Indentures and the Brokaw Act

Laurent Alpert is a partner focusing on mergers and acquisitions and Robert Gruszecki is a knowledge management attorney focusing on mergers and acquisitions at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb publication by Mr. Alpert and Mr. Gruszecki. Related research from the Program on Corporate Governance includes The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

The recently introduced “Brokaw Act” that proposes changes to the rules governing the reporting of ownership in U.S. public companies would expand the definition of “beneficial owner” to include any person with a “pecuniary or indirect pecuniary interest,” including through derivatives, in a particular security (borrowing the concept from the SEC’s insider reporting regime, which captures the “opportunity to profit” from transactions related to the relevant security). If passed and ultimately adopted, these changes would have a significant impact on the reporting obligations of investors by expanding the types of interests that would be counted toward the 5% threshold requiring the filing of a Schedule 13D. Because indentures often incorporate by direct reference the 13(d) concept of beneficial ownership, expansion of the definition could have ripple effects beyond increased public ownership filings.

Indentures routinely include the acquisition of beneficial ownership of a certain percentage of the voting securities of an issuer as one of the triggers for a change of control, with the typical result of a change of control being the requirement for the issuer to make an offer to purchase the notes issued under the indenture. Indentures typically define beneficial ownership by reference to the 13(d) rules and provide that references to a particular law also include any subsequent statutory or regulatory amendments. Thus, as the definition of beneficial ownership expands for purposes of 13(d), the definition of change of control in many indentures may expand as well—sometimes in ways the drafters may not have anticipated.

The potential for unforeseen consequences when incorporating statutes by direct reference is nothing new to practitioners, and a recent decision from the Delaware Court of Chancery illustrates this concern, although not because of changes to the underlying law. In Wilmington Savings Fund Society v. Foresight Energy LLC, decided in December 2015, the Court concluded that a change of control provision in a high yield indenture had been triggered by a transaction that was, as the relevant parties acknowledged, structured to avoid such an outcome. The case involved a transaction whereby a third party, Murray Energy Corporation (“Murray”), acquired a 77.5% economic interest and a 34% voting interest in the general partner of the issuers of high yield notes (collectively, “Foresight”), which had issued the notes pursuant to an indenture that included in its change of control provision a trigger consisting of the beneficial ownership of 35% of the voting stock of the general partner and defined beneficial ownership by reference to Rule 13d-3. Murray also acquired an array of governance and other rights, including an option to purchase an additional 46% voting interest and a veto right over the sale of the 66% voting interest in Foresight held by its other principal shareholder. The Court examined Murray’s veto right in light of Rule 13d-3, which provides that beneficial ownership can be conferred not only by voting power, but also by investment power, including the power to dispose or direct the disposition of a security. The Court concluded that Murray’s veto right gave it shared dispositive power, and thus beneficial ownership, over the voting interest held by the other principal shareholder, with the result that Murray’s aggregate beneficial ownership of Foresight exceeded the 35% threshold and triggered a change of control.

As an alternative basis for concluding that Murray had crossed the threshold, the Court determined that Murray’s option to acquire the 46% voting interest held by the other principal shareholder also gave it beneficial ownership of such voting interest despite contingencies to the exercise of the option. The option could only be exercised by Murray if Foresight successfully refinanced its outstanding indebtedness to avoid a change of control and Murray gave Foresight 61-days’ advanced notice of exercise (61 days having been chosen because Rule 13d-3 provides that a person is beneficial owner of securities that it has the right to acquire within 60 days). The Court concluded that despite the carefully constructed contingencies (or, for this portion of the opinion, because of them), Murray had become the beneficial owner of the voting interest subject to the option under the anti-evasion provision of Rule 13d-3(b), which provides that any person that uses a contract or other arrangement with the purpose or effect of divesting itself of beneficial ownership to evade the reporting requirements of Section 13(d) will be deemed the beneficial owner of the relevant securities.

Whether the drafters of the Foresight indenture (or indentures with similar change of control provisions) intended to incorporate in the change of control definition the anti-evasion provision of Rule 13d-3 is not clear. There were, however, a number of aspects of the transaction that, in the view of the Court, gave Murray “de facto control” over Foresight, and one might wonder whether the Court would have relied on the anti-evasion provisions alone in determining that beneficial ownership had been conferred upon Murray even if there had been no veto right over the disposition of voting interests. It is even less clear whether the drafters of the Foresight indenture (or indentures with similar provisions), in defining beneficial ownership for purposes of a change of control by reference to Rule 13d-3, intended to incorporate the investment power prong of this rule, and envisaged that a mere veto power over the sale of equity interests of another security holder could trigger a change of control requiring an offer to repurchase all outstanding notes.

The Foresight indenture, as many indentures, included in the definition of change of control the acquisition of beneficial ownership of more than 35% of the voting stock of the issuer, measured by voting power rather than number of shares. The Court concluded that as a result of incorporating into the indenture the Rule 13d-3 definition of beneficial ownership, Murray’s veto right gave it beneficial ownership via dispositive power of voting stock as to which it had no voting rights. By expanding the definition of beneficial ownership to include “pecuniary interest,” the Brokaw Act could similarly confer beneficial ownership of voting stock to a person who neither had voting rights nor dispositive power, with the potential result being the occurrence of a change of control even less likely to have been foreseen or intended by the indenture drafters.

A common alternative formulation in many indentures is the acquisition of beneficial ownership of X% of the total voting power of the issuer’s voting stock. Such a formulation would suggest that neither the dispositive power prong of the current definition of beneficial ownership in Rule 13d-3 nor the pecuniary interest prong that would be added by the Brokaw Act would be relevant in determining acquisition of beneficial ownership and the occurrence of a change of control. If so, it is dubious whether the indenture drafters focused on the potential differences in result when choosing either formulation.

Issuers of notes (and borrowers under credit agreements) should consider the broad and unintended consequences of incorporating Rule 13d-3 into change of control provisions and the desirability of limiting such provisions to the acquisition of voting power rather than voting stock, particularly given the potential changes to the rule looming on the horizon.

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