The Benefits of Efficient Bond Documentation
As a background matter, it is worth noting that, historically, the eurobond market was the preserve of the blue chip multinational, sovereign states, supernationals and government-backed entities. This state of affairs began to change in Europe in the late 1980s and was vastly accelerated in the 1990s, first as the high yield market developed out of the US, and, secondly, as the ECU and later the euro opened up European markets to a large constituency of borrowers that would previously not have considered the bond market. Any company can issue debt securities now. But the documents that were designed to tightly regulate a “AAA” rated borrower in the 80s may not have developed appropriately for the 21st century’s credit market. Whilst eurobond documentation has become effectively standardised, and costs of issue have been driven down, this has often been at the expense of carefully drafted documentation: nobody has really questioned whether the documentation is effective. This, as FitchRatings points out, has been brought out very starkly in recent high profile corporate collapses. The most obvious area of the documentation that is regarded as being the most outdated is the negative pledge.
This may be a classic example of the documents being behind the market. However, it is worth examining the purpose of a negative pledge clause generally and then specifically in the context of the eurobond market. In essence, the negative pledge in any financial document is there (ultimately) to ensure in the borrower’s insolvency that there is equality of treatment between the other creditors of the borrower; by requiring the borrower, where that borrower has granted security to other lenders, to grant similar security to bondholders, those bondholders with a negative pledge ensure that other lenders cannot “jump the queue” in the share-out of the insolvent borrower’s remaining assets. In a eurobond context, certain exemptions have developed that have conspired to undermine the efficiency of the negative pledge, namely:
The negative pledge is restricted to securities so that, in many cases, a eurobond negative pledge does not prevent the issuer/borrower from securing a bank loan. The restriction attaches only to “Indebtedness”/”Relevant Debt” which is often
qualified as only being affected if, as in the standard eurobond wording, it is “in the form of, or represented by, bonds, notes, debentures, loan stock or other securities which are for the time being, or are capable of being or intended to be quoted, listed or ordinarily dealt in on any stock exchange, over-the-counter or other securities market”.
FitchRatings seems almost surprised about this state of affairs but, as the market has seen (eg, British Energy and Corus Group plc), the standard eurobond negative pledge does not ordinarily prevent issuers granting security in respect of bank loans. From a bondholder perspective, there is no logic to such an exemption, as the right of an issuer to grant security over bank loans clearly defeats the purpose of preventing queue jumping by another creditor. All that can be said for this exemption is that it is sanctioned by precedent as giving equal treatment to bondholders (between themselves but not between bondholders as a class and other creditors) and therefore protecting the market price of all unsecured bonds. Companies typically do not raise secured loans except when they are in financial difficulty and this opens up bondholders to additional stress at a difficult time as the underlying assets of an issuer diminish for all creditors in the prospect of an insolvency, so the company is offered an opportunity (provided the relevant insolvency laws can be complied with) to diminish further the bondholders’ right to those assets by offering them up to a queue-jumper (the secured lender)!
Occasionally the debt affected by the negative pledge is further limited so that the restriction does not apply to “domestic” secured debt. This would allow tradeable securities denominated in the issuer’s “home” currency to be secured. This exemption sometimes extends even further to tradeable securities in any currency that are not predominantly “distributed” outside the issuer’s home jurisdiction. This again defeats the essential purpose of the negative pledge. Although there may have been good reason once for such windows (like the specific nature of the domestic bond market of a particular issuer), with the increased globalisation of credit investment, and in the absence of special circumstances, this exemption seems also to be past its “sell-by” date.
The tying into a eurobond negative pledge of an issuer/guarantor’s subsidiaries has traditionally been fairly haphazard: often the result is that “material” or “principal” subsidiaries are brought into the restrictions. This is probably an effective result, subject to other restrictions on the debt concerned, insofar as it goes but the reality is that a negative pledge does nothing to protect against lending on an unsecured basis at any level within a group. Accordingly, an all encompassing negative pledge will do nothing on its own to prevent unsecured borrowing at subsidiary level (ie, structural subordination). While investors may on occasion make a credit decision to invest in bonds issued by a holding company and accept a structurally subordinated position to other creditors, the risk of future structural subordination is countered more effectively by other means (such as overall group debt restrictions or limitations) than by way of the negative pledge.
The G26 paper makes a good point that bondholders are “generally not paid for being exposed to event risk” and the paper highlights the risk of change of control, suggesting that ordinarily all bonds should have a change of control put linked to a rating downgrade. This proposal, clearly mindful of private equity acquisitions, makes very good sense and, as the paper makes clear, will not serve as a “poison pill”.
In essence, bondholders need to address event risk. As an illustration of how this should be done, we will use a brief case study on an issuer that Norton Rose knows well, ProSiebenSat1 Media AG (ProSieben). In March 2001, ProSieben issued €400 million 5.875% notes due 2006 which were in most respects ordinary eurobonds. However, at the behest of certain initial investors, these notes contained a covenant that required all transactions with its controlling shareholder, KirchMedia, to be carried out on an arm’s length basis. When, with insolvency looming, KirchMedia sought to dip into the moneybox that was ProSieben and merge ProSieben into KirchMedia (and so drastically dilute ProSieben bondholders’ share of any asset recovery), this arm’s length covenant was instrumental in persuading the trustee of the notes that such a merger would constitute an event of default and so disallow the merger. KirchMedia subsequently fell into the hands of a liquidator. When the still independent ProSieben issued further new notes, those notes contained a change of control provision linked to a rating downgrade (this too at the behest of investors): this clearly addressed the prospective sale of ProSieben by the liquidator so that when the Haim Saban-led acquisition was announced in mid 2003, holders of the new notes could be satisfied that if the new owner wished to lower the ratings on ProSieben, their notes would first be repaid at a pre-determined amount.
In summary, the FitchRatings report and the G26 paper are symptomatic of a wider awareness in the investor community of the protections that bondholders require. Standardisation of eurobond documentation is not likely to happen soon and, with the wide variety of sector and structural issuance, is probably not the best answer to the generic concerns being expressed by bondholders. If, however, bondholders, lead managers and issuers can work together to ensure that issuer-appropriate protections are put in place for new bonds, then this is likely to benefit all constituents of the eurobond market – not least issuers, who will find investors (if better protected) more accessible. The last word should go to the reported comments of the bookrunner on Brixton plc’s recent £150 million 6% notes due 2019. Following the launch, bondholders expressed concern at the absence of change of control protection which was quickly provided: “After careful deliberation, the company decided to offer the additional covenant to be seen to be listening to investor concerns as well as building on the existing relations with the bond community. It also keeps Brixton in line with market trends, while at the same time saving them money.”
The message seems to be that the times are already changing!