On March 4, 2009, Ford Motor Company announced plans to restructure its debt including a proposed loan buyback by its financial arm, Ford Motor Credit Company, in relation to $500 million of senior secured term loan debt. Ford joins the growing number of companies taking advantage of historically low prices in the secondary loan market to attempt to buy back their debt at a discount (see Box, Loan Buybacks).
"In the current market, loans that are trading at a discount may not accurately reflect the value of a business or its prospects," says Michael Goldman, a partner at Cravath, Swaine & Moore LLP. "The debt of many otherwise healthy companies is trading at a substantial discount to par." A buyback enables a healthy company to take advantage of this market disconnect.
A buyback can also have benefits for a distressed company, according to Eric Goodison, a partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. As well as enabling a company to reduce its debt burden and improve its leverage, a buyback may also enable the company to avoid breaching financial covenants.
For lenders, buybacks present a dilemma. Successful buybacks typically take place at a price above what is offered in the secondary loan market and enable lenders to reduce the debt on their books in what is otherwise a stagnant market.
However, buybacks take place at a discount to repayment at par, which is what lenders are entitled to under the terms of the loan agreement. There are also benefits to not participating: "Secured lenders who do not participate may get increased collateral coverage, as the amount of the debt decreases but the collateral securing it remains the same," says Goodison.
There is also an objection of principle. Syndicated lending revolves around the principle of equality among lenders. For this reason, loan agreements typically require that any payments by a borrower to a lender in relation to the loan must be allocated to each lender relative to their proportion of the debt (pro rata (www.practicallaw.com/7-382-3713) payment provisions). Even if the buyback is structured as an assignment from the selling lender to the borrower, the retirement of the loan may be re-characterized as a prepayment under the pro rata payment provisions. This creates a practical problem for selling lenders, who do not want to share proceeds of the sale with other syndicate members.
In practice, the pro rata payment provisions (and certain other provisions of the loan agreement) will generally need to be amended before a buyback can take place, unless the buyback can be structured around them (see Amending the Loan Agreement).
The principal issue to be determined in structuring a buyback is who should effect the purchase.
When a borrower purchases its own debt, the common view is that the debt is extinguished rather than remaining outstanding, because the borrower cannot owe an obligation to itself (see Box, Tax Consequences). This is generally preferable for both the borrower and the lender for a number of reasons.
For the borrower, extinguishing the debt it buys back means that the borrower actually reduces the amount of debt it owes. In addition, extinguished debt and the associated interest expense will not be included in the calculations used for financial covenant ratios and other purposes of the loan agreement.
Financial covenant ratios such as leverage ratio (www.practicallaw.com/4-382-3578) (debt to EBITDA (www.practicallaw.com/8-382-3430)), interest coverage ratio (www.practicallaw.com/3-382-3550) (EBITDA to interest expense) and fixed charge coverage ratio (www.practicallaw.com/3-382-3475) (EBITDA to fixed charges) measure a company's leverage and ability to meet their payment obligations with operating cash flow (www.practicallaw.com/4-382-3314). Borrowers are required to maintain these ratios at levels specified in the loan agreement and they are typically measured at the end of each fiscal quarter. Failing to meet these ratios constitutes an event of default under the loan agreement.
Financial definitions such as EBITDA, which is the quantification of the borrower's ability to generate cash, are used to calculate the financial covenant ratios. If a borrower suffers a decline in EBITDA, it may need to reduce its indebtedness to comply with these ratios and avoid defaulting under the loan agreement. These definitions include a measure of the borrower's indebtedness, and the debt bought back will be excluded from that measure if it is extinguished.
By contrast, if the debt remains outstanding, the borrower will not have reduced the amount of debt it owes, and that debt will continue to be included in the relevant calculations and ratios, unless otherwise negotiated.
For the lenders, extinguishing the bought back debt means that they can avoid addressing the treatment of the borrower as a lender under the loan agreement, both as a potential competing creditor and with respect to possessing insider information and voting rights.
However, in practice, the borrower itself is very often prevented from buying the debt because of the pro rata payment provisions. Amending the pro rata payment provisions often requires the unanimous approval of the lenders. This is treated as virtually unattainable in practice, unless the syndicate is a relatively small group.
For this reason, buybacks are often effected by an affiliate of the borrower, the borrower's private equity sponsor (www.practicallaw.com/3-382-3828) (if the borrower is a portfolio company (www.practicallaw.com/4-382-3696)) or a newly formed special purpose vehicle (www.practicallaw.com/7-382-3826) or a holding company formed by the sponsor (see Box, Sponsor Buybacks (www.practicallaw.com/3-385-3373)).
If the debt is bought by a borrower, affiliate or sponsor and it is not extinguished under the terms of the loan agreement, the lenders typically negotiate to substantively or "synthetically" extinguish the debt, either under the terms of the amendment to the loan agreement made to permit the buyback or a related agreement, often a subordination agreement.
Synthetically extinguished debt remains technically outstanding but is not treated as debt under the loan agreement for certain purposes. Imposing restrictions on the rights of the buyer under the loan agreement and subordinating the debt can create the effect of retiring the debt.
The terms of synthetic extinguishment are typically heavily negotiated but they generally include:
Subordinating the debt to other loans of the borrower.
Excluding the debt from calculation of the financial covenant ratios and related definitions.
Subjecting the debt to turnover provisions in bankruptcy, forcing the buyer to transfer any proceeds to the other lenders.
Restricting the transfer of the debt.
Forfeiting or limiting voting rights in relation to the debt bought back.
Making the debt unsecured.
Sponsor buybacks tend to be done privately, without an amendment and undisclosed to syndicate members. "If a sponsor uses its own cash to buy back debt, it is typically not implicated in the restrictions of the loan agreement and the side deals with agents are not published," notes Mario Ippolito, a partner at Paul, Hastings, Janofsky & Walker LLP.
The administrative agent and sponsor may enter into a "side letter" or agreement restricting the rights of the sponsor under the loan agreement and the terms of the debt to protect the other lenders.
Sponsors are often willing to give up some lender rights and to accept a subordinated position as a debt holder to rescue a distressed portfolio company or for the opportunity to profit from the discounted rate based on the prediction that the price will re-bound when the debt matures.
As noted above, loan agreements may include restrictions on assignments to the borrower, affiliates and sponsor. Even if a loan agreement does not expressly prohibit such assignments, it typically includes restrictions that would in practice prevent a buyback by a borrower or affiliate and possibly the sponsor. This means that buybacks almost invariably require amendments to the loan agreement (see Standard Clause, Loan Agreement: Amendments (www.practicallaw.com/0-383-2928) and Practice Note, Loan Agreement: Amendments (www.practicallaw.com/5-382-7142)).
Following Citadel Broadcasting's successful buyback in March 2008, Booz Allen Hamilton negotiated a buyback mechanism into its loan agreement, enabling it to buy back debt without amending the agreement. However, such mechanisms are exceptional and, in a market with few new deals, unlikely to proliferate quickly. They also provide no guarantee of success: Booz Allen's own attempt to buy back its debt failed.
Agreement on amendments can generally be achieved where the commercial terms are right, unless the necessary amendment requires unanimous approval. "For the right price, almost any amendment proposal can be successful," says Goldman.
There is no established market price, but lenders typically expect fees for agreeing to amendments. For example, in October 2008, Entravision Communications offered a fee of $350,000 to the lenders to secure an amendment enabling it to purchase up to $75 million of its term debt.
In addition to seeking amendment of terms that would prevent a buyback, the borrower will also need to obtain any necessary consents and approvals under the terms of the loan agreement.
Mario Ippolito, partner at Paul, Hastings, Janofsky & Walker LLP, advises borrower clients to discuss the proposed amendment and loan buyback with the administrative agent before beginning the process. The administrative agent can discern whether the syndicate members will be receptive to the buyback proposal.
The amendment agreement may include provisions detailing how the bought back debt will be treated, including whether it will be subordinated or excluded from the calculation of the financial covenant ratios. Alternatively, the amendment agreement may contain only the amended provisions of the loan agreement and the parties may execute an additional agreement that sets out the other terms of the buyback.
Wherever they appear, the terms of the buyback will include the process by which the loans will be bought, typically a tender offer (www.practicallaw.com/9-382-3873) or Dutch auction (www.practicallaw.com/6-382-3426), as well as the terms of the sale. The terms of the sale include all of the following:
The purchase price of the debt (a fixed price or a range).
The length of time the tender offer or Dutch auction will be open.
The amount of debt that can be bought.
The number of tender offers or Dutch auctions that are permitted.
The borrower can only begin the tender offer or Dutch auction process once the terms of the amendment and the buyback itself have been agreed to with the syndicate (see The Buyback Process (www.practicallaw.com/3-385-3373)).
The key loan agreement terms typically relevant to a proposed buyback are set out below.
A loan agreement may prohibit the assignment or transfer of loans to a borrower, affiliates or sponsor under the assignment section or by excluding them in the definition of "eligible assignee". The definition of eligible assignee usually includes any lender to the loan agreement and its affiliates and anyone approved by the administrative agent. The definition may either expressly exclude the borrower, affiliates or sponsor as an eligible assignee or not include them. Assignment provisions and the definition of eligible assignee vary between loan agreements; however amending these terms usually requires only a majority vote.
Even if there is no express prohibition on assignment to a sponsor, the consent of the administrative agent is typically required to assign loans to entities other than existing lenders or their affiliates. Loan agreements often require that this consent not be unreasonably withheld by the administrative agent. However, to grant consent to the sponsor to purchase the borrower's loan, the agent must balance the dynamics of its relationship with the sponsor, which is often long-standing, and its responsibilities and obligations to the other lenders.
Loan agreements typically provide that any payments or prepayments from the borrower to a lender and any other funds received by lenders must be allocated pro rata among all lenders in the syndicate.
A payment from a borrower to a lender to purchase debt may be considered a prepayment which would violate the pro rata payment provisions. Amendment of these provisions is often subject to a 100% vote. If that is the case, the borrower must explore whether the purchase by an affiliate or sponsor will avoid the need for unanimity.
Calculation of financial covenant ratios, such as the leverage ratio and fixed charge coverage ratio and related definitions such as EBITDA may be affected by a buyback. The borrower should ensure that the bought back debt is excluded from these calculations, either by negotiating for this in the amendment or related agreement or by extinguishing the debt (see Standard Clauses, Loan Agreement: Financial Covenants (www.practicallaw.com/2-383-3168)).
Some loan agreements require the borrower to prepay loans with all or a portion of excess cash flow (www.practicallaw.com/8-382-3449). Under some loan agreements, the amount of excess cash flow that must be paid to lenders is reduced by previous debt repayments. Certain prepayments of debt may be excluded from the calculation of excess cash flow. If the buyback is deemed to be a prepayment, the borrower may request that the payment be deducted from the calculation of excess cash flow under its loan agreement. Otherwise, the borrower may discover that a substantial excess cash flow prepayment is required using money already spent to buy back the loans. Lenders, on the other hand, may reject this request on the ground that the excess cash flow sweep, which requires prepayment at par, should not be affected by opportunistic below par buybacks. The treatment of excess cash flow can be addressed in the amendment agreement or related agreement.
The ability to buy back debt may be caught by other contractual restrictions, such as a senior loan agreement preventing the borrower repaying or purchasing junior debt. In addition, negative covenants and intercreditor agreements may include provisions that require consents before the buyback can be effected.
In a buyback, lenders are particularly concerned with the voting rights of the buyer with respect to consents, waivers and amendments under the loan agreement. This is because unlike bond indentures, which typically contain restrictions on the voting rights of issuers, affiliates or sponsors that purchase debt, loan agreements typically contain no such restrictions. This means that, in principle, a borrower, affiliate or sponsor that buys back debt could in the process acquire the right to vote on a subsequent waiver or amendment.
For further information on the relevant loan agreement provisions, see Practice Note, Understanding Loan Buybacks (www.practicallaw.com/7-385-0650).
After the loan agreement has been amended, the debt must be bought from a willing lender.
Although there is no established market practice for the conduct of loan buybacks, for the most part the process for conducting the sale and purchase of loans, including the price of the loan, the amount of the loan and the length of time the buyback may be conducted, is negotiated and finalized in the amendment agreement or related agreement.
For buybacks that require an amendment, the trend is for the buyback process to be conducted in a Dutch auction, giving every lender an opportunity to participate. In a Dutch auction, a lender proposes a sale price to the buyer. The borrower (or buyer) may set a floor and ceiling price between which lenders are invited to sell their loans in the auction (the price interval is fixed at the start of the auction).
Another option is to conduct the process through a fixed price tender offer for the loans, as was unsuccessfully attempted by Booz Allen Hamilton and Hanesbrands. In a fixed price tender offer, the borrower (or buyer) offers to buy a certain amount of loans at a specified price. The offer is open for a specified period of time.
Lenders prefer fixed price tender offers and Dutch auctions to open market transactions (that is, private bilateral arrangements between the seller and buyer), as they promote transparency, openness and are generally more palatable to lenders.
The buyback price has to be right. The Booz Allen Hamilton buyback failed, despite the inclusion of a buyback mechanism in the loan agreement, because the lenders did not find the borrower's offer attractive enough to sell. Hanesbrands failed to secure the required amendment to its loan agreement because, given the company's healthy cash flow, lenders felt that the company should offer to buy back the loans at par. "There have been a couple of auctions where there wasn't enough daylight between what the company offered and the price at which the loans were trading," says Goldman. Lenders have to feel that they are getting a deal above the market price.
Loan buybacks remain an attractive opportunity for borrowers with sufficient free cash and there has been a steady flow of buyback attempts.
In a poll conducted by the Loan Syndications and Trading Association (LSTA) in November 2008, 50% of respondents predicted that buybacks will become standard practice and will be reflected in loan agreements. Well-placed borrowers will no doubt look to build in this flexibility to their future loan agreements; but in the current market their negotiating position is not strong.
In addition, the buyback amendments that have passed often impose a window of time to buy back debt, typically one to two years. These restrictions reflect the view that lenders seem to be accepting buybacks on a temporary basis until markets recover, liquidity is restored and pricing stabilizes. However, in the beginning of 2007, market participants may not have predicted that institutional lenders would accept buybacks at all.
Nadia Khattak, Practical Law Company
The first publicly announced loan buyback in the US. Citadel amended its loan agreement to permit the purchase, as "voluntary prepayments" of up to $200 million debt over a period of 90 days. Which it did using a Dutch auction. The Citadel buyback is the poster child for buybacks because Citadel had excess cash, was not subject to any excess cash flow payment requirements under its loan agreement and was not in danger of breaching any financial covenants. The discounted trading price of the debt was distorted, not reflective of the company's financial position or prospects. The company conducted a second round of buybacks for $50 million between May and December 2008.
Booz Allen was able to negotiate a buyback mechanism into its loan agreement as the loan was oversubscribed. However, its tender offer to buy back $50 million of its term loan at 87 cents on the dollar was rejected. The price was not attractive enough to the lenders.
Lenders approved an amendment to Entravision's loan agreement to enable the company to purchase up to $75 million of discounted term debt through the end of 2009. The company took advantage of the trading price of 67 cents on the dollar. To ensure the amendment would pass, Entravision offered a fee of $350,000 to the lenders as the deadline approached.
R.H. Donnelly executed an amendment to purchase $400 million of its term loans at a discount during a period of 270 days. Since then the company completed two rounds of term loan buybacks through Dutch auctions.
Rent-A-Center received approval from lenders on October 29, 2008 to purchase up to $75 million of its term loans over the following six months and was approved to buy an additional $25 million on November 4, 2008. Each sale had to be a minimum of $10 million. The buybacks were completed through tender offers.
Hanesbrands rescinded its buyback offer after its proposed amendment to enable it to buy $200 million of debt failed to obtain the required majority vote on November 12, 2008. Some lenders wanted the offer at par given the company's cash flow.
LNR Property sweetened its buyback offer twice, succeeding on December 8, 2008 after the initial amendment, launched on October 22, 2008 failed. The buyback was conducted through a combination of a Dutch auction and tender offer. The debt was to be held in a newly created subsidiary and remain outstanding. The company forfeited its voting rights on all bought back debt.
If a debt is cancelled or forgiven the borrower generally must include the cancelled amount in its gross income for tax purposes as cancellation of indebtedness income (www.practicallaw.com/9-382-3298) (CODI) (Internal Revenue Code of 1986, as amended, § 61(a)(12)).
CODI can arise when a borrower buys its own debt for an amount less than it owes, or when that debt is extinguished. This means that any discount the borrower achieves on the buyback is added to the borrower's income for tax purposes.
However, certain eligible borrowers can now elect to defer for up to 5 years CODI incurred as a result of debt restructured from January 1, 2009 through the end of 2010 (American Recovery and Reinvestment Act of 2009, H.R.1-224, 111th Cong. § 1231 (2009)). Eligible borrowers include C corporations, partnerships and S corporations.
For more information on tax consequences of loan buybacks see Practice Note, Loan Buybacks and Loan Amendments: Cancellation of Indebtedness Income for Borrowers (www.practicallaw.com/7-385-3432).