Margin rules create trap for unwary purchasers of CBO debt (part one)

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1 Margin rules create trap for unwary purchasers of CBO debt (part one), Partner 25 September 2000 In the first of three articles, Adam Glass explains why buyers of CBO debt backed by margin stock should beware Suppose a US-domiciled commercial paper conduit bought senior notes, which were collateralized bond obligations (CBOs) issued by a Cayman Islands company in a private placement, and the notes were directly secured in part by convertible debt. Would the conduit be subject to margin restrictions? And what steps could the issuer or the conduit take to provide relief from application of the margin rules? The answer may surprise some readers. Generally, debt securities issued in a private placement to purchase or carry convertible debt are subject to margin regulation if they are secured directly or indirectly by margin stock, which includes debt that is convertible into publicly traded equity securities. Margin stock includes equity securities listed in the US, most over-the-counter securities and convertible debt. Regulation U governs the extension of credit by a US commercial paper conduit. It also governs extensions of credit by banks and persons other than brokers or dealers, for the purpose of purchasing or carrying margin stock. The face amount of the debt may not, as of the date of commitment (generally viewed to be the date of closing), exceed half the market value of the margin stock plus the market value of any other collateral. Put another way, the advance rate against margin stock by market value may not exceed 50%. To comply with the margin rules the total debt must be covered dollar-for-dollar by margin stock (at 50% of market value), plus other non-margin stock collateral. The latter will be valued at up to 100% of market value, but not exceeding the amount a lender exercising sound credit judgment would lend against it. The margin rules do not apply if the issuer and its parent are not US persons and there is no US broker/dealer, bank or investor in the transaction. And the margin rules do not apply to a typical CBO, where the indenture generally does not permit the issuer to acquire margin stock except pursuant to narrow, limited exceptions. Based on market practice, market value CBOs are more likely to be subject to margin regulation than cash flow CBOs. Practical example Assume the issuer issues notes with a face amount of $350,000,000 and equity interests of $20,000,000, and the aggregate funds raised are used to purchase $370 million in high yield bonds and leveraged loans, with sublimits, or buckets, for less liquid subclasses such as distressed debt,

2 mezzanine issues, trade receivables, equities, investments in foreign issuers and emerging market securities. The issuer s equity interests will have to be equity in form, such as common or preferred stock, partnership interests or limited liability company interests. The economic equity, or mostsubordinated, first-loss position, in a CBO is often the income notes. In other words income notes are equity in substance but debt in form. If this were to occur in a CBO that can acquire margin stock, then the equity as well as the debt would become part of the margin calculation (because the equity would be treated as debt issued to purchase margin stock), leading to an unacceptable result. Assume also that under the terms of the indenture, margin stock may be acquired with a market value of up to $20 million, and that, for purposes of the example, a lender exercising sound credit judgement would lend 100% against the market value of the collateral other than margin stock. In this example, the total debt issued is $350 million. The market value of the collateral is $370 million. The equity has a market value of $20 million. The comparison required is whether the total debt ($350 million) is less than half the market value of the margin stock (half of $20 million, or $10 million) plus the value of the other collateral ($350 million). In this example, $350 million is less than $360 million, and the margin rules are satisfied. If the margin stock had been allowed to reach $50 million, the result would be different. In that case, total debt ($350 million) would not be less than half the market value of the margin stock (half of $50 million, or $25 million) plus the value of the other collateral ($320 million). That is, $350 million is not less than $345 million, and the US purchasers of the CBO debt would be in violation of the margin rules.

3 Margin rules create trap for unwary purchasers of CBO debt (part two), Partner 2 October 2000 In the second of three articles, Adam Glass asks: When is margin compliance measured? and highlights an important exception to the rule Margin compliance is usually tested only as of the closing date. For a US conduit, so long as the market value of the margin stock is less than or equal to the issuer s equity capital on the closing date of the CBO, no margin violation will occur upon issuance of the debt or thereafter. Subject to the exception discussed below, Regulation U provides that a lender may continue to maintain any credit initially extended in compliance with Regulation U, without the requirement of margin calls or any similar adjustments. The credit may be maintained regardless of any post-closing reduction in the borrower s equity resulting from change in market prices, change in the maximum loan value (effectively, the permissible borrowing base) prescribed by Regulation U, or any change in the status of a security from non-margin to margin. Substitution of margin stock for non-margin collateral requires post-closing compliance testing If any withdrawal or substitution of any collateral is to be made over the term of the credit facility, attention will need to be paid to the borrowing base features of Regulation U. Under Regulation U, a lender may permit any withdrawal or substitution of cash or collateral by the borrower that does not cause the credit to exceed the maximum loan value of the collateral, or increase the amount by which the credit exceeds the maximum loan value of the collateral. If the borrower s equity has declined because of changes in market prices, so that the maximum loan value, or borrowing base, post-closing does not currently support the amount of the credit, the lender may continue to maintain the credit, notwithstanding the drop in market value of the collateral. But in such circumstances the lender may not permit a withdrawal or substitution of collateral unless the transaction does not cause the borrowing base to move further out of compliance. Since cash and non-margin collateral have a maximum loan value of 100%, while margin stock has a maximum loan value of 50%, unless there is excess collateral value at the time the reinvestment is made, the replacement of cash or non-margin collateral with margin stock may not be permitted. Prompt replacement of margin stock with new margin stock should be permitted A post-closing reinvestment of cash proceeds of margin stock in new margin stock could be viewed as representing the substitution of one type of collateral (cash) for another type of collateral margin stock. The maximum loan value of the new margin stock will be less than that of the cash. Nevertheless, we believe such a substitution should be permissible, so long as the new margin stock is acquired within a reasonably short time after receipt of the proceeds of the old margin stock. On the

4 other hand, if the cash is held uninvested for too long, it may not be permissible to use it to purchase margin stock. Purchase of margin stock with cash or proceeds of non-margin collateral not permitted The post-closing reinvestment of cash proceeds of non-margin collateral in new margin stock is problematic. If the maximum loan value or borrowing base does not support the credit, the replacement of cash or non-margin collateral with margin stock, which will tend to increase the amount by which the credit exceeds the maximum loan value, is likely to violate the margin rules. To avoid this, a conservative approach would require the operative documents of the issuer to prohibit the purchase of new margin stock where the amount of the credit would exceed the maximum loan value after giving effect to the purchase, unless the excess amount was maintained or reduced by the transaction (an unlikely occurrence where the purchase is made with proceeds of non-margin collateral). However, to our knowledge such a provision has not generally been adopted in market value CBOs. Limiting the acquisition of margin stock held by a CBO issuer on the closing date to the amount of the issuer s equity capital will prevent any violation of the margin rules absent the purchase of additional margin stock. But subsequent purchases of margin stock are often permitted. If the market value of either the margin stock or other non-margin collateral has declined, such purchases may constitute a margin violation if the margin stock is bought with the proceeds of non-margin collateral.

5 Margin rules create trap for unwary purchasers of CBO debt (part three), Partner 9 October 2000 In the last of a series of short articles, Adam Glass discusses structuring solutions for CBOs backed by margin stock and examines penalties for violation of the rules In the first of this series of articles, we introduced the concept of margin stock as it applies to CBO transactions. In the second we analyzed the testing date or dates on which margin borrowing base compliance must be measured. In this third and final part, we discuss some possible structuring solutions, and review the potential penalties if compliance is not achieved. Structuring solutions Offshore conduit One structuring solution is for the conduit to establish itself offshore (or acquire the CBO securities through an offshore affiliate). If there is no US lender and no US borrower (including as a US borrower a foreign company with a US parent), the margin rules do not apply. Twenty-five percent basket for negative pledge structure Another solution would be for the indenture trustee to take a pledge of (and a negative pledge by the issuer in respect of) the non-margin collateral, but rely solely on a negative pledge in the case of the margin stock. The indenture would also provide that margin stock may only be acquired if it is less than or equal to 25% of all the collateral (by value). Under this structure, the credit is not directly secured by margin stock (because there is no pledge or grant of a security interest). The question becomes whether the credit is indirectly secured by margin stock. Under Regulation U, an extension of credit is indirectly secured by margin stock (and therefore subject to Regulation U) if the borrower s right or ability to sell, pledge or otherwise dispose of margin stock that it owns is in any way restricted while the credit remains outstanding. A negative pledge would be a restriction of the type that generally gives rise to indirect security. The credit is not indirectly secured, however, if after applying the proceeds of the credit (which in this case would be used to purchase the CBO collateral), not more than 25% by value of the collateral (by value) is comprised of margin stock. Thus, foregoing a direct pledge of margin stock and obtaining only indirect security allows a 25% by value basket for margin stock. While this method allows a greater amount of margin stock to be purchased, it is not customary for an indenture trustee to obtain a direct pledge of less than all the collateral in a CBO transaction, and we are not aware of any transaction to date in which the negative pledge approach has been employed.

6 Penalties for violation The margin rules, including Regulation U, are promulgated under the authority of Section 7 of the United States Securities Exchange Act of The penalty for violation of rules or regulations, such as Regulation U, is a fine of up to $1,000,000 ($2,500,000 for foreigners) and imprisonment for up to 10 years. Innovative CBO transactions, especially market value CBOs, are expanding the eligible collateral types for CBOs to include convertible debt securities. However, US conduits and other US purchasers of these securities must ensure their acquisition does not lead to inadvertent noncompliance with the margin rules.