15 July 1999
Jonathon G. Katz
U.S. Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington D.C. 20549
Dear Mr. Katz:
Re: File No. S7-7-99
We regularly represent foreign private issuers of debt securities and investment banks acting as initial purchasers of those debt securities in transactions exempt from registration under the Securities Act of 1933, as amended (the "1933 Act"), pursuant to Rule 144A and Regulation S there under, or as underwriters in offerings of debt securities registered under the 1933 Act. As you know, normal practice in Rule 144A/Regulation S offerings is to conform the disclosure document as closely as possible to the standards that would be applicable in registered offerings, particularly where those offerings will be the subject of an A/B exchange offer under the Exxon Capital line of no-action letters.
We respectfully submit this letter in response to the proposed revisions to Rule 3-10 of Regulation S-X, proposed in Release No. 33-7649, 34-41118; International Series Release No. 1187 (the "Release"). As discussed more fully below, there are important differences between leveraged acquisition financing structures emerging in Europe and those commonly used in the United States. Differences in the market for syndicated senior secured debt and in applicable bankruptcy laws have led, in several European transactions, to limited "standstill" periods where subsidiary guarantees of subordinated debt do not become due for a specified period after default on the parent's debt securities. The Release states that "when an issuer fails to make a payment called for by the security, the guarantor is obligated to make the scheduled payment immediately and, if it doesn't, the holder of the security may take legal action directly against the guarantor for payment." (emphasis supplied) Under this interpretation, it appears that guarantees that become due after the passage of time (even though not subject to any conditions when due) would not be "full and unconditional". Accepting this interpretation for purposes of this letter, if adopted as proposed the Release would appear to require separate audited financial statements for each guarantor that issues a guarantee that becomes due after the underlying debt instrument.
We suggest that the proposed amendment to Rule 3-10 be revised to permit offerings of debt securities that include guarantees with "standstill" provisions to provide footnote reporting for such guarantors on a combined basis. We believe our suggestion accommodates the disclosure purposes of Rule 3-10 of Regulation S-X, the rationale for SAB 53 and differences in applicable law - most notably insolvency law - affecting many foreign private issuers in Europe. We believe our proposal can be included in any final rule as a matter of comity without affecting the purposes of the rule or the quality of disclosure. We do not believe investors would receive any meaningful incremental benefit from complete, separate audited financial statements from each such guarantor. Moreover, if the Rule is adopted without permitting this combined footnote disclosure, we believe the requirement for separate audited financial statements could result in the elimination of subsidiary guarantees altogether in some transactions, to the detriment of subordinated debt purchasers, or cause issuers to exclude the U.S. capital markets from their financing plans.
Separately, in response to the Staff's request for comments on the subject of the scope of required financial statements for recently acquired guarantors, we suggest that the Commission adopt the significance tests that are already applicable to recent material acquisitions under Rule 3-05 of Regulation S-X.
Enforcement Standstill Provisions
To understand the business rationale that has led to enforcement standstill provisions in some subsidiary guarantees in European transactions, it is helpful to understand the historical differences in European and U.S. leveraged financing structures.
The European Model. The increasing prominence of leveraged acquisition transactions in Europe has been widely publicized, with rapid and substantial growth in private equity capital available to finance these transactions in Europe, including a proliferation of European offices by U.S. merchant banking firms.
Historically, the most common structure for financing leveraged transactions in Europe has included senior secured bank financing and subordinated "mezzanine" debt, typically secured by junior liens, at the top of the capital structure. In jurisdictions where applicable law permits "upstream" guarantees by subsidiaries, the senior secured debt and the mezzanine debt would often benefit from senior and subordinated secured guarantees, respectively, from operating subsidiaries. The relationship between the senior lenders and mezzanine lenders, and their respective rights to take enforcement action against the issuer and the guarantors and to proceed against the collateral, are typically spelled out in an inter-creditor agreement wherein the mezzanine lenders typically surrender the right to commence enforcement action to the senior secured lenders, at least for a specified "standstill" period.
During this enforcement "standstill" period, in a default scenario the senior secured lenders have the ability to determine when and how to proceed against the borrower without interference from the mezzanine lenders. This structure has evolved in part as a result of differences in applicable bankruptcy laws. In the United Kingdom, in particular, the senior secured lenders would generally be able to appoint a receiver to administer the borrower's affairs and sell collateral for the benefit of the secured creditors. They could generally take this action without any judicial or administrative order or other governmental involvement. Without the agreed "standstill" period, in this example, the defaulted subordinated mezzanine creditors could enforce their claims and seek judicial appointment of an administrator which, when appointed, could in some circumstances prevent the senior secured creditors from appointing a receiver. Senior creditors maintain that this could deprive them of a potentially important tactical advantage and adversely affect their recoveries.
With this environment as a backdrop, European leveraged transactions in recent years have begun to include unsecured debt securities sold in the global capital markets, usually issued pursuant to Rule 144A and Regulation S with A/B exchange offer registration rights. The transactions completed to date present a variety of structural approaches to the relationship between the senior secured lenders and the holders of capital markets debt. Large leveraged acquisitions have most often been structured with the senior secured debt at an operating company or lower level holding company, with the capital market debt securities structurally subordinated at a higher level holding company. Those European leveraged transactions that have included subordinated operating company guarantees in favor of the capital markets debt have often been structured to include "standstill" periods that, properly structured, delay the due date of the guarantee until the end of the negotiated standstill periods.
The U.S. Model. Many leveraged transactions in the U.S. have been financed with a combination of senior secured bank debt and subordinated unsecured notes issued in registered or Rule 144A/Regulation S capital markets transactions. The unsecured junior debt is typically contractually subordinated to the senior secured debt, and typically agrees to a payment blockage provision wherein the issuer agrees not to pay the junior debt in the event of a payment default under the senior debt, or for up to 179 days per year after delivery of a "blockage notice" in the event of a non-payment default, and the trustee for the subordinated debt holders agrees to "turn over" blocked payments to the representatives of the senior lenders. Notwithstanding this payment blockage feature, there is rarely any enforcement "standstill" mechanism that would prevent the subordinated debt from accelerating and, potentially, instigating bankruptcy proceedings, after a default. This ability to accelerate usually gives the subordinated debt important negotiating leverage in any workout negotiations involving the issuer and subsidiary guarantors. Combined with the operation of U.S. bankruptcy laws generally (including, inter alia, the automatic stay provisions, the absolute priority rule, and class voting mechanics under Chapter 11), this ability to enforce and accelerate at any time has been a standard feature of the U.S. subordinated debt market.
Reconciling the Models and the Proposed Rule. There is still a structural divide between the European model and the U.S. model in most leveraged transactions in Europe. One approach to accommodating the differences - with a delayed enforcement feature on subsidiary guarantees, as discussed above - has been successfully negotiated in some transactions but appears incompatible with the Release. From the perspective of the bondholders, these guarantees improve their position, compared to structural subordination, by giving them direct (albeit delayed) creditors' rights claims against the operating subsidiaries.
As summarized above, to adapt the Release's proposed changes to Rule 3-10 to market practices in Europe, we suggest that (i) enforcement standstill periods affecting guarantors be resolved by disclosure of the terms of the standstill arrangements (in the same manner that other material facts about the guarantor, such as limited ability to provide funds to the parent, are disclosed, as contemplated by the instructions to proposed Rule 3-10) and (ii) condensed consolidating financial information of all subsidiary guarantors that are subject to substantially identical enforcement standstill periods be reported on a combined basis in the same manner contemplated by the Release for multiple subsidiary guarantors generally (see the Release at VI.B.5). For example, guarantors that are subject to a 120 day enforcement standstill would be grouped separately from guarantors that are subject to no standstill provision and from non-guarantors. In the unlikely event that guarantors had differing standstill provisions, separate combined columns could be presented for each group.
Our proposal to allow the consolidating financial statements of any such guarantors to be reported on a combined basis is fully consistent with the purposes of Rule 3-10 and SAB 53. The Release would permit, as the Staff's interpretive advice has for years, combined footnote reporting for guarantors with "full and unconditional" guarantees. This allows the investor to evaluate that portion of the overall credit support that is directly attributable to guarantors, in comparison to the issuer itself on a stand-alone basis and any non-guarantors, as applicable (See Release at Section VI.B.5). Our proposal would simply add another column for guarantors that are subject to standstill provisions, and this disclosure would allow investors to evaluate that portion of the overall credit that is represented by guarantors whose guarantees are not due for a period of time after a default. In most circumstances where the intercreditor negotiations result in such an arrangement, this column would likely replace the subsidiary guarantor column in the footnote, since it is unlikely that some guarantees would be negotiated with standstills and some without, although our proposal would permit this distinction through an additional column.
Recently Acquired Guarantors
The Release requests comments on the significance level for inclusion of separate audited financial statements of recently acquired guarantors, suggesting that one year of financial statements will be required. We believe that any such requirements will in most or all circumstances overlap with those already applicable to recent material acquisitions under Rule 3-05 of Regulation S-X, and that separate standards are unnecessary or could be accomplished by cross-reference. In an acquisition financing structure contemplating subsidiary guarantees, it is typical to require the acquired entity to become a guarantor at closing. If Rule 3-10 would require separate financial statements for that entity, when Rule 3-05 would not (assuming the 50% significance test is not met and the acquisition occurred less than 75 days before the offering), the timing and terms of the acquisition itself could be jeopardized by the financial statement requirements of Rule 3-10. We see no compelling disclosure distinction between the purposes of Rule 3-05 and Rule 3-10 in this context, and suggest that they be harmonized in the final rule.
In addition, if shareholders' equity is to be the key measure, as indicated in the Release, it would be helpful if the adopting release, or instructions to the Rule itself, would provide guidance as to evaluating the significance of a guarantor acquisition when the guarantor has negative shareholders' equity.
If you would like to discuss any of the contents of this letter, please call the undersigned at 011-44-171-710-1058 or my partner Gay Bronson at 011-44-171-1006. Thank you for your consideration.
Mark A. Stegemoeller
LATHAM & WATKINS