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Financial Reporting Covenants in the Era of "Covenant Lite" and "PIK Toggle" Indentures
July 10, 2007
The unprecedented level of liquidity in the financial markets has permitted companies to issue public debt securities utilizing "covenant lite" indentures. There has also been a revival of "issuer option" coupons (now known as "PIK toggle" notes) that permit issuers, in their discretion (this is the "toggle" feature) to make coupon payments either in cash or in new debt instruments (this is the "PIK" feature). While not a new concept, what is new is the market's general receptiveness to PIK toggle notes in ever-higher leverage situations (although very recently there has been a hint of market push-back).
One consequence of the current indenture environment is that financially troubled issuers can defer default situations for a long time either by staying in compliance with the few remaining covenants in the indenture and/or making coupon payments in new debt instruments to postpone (but seldom to overcome) a liquidity crunch. In this environment, investors are forced to pay even greater attention to the few covenant protections that they have, such as the financial reporting covenant that obligates the issuer to deliver copies of its SEC filings to the indenture trustee pursuant to the terms of the indenture and § 314 of the Trust Indenture Act (the "TIA").
As an initial matter, we reject the notion that a breach of the reporting covenant is a "mere" technical breach. Covenants are either complied with or they are breached and there is nothing "mere" about the breach of any covenant. Further, reporting requirements are close to sacred for investors in public companies, and when an issuer misses an SEC filing deadline there is often the possibility that something serious may be occurring behind the scenes. Why won't the auditors sign off? What might the "minor internal investigation" or the "routine SEC inquiry" reveal? How significant, and for how many years, will the need to restate prior financials extend? There may not always be fire where there is smoke and in the current environment of increased scrutiny of back-dated stock options, investors should exercise prudence. Sometimes, however, there really is a fire, and the failure to make a timely SEC filing should always be taken as a potentially serious matter by investors and issuers alike.
Interestingly, not all financial reporting covenants are alike, even though one would think that they should be "boilerplate." Some specifically mandate that the company must make all SEC filings on a timely basis and then provide copies thereof to the indenture trustee. Others, however, only require the issuer to provide copies of the SEC filings to the indenture trustee. And there are other variations in between.
If the foregoing language variations sound like semantics, they are not—the difference could be quite substantive. In 2006, a New York court issued a significant decision in The Bank of New York v. BearingPoint, 2006 N.Y. Misc. LEXIS 2448 (N.Y. Sup. Ct. 2006), finding that an issuer's failure to make its SEC filings was an indenture default. The decision provides two significant holdings. First, the court held that, as a matter of New York contract law (which governs most indentures), the indenture's language contractually obligated the issuer to make such filings. Second, the court held that TIA § 314, which was expressly incorporated into the indenture, similarly obligated the issuer to make such filings. This was the first decision on this issue and it was a significant development for distressed investors seeking a seat at the table when an issuer displays signs of financial distress by failing to make its SEC filings.
On June 14, 2007, in Cyberonics v. Wells Fargo Bank Nat'l Assoc., Civ. Act. No. H-070121 (S.D. Tex. June 14, 2007), a Texas court came to the opposite conclusion in a case involving an indenture with language that was very similar to the BearingPoint indenture.
Thus, there is now a split of authority with respect to whether a covenant default arises when an issuer fails to make its SEC filings, at least in the context of the specific indenture language that was at issue in these two cases. Issuers can find some comfort in the Cyberonics decision, but it is by no means clear that it will have widespread applicability.
To begin with, at the heart of both decisions is a contractual interpretation of SEC-filing covenants in each indenture. As noted, the BearingPoint and Cyberonics indentures contained virtually identical language, which the courts interpreted in mirror opposite ways. Notably, both indentures (like most U.S. indentures) are governed by New York law. With two competing interpretations, issuers must continue to be concerned as to whether their late SEC filings will trigger an indenture default, or at least a dialogue with concerned investors as to whether an indenture default has occurred. This may be especially so if greater deference is properly accorded to the BearingPoint interpretation by a New York court interpreting a New York law indenture.
Moreover, as a primarily contractual decision, Cyberonics' impact is also limited to the language of the specific indenture at issue. As noted, not all reporting covenants are alike. Notably, the covenant language in Cyberonics (and BearingPoint) is among the weakest strain that exists in today's market. Many indentures contain stronger reporting covenants that leave no doubt that timely SEC filings are required. Cyberonics has no impact upon these other variations of these covenants.
With respect to TIA § 314(a), Cyberonics provides virtually no meaningful analysis of the impact of the TIA. BearingPoint, on the other hand carefully examined the purpose and intent of the TIA in rendering its decision that § 314(a) was violated by the issuer's failure to make its SEC filings. In fact, Cyberonics sidestepped analyzing § 314(a) based upon its contractual interpretation that the indenture actually expressly excluded any SEC filing obligations under § 314(a). The Cyberonics covenant stated that the issuer "shall comply with the other provisions of § 314(a)." Because the court interpreted the reporting covenant's other language as not requiring SEC filings, it interpreted this language as the parties "contracting out" of any obligation to make SEC filings under § 314(a).
As noted above, this interpretation (even if correct) would only apply to other indentures with substantially identical language relating to § 314(a). Other indentures use different language that is not susceptible to the Cyberonics interpretation. Moreover, the § 314(a) language in Cyberonics can also be interpreted as a wholesale incorporation of § 314(a), not an exclusion of TIA obligations. Notably, this is how the BearingPoint court interpreted virtually identical language. Our point is not that Cyberonics is clearly wrong or that BearingPoint is clearly right. We will need more decisions from higher courts before the debate is resolved with some certainty.
Instead, our point is that, while issuers may find some comfort in the Cyberonics decision, the decision has significant limitations. Accordingly, and particularly in today's "covenant lite" environment, public debt investors should continue to consider the financial reporting covenant as an important weapon in their arsenal in those situations where they believe that an issuer should engage in an investor dialogue with respect to actual and prospective financial concerns affecting the business.