High yield bonds with registration rights have been a fixture of private equity transactions for over thirty years, notwithstanding changes in law and predictions to the contrary. High yield bonds used to finance private equity transactions or dividend recaps are typically sold in private offerings utilizing Rule 144A with the issuer entering into a registration rights agreement at the time the bonds are initially issued, typically requiring the issuer to conduct a so-called “A/B” exchange offer1 within a certain time period thereafter. In the A/B exchange offer, the issuer offers bondholders SEC-registered bonds with terms essentially identical to the terms of the bonds sold in the initial 144A offering, in exchange for the initial bond. As a back-up mechanic, the registration rights agreement also generally requires the issuer to file a shelf registration statement to permit SEC-registered resales of the bonds in certain circumstances, which kicks in if the exchange offer mechanic is unavailable due to a change in law or SEC policy, or if a bondholder can’t participate in the exchange offer under SEC policy because it is an affiliate of the issuer. The bondholders are entitled to receive additional “penalty” interest2 if there is a default in these obligations for so long as the registration default continues. Some agreements also contemplate that bondholders may seek specific performance to enforce the issuer’s registration obligations. A failure to comply with these registration obligations typically does not result in a default under the bond indenture.
The combination of an initial 144A offering with a subsequent exchange offer requirement gives an issuer the ability to access the high yield markets quickly, while providing assurance to investors that, within designated time periods after issuance, the bonds will be freely tradable for securities law purposes. In addition to SEC registration, though, bonds issued in a Rule 144A offering may become freely tradable simply through the passage of time, as provided in Rule 144 under the Securities Act. The extent and manner in which registration rights agreements take that into account can vary. Some agreements contain “fall away” provisions whereby the registration requirements no longer apply, or additional interest no longer accrues, once the bonds become freely tradable, or after a certain period of time has elapsed after the bonds have been freely tradable. Other agreements contain fall away provisions that apply after a designated period of time has elapsed, rather than tying the fall away to the bonds becoming freely tradable. Some agreements may provide for continuing registration requirements until all the eligible bonds have been traded.
We reviewed a sample of registration rights agreements from over seventy high yield 144A offerings that closed during 2011 to assess the current state of the market with respect to A/B exchange offer deadlines, additional interest rates, specific performance and fall away provisions. The sample focused on private equity sponsor portfolio companies, and included both bonds issued to finance leveraged buyouts and bonds issued by existing sponsor portfolio companies. Our review revealed some interesting findings.
The Continuing Prevalence of Registration Rights
In February 2008, the SEC adopted a number of changes to Rule 144 under the Securities Act, which shortened the holding periods for unregistered, or “restricted,” securities. At the time of the 2008 amendments, some commentators predicted that investors in securities sold in Rule 144A offerings would no longer require A/B exchange offers, pointing out that the new holding periods under revised Rule 144 were shorter than the registration deadlines found in many registration rights agreements. A task force convened by the Securities Industry and Financial Markets Association (SIFMA) proposed an alternative to traditional registration rights that, instead of requiring an A/B exchange offer, would require removal of the restrictive legend from securities after the Rule 144 holding period had run.3
Four years after the adoption of revised Rule 144, it is clear that predictions of the demise of traditional registration rights in high yield debt offerings were greatly exaggerated. Traditional registration rights, providing for an A/B exchange offer and, if an A/B exchange offer is not possible, a shelf registration statement, are still the norm in the U.S. high yield market. Only a couple of the agreements in the sample provided for a de-legending alternative along the lines of that proposed by the SIFMA task force, and one of those agreements involved a secured note deal, where registration rights tend to be somewhat less common in large part due to certain compliance requirements imposed on issuers of registered secured notes under the Trust Indenture Act of 1939.
The reason for the resiliency of traditional registration rights in the high yield market is likely two-fold. First, investment guidelines for many high yield investors limit their ability to invest in unregistered securities. For example, an investment fund’s formation documents may provide that no more than a certain percentage of the fund’s portfolio may consist of unregistered securities. As a result, providing for registration of a high yield debt security may boost the liquidity of that security, even if it is already freely tradable under Rule 144, and providing registration rights generally for high yield offerings may facilitate their marketing as well as overall market liquidity by limiting the time period during which any one bond issue occupies the unregistered securities allocations of investors and freeing up those allocations for new offerings.
Second, many high yield investors want issuers to be subject to SEC reporting requirements. Although the SEC permits certain companies to file Exchange Act reports on a voluntary basis, it has indicated in a staff interpretation that an issuer not previously subject to Exchange Act reporting cannot file Exchange Act reports on a voluntary basis.4 As a result, for an issuer that is not already an Exchange Act reporting company, traditional registration rights provide the bridge to the bond indenture’s SEC reporting requirements. Once a high yield issuer completes an A/B exchange offer or shelf registration, it becomes subject to Exchange Act reporting obligations, and the bond indenture’s reporting covenant will typically require the issuer to continue to file SEC reports, even if it is no longer required to do so under SEC rules, so long as those filings are permitted by the SEC.
A/B Exchange Offer Deadlines
Deadlines for A/B exchange offers are negotiated from deal to deal, and may include one or more of (1) a deadline to file a registration statement, (2) a deadline for the registration statement to become effective, and (3) a deadline for the exchange offer to be completed. The most common formulation in the sample provided for a single completion deadline — that is, additional interest would begin to accrue upon failure to complete the A/B exchange offer by a specified deadline—with no preceding filing or effectiveness deadline. A significant number of agreements also provided for an effectiveness deadline, or for all three deadlines.
In agreements with a filing deadline, the deadline ranged from 45 to 420 days after issuance, with 180 days being the most common. In agreements with an effectiveness deadline, the deadline ranged from 150 to 510 days after issuance, with 270 and 365 days being the most common. Deadlines for completion of an A/B exchange offer ranged from 180 to 450 days after issuance, with the most common being 360, 365 or 395 days. The longer completion deadlines tend to be found in agreements with no other deadline and agreements with an effectiveness and a completion deadline but no filing deadline. A significant number of agreements did not specify a specific deadline for completion, but rather required that the exchange offer be consummated within a specified period—typically 30 days or 30 business days—after the registration statement became effective; effectiveness deadlines in these agreements ranged from 160 to 510 days after issuance (with 270 and 365 days being the most common). Perhaps not surprisingly, agreements with shorter deadlines tended to be for seasoned issuers that were already SEC registrants with reporting obligations under the Securities Exchange Act of 1934.
Additional Interest Rate
Additional interest provisions in high yield registration rights agreements typically provide for an increasing additional interest rate, subject to a cap. All but a handful of the agreements in the sample contained a starting additional interest rate of 25 basis points (0.25%) per annum. All but two agreements provided for increasing additional interest over time, typically increasing in 25 basis point increments every 90 days during the continuance of registration default. A majority of the agreements in the sample capped the additional interest rate at 100 basis points (1.0%), although a significant number provided for a cap of 50 basis points (0.5%).
Over half of the agreements in the sample contemplated that specific performance may be a remedy to a registration default, either by explicitly providing that the bondholders are entitled to specific performance or by providing a waiver by the issuer of certain defenses relating to specific performance. While only a couple agreements expressly provided that specific performance does not apply in the case of a registration default, a significant number were silent about whether specific performance applies.
Fall Away Provisions
Fall away provisions in high yield registration rights agreements provide that the registration requirements under the agreements cease to apply, or additional interest ceases to accrue, after the relevant bonds become freely tradable for securities law purposes, or after a certain period of time has elapsed after the bonds have become freely tradable, or after a certain period of time has elapsed after issuance. In our sample, almost half of the agreements had some sort of fall away provision.
Market practice with respect to fall away provisions has evolved over the past few years in response to the changes in Rule 144 adopted in 2008. Prior to the 2008 amendments, Rule 144 permitted holders who were not affiliates of the issuer to freely resell securities without volume limitations after two years. The 2008 amendments reduced the Rule 144 holding periods, and allow non-affiliates to freely resell securities of Exchange Act reporting companies after a six-month period and to resell freely securities of all companies, regardless of Exchange Act reporting status, after a one-year period.
The change to Rule 144 holding periods has affected the timing reflected in fall away provisions. Prior to the 2008 amendments, it was not uncommon in private equity sponsor transactions for registration rights agreements to provide for a fall away upon the bonds becoming freely tradable without restrictions under Rule 144. A simple fall away upon the bonds becoming freely tradable has become less common following the 2008 amendments. Only a handful of agreements in the sample provided for such a fall away, and nearly all of these had a relatively short, 180-day or 270-day registration completion deadline, inside of the shortened one-year Rule 144 holding period. The most common formulation in the sample provided for a fall away on the second anniversary of the closing date, in effect preserving the fall away construct under the old Rule 144 holding period. A handful of agreements provided for a fall away upon the later of the bonds becoming freely tradable and a specified date ranging from 545 days to 2 years after closing.
The registration regime for high yield bonds has remained remarkably stable through a variety of business cycles and a liberalization of the securities laws. For high yield issuers, the price of admission to the high yield marker continues to be offering liquidity through registration rights with an incentive to deliver registered securities within a finite period of time after issuance.
1. This mechanism is sometimes called an "Exxon Capital" exchange offer, after the first SEC no-action letter approving the A/B exchange procedure. See Exxon Capital Holdings Corp., SEC No-Action Letter, 1988 SEC No-Act. Lexis 682 (May 13, 1988).
2. Many agreements structure the additional amounts as liquidated damages rather than incremental interest. Those that use the incremental interest construct often characterize the additional interest as liquidated damages.
3. See SIFMA Guidance: Procedures, Covenants, and Remedies in Light of the Revised Rule 144 (October 2008).
4. See Compliance and Disclosure Interpretations: Exchange Act Sections (Updated August 14, 2009), Question 116.03, available at http://www.sec.gov/divisions/corpfin/guidance/exchangeactsections-interps.htm.