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BOND INDENTURES

AND BOND

CHARACTERISTICS

William J. Whelan, III

Partner,

Cravath, Swaine & Moore LLP

High-yield bonds are issued pursuant to a document called a trust indenture. The indenture is a

contract between the issuer of the bonds and a banking institution that acts as trustee for the

benefit of the holders of the bonds from time to time. High-yield bonds are most commonly sold

to investors by the issuer through investment banks, or underwriters, in an offering that is

registered under the Securities Act of 1933 or in a private placement (often referred to as a Rule

144A offering) that is exempt from the registration requirements of the Securities Act.

In the indenture, the issuer subjects itself to restrictions on its future ability to carry on certain

activities, such as issuing additional indebtedness and paying dividends. These restrictions are

called covenants, and although they reside in a contract signed by the trustee, they are there for

the benefit of the bondholders. Since the terms of these covenants have to be included in the

offering document that is distributed to investors to solicit their interest, they must be established

in advance and are therefore typically negotiated between the issuer and its counsel on the one

hand and the underwriters and their counsel on the other. In this chapter we describe some of the

common characteristics of high-yield bonds in the U.S. market and also focus on some of the

more standard covenants and related terms of U.S. high-yield indentures.

Common Characteristics

Almost all high-yield bonds are issued with a “bullet” maturity, which means that they have a

single maturity date for the entire principal amount of the bonds. It is uncommon for bonds to

have any early mandatory redemption terms (with the exception of some “put” provisions related

to the occurrence of specified events, discussed below) or any sinking fund feature. Although

high-yield bonds increasingly are issued with floating rates of interest, it is still more common for

the bonds to be issued with a fixed coupon.

The decision concerning which type is appropriate in a particular situation will depend in part on

the needs of the particular issuer but also on the judgment of the underwriter as to which will lead

to the most successful offering. This in part depends on which type of institutional investors is

most likely to participate in a transaction. If the bonds have a fixed coupon, interest is paid

semiannually. Floating-rate bonds usually have quarterly interest payment dates. In either case,

interest payment dates are typically the first or fifteenth of a month by market convention.

In addition to “cash-pay” high-yield bonds, some issuers will issue “zero coupon” bonds, where

no cash interest payments are made for a period of time (not longer than five years, for U.S. tax

reasons), but instead the original principal amount of the bonds accretes semiannually at the

implied interest rate, such that at maturity the repayment obligation of the issuer is substantially

in excess of the initial gross proceeds received by the issuer. Related to zero coupon bonds are

“pay-inkind” securities, where the semiannual payments of interest are made not in cash but in

additional securities of the same class having a principal amount equal to the accumulated six

months of interest. During the initial term that the high-yield bonds are outstanding, typically

approximating the halfway point of the scheduled term of the bonds, the issuer is precluded from

redeeming the bonds at its option. From a bondholder’s perspective, this is an important

provision. Often referred to as the “no call” period, the prohibition on optional redemptions

during this period means that the bondholder can “lock in” the yield for this period and is not at

risk that it will have to reinvest redemption proceeds too soon after making the initial investment

decision. Beginning at the end of the no-call period, the bonds can be redeemed (or “called”) at a

premium that thereafter declines on each anniversary date until there is no premium in the last

year or two of the life of the bonds.

One significant exception to the no-call period, which is typically effective for the initial three

years of the term of the bonds, was created to allow an issuer to redeem a portion (typically 35%)

of the outstanding bonds, but only to the extent that it has raised cash proceeds from the issuance

of common equity. From the bondholders’ perspective, they are willing to give up some of their

yield protection so long as the issuer’s stockholders’ equity is increased. The redemption price is

usually par plus the coupon (e.g., 110% for a 10% bond). This provision is often referred to as the

“equity clawback.” This provision was originally limited to the issuance of equity in the public

markets by a private company, since bondholders not only wanted an increase in equity but also a

public company valuation (which would improve the valuation methodology on the bonds).

However, that limitation has all but disappeared, particularly with the substantial involvement of

private equity firms in the high-yield market to finance acquisitions. High-yield bonds are

typically denominated as senior notes or senior subordinated notes. Occasionally you will see a

more junior subordinated security, which is often either a discount security or convertible into

common stock of the issuer. It is important in any high-yield offering to understand the relative

contractual and structural priorities of the potential claimants against the issuer and its

subsidiaries. When bonds are “senior subordinated,” this means that the bonds are contractually

subordinated by their terms to other specified classes of indebtedness.

The other type of subordination, called “structural subordination,” cannot generally be discerned

from the title of the bonds, but rather only by an understanding of the corporate structure of the

issuer and its affiliates and subsidiaries. Structural subordination refers to the fact that the

liabilities of subsidiaries of the issuer, which often include claims in addition to those of debt

holders (e.g., trade creditors and preferred stock of subsidiaries), are superior to the claims of the

bondholders to the extent of the value of the assets of such subsidiaries, even if the bonds are

senior notes. This is because in any bankruptcy or liquidation involving the issuer and its

subsidiaries, bondholders who do not have any direct claims against the subsidiaries (e.g.,

through a subsidiary guarantee) are entirely dependent on the recovery by (or on behalf of ) the

issuer of any value of the issuer’s common equity claim against the subsidiaries.

Of course, that common equity claim is junior to those of the debt, trade, and preferred

stakeholders of the subsidiary. Thus the bondholders’ claim against the issuer is said to be

structurally subordinated to those against the subsidiaries. This can be particularly meaningful if

the issuer is a shell holding company and most of the consolidated assets are held in the

subsidiaries. If the bonds are contractually subordinated, then pursuant to the subordination

provisions of the indenture, the issuer will be contractually prohibited from making payments of

principal or interest to bondholders under specified circumstances. In short, if there is a payment

default with respect to senior indebtedness, the issuer is automatically prohibited from making

payments on the bonds for as long as the default continues. If there are other defaults under senior

indebtedness that entitle the holders to accelerate their debt, then the senior debt holders have the

right to instruct the issuer not to make any payments with respect to the subordinated bonds. Such

instructions are typically valid for no more than 179 days, at which point the issuer is entitled to

resume making payments on the bonds unless the holders of the senior indebtedness have

accelerated their indebtedness. Notwithstanding this contractual arrangement, the nonpayment on

the bonds by the issuer during the 179-day period constitutes a default under the indenture, and

depending on the specific provisions of the indenture, the bondholders may have certain rights to

accelerate payment of the bonds as a result of such nonpayment. However, the bondholders’ right

to actually receive payment from the issuer will continue to be restricted by these very same

contractual subordination provisions.

Nearly all Rule 144A high-yield offerings contain contractual obligations on the part of the issuer

to ensure that the bonds are freely tradable under the securities laws within specified time periods

following the closing of the Rule 144A offering. This can be achieved with the passage of time

under Rule 144, which generally provides that after six or twelve months, nonaffiliates of the

issuer can freely trade securities issued by the issuer in a private placement. Other methods to

achieve this liquidity are to require the issuer to subsequently offer to the bondholders in an SEC-

registered offering bonds that are identical to the restricted bonds acquired in the initial 144A

distribution or to require the issuer to file with the SEC a “resale” registration statement that

allows the investors to freely resell their bonds into the public markets. The concept here is that in

exchange for their willingness to buy the bonds without the benefit of a registration statement so

that the issuer can obtain its financing on an expedited basis, the bondholders insist that the issuer

agree to these obligations. The sole remedy available to the bondholders for the issuer’s

noncompliance with these obligations is an increase in the interest rate on the bonds for so long as

the default continues. The failure to comply with these covenants does not constitute a default

under the indenture.

Covenants

High-yield covenants are crafted to proscribe specified actions by the issuer on a case-by-case

basis. As a result, they are often referred to as “incurrence-based” provisions, as opposed to

provisions that require the issuer to maintain compliance with specified terms on an ongoing

basis, which are referred to as “maintenance” covenants. Maintenance covenants are intended to

measure the ongoing health of the issuer and to give “early warning signals” to the lenders if the

business of the issuer is deteriorating. In such an event, the lead, or agent, bank may spearhead

negotiations with the borrower to amend the applicable covenant to avoid an imminent default

and possibly to provide new or incremental economic or contractual benefits to the bank group in

order to obtain the requisite consent to the amendment. In many cases this process can be

completed quickly and efficiently.

By contrast, an issuer’s series of high-yield bonds might be held by 50 or more institutional

investors, none of which has the predesignated role of lead or agent. If the high-yield indenture

contained maintenance covenants, an issuer would be hard-pressed to get the holders organized

on short notice to consider and agree to a revised maintenance covenant based on the issuer’s then

present financial condition. As a result, a covenant default would be hard to avoid, and the

consequences of public disclosure and possible cross-defaults could be disastrous.

With incurrence-based covenants, an issuer need not worry about falling out of compliance based

on events beyond its control. Rather, it need only test compliance with the covenant if it

proactively intends to take an action, such as to borrow more money, to pay a dividend, or to sell

assets. And if it finds itself in a situation in which it desires to solicit consents to amendments to

the terms of the covenants in order to take an action, it can do so in an orderly process where the

result, even if unfortunate, is not disastrous if it fails to obtain the requisite consent of

bondholders.

The three primary objectives of the covenants from the bondholders’ perspective are to (1)

prevent the issuer from undertaking new obligations that could divert the issuer’s cash flows

toward competing claimants, rather than being available to meet its preexisting cash obligations,

including debt service on the bonds themselves, (2) prevent the issuer from favoring another class

of creditors over the bondholders by preserving the relative priorities of claimants, and (3)

prevent the issuer from disposing of assets for less than equivalent value such that the remaining

assets are not sufficient to discharge its remaining obligations, including debt service on the

bonds. In crafting these covenants, a balance must be struck between achieving these objectives

and giving the issuer the flexibility to grow and execute its business plan (which is presumably in

the bondholders’ interest) during the term of the bonds, which might be as long as 10 years.

Most bond indentures will contain the same list of covenants that will all start with the same basic

proscription and then include a list of exceptions, some of which will be customary from deal to

deal and the rest of which will be specifically negotiated for each deal. Many regular participants

in the market will agree that some terms are “absolutely market” and then disagree about the rest.

In fact, the concept of “market” evolves over time and depends on the type of issuer, the then

strength of the high-yield market, the prospective rating on the bonds, and other factors. Certainly

the active participation of private equity funds in the high-yield market over the past decade has

had a substantial impact on the form of the covenants, particularly the emergence of significant

exceptions and carve-outs from the basic covenants. The marketing spin on the issuer’s business

strategy will also justify certain departures from market: for example, a start-up company may

need to borrow substantial amounts after the bonds are issued, so the concept of leveraging new

equity (permitting the incurrence of new amounts of debt based on the amounts of the equity

raised after the bonds are issued) was created; similarly, a company with the stated strategy of

pursuing joint ventures needs plenty of room to make investments.

One last general observation: the definitions matter. Much of the substance in understanding the

covenants is actually in the definitions. They are often complex, and all the participants, but

particularly the issuer’s internal finance staff, must familiarize themselves with their nuances.

Restricted Subsidiaries versus Unrestricted Subsidiaries

It goes without saying that the issuer itself will be governed by the covenants. The other entities

that will also be governed by the covenants will be certain of the issuer’s subsidiaries, which are

referred to as restricted subsidiaries. Generally, a subsidiary is any entity (corporate, partnership,

etc.) in which a majority of the voting power is held by the issuer. Thus, the borrowing and other

activities of a 50%-owned joint venture are not governed by the covenants. Because the activities

of restricted subsidiaries are governed by the terms of the covenants to the same extent as those of

the issuer, generally an issuer is free to conduct any business transactions (e.g., intercompany

borrowings and investments) with subsidiaries that are restricted subsidiaries.

The activities of unrestricted subsidiaries are not governed by the covenants. In fact, the

covenants treat unrestricted subsidiaries as if they were unrelated third parties, and accordingly

the issuer has to evaluate every transaction with an unrestricted subsidiary for its compliance with

the covenants. Thus, while cash generally is permitted to flow freely among the issuer and its

restricted subsidiaries, this is not the case with unrestricted subsidiaries.

Whether a subsidiary is restricted or unrestricted is ultimately up to the issuer, although for the

reason stated at the end of the preceding paragraph, most subsidiaries are restricted, even though

this requires that they must abide by the indenture covenants. So why would an issuer elect to

treat a subsidiary as unrestricted? An issuer might conclude that a start-up subsidiary, especially

one that is engaged in a business line that represents a new venture for the issuer and is incurring

net losses in its early start-up phase, might adversely affect the calculation of the issuer’s

covenant net income if it is part of the restricted group; at the same time, if it were not governed

by the covenants and could incur substantial amounts of debt to finance its growth, it might

thrive. Whatever the reason, a bondholder would generally be willing to allow an issuer to

designate a subsidiary as unrestricted (which would leave it exempt from the covenants and

therefore potentially of no residual value to the bondholders), if this designation is made at the

time of the issuance of the bonds. Bondholders are also usually willing to permit issuers to

designate a subsidiary as unrestricted after a bond has been issued, so long as at the time of

designation the subsidiary has only nominal assets or the issuer is forced at the time of the

designation to tap into one of its covenant baskets that it might have otherwise used for some

other purpose, such as paying out a dividend to equity holders.

If the issuer chooses to bring a previously unrestricted subsidiary back into the restricted group (it

may elect to do this because the subsidiary is now generating positive net income and it wants to

be allowed by the covenants to freely transfer cash or other assets to and from such subsidiary), it

may do so under the covenants only if, after giving pro forma effect on a consolidated basis to

that subsidiary’s then outstanding levels of indebtedness and cash flow, the issuer would have the

capacity to incur additional indebtedness according to the indebtedness covenant. In this way the

bondholders can have some assurance that the issuer is not bringing into the restricted group an

entity with too much debt that may need to be serviced by cash flow from the issuer or other

restricted subsidiaries.

Change of Control

The change of control provisions of the indenture are designed to allow the bondholder, upon the

occurrence of certain events, to reevaluate the investment in the issuer represented by the bonds.

If in light of the occurrence of such an event, the bondholder for any reason elects to exit the

investment (and does not want to sell on the open market because the then current market price of

the bonds is depressed), the issuer is required to buy the bonds at a purchase price of 101% of the

principal amount of the bonds. This is commonly referred to as a change of control “put.” Also

common, especially in private equity deals, the indenture also includes a change of control

redemption right on the part of the issuer. The market will accept this concept, even if it infringes

on the no-call period, because the redemption premium is typically quite expensive for the issuer.

If the issuer is not at the time of bond issuance a public company, a change of control is often

deemed to occur if a designated group of controlling shareholders (the so-called “permitted

holders”) fails to continue to own at any time a majority of the outstanding voting stock of the

issuer. The permitted holders will usually include the majority shareholder, if there is such a

single shareholder at the time issuance, or a group of shareholders that at the time of the issuance

of the bonds collectively owns a majority of the voting stock of the issuer. The theory is that the

bondholders have made an investment decision based upon an evaluation of the merits of

shareholder control at the time of the investment, and if such controlling shareholders fail to

continue to hold that controlling position (which in a private company context is assumed to be a

majority), then the bondholders should be entitled to reevaluate their investment in the bonds.

Another event that is considered a change of control is somewhat similar to the first, but it applies

in a public company context (whether the issuer was public at the time of issuance or becomes so

thereafter). Here the permitted holders are entitled to fall below 50% and in fact could fall all the

way to zero in terms of voting percentage ownership, without triggering a change of control. A

change of control under this prong occurs only if persons other than the permitted holders acquire

(typically) 35% or more of the voting power of the issuer and the permitted holders own a smaller

percentage and the permitted holders do not have the right, by contract or otherwise, to elect or

designate a majority of the members of the board of directors. The 35% level is used as a proxy

for a level of voting power in a public company that is considered to be de facto controlling, even

if not in actuality. Many private equity deals are negotiated so that this event does not happen

unless the voting power of third parties exceeds 50%.

Other events that can trigger a change of control would be a successful proxy fight for control of

the board, without regard to who holds shareholder voting power, as well as a liquidation of the

issuer. A final common event that would constitute a change of control is an acquisition of a

publicly held high-yield issuer by merger with another publicly held company, such that the

public shareholders of the acquirer are the majority shareholders of the survivor, even if after the

merger the voting stock of surviving entity in the merger is widely held. Many bondholders

believe that a transaction of such magnitude is a significant enough event in the life of a high-

yield issuer to allow the bondholders to reevaluate the investment, even if no single shareholder is

technically in “control.”

Restricted Payments

The restricted payment covenant is focused on limiting what the issuer is allowed to do with cash

or other assets that it may have generated from operations or otherwise. The general principle is

that the bondholders want to trap the cash and other assets of the issuer and its restricted

subsidiaries and allow them to exit the credit group only under limited circumstances. Restricted

payments include dividends on capital stock, the purchase of capital stock, the early purchase or

redemption of debt that is subordinated to the bonds, and the making of investments.

With respect to dividends, the payment of a dividend in an issuer’s own stock (other than certain

types of stock), is freely permitted. The type of stock that would not be permitted (so-called

“disqualified stock”) is stock that has terms that are debtlike—they may have mandatory

redemption provisions or otherwise be subject to maturity prior to the maturity of the bonds.

With respect to the purchase of capital stock, restricted payments include not only the purchase of

the issuer’s own capital stock but also, typically, the purchase of capital stock of a restricted

subsidiary to the extent it is held by an affiliate of the issuer. Investing in or purchasing capital

stock of restricted subsidiaries is generally viewed as a permitted investment (that is, not subject

to this covenant). However, if such capital stock is held by an affiliate, the benefits for creditors

such as bondholders obtained by the issuer’s acquisition of a greater percentage of the restricted

subsidiary may be offset to the extent that a controlling person is perceived to be cashing out of at

least a part of his or her investment. The term investment has a broad definition to include any

debt or equity investment in another person. Guarantees of another person’s debt are also

typically considered to be investments in that person. Capital expenditures, or acquisitions of

assets, are not investments and are not restricted by this covenant.

Certain types of investments are excluded from the definition of restricted payments. These

permitted investments are generally ordinary course types of investments, such as accounts

receivable (which are in effect investments in the customer), and advances to employees (which

are investments in the workers). However, permitted investments also include any investment that

the issuer makes in a restricted subsidiary or in a person that as a result of the investment will

become a restricted subsidiary. These are important provisions that permit the free flow of cash

and assets between an issuer and its restricted subsidiaries and are the quid pro quo for subjecting

the restricted subsidiaries to the terms of the indenture.

This is perhaps the most significant consequence of having distinctions between restricted

subsidiaries and unrestricted subsidiaries (cash is not permitted to flow freely from the issuer to

an unrestricted subsidiary). Occasionally one will also see significant exceptions to the restricted

payments covenant buried in the definition of permitted investments. For instance the definition

might include joint venture investments up to a specified dollar amount.

Once an issuer has determined that the action it proposes to take involves a restricted payment, it

must test it against the covenant itself. In the first instance, before an issuer can make a restricted

payment, it must be in a position to incur indebtedness under its general debt incurrence test that

is discussed below. The theory of this requirement is that if the issuer is not healthy enough to

meet the minimum threshold for incurring debt (i.e., it doesn’t have sufficient cash flow vis-à-vis

interest expense), then it should not be permitted to make any restricted payments for the benefit

of junior security holders.

The amount that can be paid out by the issuer as a restricted payment at any time is often referred

to as the “dividend basket” or the “restricted payment basket.” This basket will be increased, or

built up, by the factors described below and will be reduced, or depleted, by the amount of

restricted payments actually made over time.

The general test for building up the restricted payment basket is based on the cumulative

consolidated net income of the issuer and restricted subsidiaries subsequent to the issue date of

the bonds. To the extent that the issuer has recognized, over the entire time period since the

issuance of the bonds, positive net income, it is allowed to take 50% of that amount and pay it out

as dividends or make other restricted payments. Net income is essentially based upon generally

accepted accounting principles (GAAP) and is not a cash calculation. On the other hand, if the

issuer has, since the original issuance date of the bonds, recognized a cumulative net loss, then

100% of the loss counts against the issuer in determining dividend-paying capacity. This negative

amount will become relevant if the issuer has otherwise developed some dividend-paying

capacity pursuant to other methods of increasing the dividend basket.

In calculating consolidated net income, the net income of an unrestricted subsidiary (even if

wholly owned by the issuer) or of any “investee” company (i.e., less than majority-controlled)

can be included by the issuer only to the extent that cash is actually received by the issuer or one

of its restricted subsidiaries from such unrestricted subsidiary or investee company. This

limitation recognizes that the issuer probably does not, typically because of limitations in other

contracts, have full access to the net income of these entities, and therefore it should not be

entitled to a full credit for the net income—only for the cash it receives. Similarly, to the extent

that a restricted subsidiary is subject to restrictions (contractual or otherwise) on its ability to pay

dividends to the issuer, the issuer does not get credit for the net income of that restricted

subsidiary, except to the extent that the issuer receives (or could have received) cash from that

restricted subsidiary.

The second important way that an issuer can develop or increase its dividend basket is through

the issuance of equity. If the issuer raises equity proceeds after the issuance of the bonds, other

than proceeds from the issuance of disqualified stock, then it is entitled to receive a dollar-for-

dollar credit to its dividend-paying capacity. Bondholders are willing to give credit to an issuer

for this purpose to the extent that the issuer has raised the corresponding amount of cash through

the issuance of junior securities. The issuer can also develop or increase its dividend basket

through the conversion of its outstanding debt into equity or through the realization of proceeds

from the divestment or repayments of certain investments it has made since the issuance of the

bonds.

Many indentures include some common exceptions to the restricted payments covenant that

entitle the issuer to make specified types of payments even if it is unable to incur additional

indebtedness under the debt incurrence test or it has been unable to generate sufficient dividend-

paying capacity through net income and equity proceeds to make these payments. The first

exception allows the issuer to make a restricted payment with the proceeds of the issuance of

capital stock (so long as it is not an issuance of disqualified stock), provided that the making of

the restricted payment must occur substantially concurrently with the issuance of the new stock.

Note, as discussed above, that while ordinarily the issuance of capital stock would increase an

issuer’s dividend-paying capacity, the issuer may not be able to access that capacity if it is unable

to pass the debt incurrence test (the first condition described above under the covenant). In that

event, this exception allows the issuer to use equity proceeds to effect a restricted payment when

it is not otherwise allowed to make a restricted payment, although of course it is not entitled to

double-count the dollar amount of the proceeds of this equity offering by adding it to the dividend

basket.

The second common exception allows the issuer to acquire subordinated debt with the proceeds

of other subordinated debt. Generally the bondholder is indifferent to the exchange of one

subordinated security for another, and allowing the issuer to do this may help the issuer to avoid

defaults or other financial crises under the debt to be replaced. There are usually several

customized exceptions for each issuer based upon its particular capital structure (e.g., if there is

an existing class of preferred stock, you may see an exception to allow the issuer to pay dividends

on the preferred stock). You may also see exceptions designed to permit the issuer to effect its

ongoing business strategy (e.g., if it is the stated intent of the issuer to make certain investments,

then this covenant should allow the issuer to make these investments, usually up to certain

specified dollar levels).

Indebtedness

The limitation on the incurrence of indebtedness is designed to protect the bondholders from the

issuance by the issuer of additional debt unless the issuer has the demonstrated capacity (usually

tested based upon a comparison of cash flow to interest expense) to service all its debt, including

the proposed new debt. This test is generally known as the “coverage” or “debt incurrence” test,

and the debt permitted to be incurred is generally referred to as “coverage debt.” If the issuer does

not have the demonstrated capacity, then it may not incur any additional debt except to the extent

that it can take advantage of certain specified exceptions to the debt incurrence test that are

available to the issuer without regard to its debt-servicing capacity. This kind of debt is often

referred to as “permitted debt.”

This is a limitation on the incurrence of indebtedness; once incurred, the issuer is permitted to

leave that debt outstanding notwithstanding any subsequent deterioration in debt-servicing

capacity. Indebtedness as defined in most high-yield indentures generally includes indebtedness

for money borrowed, lease obligations that would appear on the balance sheet of the issuer,

reimbursement obligations with respect to standby letters of credit (i.e., excluding trade letters of

credit that are obtained in the ordinary course of the issuer’s business), obligations with respect to

disqualified stock, preferred stock of subsidiaries, guarantees issued by the issuer that are in

respect of indebtedness of other persons, and security arrangements undertaken by the issuer to

secure indebtedness of other persons. Indebtedness does not include obligations to pay interest or

dividends. Note that guarantees are indebtedness (they are also investments in the person whose

obligation is guaranteed).

The basic debt incurrence test allows the issuer to incur “coverage debt” if the issuer—on a

trailing 12-month basis and on a pro forma basis assuming the proposed indebtedness had been

incurred at the beginning of such 12-month period—has enough cash flow (typically based on

earnings before interest expense, taxes, depreciation and amortization, or EBITDA) in relation to

its cash and noncash interest expense (typically a minimum ratio of 2 to 1). An occasional

alternative to the interest coverage test is a leverage test, which evaluates the relationship of the

issuer’s consolidated debt to its trailing 12-month EBITDA on a pro forma basis for the

incurrence of the indebtedness.

Regardless of whether a proposed borrowing would be considered coverage debt or permitted

debt, it is important to the issuer and bondholders alike whether the covenant allows restricted

subsidiaries, as well as or instead of, the issuer to incur the debt. For instance, if the bonds are

senior notes, the bondholders would prefer that most, if not all, incremental debt be issued by the

issuer itself and not by subsidiaries. If subsidiaries were allowed to issue the incremental debt,

substantial amounts of indebtedness could potentially be issued at a structurally superior level,

and thus the notes, which were marketed as senior notes, might become structurally subordinated

to substantial amounts of debt. The same considerations may not exist in a senior subordinated

note offering, where the bondholders have already agreed to contractual subordination and may

therefore care somewhat less about the potential amounts of structurally superior debt.

In calculating an issuer’s interest coverage ratio to determine eligibility at any time to issue

coverage debt, the indenture definitions look back over the preceding four fiscal quarters and

include on a pro forma basis the incurrence of the proposed indebtedness and any other

incurrences or repayments of indebtedness as if these incurrences and repayments had occurred at

the beginning of the period. Similarly the definitions give the issuer pro forma credit for

investments that have had the effect of adding EBITDA during the course of the preceding four

fiscal quarters and require the issuer to subtract EBITDA that may have been attributable to a

restricted subsidiary or line of business that may have been disposed of during the course of the

year.

If an issuer does not qualify at the time to issue coverage debt, it would then review the various

categories of permitted debt to determine whether the proposed borrowing can fit in one of those

exceptions. Almost every high-yield debt covenant contains an exception for the issuer to incur

bank debt. The exception may be constructed around the issuer’s borrowing base (inventory and

accounts receivables), or it may be limited to a specified dollar amount. Another important

category of permitted debt is intercompany debt between the issuer and its restricted subsidiaries,

so long as it is issued to the issuer or a restricted subsidiary and also remains with that person (or

with another member of the same group). If the debt is transferred outside the group to a third

party, it no longer qualifies for this exception and is deemed to be incurred again at the time of

transfer. In that event, the issuer would need to identify another provision of the covenant that

would allow it to incur this debt.

Every indenture needs to permit the issuer to refinance any of its indebtedness, whether it was

outstanding at the time of the indenture or was issued after the debt was incurred, in order to limit

the possibility of a default at the maturity of the other indebtedness. In issuing any refinancing

debt, the issuer may not increase the principal amount (except to the extent needed to pay related

costs, e.g., accrued interest, premium, and other retirement costs), the issuer may not shorten the

average life of the debt that is being refinanced, and the issuer may not refinance subordinated

debt with senior debt.

Almost every high-yield debt covenant contains a general basket— generally referred to as the

“debt basket”—that permits the issuer, and sometimes its restricted subsidiaries, to issue a

specified dollar amount of indebtedness, again without regard to whether the issuer has the

necessary interest coverage ratio that would permit it to issue coverage debt. This catchall basket

is intended to protect the issuer in the case of an “emergency,” where it may need to incur debt

and cannot satisfy the debt incurrence test and cannot identify any other specific exception. In

addition to these customary categories of permitted debt, most indentures will include additional

exceptions that would apply to a specific issuer. For instance, an issuer that historically has

acquired capital assets with purchase money indebtedness or through capital lease transactions

would typically negotiate for an additional exception that would permit such transactions in the

future.

In connection with any individual incurrence of indebtedness, the issuer does not need to identify

a single provision that will permit the entire amount of this indebtedness. For instance, the issuer

could incur a portion of the indebtedness based upon the credit agreement exception and could

also incur a portion of the indebtedness with respect to its general basket. In senior subordinated

note indentures, the issuer is not allowed to incur any debt that is contractually subordinated to

any indebtedness unless the debt to be incurred is also senior subordinated (i.e., equal to the high-

yield bonds) or is subordinated to the bonds. In other words, the issuer cannot have any

subordinated debt that is senior to these senior subordinated bonds.

Restrictions on Distributions from Restricted Subsidiaries

The general thrust of the covenant that places restriction on distributions from restricted

subsidiaries, which is not heavily negotiated, is to prevent the issuer and its restricted subsidiaries

from agreeing to any contractual limitations on the ability of the subsidiaries to send cash and

other assets, whether in the form of dividends or loans or other property transfers, to the issuer.

Obviously, to the extent that such contractual limitations were in place, the issuer would have

substantially less ability to service its own debt, including the bonds. Generally the exceptions to

this proscription include those that are in effect on the date the bonds are issued (and presumably

are disclosed to prospective investors) and encumbrances that are contained in refinancing

agreements and which are not more restrictive than those in the debt agreement to be refinanced.

Given the adverse consequences of these limitations to the issuer’s cash flow and therefore to the

issuer’s creditors, to the extent that a subsidiary is allowed by this covenant to contractually

restrict itself from paying dividends to the issuer, the definition of consolidated net income

typically excludes some or all of the income of a subsidiary from the issuer’s calculation of

consolidated net income.

Sales of Assets

The limitation on the sales of assets covenant does not prohibit an issuer from effecting asset

sales. Although the covenant requires sales of assets to be made at fair value and that a large

percentage (between 70% and 90%) of the consideration be received in cash, the main purpose of

the covenant is to limit the uses of proceeds in the event that the issuer does sell assets. From the

bondholders’ perspective, when an issuer sells an asset, it has removed potential income-

producing assets from the consolidated group. As a result the bondholder expects the issuer

within some reasonable period of time to either pay off debt (thereby reducing the debt service

burden on the assets that remain) or else invest in new assets (typically only assets that are related

to the issuer’s core business) that in theory will also be producing income. This covenant is one of

the easiest for an issuer to comply with because the issuer has substantial discretion over a period

that often extends for a year whether to retire other indebtedness or to make capital expenditures

(or even certain investments) with the proceeds of the asset sale. To the extent that the issuer does

neither within this period, the covenant requires the issuer to make an offer to the bondholders to

purchase their bonds at par to the extent of the proceeds. To the extent that any proceeds remain

after all bonds tendered in such an offer are in fact purchased, they are usually available to the

issuer to use however it sees fit, including, if the issuer has built up any dividend-paying capacity,

making restricted payments.

This covenant is designed to capture proceeds only from asset dispositions that are outside the

ordinary course of business, and then only to the extent that they exceed some negotiated floor

amount that is deemed immaterial. Issuers may request special treatment or other exceptions from

the application of this covenant for dispositions that are reasonably foreseeable by the issuer at

the time the bonds are issued. Since most issuers usually intend to or are required by their bank

lenders to repay debt with the proceeds of asset sales anyway, issuers often decide not to spend

much time negotiating significant carve-outs to this covenant.

Transactions with Affiliates

The covenant relating to transactions with affiliates is designed to prevent the issuer from

circumventing the restricted payment covenant by disguising a dividend-like transaction in the

form of a business transaction. Accordingly, the covenant requires the issuer to ensure that any

transaction with an affiliate is conducted on terms that are similar to those that would be obtained

with unrelated third parties and, depending upon the dollar amount involved in the transaction,

that such terms are approved by the majority of disinterested directors and/or that such terms are

determined to be fair to the issuer in the opinion of an independent valuation firm.

This covenant takes on added significance when the issuer is a private company that is controlled

by one shareholder or a small group of shareholders. An issuer that is publicly held is likely to be

concerned about the fairness of affiliate transactions for reasons of corporate law and usually does

not object to any significant degree to the terms of this covenant. A private company issuer is

likely to request carve-outs for fees paid to financial sponsors, for example, and for other

transactions that are reasonably foreseeable. These exceptions are typically kept to a minimum,

since the effect of creating an exception is to permit a transaction that may have terms that are not

fair to the issuer.

A common exception recognizes that if an issuer is permitted by the restricted payments covenant

to pay a dividend that depletes its dividend basket, thereby sending assets completely out of the

consolidated group, the investor should be relatively indifferent if, rather than electing to pay the

dividend, the issuer elects to enter into some other kind of transaction (e.g., an investment) with

an affiliate. Another common exception permits transactions between the issuer and its restricted

subsidiaries. Also permitted are transactions with entities that are technically affiliates of the

issuer because they are controlled by the issuer (e.g., 45% voting stake), but otherwise should be

viewed as a third party (e.g., the remaining 55% voting stake is held broadly by persons that are

not affiliates of the issuer). The covenant does not typically restrict the issuer from issuing capital

stock to affiliates (other than disqualified stock). Among other common carve-outs are provisions

that permit transactions relating to contracts in effect at the time of the issuance of the bonds (and

which should probably be described in the offering document), as well as relating to renewals or

extensions of the contracts that have terms not less favorable to the issuer than those in the

original contract.

Liens/Sale-Leasebacks

The lien covenant has primary importance in an indenture for senior notes. In a senior

subordinated note offering, the holders typically insist only on the “antilayering protection”

arising from the issuer’s agreement not to grant any liens to secure other subordinated debt.

Conversely, the holders of senior notes, in an effort to remain as senior as possible with respect to

the assets of the issuer, restrict the issuer from incurring liens (which includes security interests,

mortgages, and similar contractual or legal encumbrances) on its assets except for limited

permitted exceptions, or unless the issuer is willing to simultaneously grant an equal lien for the

benefit of the bondholders.

These exceptions usually appear in a definition of permitted liens, which usually includes a long

laundry list of ordinary course liens (e.g., warehousemen’s liens). In addition to those, however,

and the ones that are typically the most important to the issuer, are those that deal with purchase

money financings, financings under one or more of the categories of permitted debt, preexisting

or acquired liens, and refinancings of debt that is already secured. An important but subtle point is

to determine whether the assets that are permitted to be subject to the liens should be limited (e.g.,

for purchase money debt, only the asset acquired should be permitted to secure purchase money

debt, but for permitted bank debt, any assets of the issuer or its restricted subsidiaries are typically

permitted collateral).

Another covenant that would typically be found only in a senior note offering and is considered a

corollary to the limitation on liens covenant is a covenant limiting the issuer’s ability to enter into

saleleaseback transactions. A sale-leaseback transaction, in which the issuer sells an asset and

immediately leases it back, is economically very similar to a secured financing, since the issuer

will receive sale proceeds (similar to loan proceeds) and will make rental payments over the life

of the lease (similar to loan repayments). Thus, this covenant generally permits an issuer to enter

into sale-leaseback transactions as long as the issuer has the ability to incur the related

indebtedness represented by the lease obligation and would be able to incur the lien on the

property securing the lease. However, since the asset has been sold and is therefore not part of the

issuer’s consolidated assets subsequent to the sale (unlike a secured financing), this covenant

contains the added requirement that the issuer treat the sale proceeds as it would in connection

with any other asset sale.

Mergers and Consolidations

The merger covenant is designed to ensure that the successor or survivor in any major transaction

involving the issuer, including the transferee of substantially all the assets of the issuer, assumes

the obligations with respect to the bonds. As for substantive requirements in connection with such

transactions, the covenant requires that the issuer on a pro forma basis be able to incur

indebtedness under the debt incurrence test. This substantive requirement is often the subject of

some negotiation because it is not readily clear to many issuers why this particular measurement

is relevant in determining whether a merger is one that makes financial and business sense from

the perspective of the bondholders.

Nonetheless, the high-yield market has historically insisted that the issuer be financially healthy

(as measured by the debt incurrence test) before it is entitled to engage in any significant merger

transactions. As a general rule, bondholders reasonably expect some improvement in the issuer’s

creditworthiness over the life of the bonds, as measured by interest coverage, and it could

substantially and adversely affect the secondary trading value of bonds if the indenture permitted

a reasonably healthy and deleveraged issuer to releverage itself as part of a merger transaction.

SEC Reporting

In the infancy of the high-yield market, many issuers were able to avoid regular reporting to

bondholders and certainly often were able to avoid regular SEC reporting. Since most high-yield

note deals are ultimately held by fewer than 300 holders, issuers would automatically be relieved,

pursuant to the Securities Exchange Act of 1934, of any SEC reporting requirements beginning

with respect to the fiscal year following the year in which the registration statement for the bonds

became effective. It is now almost universally true in high-yield indentures that the issuer is

required to make regular SEC reports (and to post such information on the issuer’s own Web site)

to ensure the steady flow of readily accessible information for current holders and prospective

holders. (Note that this is one of the few affirmative covenants in a high-yield indenture and one

that does require some maintenance efforts on the part of the issuer.) It is important in

transactions involving foreign issuers to review the indenture language to understand whether

they are bound to report on a basis similar to U.S. domestic issuers or whether they are entitled to

follow the more relaxed SEC rules for foreign private issuers. This is usually a matter of some

negotiation prior to the issuance of the bonds. Because of the uptick in the number of financial

restatements by SECreporting companies in the past few years, which causes delays in the filing

of regular reports with the SEC and therefore defaults under this covenant in high-yield

indentures, issuers are likely to obtain some relief in the language of this covenant (or in the

language in the related default provision) to avoid a hair-trigger event of default and acceleration

of the bonds as a result of a tardy SEC filing.

Defaults

High-yield indentures contain standard default provisions for the nonpayment of principal or

interest. While there is no grace, or cure, period for principal payment defaults, the grace period

for nonpayment of interest is typically 30 days. It is also common that issuers have a 30-day grace

period after notice to the issuer to comply with the substantive covenants of the indenture before

an event of default is deemed to have occurred (which would allow for the exercise of contractual

remedies against the issuer). As for more administrative obligations of the issuer under the

indenture (e.g., maintaining a registrar for the registration of the bonds), the grace period is

typically 60 days following notice to the issuer. High-yield indentures also contain a default

provision related to the noncompliance by the issuer with its obligations under other debt

instruments (e.g., bank credit agreements), but the default is triggered upon the actual

acceleration of indebtedness (a “cross-acceleration” provision) by the other lender, not simply the

right of the other lender to accelerate (known as a “cross-default” provision, which is the standard

in bank credit agreements).

Amendments/Waivers

The general rule for amendments in high-yield transactions is that the issuer needs to obtain the

consent of a majority in principal amount of the outstanding bonds in order to effect amendments

or waivers to the indenture. To the extent that the issuer does seek the consent of holders and

offers to pay them for their consent, many indentures require the issuer to offer to pay a consent

fee to every holder that is willing to provide its consent in the prescribed time period. The

indenture usually includes a list of those items in the indenture, generally related to the “money

terms,” such as principal, interest rate, and maturity, that may not be amended except with the

unanimous consent of the holders.

There usually are also included a list of amendments that can be made without the consent of any

holder on the theory that amendments are harmless to the bondholders (e.g., clarifying

ambiguities, adding covenants on the part of the issuer, adding guarantees).

Defeasance

Keeping in mind that the issuer is typically subject to some period during which it is not entitled

to redeem the bonds, the indenture does allow the issuer at any time to escape the restrictions in

the covenants through the mechanism of defeasance. Essentially the issuer is required to deposit

in trust with the bond trustee enough cash or government securities with a present value based on

calculations confirmed by an independent accounting firm so that there will be sufficient cash

available, after taking into account the earnings on the deposited funds, to pay all the interest and

principal of the bonds when they are due. Once the issuer has made the deposit of cash or

government securities into the defeasance trust, it is entitled to ignore the substantive covenants

discussed in this chapter. Similarly the related events of default are rendered inoperative.

Defeasance is expensive for an issuer because the earnings growth rate the issuer must use in

calculating the minimum cash deposit is low—the U.S. Treasury rate then in effect. As a result,

defeasance is not an attractive option to most issuers. A common alternative is for issuers to offer

to buy the bonds from holders in a tender offer that is usually accompanied by a solicitation by

the issuer for consent of the tendering holders to amendments to the indenture. As long as a

majority of the holders give their consent, then the issuer can usually achieve its goal of obtaining

relief from the covenants, and the price that it needs to pay to clear the market is usually less

expensive than the defeasance option.

Conclusion

In this chapter we attempt to describe the common characteristics of high-yield bonds as well as

the most common covenants that can be found in high-yield indentures. Every bond indenture is

different, however, and in practice significant variations will be found both in the types of

covenants and in the types of exceptions to the covenants based on the issuer’s industry, the

proposed ratings on the bonds, general economic and market conditions, and the sophistication

and experience of the issuer and its counsel. In reviewing actual covenant language, it bears

repeating that the language of the accompanying definitions is critical. Well-crafted high-yield

covenants will usually strike a balance between the bondholders’ reasonable and legitimate

expectations for the protection of their investment and the legitimate needs of an issuer to have

the flexibility to grow its business in accordance with its stated business strategy.