determined to be below its issue price if discounted pricing for the instrument appears on a quotation medium (such as Bloomberg or TRACE) or is otherwise readily available through quotes obtained from dealers, brokers, or traders. 

In addition to the recognition of COD income, an exchange could also trigger the accrual of OID deductions over the remaining term of the debt to the company. Interest limitations may also affect the deductibility of OID. While a company will incur additional interest deductions over time on the new debt (and the holder will recognize taxable income in a corresponding amount), a company may not be able to deduct the additional interest given the limitations in Section 163 of the Code. For example, Section 163(j) of the Code generally limits business interest deductions to 30% of “adjusted taxable income.” For taxable years beginning prior to January 1, 2022, “adjusted taxable income” is determined without regard to deductions for depreciation, amortization or depletion, but no such adjustment may be made for taxable years beginning on or after January 1, 2022. However, Congress recently passed the Coronavirus Aid, Relief, and Economic Security Act, H.R. 748 (the “CARES Act”)[2], which temporarily increased, for tax years beginning in 2019 or 2020, the threshold from 30% to 50% so that taxpayers generally may deduct interest up to the sum of 50% of adjusted taxable income plus 100% of business interest income. Taxpayers may also elect to use their 2019 adjusted taxable income for determining their 2020 interest deduction limitation. In addition to the limitation in
Section 163(j) of the Code, other limitations may apply if the new debt is deemed to be an AHYDO under Section 163(i) of the Code.

Finally, if the exchange or modification constitutes a “recapitalization” within the meaning of Section 368(a)(1)(E) of the Code, such exchange or modification generally should not result in gain or loss to the debt holder. In general, in order for the exchange to constitute a “recapitalization,” the old debt and new debt must each be of a sufficient maturity (typically, at least five years) in order to constitute “securities” for U.S. federal income tax purposes. In addition, depending on the terms of the new debt relative to the old debt, certain taxable consequences could still follow even if the exchange or modification qualifies as a “recapitalization.” For example, if the principal amount of the new debt exceeded that of the old debt, the holder could still recognize gain equal to the fair market value of such excess. Exchanges and modifications can also create OID or, conversely, an amortizable premium, due to differences in the issue price of the new debt and the stated redemption price at maturity.

The tax consequences of any consent solicitation fees are unclear.

Conclusion 

COVID-19 continues to present unprecedented challenges to the world, including wide ranging economic and financial impacts. As companies struggle to adapt, considering liability management transactions to delever or create additional covenant or interest payment flexibility may be a critical tool to weather the storm. 

[1] See our March 26, 2020 client alert, COVID-19: Liquidity Issues and Debt Incurrence Capacity in High Yield Bonds.

[2] See our March 27, 2020 client alert, Coronavirus (COVID-19) “CARES Act” Provides Targeted Tax Relief for Businesses.

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