Investor Protection in Corporate Bond Issues Nordic Capital Markets Forum

1. Investor Protection in Corporate Bond IssuesNordic Capital Markets Forum Catherine Tholstrup and Anna Iversen

2. Why is investor protection in corporate bond issues topical? • Relatively recent issues • 20 years back: national, supranational and multinational issuers (AAA-rated) or secured mortgage bonds • Now used by companies to raise finance in the bond market • US market has matured • European market still relatively immature • Documentation (possibly) not in sync with market development • 2002/3 corporate defaults/restructurings • 2004/5 Leveraged Buy-Outs • Developments reveal need for tighter documentation and stronger investor involvement

3. The ranking of creditors Lender: Syndicate of banks Debt: Secured loan Lender: Bank Debt: Unsecured bilateral loan Lender: Bondholders Debt: “Senior” (unsecured) bonds Company Lender: Bondholders Debt: Hybrid subordinated debt Shareholders

4. Ratings Standard & Poor’s Moody’s Fitch AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- A+ A1 A+ A A2 A A- A3 A- BBB+ Baa1 BBB+ BBB Baa2 BBB BBB- Baa3 BBB- BB+ Ba1 BB+ BB Ba2 BB BB- Ba3 BB- B+ B1 B+ B B2 B B- B3 B- CCC+ Caa1 CCC CCC Caa2 CC CCC- Caa3 C CC Ca DDD R C DD D

5. Investor Protection in Corporate Bond Issues When do bondholder rights become relevant?

6. When do bondholder rights become relevant? • Negative development in respect of bond issuer • Restructuring of the bond issuer’s debt (e.g. the establishmentof new, secured debt) • The sale of assets or divisions of the bond issuer • A take-over of the bond issuer (e.g. “Leveraged Buy-Out”) • A downgrade of bonds (e.g. as a result of a Leveraged Buy-Out or corporate restructuring of the bond issuer) • De-listing of bond issuer (less information available to the market)

7. Credit Risk vs. Event Risk • Traditionally fixed income portfolio managers have focused on the valuation and pricing of credit risk • Recent history shows that “event risk” is an equally important factor

8. “Event Risk” – a proposed definition “A deliberate change of risk parameters of an issuer that results in an immediate benefit to equity investors, at the expense of fixed income investors.”

9. Event case 1 – change of capital structure Secured bank debt Rating Agency Bonds Price 110 Price 88 A+ BB+ Hybrid Capital Company (issuer of bonds) Shares

10. Event case 2 – Leveraged Buy-Out Purchase price Purchase price Shareholders Buyers (new shareholders) Bank Shares Proceeds from distribution Distribution Company (issuer of bonds) Loan Security in Company assets A+ BB+ Bonds Price 110 Price 88 Rating Agency

11. Event risk – what remedies are available to bondholders after the event? • Underlying legislation (in Denmark, the Danish Public Companies Act, “Aktieselskabsloven”) • what remedies does it offer bondholders? • Bond documentation • covenants - is “event risk” dealt with?

12. Investor Protection in Corporate Bond Issues Legislative remedies against event risk

13. Financial assistance provisions – The Danish Public Companies Act § 115, 2 • Prohibits financial assistance in connection with a take-over • A company may not grant loans, which directly or indirectly fund the acquisition of shares in the company itself • A company may not make assets available or provide security in connection with such acquisition • Exception: “After-financing”, for example through dividend payments, is permitted, if relevant company legislation is observed

14. “After-financing” of a company take-over: dividend payments • “After-financing” may be made by payment of dividends from the free reserves of the target company to the new shareholders (the purchaser) • Requires i.a.: • Decision of the general meeting, • That the dividend payment does not exceed an amount which is reasonable in consideration of the financial position of the target company, • That the financial position of the target company always remain warrantable in the context of its business operations • The target company may not guarantee future dividend payments

15. Dividend payments – the company’s financial position must be warrantable • The board shall take into consideration whether the capital reserves of the target company are warrantable in the context of its overall operations • This rule was implemented after certain business scandals • Liquidity requirements must be complied with • The capital reserves of a company include both its equity capital and debt capital, as well as prospective, warrantable loans

16. Other forms of “after-financing” • Other forms of permitted “after-financing”: • Capital reduction in the target company with payment to the shareholders • Target company’s purchase of own shares from buyer (treasury share rules must be observed, including 10% limit)

17. Conclusion on The Danish Public Companies Act • A change in capital structure or the financing of a Leveraged Buy-Out is easily structured without violating Danish company law • Danish company law does not provide effective remedies for bondholders to address “event risk” • If, which is unlikely, Danish company law is not complied with, bondholders are likely to have a claim for damages against the board of the target company, provided there is an actual, provable, loss.

18. Investor Protection in Corporate Bond Issues – Bond Terms and Conditions Is ”event-risk” taken into account in the Terms and Conditions?

19. Bond Terms and Conditions • What proctective provisions do bondholders have in the Terms and Conditions? • What bondholder rights are typically missing? • How may the Terms and Conditions be improved? • Can “event risk” be priced in? • Do bond/debt ratings cover “event risk”?

20. Investor Protection in Corporate Bond Issues Investor protection in the Terms and Conditions

21. Bond Terms and Conditions • European/UK documentation vs. US documentation • Event risk is traditionally only superficially dealt with, if at all • Reasons: • Standardized documentation prepared by issuers • Lower rated bond issuers have only recently started borrowing money on the European capital markets • The lenders (bondholders) have little or no influence when the bond Terms and Conditions are being drafted • The lenders (bondholders) are not organized and do not speak with one voice

22. Terms and Conditions compared with loan documentation • Lender due diligence on borrower • Typically heavily negotiated • Long list of lender protections: • insolvency • cross default • Material Adverse Change • change of control • negative pledge • financial covenants • financial ratios • disposal of assets

23. Comparable bond covenants • Negative pledge (limited to “relevant debt”) • Breach of agreement (subject to a grace period) • Failure to pay (subject to a grace period) • Cross default • Insolvency • Misrepresentation

24. Negative Pledge – bond covenants • A covenant that the bond issuer shall not provide security for “relevant debt” • “Relevant debt” covers only transferable debt (i.e. either listed or traded OTC) issued by the company (or by “material subsidiaries”) • Debt to domestic lender in domestic currency is often excepted from negative pledge

25. Failure to Pay – bond covenants • Failure to pay interest or principal after expiration of grace period (typically 7-14 days)

26. Breach of Agreement – bond covenants • Breach of agreement (grace period, typically 30 days)

27. Cross Default – bond covenants • Imports breaches from other loan relations (“borrowed money”) • Operates with a threshold • Often expands to “material subsidiaries”

28. Insolvency – bond covenants • Standardized, global, insolvency event of default

29. Investor Protection in Corporate Bond Issues What is missing?

30. Development of documentation in corporate bond issues • Driven by the US and (in part) the UK • In the US event risk covenant protection was normal through the 1960’s until the mid 1970’s, but disappeared thereafter. • Event risk covenants became common again in the US from 1988 with the many LBO’s of the 1980’s, including the KKR acquisition of RJR Nabisco in 1988 that resulted in a $ 1 billion loss to bondholders (about 20% decrease). • Media attention • Investment parameters? • Bondholder groups? • Rating considerations?

31. Change of Control – the covenant of the future? • Change of Control • May be coupled with a downgrade trigger below “investment grade” • This means that the acquisition must be financed without reducing the issuer’s creditworthiness • If the covenant is triggered, the bondholders are given a put option at par (sometimes at the higher of par and reference government bond yield) • Often referred to as “poison puts” because they may be used to deter a hostile take-over and secure management entrenchment

32. Negative Pledge – the covenant of the future? • The negative pledge clause should take into account issuer flexibility without compromising the position of the bondholders • An effective negative pledge? • Prohibition on the granting of security over assets or securitization of cash flows • Maximum 20% of all debt at higher priority (secured) • Otherwise bonds will not be considered “senior unsecured” • No “carve-outs” for domestic debt or debt in domestic currency

33. Disposal of assets – the covenant of the future? • An effective disposal of assets clause? • Maximum 20% of assets on group-basis per year • Exceptions: - Proceeds are invested in similar assets - Proceeds are used to pay off senior/pari passu debt - Proceeds are used to redeem bonds themselves

34. Disclosure Covenant – the covenant of the future? • An effective Disclosure Covenant? • Detailed accounts to be disclosed to bond investors • Annual bondholder meeting in connection with publication of annual accounts • Information significant to the price of the bonds must be disclosed to the market • Disclosure of bank and bond covenants in annual accounts

35. Maintenance of Rating Covenant – the covenant of the future? • Demand that issuer maintains at least two ratings • More than one rating reduces the risk of “rating shopping” • Ratings lead to higher degree of openness

36. Demand more disclosure • Generally, issuers do not disclose much information to their bondholders (cf. shareholders) • Particularly in respect of unlisted companies • Buy-Out and de-listing affects the flow of information to the market • “Disclosure covenant” in bond documentation may help to regulate this

37. Conclusion • Legislation does not provide adequate remedies “post event” • “Event risk” is not priced in • UK and European bond documentation typically does not provide adequate protection against “event risk” • Ratings normally do not reflect missing protection against “event risk” in bond documentation • Protection against “event risk” requires careful drafting • Improved bond documentation could benefit issuers too (demand, pricing)

38. Investor Protection in Corporate Bond Issues When will we see changes?

39. Investor Protection in Corporate Bond Issues Investors should consider: • Making documentation a parameter when investing • Assessing event risk – what type of issuer? • Communication with issuer • Contacting other bondholders

40. Investor Protection in Corporate Bond Issues Issuers should consider: • Event risk covenants could lead to better pricing • A change of control-covenant may be used to prevent a hostile take-over • On the other hand, covenants can limit some company actions that would have increased the value of the business as a whole • Some covenants will impose costs on the company (eg. costs involved in complying with a disclosure covenant) • Finding the right balance between giving bondholders some protection, and retaining flexibility to manage the company

41. For further information please contact: Catherine Kendal Tholstrup ckt@plesner.com+45 3694 1175 Anna Iversen ani@plesner.com +45 3694 1221 WWW.PLESNER.COM