Comfort or caution from the use of the US model in Europe?
Lyndon Norley and James H M Sprayregen pose the question
(taken from Issue No 21  – October 2002

The last five years have seen a significant increase in the issue of high yield bonds in Europe. Nevertheless, the European high yield bond market remains significantly less developed than the US high yield bond market which began in the 1980s. In addition, the volume of bond issues in the US market continues to dwarf that of the European market.

Given the more developed US market, it is no surprise that the European high yield bond market has been modelled on the US system, in particular with respect to the bond documentation. There is much comfort to be derived from the familiar and many investors in Europe, who are predominantly US based, either as initial investors, or to an even greater extent, in the secondary and distressed market, will expect to see US style bond documentation.

Whilst familiarity can be comforting, it may also lead to complacency. Familiarity with documentation may lull an investor into a false sense of security to the extent that it may not be put on enquiry to the extent that would be the case with unfamiliar documentation. This is a fundamental issue, because European insolvency laws and procedures are quite different from the US and can lead to very different results. A very careful review of the bond documentation is therefore necessary with such amendments being made to tailor the documentation to the particular transaction, taking into account the structure of the bond issuer’s group of companies, the financing arrangements of the group and the jurisdiction of the companies and their respective assets.

It is an obvious statement that US bond documentation has been developed in conjunction with US insolvency laws and work-out procedures. Whilst the documentation may work perfectly well in the US, this is not necessarily the case in Europe. In Europe, documentation has traditionally been based on the Eurobond. There are fundamental differences between the Eurobond model and the US model, most particularly in relation to provisions regarding amendments to the terms of the bonds.

These issues are particularly highlighted in bond restructurings. If the bond is fully performing there is, in reality, little reference to the bond documentation. If the bond issuer becomes financially troubled, the documentation will be carefully examined, both by the issuer and the bondholders as they each consider the terms of the bonds and what steps can be taken to restructure the bond issue.

Particular areas for consideration by US investors should include the following:

Perhaps the most significant difference between US and European bond documentation concerns provisions relating to amendments to the bonds. US style bond documentation will provide for unanimity for amendments to such provisions as the maturity date, the principal sum, interest rates and so on, either in the documentation itself, or if silent, or if the terms provide otherwise, by operation of the Trust Indenture Act 1939. Eurobond styled bond documentation often provides for amendments by extraordinary resolution which requires only a majority of three-quarters or perhaps two-thirds of the principal nominal value of the bond issue. This can be of critical importance and provides the opportunity for amendments to be made to the bond documentation (including amendments to the maturity date, or interest rates, or perhaps an exchange of the bonds for equity) without the necessity of obtaining the consent of each and every bondholder or without overriding such dissenting or disinterested bondholders through a court procedure.

Unanimity provisions can be overcome, either by operation of a pre-arranged or pre-packaged reorganisation plan within the provisions of Chapter 11 of the US Bankruptcy Code or through a scheme of arrangement pursuant to s.425Companies Act 1985 or its equivalent in some other European jurisdictions. However, each of these procedures takes time and money to implement. A scheme of arrangement requires the approval of a majority in number representing three-quarters in value of the creditors attending either by person or by proxy at the meeting convened to consider the scheme. Often time is of the essence and it would be more efficient if a consensual arrangement, outside a court process could be achieved. Unanimity provisions leave open the risk of ‘hold-out’ bondholders. The Eurobond method, with amendments by extraordinary resolution, provide for the possibility of a quick and efficient, non court based system which can override a dissenting minority.

Insolvency regimes
The insolvency regimes in the US and Europe are quite different. US insolvency procedures are on the whole more debtor orientated. The reverse is true for the UK and many other European jurisdictions. A US Chapter 11 procedure, which is initiated by the debtor, will apply a stay of proceedings to secured as well as unsecured creditors. Secured creditors in Europe have extensive powers to protect their own rights which in the majority of cases will override the interests of other creditors and the debtor. There is no true Chapter 11 regime in Europe. The closest comparison is the administration procedure in the UK and the composition procedure in The Netherlands, but these procedures can be either vetoed by, or broadly irrelevant to, secured creditors.

Role of Bond Indenture Trustee
The role of a U.K. styled bond indenture trustee is governed not only by the terms of the bond documentation, but also by statute, the Trustee Act 1925. In general terms, a UK modelled bond indenture trustee will have greater fiduciary duties, certainly pre-insolvency, than its US counterpart. As a consequence, a UK bond indenture trustee is likely to be more proactive through the life of the bond. Nevertheless, whilst the bond indenture trustee will have a duty to act in the interests of bondholders as a whole and will, where necessary, be appointed as a member of a steering committee of creditors, bond indenture trustees have been amenable to take a less active role when a representative steering committee of bondholders has been formed. This is likely to be the case following a bond default where the steering committee takes the lead role in negotiating from a commercial perspective a restructuring package.

Nevertheless, the role of the bond indenture trustee can remain important, particularly if action needs to be taken by the bondholders. Documentation often provides that only the bond indenture trustee can take action to enforce the terms of the bond.

With regard to steering committees, the norm in the US is for the debtor to agree to meet the costs incurred by the steering committee in retaining their own financial and legal advisers to assist in relation to the restructuring plan. Traditionally in the UK, this has not been the case, with the bond indenture trustee acting on behalf of the bondholders to negotiate arrangements with the debtor and for the costs of the bond indenture trustee to be paid by the issuer. As bondholders have become more active in Europe and have taken the lead role in negotiating with the debtor, the US model of the debtor agreeing to pay the costs of the steering committee’s advisers has become more common place.

Separately, in a number of bond restructurings, there have been questions raised as to who is the creditor of the issuer for the purposes of voting on any restructuring proposal. In the US there is clear law to indicate that it is the beneficial holders of the bonds. In the UK, in particular, there is no clear case law and the options would be (1) the trustee; (2) the common depositor; (3) the account holders if the bonds are in the clearing systems; (4) custodians within the clearing systems; or (5) the beneficial bondholders. Whilst in consensual arrangements methods can be devised to address this issue, for example, by all agreeing that the account holder should be considered the creditor for the purposes of voting, it is far more difficult if the debtor bond issuer is challenging the action being taken by the bondholders.

A further difference between the UK and the US is that there is no requirement for the Trust Deed, which is made between the issuer of the bonds and the bond indenture trustee, to be made publicly available through any public filing procedure. The Trust Deed, whilst summarised in the offering memorandum, is an important document and in particular will set out in detail the procedures for making amendments to the terms of the bonds and will detail the powers and rights of the bond indenture trustee. These can be particularly important in a restructuring. We would suggest that Trust Deeds are freely available for inspection, perhaps through a central filing registration at Companies House, not just on request to the bond indenture trustee from present bondholders.

Corporate Structure of the Bond issuer and group companies
One fundamental difference which often arises between a US style bond issue and a European style bond issue will be the corporate structure of the bond issuer’s group of companies. In many cases, the US bond issuer will also be the borrower of senior and/or secured bank facilities. Often there is no structural subordination, only a contractual subordination whereby the bonds are subordinated by the terms of the bond documentation to the senior facilities.

In Europe, the more traditional model is for the bond issuer to be the parent or holding company of the company or companies with liabilities to the senior facilities (often an intermediate group company and/or the operating subsidiaries). As a consequence, without further arrangements, the bondholders will be subordinated to the senior facilities in that the bondholders will be dependant on a surplus being made available through dividend returns to the parent bond issuer before any payments can be made on the bonds.

A further point to consider is that structurally subordinated arrangements can often be varied, either knowingly or otherwise, by secured lending, guarantees and inter group loans which will need to be carefully covenanted in the bond documentation and monitored thereafter so as to ensure, as far as possible, that the subordination arrangements work as they were intended.

There is much to be learnt from both the US and the European systems. On the one hand, recognition must be given to the fact that European insolvency procedures are different and US style bond documentation should be modified to reflect this – particularly with respect to amendments. On the other hand, advantages can be taken of the more developed US system. If this can be achieved, investors will have the benefit of documentation which accurately reflects the market within which the bonds were issued, whilst taking the best elements of the most developed bond market. In turn, it should be possible for restructurings to be achieved in a more efficient and timely manner which will be beneficial to all parties concerned.

Lyndon Norley and James H M Sprayregen
Kirkland & Ellis, London and Chicago