Rethinking bond covenants

In addition, the covenant specifies numerous categories of "permitted debt" that may be incurred by the members of the restricted group regardless of their financial condition and without their having to meet the coverage ratio test. These exceptions may either be designated as "permitted debt" or carved-out of the definition of "indebtedness" altogether. One category of permitted debt is a specific capped basket for debt issued under senior credit facilities (the "credit facilities basket").

In the event an item of indebtedness meets the criteria for ratio debt and/or more than one of the types of permitted debt, most indentures will generally permit the issuer, in its sole discretion, to classify and, from time to time, reclassify any such item of indebtedness. In particular, if the financial performance of the issuer improves (resulting in increased debt incurrence capacity under the coverage ratio exemption), the issuer will typically (but not always) be permitted to reclassify debt initially incurred under one or more permitted debt baskets as ratio debt, thereby freeing up capacity under the relevant permitted debt baskets.

THE CREDIT FACILITIES BASKET

Every indenture will include a dollar-capped credit facilities basket designed to allow a maximum amount of indebtedness incurred under one or more "credit facilities." The definition of "credit facility" is typically broad enough to include bank financings and indenture debt. Debt incurred under this exception is typically permitted to be secured. In that case, the definition of permitted liens will include a provision permitting liens to secure debt incurred under the specific clause of the indenture permitting the credit facilities basket.

In recent years, many noteholders of E&P bonds have been surprised to discover that essentially all debt permitted to be incurred under the indenture may be secured. This is because the permitted lien clause described above has been revised to permit "liens securing any credit facility," without specifically cross-referencing the dollar-capped credit facility basket. Because the term credit facility is typically defined as any bank or bond debt, this means that any debt permitted to be incurred under the limitation on indebtedness covenant, including ratio debt and refinancings or exchanges of unsecured debt, may be secured. In such situations, an unsecured noteholder could be subject to significant structural subordination.

RECLASSIFICATION OF DEBT

As described above, to the extent debt or any portion of debt qualifies to be incurred under any number of clauses of permitted debt or maybe incurred as ratio debt, then an issuer is typically allowed to classify, and then later reclassify, such debt or any portion thereof under any such clauses of permitted debt or as ratio debt provided that ratio test is satisfied at the time of such reclassification. However, an important traditional restriction to this ability is often not included. Noteholders should determine if any debt outstanding on the issue date (or incurred in the future) under the credit facility basket (or any other identified existing debt exception) is expressly deemed to be outstanding under only that particular exception or whether it is subject to reclassification. If subject to reclassification, an issuer can "empty" that basket at any time that it can incur that debt as ratio debt. The issuer is then free to incur additional debt under the emptied basket. This may result in significantly more leverage than expected by the noteholders.

PERMITTED REFINANCING INDEBTEDNESS

The limitation on indebtedness covenant will include the ability to refinance certain debt under certain conditions. The wording of this provision (the "permitted refinancing" exception) should be carefully examined by noteholders.

Typically, the permitted refinancing definition will restrict the amount, maturity, amortization, obligors, collateral, and subordination of the refinancing indebtedness. However, as discussed above, many E&P indentures have revised the definition of the permitted refinancing to exclude from its requirements "any Indebtedness incurred under a credit facility." Because "credit facility" is often defined to mean any bank financings or debt securities, all such protections are essentially eliminated by this exception. Similarly, the definition of permitted refinancing indebtedness often does not expressly prohibit a non-guarantor restricted subsidiary from incurring debt to refinance debt of a guarantor. Such a definition therefore permits subordinated debt to be refinanced with senior debt and pari passu debt to be refinanced with structurally senior debt, resulting in increased structural subordination of the notes.

A second issue arises because indentures often do not provide that any permitted debt basket that is refinanced by the permitted refinancing exception should not thereby "empty-out" the permitted debt basket. Unless each permitted debt basket also includes in its calculation of the maximum amount that can be incurred thereunder any debt refinancing such debt, this outcome will occur, and thus permit an issuer to become more highly leveraged than the noteholders may have expected.

INDEBTEDNESS AND LIENS EXISTING AS OF THE ISSUE DATE

The limitation on indebtedness covenant will often include an exception permitting "indebtedness existing on the issue date." Unless this exception further excludes the credit facility basket and other permitted debt exceptions identifying other existing debt, then all debt outstanding on the issue date under those specific permitted debt exceptions may be permitted to be reclassified as "indebtedness outstanding on the issue date," thus freeing up future debt capacity under those permitted debt baskets.

Similarly, most indentures permit "liens existing on the issue date." Unless that exception further excludes liens securing the credit facility basket (or any other specific categories of existing secured debt), any debt incurred in the future under such debt agreements (such as future revolving borrowings or additional notes issued under a secured indenture) that may be incurred as ratio debt may be incurred as secured ratio debt, thus "emptying" the credit facility basket and permitting additional future secured debt.

This result may also occur due to a permitted lien permitting "liens securing any permitted refinancing that refinances secured debt." Unless that exception excludes any secured debt that was incurred under the credit facility basket, if the issuer is able to incur or refinance debt under the credit facility basket with ratio debt or permitted refinancing debt, then that refinancing debt can be secured and the credit facility basket will be "emptied," thereby permitting more secured debt than the noteholders may intend.

ADDITIONAL STRUCTURALLY SENIOR DEBT

Required guarantors. Noteholders should understand under what circumstances the issuer's subsidiaries may incur or guarantee other debt without being required to guarantee the notes. Often a restricted subsidiary is required to guarantee the notes if it guarantees other debt of the issuer, but is not required to issue a guarantee of the notes if it guarantees debt of another guarantor. Also, indentures often do not require a guarantee of the notes due to a restricted subsidiary directly incurring other debt. As a general rule, any restricted subsidiary that guarantees debt of the issuer or a guarantor, or that directly incurs debt, should be required to guarantee the notes. Otherwise, the noteholders could find themselves structurally subordinated to the debt of a non-guarantor restricted subsidiary.

Ratio debt. A traditional ratio debt exception allows debt to be incurred only by the issuer and guarantors, not non-guarantor restricted subsidiaries. This is designed to limit structurally senior debt incurred by non-guarantor restricted subsidiaries. However, many E&P indentures have revised this provision to permit the issuer and any restricted subsidiary to incur ratio debt. Such a provision could permit the notes to be structurally subordinated to all ratio debt incurred by a non-guarantor restricted subsidiary.

Limitation on layered indebtedness covenant. The limitation on layered indebtedness covenant prohibits the restricted group from incurring debt which is senior or pari passu in right of payment to the notes but expressly subject to payment subordination to other indebtedness. While such a provision was historically prevalent in the high-yield market in general, this provision has disappeared from many indentures of issuers in the oil and gas industry.

Noteholders should consider whether they should require protection from such subordination. Moreover, given the growth of the second-lien debt market and pari passu "first out" facilities, noteholders should consider whether the covenant should be revised to also address lien subordination. The second-lien debt market grew, in part, as a way of avoiding the restrictions of this covenant. This was possible because the covenant traditionally only restricts debt subject to payment subordination, not lien subordination. In today's distressed markets, noteholders should consider whether this distinction between payment and lien subordination is meaningful.

ABOUT THE AUTHOR

Bill Hart ([email protected]) is a banking and finance partner in Mayer Brown's Houston office. He is also a key member of the firm's high-yield debt practice. Hart has broad financial experience representing major banks, underwriters, borrowers, and issuers in such matters as placement of high-yield debt securities, project finance, large syndicated bank transactions, oil and gas financings, asset-based financings, and acquisition financings. He has industry-specific financing experience in the areas of oil and gas and chemicals.

John Berkery (Mayer Brown partner in New York) contributed to this article.