As soon as Vitesse Seminconductor Corp. said it was under investigation for securities law violations that may delay routine regulatory filings, the Camarillo, California, maker of computer chips also learned it was about to be held up for ransom in the bond market.
(Bloomberg.com, Sept. 12, 2006) 1
In recent months, some hedge funds have been looking to extract bigger returns from the companies whose bonds they hold when the companies fail to file a quarterly report with the SEC on time. More bondholders are declaring technical default and either demanding immediate payment of debt or extracting substantial fees in exchange for an extension.
(Wall Street Journal, Oct. 6, 2006) 2
Over the last few years, hundreds of companies delayed filing their annual and quarterly reports with the Securities and Exchange Commission (the "SEC") in order to complete internal investigations into matters that may impact their financial statements, primarily backdated employee stock option grants.3Internal investigations overseen by special committees and their outside counsel can take months to complete; the timing of their completion is often outside of the company's control. If the company is unable to timely file a quarterly or annual report with the SEC under the Securities Exchange Act of 19344(the "Exchange Act") the company must file a Form 12b-25 with the SEC notifying investors of the reason for the delay. 5Rule 12b-25 provides for a 15 day extension for filing a Form 10-K, and 5 days for a Form 10-Q, if the rule's requirements for an extension are satisfied.6
With hundreds of financially sound companies missing their SEC filing deadlines, a number of hedge funds have sought to capitalize on these delays by accumulating a sufficient percentage of the company's bonds to obtain standing under the indenture governing the bonds7to declare a default due to the company's failure to comply with the Exchange Act's quarterly or annual reporting requirements, claiming this constitutes an event of default under both the indenture and the Trust Indenture Act of 1939 ("TIA")8 . A default can lead to an acceleration of the company's publicly traded debt. Investors who purchase bonds for the express purpose of declaring a default pursue their claims for acceleration even if the company continues to make regular interest payments and report current unaudited financial information. Most indentures permit bondholders to compel the indenture trustee9to issue a notice of default once they become the registered holders of a specified percentage of the outstanding bonds, usually a minimum of 25 percent, thereby enabling them to direct the actions of the indenture trustee, including filing suit in the name of the trustee. Once an event of default occurs, the indenture provides for a cure period, typically 60 days. Activist bondholders often use this cure period to seek to negotiate new covenants, such as a higher interest rate, thereby increasing the yield on notes which they might have purchased at a discount to par value.
When a company receives a notice of default due to its failure to timely file an SEC report, it faces the difficult choice of either (1) engaging in a high stakes litigation which, if lost, can trigger the immediate repayment of hundreds of millions of dollars of debt, as well as trigger cross-defaults/accelerations of indebtedness in other loan agreements, and imperil the company with bankruptcy; (2) settling with the holders by paying a consent fee and higher interest in exchange for withdrawing the default claim; or (3) seeking consents from a majority of its bondholders to waive the alleged defaults. The third option is not available where the noteholders seeking acceleration own a sufficient percentage of the outstanding notes to defeat such consent.
While many companies have chosen to settle rather than litigate over whether the failure to file annual or quarterly reports on time constitutes an event of default that triggers an acceleration of debt, three recent federal court decisions provide strong precedent for companies to resist acceleration demands by noteholders where the operative indenture contains a financial reporting covenant similar to Section 314(a)(1) of the TIA10and the one at issue in Bank of New York v. BearingPoint, Inc .11This covenant, referred to as a "delivery" or "reporting" covenant, is routinely included in indentures and it requires a company to deliver to the indenture trustee the quarterly and annual reports and other information required to be filed with the SEC pursuant to Sections 13(a) and 15(d) of the Exchange Act.12Often, the language of reporting covenants is simply copied verbatim from other indentures.
For a period of almost nine months, BearingPoint was the only precedent on whether the failure to file an SEC report on time constitutes an event of default under a standard reporting covenant; the absence of any contrary authority raised the stakes for companies faced with default claims, particularly companies that lacked the wherewithal to withstand an adverse judgment. Now, a trio of new federal court decisions turns the tables on the bondholders: these decisions reject the BearingPoint court's indenture construction as well as its holding that the TIA, Section 314(a)(1), requires issuers to file their annual and quarterly reports with the SEC on the dates specified in the Exchange Act. Since Section 314(a)(1) has not been the subject of any SEC interpretative releases, these decisions provide significant guidance.
This article reviews Section 314(a)(1) of the TIA's requirement that companies provide their indenture trustees with periodic reports on the company's financial condition, and the three recent decisions: Cyberonics, Inc. v. Wells Fargo Nat'l Ass'n, 13 Affiliated Computer Servs., Inc. v. Wilmington Trust Co. ,14and UnitedHealth Group Inc. v. Wilmington Trust Co. 15All three cases involve a similar reporting covenant to the one at issue in BearingPoint.
The courts in Cyberonics , Affiliated Computer , and UnitedHealth held that this standard reporting covenant simply required that the company, if and when it files reports with the SEC, must provide copies of such reports to the indenture trustee within 15 days after filing with the SEC. While these decisions provide much needed clarity, they also point out the need for the careful selection and drafting of reporting covenants when preparing a bond indenture, delineating in advance who bears the risk if the company is unable to timely file its periodic reports with the SEC.
Reporting Requirements Under the TIA
The Trust Indenture Act of 1939 applies to all "notes, bonds, debentures [and] evidences of indebtedness" issued to the public in the United States,16subject to statutory and regulatory exemptions.17The TIA was enacted following a study by the SEC in 1936 which "revealed widespread abuses in the issuance of corporate bonds under indentures."18
To address these abuses, the TIA requires the appointment of an independent trustee to act for the benefit of the bondholders19and that certain provisions of the TIA, §§ 310-317, be included in all indentures of debt securities not exempt from the TIA.20After the TIA was amended in 1990, these provisions, including Section 314(a)(1)'s reporting requirement, apply to any qualified indenture, whether or not they are actually contained in the indenture. 21"[I]f any provision of the indenture to be qualified limits, qualifies or conflicts with the duties imposed by" the mandatory provisions "the imposed duties shall control."22Thus, in the reporting covenant cases, bondholders have argued that an indenture cannot provide less disclosure than that mandated by Section 314(a)(1).23
Section 314(a)(1) of the TIA
One of the TIA's mandatory provisions is a requirement that the issuer's periodic reports which are required to be filed under the Exchange Act be provided to the indenture trustee:
[the issuer shall] file with the indenture trustee copies of the annual reports and of the information, documents, and other reports . . . which [the issuer] is required to file with the Commission pursuant to section [13 or section 15(d) of the Securities Exchange Act of 1934].24
Sections 13 and 15(d) of the Exchange Act25and the regulations promulgated thereunder require, in turn, that every issuer of a registered security file annual and quarterly reports with the SEC within specified periods of time after the end of the fiscal year or quarter covered by the report. 26Section 314(a)(1) of the TIA also provides that if an issuer of registered debt securities ceases to be a reporting company, then it is required "to file with the indenture trustee and the Commission" such information as is required "in accordance with rules and regulations prescribed by the Commission."27
The Legislative History of Section 314(a)(1)
The legislative history of the TIA reflects that Congress did not specifically address in Section 314(a)(1) when reports must be provided to the trustee. Congress was concerned that bondholders, unlike stockholders, had not been receiving periodic reports before the enactment of the TIA because the issuer was not required to file the reports with the trustee:
In a substantial portion of indentures examined by the Commission, the issuer was under no obligation to file an annual report with the indenture trustee. None of the indentures studied by the Commission, including those filed under the Securities Act, required the transmission to the bondholders of periodic reports, such as stockholders customarily receive. None of them established machinery for the transmission of such reports to bondholders . . . Such provisions are an essential part of full and fair disclosure throughout the life of the bonds.28
As the House Committee Report further explains, without periodic reports, bondholders would have no advance warning of problems related to their investment:
In the absence of [periodic reporting] provisions, the first danger signal received by the bondholders may well be the return of an interest coupon unpaid, or a circular announcing the formation of a committee for the protection of their interests.29
Section 314(a)(1) of the TIA therefore, sought to provide bondholders access to information that shareholders already received by requiring the issuer to mail "copies of such [periodic] reports" to the trustee.30The unequal access to information which Congress sought to remedy in 1939 has little relevance today when all investors have access to the same information through the SEC's electronic filing system, EDGAR, and can view a company's 10-Ks and 10-Qs online as soon as they are filed with the SEC. Nonetheless, the protection afforded by Section 314(a)(1), is still necessary today, where a company ceases to be a reporting company under the Exchange Act. For example, if a company is taken private or repurchases its own registered shares and is no longer required to file periodic reports with the SEC, the TIA requires the issuer to file "reports" with both the indenture trustee and the SEC, to provide the bondholders with full disclosure "throughout the life of the bonds."31While the variations on Section 314(a)(1) found in many indentures may appear subtle, they can be significant.
II. Typical Reporting Covenants
There are a few commonly used forms of reporting covenants; the most restrictive for the company incorporates the SEC's filing deadlines:
Whether or not required by the Commission so long as any Notes are outstanding, the Company shall furnish to the Trustee, within the time periods specified in the Commission's rules and regulations [all quarterly and annual reports] . . . In addition, whether or not required by the Commission, the Company shall file a copy of all of the information and reports . . . with the Commission for public availability within the time periods specified in the Commission's rules and regulations. 32
A similar covenant appears in a model indenture published by the ABA in 2006:
Whether or not the Company is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act, the Company shall file with the SEC . . . and provide the Trustee and Security-holders with such annual reports and such information, documents and other reports as are specified in Sections 13 and 15(d) . . . to be so filed and provided at the time specified for the filings . . . If, at any time, the Company is not subject to the periodic reporting requirements . . . the Company shall nevertheless continue filing reports . . . with the SEC within the time periods required .33
The commentary on this model covenant notes that it "requires timely filing of SEC reports (vs. providing such reports to Security holders once reports have been filed)."34Thus, if a company with this type of indenture covenant misses its SEC filing deadline this can be a basis for accelerating its bonds.
Other reporting covenants are based on a model originally published in 1965 by the American Bar Foundation, which requires the issuer to provide SEC reports to the trustee "within 15 days after the company is required to file [the reports] with the [SEC]."35This covenant only impliedly ties delivery of the reports to the SEC's filing deadlines. 36
Another standard covenant provides that: "The company will file with the Commission. . . and the Trustee" annual and quarterly reports,37without addressing when they are to be filed. This covenant does not provide a basis for acceleration where the SEC filing is simply delayed.
The covenants at issue in the four widely watched cases discussed in this article were based on the 1983 Model Simplified Indenture, published by the American Bar Association, which reads as follows:
The Company shall file with the Trustee, within 15 days after it files them with the SEC, copies of the annual reports and of the information, documents and other reports . . . which the Company is required to file with the SEC pursuant to Section 13 or 15(d) of the Securities Exchange Act. The Company also shall comply with the other provisions of TIA § 314(a). 38
The Model Simplified Indenture was updated in 2000 to include a provision that "the Company will cause any quarterly and annual reports which it makes available to its stockholders to be mailed to the Holders,"39further indicating that timely filing with the SEC is not required; a company is required to mail to bondholders quarterly and annual reports " if" they were made available to shareholders.40 1 Caroline Salas , Options Scam Lets Citadel Hedge Funds Exploit Bonds (update 2), http:/www.bloomberg.com/apps.news?pid=20601109&sid=9Gzw..mZlbuc
2 Peter Lattman , Amkor Dangles Chapter 11 Threat in Bondholder Spat, Wall St. J., Oct. 6, 2006, at C4.
3 "Stock options 'backdating' is a practice whereby a public company issues options on a particular date while falsely recording that the options were issued on an earlier date when the company's stock was trading at a lower price. The options are purportedly issued with an exercise price equal to the market price on the date of the option grant. But, in fact, because the grant dates were falsified, the options were 'in the money' when granted." Desimone v. Barrows, 924 A.2d 908, 918 (Del. Ch. 2007).
415 U.S.C. § 78a, et seq.
5 17 C.F.R. § 240.12b-25(a). Companies will delay their quarterly and annual filings beyond the deadlines in Rule 12b-25 if their officers cannot certify the accuracy of their financial information, as required by § 302 of the Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7241 and Rule 13a-14, 17 C.F.R. § 240.13a-14. The new requirements of the Sarbanes-Oxley Act "have led many auditors to take their time in finalizing corporate financial reports and encouraged issuers to take extra care in filing quarterly and annual reports with the SEC in order to make sure their representations and numbers are as accurate as possible." Kaplan and Northrop, Reading Indentures Strictly: The Rise Of Delayed SEC Filings Defaults And Aggressive Bondholders , ABA Trust & Investments (January/February 2007).
6 17 C.F.R. §§ 240.12b-25(b)(2)(ii), 240.12b-25(b)(3).
7 The trust indenture is a lengthy contract between the borrower, the indenture trustee, and the holders of the bonds issued under the indenture. S. Rep. No. 76-248, at 3 (1939); see also 15 U.S.C. § 77ccc(7).
8 15 U.S.C. § 77aaa , et seq .
9 The indenture "vests in the indenture trustee powers with respect to enforcement of the issuer's obligations and the bondholders' rights." S. Rep. No. 96-248, at 3 (1939); see also 15 U.S.C. § 77ccc(10).
10 15 U.S.C. § 77nnn(a)(1).
11 824 N.Y.S.2d 752 (Table); text available at 2006 WL 2670143 (N.Y. Sup. Ct. Sept. 18, 2006).
12 15 U.S.C. § 78m(a); 15 U.S.C. § 78o(d).
13 2007 WL 1729977 (S.D. Tex. June 13, 2007), appeal dismissed, No. 07-20539 (5th Cir. April 21, 2008).
14 2008 WL 373162 (N.D. Tex. Feb. 12, 2008), notice of appeal filed, No. 3:06-cv-01770 (5th Cir. March 12, 2008).
15 538 F. Supp. 2d 1108 (D. Minn. 2008), notice of appeal filed, No. 06-cv-04307 (8th Cir. April 8, 2008).
16 15 U.S.C. § 77bbb.
17 15 U.S.C. § 77ddd.
18Zeffiro v. First Pa. Banking & Trust Co., 623 F.2d 290, 292-93 (3d Cir. 1980).
19 15 U.S.C. § 77jjj.
20Zeffiro, 623 F.2d at 293 & n.3.
21 15 U.S.C. § 77rrr(c).
22 15 U.S.C. § 77rrr(a).
23Affiliated Computer, 2008 WL 373162, at *4; UnitedHealth, 538 F. Supp. 2d at 1114.
24 TIA § 314(a)(1); 15 USCA § 77nnn(a)(1).
2515 U.S.C. § 78m; 15 U.S.C. § 78o(d).
26 17 CFR §§ 240.13a-1, 240.13a-13, 240.15d-1, 240.15d-13, 249.308a, 249.310 .
27 TIA § 314(a)(1); 15 USCA § 77nnn(a)(1).
28H.R. No.1016, at 35 (1939).
32See Landry's Restaurants Inc. Form 8-K (Jan. 4, 2005).
33 Model Negotiated Covenants and Related Definitions, 61 Bus. Law. 1439, 1536 § 4.13 (August, 2006) (emphasis added). Model covenants and their commentary "have provided a drafting standard and authoritative guidance." Id . at 1439.
34Id. at 1535 (emphasis added).
35 American Bar Foundation, Commentaries On Model Debenture Provisions, 288 § 704 (1971).
36 Compare Moody's Corporate Finance, Sec Filing Delays And Potential Bond Defaults: What Is The Issuer's Real Promise ? (January 2008) (hereinafter: "Moody's report").
37 See Saks Inc.'s Indenture (Moody's report at 11).
38Model Simplified Indenture, 38 Bus. Law 741, 755 § 4.02 (1983) (emphasis added).
39 Revised Model Simplified Indenture, 55 Bus. Law. 1115, 1134 § 4.02 (2000).
40Id. at 1184 § 4.02 note 2 (emphasis added).
Miranda Schiller is a Partner in Weil Gotshal's Securities Litigation and Corporate Governance department. Margarita Platkov is an Associate with Weil Gotshal. Part II of this article will appear in the July issue. Please see our website at www.metrocorpcounsel for the footnotes to this article.