Overview Of Debt Agreements - Corporate Bonds and Credit Agreement

01. Introduction and Overview of Debt Agreements

Introduction

• Corporate bonds and Credit Agreements involve large loans to corporations

• Class is about the contractual provisions of these lending arrangements

  • macro perspective: general purpose

  • micro perspective: how clauses should be constructed, exceptions

  • nano perspective: is expression ambiguous, does the literal meaning conforms what we intended

• Credit Agreements

  • typically/ mostly with banks

    • one bank

    • syndicate

  • types

    • term loan: due on a specific date

    • revolvers: co. can borrow and repay up to a certain amount (line of credit)

      • difficult to transfer your participation to another bank

    • letters of credit: co. handle payment for goods purchased, future obligation

    • credit facilities: multiple types of agreement

• Corporate Bonds

  • Debt Securities

  • Often issued publicly and traded

  • Multiple holders of bonds of same issue

    • Insurance companies

    • Other institutional investors

    • Few retail investors

  • Indenture and Certificate

  • Some bonds are “private placements:” not publicly issued, less trading, usually no “indenture” but Note Purchase Agreement (or so).

• Comparison

  • Corporate Bonds

    • Holdings tend to be more dispersed than Lenders in Credit Agreement

    • Trading is more frequent than trading/assignment in Credit Agreement

  • To the extent Credit Facility involves ongoing obligations of lenders (as in revolver, letter of credit), assignment is difficult.

    • Not doable via bonds.

  • Interest rate variable versus fixed

    • Variable: revolvers tied to market rate, LIBOR (determined by a no. of banks)

  • trading in corporate bonds

    • public placement

    • larger number of holders

    • trading frequently

  • trading/ assignment in credit agreement

    • private placement

    • lower no. of creditors, little or no trading

• Focus of the Course

  • Study contractual provisions in agreements through Problem Sets

    • What is purpose of provisions?

    • How do provisions within one agreement relate to other provisions in same agreement?

    • Compare provisions within same type of agreement.

    • Compare provisions across types of agreements?

    • Drafting problems: mistakes, loopholes, imperfections

    • Case law

  • Parts are very detail oriented. Prior Preparation is KEY

• Terminology

  • Bonds, Debenture, Notes

  • All terms for debt securities

  • (Even Bank Agreement will contain a “Note”)

  • “Bonds”

    • used as catch-all term

    • Also used more narrowly for secured obligations - What is “secured?”

  • Notes

    • Used for short-term publicly issued securities

    • Also used for non-public debt

    • Also a promise to pay, used for all kinds of debt

  • Debentures

    • Used for public debt than is longer term

  • Terminology and usage conventions have no legal significance

  • Certificated versus Uncertificated

    • Certificated = an actual piece of paper representing the security, the Note, Debenture, Bond, etc. Signed, often kept in a safe

    • Most corporate bonds in the US are certificated.

  • Registered versus Bearer

    • Registered = owner of the security is the person registered as owner by the Registrar, and not the person who possesses the piece of paper.

      • A register is kept, can get replacement

    • Bearer bonds are virtually non-existing in US for tax reasons.

      • Equivalent to cash, ownership transferred by that piece of paper

• Sources of Legal Provisions

  • Indenture

    • For public bonds, most legal provisions are contained in the “indenture.”

    • contract between the Issuer/Company and a trustee

      • Trustee acts as representative of the bondholders (not contractual party but are third party beneficiaries of the indenture)

      • Bondholders are “third party beneficiaries”

  • Security

    • Some additional terms are on the Security itself.

    • “Form of” Security is usually part of Indenture.

    • Not the actually signed note, only a copy of the note before being signed

• Interest Provision

  • In public bonds, typical pattern

    • Semi-annual

    • Interest Payment Date

    • Interest record date

      • slightly before the interest payment date, cut-off date established by a company in order to determine which shareholders are eligible to receive a dividend or distribution.

  • Example: Freeport Indenture

    • Where do you find payment and record dates?

    • What are the dates?

Amihud, Garbade & Kahan, A New Governance Structure for Corporate Bonds

• Conflict of interest between creditors and shareholders & managers

• Managers serve interests of shareholders – acts to maximise company’s common stock’s value

• But enhancing value of equity may reduce value of company debt, e.g.:

  1. cash distributions to shareholders (dividend/ stock repurchases)

  2. spin-offs to shareholders of common stock of lightly leveraged subsidiaries owning valuable corporate assets

  3. dealings between shareholders and co. on terms favourable to shareholders

  4. investments in projects with greater risk than originally anticipated by creditors

  5. financing new projects with debt (and not equity)

• Shareholders still want co. to take such actions if it reduce co.’s debt by more than they increase value of equity (overall value of co.)

• Agency costs of debt: losses in corporate value caused by shareholders’ actions in advancing their parochial (narrow-minded) interests, while in control of a leveraged enterprise

• E.g. Co. with $100 cash + $80 short-term debt Debt = $80; Stock = $20.

If co. invests all cash in a project with 50% chance of yielding $10 + 50% of yielding $150:

• value of equity will increase from $20 to $35 shareholders would benefit

• value of debt will decline from $80 to $45 creditors would be hurt

• value of co. as a whole decline from $100 to $80

• Co. should be managed to maximise the aggregate value of its debt and equity (economic efficiency) hence minimizing agency costs is important

• To reduce agency costs of debt, loan agreements contain covenants to limit shareholders from running the co. in a narrow-minded way, e.g.:

  • Limiting the dividends, a co. may pay, amount of new debt a co. may incur

  • Covenants that reduce agency costs of debt are ex ante beneficial to shareholders creditors less concerned that co. will reduce value of their debt, hence willing to lend at a lower interest rate

• But covenants also entail costs: costs of

  • monitoring compliance with covenants,

  • enforcing covenants

  • costs stemming from limitations on co’s action imposed by the covenants (as covenants often also restrict some actions that increase value of equity by more than they reduce the value of debt which increase value of the firm as a whole)

• E.g. covenant restricting dividend payments to shareholders

  • harmful to creditor: assets of co. available to repay debt

  • beneficial to shareholder at the expense of creditors: from payment of dividends even if such payments reduce firm’s value

  • If co. doesn’t have profitable investment opportunities, distributing cash may increase co.’s value, because money retained in the co. may be invested in degreasing projects

  • Such covenant may either be

    • too lose: allowing shareholders to distribute cash even when it reduces debt value by more than it increases equity value; or

    • too tight: prohibiting distributions of cash even when available investment projects are not value-increasing

    • note re-negotiating is possible (sometimes) but costly

• Having more and tighter covenants may not necessarily be preferable – should balance benefit of covenant (only strict actions that reduce firm value) and cost of a covenant (monitoring, enforcing, renegotiating, restricting actions that increase co. value)

Fabbozi & Wilson, Overview of U.S. Corporate Bonds

• Debt (tax reduction for issuer) vs. equity instrument (payments seen as dividends)

  • Equity: corporate security gives the holder a right to share in the profit of the enterprise, while sharing in the risks

  • Debt: doesn’t share profit of business +...