Rethinking bond covenants

ASSET SALES COVENANT

The asset sale covenant has become subject to an increasing number of exceptions and qualifications that may have consequences unanticipated by noteholders. The covenant prescribes the permitted use of proceeds from asset sales by the issuer and its subsidiaries that are subject to the indenture's covenants ("restricted subsidiaries," as opposed to "unrestricted subsidiaries" that are not subject to the indenture's covenants). Asset sales are a potential cause for concern for noteholders because they may drain value from the issuer and its restricted subsidiaries (collectively, the "restricted group"). Under an asset sale covenant in a traditional senior unsecured bond indenture:

• the issuer must receive fair market value for the assets sold;
• at least 75% of the consideration received must be cash or "deemed cash";
• any net cash proceeds received from the sale ("net proceeds") must be either applied within an agreed time (e.g., 365 days) to either repay identified types of debt ("senior debt") or reinvested in the business of the restricted group through purchases of long-term assets, capital expenditures or the acquisitions of related businesses ("additional assets"); and
• any net cash proceed not so applied within the specified time frame ("excess proceeds") must be used to make an offer to repurchase all outstanding notes at par, along with any other pari passu debt containing similar asset sales repurchase provisions on a pro rata basis.

The general purpose of the covenant is to ensure that when operating or revenue-producing assets leave the restricted group, (i) the restricted group gets fair value in return and predominantly in cash and (ii) the cash received is used to either de-lever or reinvest in additional revenue-producing assets.

DEFINITION OF ASSET SALE

The term "asset sales" is defined broadly but will include numerous exceptions that may result in unanticipated consequences. One example is the exclusion of permitted restricted payments and permitted investments. The definition often excludes "any permitted restricted payment or permitted investment." The term "restricted payments" is typically defined to include:

• the payment of cash dividends or certain other distributions to shareholders (other than to another member of the restricted group and to minority shareholders of restricted subsidiaries on a pro rata basis);
• repurchases, redemptions or (pre-)payments, as applicable, of equity interests of the issuer or any Indebtedness that is subordinate in right of payment to the bonds or any guarantee of the notes ("subordinated debt"); and
• making any investment other than permitted investments.

As discussed, more fully below, certain restricted payments will be permitted and are identified as "permitted restricted payments", and certain investments that qualify as "permitted investments" are not even restricted payments and therefore not subject in any manner to the restricted payments covenants. The exclusion of permitted restricted payments and permitted investments from the asset sale covenant is predicated on the theory that these transfers will be subject to the restrictions and limitations imposed by the restricted payments covenant.

The broad wording of this exception, however, can result in unintended consequences. For example, consider a transaction where operating assets are exchanged for a minority equity interest in the buyer, and the acquisition of such equity is either a permitted restricted payment or a permitted investment. Similarly, the receipt of a promissory note from a buyer may technically qualify as a permitted restricted payment or permitted investment. However, in each transaction, the transfer, as opposed to the consideration received, is not a permitted restricted payment or permitted investment. The proper application of this exception is when the permitted investment or restricted payment is a permitted transfer.

A transfer of assets constituting a permitted restricted payment or permitted investment should not be an asset sale, but a transfer in which the consideration received qualifies as a permitted restricted payment or permitted investment should not for that reason be excluded from the asset sale covenant. To clarify this distinction, noteholders may want to revise this exception to exclude only "dispositions of assets constituting a dividend, distribution, or capital contribution in a joint venture, to the extent constituting a permitted restricted payment or a permitted investment, other than to the extent such transaction results in the receipt of cash or cash equivalents by the company or any restricted subsidiary."

Another example is the exclusion of undeveloped acreage. Many E&P indentures exclude from the definition of asset sale the sale of "undeveloped acreage" or "properties to which no proved reserves are associated" or even "proved reserves not capable of being produced in material economic quantity." However, if any such sale results in significant consideration, a noteholder may rightfully object to such a transfer being treated differently than the sale of any other valuable asset.

A third example is the exclusion of assets no longer used or useful. Many indentures exclude from the definition of asset sale any assets that "are no longer used or useful" or that are "obsolete," regardless of value. This description could include valuable assets that are no longer strategically valued by the particular issuer. In today's environment, that might include entire business divisions or geographical areas. To address this concern, noteholders may want to limit the exception to "the disposition of obsolete assets or assets that are no longer used or useful in the issuer's or any of its restricted subsidiaries business for no value or de minimis consideration."

NON-CASH CONSIDERATION AS A PERMITTED INVESTMENT

As discussed above, many indentures exclude permitted restricted payments and permitted investments from the asset sale covenant on the theory that these transfers will be subject to the restrictions and limitations imposed by the restricted payments covenant. However, many E&P indentures have eliminated those limitations from such transfers. This is due to a revision to the definition of "permitted investment." The definition often includes "investments made by the company or a restricted subsidiary as a result of non-cash consideration permitted to be received in connection with an asset sale made in compliance with the asset sale covenant." This exception thus permits the 25% non-cash consideration typically permitted by the asset sale covenant.

In today's market, noteholders may wish to reconsider whether such non-cash consideration should be subject to a carte blanch exception from the restricted payments covenant. In any event, many E&P indentures have modified this exception to also apply to "any asset swap or other non-cash consideration received for a disposition not constituting an asset sale."

Presumably intended to pick up non-cash consideration permitted by the de minimis exception to the definition of asset sale, this language removes any limitation from any non-cash disposition. In combination with the exclusion of all permitted investments from the definition of asset sales, the circular conclusion is that "all permitted investments are not asset sales and the receipt of all non-cash consideration in exchange for an asset transfer is a permitted investment." Such a result allows an issuer to transfer assets without any restriction by the asset sale covenant or the restricted payment covenant.

Noteholders should carefully review the indenture's terms to determine whether any permitted non-cash consideration for any transfer of assets (at least to the extent not constituting the 25% non-cash consideration allowed in an asset sale) is subject to the restrictions of either the asset sale covenant or the restricted payment covenant.

SERVICES AS PERMITTED CONSIDERATION

A number of E&P indentures provide that the obligation of a transferee (or its affiliate) to pay for exploration and operating expenses of the transferred property qualifies as "deemed cash" consideration where the issuer or a restricted subsidiary retains an interest in such property. The concern for noteholders is that this exception does not take into account the credit-worthiness of the transferee. Such credit-worthiness is of particular concern in today's environment. In this respect, a noteholder might question whether such consideration should be treated differently than the receipt of a promissory note from a buyer, which is typically not "deemed cash" consideration.

APPLICATION OF ASSET SALE PROCEEDS

Other exceptions have recently been added to the requirement to apply net proceeds to identified purposes. Traditionally, net proceeds were only be permitted to be applied to repay debt that was structuring senior to the notes or any note guarantees, including (i) in the case of unsecured notes, the repayment of any unsubordinated debt that was secured by the assets that were sold in the asset sale or (ii) to the extent assets of a non-guarantor restricted subsidiary were sold, the repayment of unsubordinated debt of that restricted subsidiary. Any debt that was pari passu with the notes would typically be permitted to be repaid with net proceeds only on a pro rata basis with the notes pursuant to an offer to repurchase at par and only if such an offer was required by such pari passu debt.

However, in recent E&P indentures, the definition of "net proceeds" often nets any other debt that must by its terms be paid with such proceeds, and any other debt that must be paid in order to obtain a necessary consent to such asset sale. This provision would permit repayment ahead of the noteholders of any pari passu debt, subordinated debt and debt held by affiliates.

This issue also arises when an indenture permits net proceeds to be applied to the payment of pari passu or subordinated debt ahead of the notes. Many indentures provide that "senior debt" is permitted to be repaid with net proceeds ahead of the notes. However, the term "senior debt" is defined in many E&P indentures as:

• all indebtedness of the company or any of its restricted subsidiaries outstanding under credit facilities and all hedging obligations with respect thereto;
• the notes and any other indebtedness of the company or any of its restricted subsidiaries permitted to be incurred under the terms of the indenture, unless the instrument under which such indebtedness is incurred expressly provides that it is subordinated in right of payment to the notes or any note guarantee; and
• all obligations with respect to the items listed in the preceding clauses.

As drafted, the restriction on subordinated debt applies only to clause (ii). An issuer is therefore permitted to apply net proceeds independently under clause (i) to the payment of all pari passu debt, subordinated debt, and debt held by affiliates. Such a provision would also allow an issuer to use such net proceeds to selectively repurchase notes in the open market below par, as opposed to a pro rata asset sale repurchase offer at par to all noteholders.

RESTRICTED PAYMENTS COVENANT

The restricted payments covenant is designed to prevent "leakage" of funds and assets from the restricted group by limiting the ability of the restricted group to make restricted payments.

Under the covenant, unless a restricted payment qualifies as a permitted restricted payment or, in the case of investments, the investment qualifies as a permitted investment, members of the restricted group are prevented from making any restricted payments unless:

• the issuer would have been able to incur at least $1.00 of additional indebtedness under its fixed charge coverage ratio of the limitation on indebtedness covenant (the "coverage ratio") on a pro forma basis after giving effect to the restricted payment (the "ratio test");
• the issuer is not in default under the indenture; and
• the aggregate amount of restricted payments made since the date the notes were issued (subject to agreed exceptions).

With regard to the last item, the aggregate amount of restricted payments should not exceed the following:

• 50% of consolidated net income (or in the case of a loss, minus 100% of the loss) for the period commencing on the first day of the first fiscal quarter either immediately prior to or immediately after the issue date of the notes and ending on the last day of the most recent fiscal quarter immediately prior to the date of the restricted payment for which consolidated financial statements for the issuer are available;
• 100% of the aggregate net cash proceeds and fair market value of marketable securities received from sales of the issuer's stock and certain other types of capital contributions received since the issue date of the notes (subject to certain exceptions discussed below);
• 100% of the value of certain restricted payments that are "reversed" (e.g., investments in unrestricted subsidiaries that subsequently become restricted subsidiaries) and any investment return on any investments that are not permitted investments (collectively, the "investment return");
• 100% of distributions received from unrestricted subsidiaries; and
• the amount by which indebtedness has been reduced on the issuer's balance sheet as a result of the conversion or exchange of such indebtedness into equity of the issuer after the issue date of the bonds (collectively, the "builder basket").

The covenant should be carefully reviewed by noteholders to understand how much leakage from the restricted group is permitted. A few of the most significant issues are discussed below.

PAYMENT OF SUBORDINATED DEBT

As described above, the prepayment of subordinated debt is typically a restricted payment. However, a permitted refinancing of subordinated debt is typically an exception to this restricted payment. The definition of "permitted refinancing" traditionally requires that subordinated debt may only be refinanced with other subordinated debt. Often, however, the definition of "permitted refinancing" further provides that:

Notwithstanding the preceding, any indebtedness incurred under the credit agreement shall be subject only to the refinancing provision in the definition of credit agreement and not pursuant to the requirements set forth in this definition of permitted refinancing indebtedness.

A number of E&P indentures have revised this provision to apply to "any credit facility" as opposed to only the "credit agreement" (i.e., a specifically identified bank facility). Consequently, subordinated debt is permitted to be refinanced with unsubordinated debt without complying with the covenant.

THE BUILDER BASKET

The "builder basket" has often become subject to a number of carve-outs and exceptions which significantly increase an issuer's ability to remove cash and assets from the restricted group.

NETTING OF PERMITTED RESTRICTED PAYMENTS

Some indentures do not accurately calculate availability under the "builder basket." The calculation of availability under the builder basket should take into account all restricted payments previously made under the builder basket and, with limited exceptions to be noted, all permitted restricted payments that have been made. Traditionally, the only exclusions from this calculation are permitted restricted payments which either:

• expressly provide that the assets or cash utilized in such permitted restricted payment do not also build the builder basket,
• are credit neutral, or
• are de minimis.

Over time, the builder basket has been revised to not deduct any (or very few) permitted restricted payments from the builder basket's availability, thereby increasing the amount of restricted payments permitted thereunder by ignoring the prior use of availability thereunder.

NON-CASH ASSETS

Often, the builder basket includes the fair market value of any non-cash assets (including equity interests) contributed to the issuer or acquired with equity or proceeds of an equity issuance. Noteholders should consider whether they should permit such non-cash assets to be exchanged for an equal amount of cash leaving the restricted group as a distribution or investment. Even if non-cash assets are permitted to build the builder basket, care should be taken in drafting the restricted payments covenant.

Typically, any investment made with the net cash proceeds of, or in exchange for, any equity issue is listed as a specific permitted restricted payment or a permitted investment. That exception should, and typically does, provide that those net cash proceeds do not build the builder basket. However, the exception almost never provides that the fair market value of the non-cash assets received in exchange for, or acquired with the proceeds of, such equity interests should be excluded from the builder basket. Without such an exclusion, such amount is double-counted by allowing the permitted restricted payment or permitted investment and fair market value of the not-cash assets building the basket.

CONTRIBUTION DEBT

When an issuer is owned by a parent, indentures often permit the parent to incur debt and contribute the debt proceeds to the issuer. In return, a permitted restricted payment allows the issuer to distribute cash to the parent to pay principal and interest on such debt (often capped to the amount contributed, plus accrued interest). Although, most indentures with this mechanism provide that the contributed debt builds the builder basket, they almost always fail to provide that payments on the contributed debt reduce the builder basket.

INVESTMENT RETURN

The builder basket typically builds based upon any investment return. However, the calculation of this investment return should be limited to investments that originally were subtracted from the builder basket. If, instead, those investments were made utilizing a specific permitted restricted payments exception or qualifying as a permitted investment, then it makes sense for the investment return to be netted against those exceptions, not the builder basket. Many indentures net investment return from any Investment constituting a permitted restricted payment or permitted investment as well as including such amount in the calculation of the builder basket, resulting in a double-count of restricted payments capacity.

PERMITTED BUSINESS INVESTMENTS

The restricted payments covenant does not apply to any "permitted investment." In recent years, E&P indentures have often included "permitted business investments" as a permitted investment. A typical definition is as follows:

"Permitted business investments" means investments made in the ordinary course of, and of a nature that is or shall have become customary in, the oil and gas business as a means of actively exploiting, exploring for, acquiring, developing, processing, gathering, marketing, or transporting oil and gas through agreements, transactions, interests or arrangements that permit one to share risks or costs, comply with regulatory requirements regarding local ownership, or satisfy other objectives customarily achieved through the conduct of oil and gas business jointly with third parties, including (i) ownership interests in oil, natural gas, other hydrocarbon properties or any interest therein or gathering, transportation, processing, storage or related systems, (ii) investments in the form of or pursuant to operating agreements, processing agreements, farm in agreements, farm-out agreements, developments agreements, area of mutual interest agreements, unitization agreements, pooling agreements, joint bidding agreements, service contracts, joint venture agreements, partnership agreements (whether general or limited), subscription agreements, stock purchase agreements and other similar agreements with third parties, and (iii) direct or indirect ownership interests or investments in drilling rigs, fracturing units and other related equipment or in persons that own or provide such equipment.

This definition creates a significant exception to the protections normally afforded by the restricted payments covenant by overriding any restriction on the amount of investments permitted in joint ventures and unrestricted subsidiaries. Under this exception, any such investments are permitted without any limitation so long as "made in the ordinary course of, and of a nature that is or shall have become customary in, the oil and gas business."

Noteholders should consider if it is acceptable for productive assets to be exchanged for equity in an entity that is not subject to the indenture's restrictive covenants.

Part 2 in the series runs in June.

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.

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