Securing Unsecured Notes (Part I)

Willy Wonka, a local candy maker and CEO of Willy Wonka Candy Company, calls you in a state of high excitement. The global recession is taking its toll on WWCC, and Mr. Wonka needs to raise money quickly. But Mr. Wonka is discovering that no one is willing to lend funds to WWCC on an unsecured basis. Nor are his bankers interested in Mr. Wonka’s offer to sign over the Wonka name – they just want a lien over WWCC’s factory.

Mr. Wonka has urgent concerns that must be addressed before he will consider granting a lien over the factory. For example, in the event of foreclosure, what will happen to Mr. Wonka’s hard-working (but vertically challenged) staff?
By contrast, you have some issues to consider under WWCC’s outstanding unsecured high yield bonds. In particular, the typical limitation on liens covenant – sometimes called a negative pledge – can present a significant constraint on an issuer’s ability to participate in business combinations and other transactions financed with new secured debt, such as leveraged acquisitions or, in WWCC’s case, rescue financing.

Here is some guidance in thinking through this sticky problem.
Background on the limitation on liens covenant

The limitation on liens covenant in a bond indenture typically restricts an issuer’s ability to secure future debt with liens on the assets of the issuer and its subsidiaries, other than specified “Permitted Liens.” For high yield issuers, the limitation on liens will generally apply to all of the assets of the issuer and the guarantors, but it will include significant carveouts. The high yield carveouts typically permit the issuer to incur only a limited amount of senior secured credit facilities, secured purchase money debt and capital leases and secured debt of foreign subsidiaries, as well as other miscellaneous secured debt.

Investment grade indentures with limitations on secured indebtedness may have a narrower scope – rather than covering all of the assets, the limitation may apply to only certain assets, usually defined as “Principal Properties” (such as WWCC’s factory) and stock and intercompany debt of subsidiaries. In that event, the covenant typically provides narrower carveouts as well, for example that the issuer is unable to incur material secured debt for borrowed money above a general basket.
Exception for securing existing notes “equally and ratably”

Generally, the limitation on liens covenant in both investment grade and senior high yield indentures includes one major exception: the issuer may grant additional liens over its assets above and beyond Permitted Liens so long as it “equally and ratably” secures the existing notes. This exception, which is known as the “equal and ratable clause,” is consistent with the purpose of the negative pledge provision. Its mission is not to prohibit the issuer from encumbering its assets, but merely to assure noteholders that if the issuer grants a lien to secure other people’s debt, the issuer will equally and ratably secure the existing notes.

If the negative pledge under the existing notes applies to certain assets only (e.g., “Principal Properties held by domestic subsidiaries”) then only those assets need to be subjected to the new lien securing the existing notes. By contrast, assets that are not subject to the negative pledge may be independently pledged in favor of other financing sources without providing a ratable lien in favor of the existing noteholders. For example, lenders under an asset-based senior secured credit facility could obtain an independent lien over accounts receivable and inventory that does not need to be shared with the existing noteholders if such assets are not covered by the negative pledge covenant in the existing notes indenture. Further, WWCC could seek separate financing secured by a pledge of the Wonka logo or other intellectual property assets.
What constitutes securing existing notes equally and ratably?

In the context of acquisition financing, the new triggering lien is typically created to secure borrowings under a new senior secured credit facility. Bank lenders do not like to share their liens with anyone. If they do agree to be equally and ratably secured with other creditors, they will likely insist that the other creditors take a silent role in all decision-making concerning remedies, etc.
Industry practice is to take the view that a plain obligation to secure existing notes equally and ratably, without more, requires only equal and ratable treatment in the application of proceeds of collateral and does not require that the existing notes trustee have any ability to control the collateral or the enforcement of remedies. Accordingly, unless an indenture provides otherwise, it is not necessary to give the noteholders any control over the release of collateral from the derivative lien granted to them by operation of the obligation to equally and ratably secure the notes. Shared collateral agreements can provide bank lenders with exclusive control over the release of shared collateral, without the consent of the existing noteholders.

Senior secured credit facilities generally require the borrower to apply certain proceeds from asset sales to repay the loans. If the disposed assets are subject to an equal and ratable lien in favor of existing notes, such proceeds could arguably constitute “proceeds of the collateral” and an argument could be made that the noteholders are entitled to their ratable share of such proceeds. The security documents that grant the new equal and ratable lien to secure existing notes often provide for a collateral trust account that will hold the noteholders’ ratable share of the proceeds of collateral following an enforcement event. However, outside of the enforcement context and absent an explicit provision to the contrary, market practice is that proceeds of asset sales (in the ordinary course or otherwise) need not be applied to ratably repay or redeem existing notes and, in fact, there may be no mechanism under the existing notes indenture to prepay, redeem or make an “asset sale offer” with respect to the existing notes.
Some practical concerns

  • The requirement to equally and ratably secure the notes can be effected by a collateral trust agreement in favor of the collateral agent under the new senior secured credit facilities, who will hold the lien for the ratable benefit of each of the lenders under the senior secured credit facilities and the existing noteholders.
  • Intercreditor provisions regarding the application of proceeds of the collateral among the various secured parties and control of the enforcement of remedies can be included in the security agreement regarding the shared collateral.
  • Assuming that no consent or other action is needed from the existing notes trustee in connection with the transactions (and that the existing notes trustee is not otherwise involved in the transactions, e.g., as trustee with respect to new notes to be issued), the question arises whether the existing notes trustee need even be involved in or aware of the process of equally and ratably securing the existing notes.
  • Legal counsel to the issuer will need to have enough certainty, even without explicit sign‑off from the existing notes trustee, that the arrangement complies with the existing notes indenture in order to be able to render its legal opinion with regard to the absence of conflicts with the existing notes indenture. As a result, it is good practice to provide drafts of the new shared collateral agreements to the existing notes trustee’s counsel for review and (typically, limited) comment, although, as discussed above, trustee sign‑off is generally not required.

In a subsequent installment, we tackle traps for the unwary that can arise once WWCC starts granting liens in favor of the outstanding notes.