We conclude our overview of bond mechanics with an examination of a few complexities associated with tack-on offerings. Tack-on deals are often viewed as so easy that they can practically run themselves. And yet, there a few nuances that can really gum up the works if you’re not a Ms. (or Mr.) Goodwrench.
A “tack-on offering” is an issuance of bonds with terms that are identical to a previously issued series of bonds, under the same indenture, such that the additional bonds are (or will soon become) fungible with the initial bonds and hence, share a single CUSIP number.1 With a single CUSIP number, the additional bonds issued in the tack-on offering can trade interchangeably with the previously issued bonds, which improves the pricing of the tack-on offering due to increased liquidity in the aftermarket.
However, in order to ensure fungibility, investors in the additional bonds issued in the tack-on offering generally are required to buy them with accrued interest in an amount equal to the amount of interest that has accrued on the initial bonds as of the date of purchase of the additional bonds. That way, on the next interest payment date, holders of the additional bonds will receive the same interest payment that holders of the initial bonds will receive. That’s essential, since there will be no way to distinguish additional bonds from the initial bonds once they are released to trade if they share a single CUSIP number.
Another critical component of fungibility is that the additional bonds have the same tax characteristics as the initial bonds. We cover that complex topic in detail in our Client Alert entitled New Treasury Regulations Make it Easier to Issue Tack-On Bonds or Loans But New FATCA Regulations Add Complexity. For purposes of this discussion, we assume the additional bonds and the initial bonds will be fungible for tax purposes.
What about a tack-on offering where the additional bonds are issued after a record date but prior to the interest payment date?
If the tack-on offering will close at least five business days before the next interest payment date, the issuer can ask The Depositary Trust Company to treat the issue date as a “special record date”2 for purposes of determining the holder of record who will receive the first interest payment following issuance of the additional bonds. In this case, investors purchase the additional bonds with accrued interest, as described above. Several days later, the new investors will receive the same interest payment as the holders of the initial bonds. If there is any likelihood that this issue will arise in your deal, you should raise it early with the working group.
If you are unable to get a “special record date,” or if your tack-on offering will close less than five business days prior to the next interest payment date, the additional bonds can be issued without accrued interest and the future accrual of interest on the additional bonds can be suspended until the next interest payment date on the initial bonds. In this scenario, the new bondholders will not have to "purchase" the interest payment that is coming down the pike for the holders of the initial bonds in the next few days, but they will also not get paid that interest payment even though the holders of the initial bonds will. One consequence of this approach is that, during the brief interim period between the issue date of the additional bonds and the next interest payment date on the initial bonds (lasting between one and five business days, depending on the date on which the additional bonds are issued), the additional bonds will not be fungible with the initial bonds. As a result, during that brief interim period, the additional bonds will need a separate CUSIP number. After the interest payment date, subject to DTC confirmation, the additional bonds can undergo a “mandatory” (i.e., automatic) exchange for new additional bonds that will bear the same CUSIP number as the initial bonds.
Note, however, that this approach should always be cleared with the tax team on your deal prior to launch.
If you are working on a tack-on offering that may close during the two-week period between a record date and the related interest payment date, you should flag this accrued interest issue to the other members of the working group, including the trustee and DTC.
What about a tack-on offering where the initial bonds were issued with registration rights and have already been exchanged in a registered exchange offer for unrestricted securities?
As discussed above, the additional bonds issued in a tack-on offering are always happiest if they can be fungible with the initial bonds and share a single CUSIP number. However, if the initial bonds have already been exchanged for new bonds bearing an unrestricted CUSIP number, any additional bonds issued in a Rule 144A or other private offering will initially need to trade separately, under a restricted CUSIP number (which will be different from the restricted CUSIP number for the initial bonds, since that CUSIP number will be retired once the initial bonds have undergone a registered exchange offer), during the period from the issue date of the additional bonds until the additional bonds are exchanged for unrestricted bonds in a registered exchange offer. As a result, depending on the size of the tack-on offering, the additional bonds may temporarily be less liquid (until the registered exchange offer can be completed).
What about a tack-on offering where the initial bonds were issued without registration rights (144A-for-life)?
For securities that are issued without registration rights, Rule 144 provides an alternate path to freedom from transfer restrictions. Following a one-year holding period,3 subject to certain conditions, restricted securities can be “delegended” and be assigned a different, unrestricted, CUSIP number and, occasionally, the issuer will covenant to do just that. However, when additional restricted securities that are otherwise fungible with the initial restricted securities are issued during that holding period, it has the practical effect of re-starting the holding period, since a purchaser in the aftermarket has no way of knowing whether the bonds she bought were part of the initial batch or the additional batch.
If it is important to the initial purchasers (or the issuer) to remove the transfer restrictions from the initial bonds promptly after the holding period expires, the additional securities can be issued under a separate restricted CUSIP. Once the subsequent holding period applicable to the additional bonds is complete, the initial bonds and the additional bonds can be united in the same unrestricted CUSIP.
Aside from the situation where the issuer is bound by a covenant in the indenture to remove the restricted legend on the initial bonds (which is relatively unusual in the case of high yield bonds), there is no clear market approach to this situation. We have seen instances where the participants in the tack-on offering decided to issue the additional bonds under the same CUSIP as the initial bonds, notwithstanding the fact that this will delay the date on which purchasers of the initial bonds can have their bonds trade under an unrestricted CUSIP number. But we have also seen instances where the additional bonds were issued into a separate restricted CUSIP number to avoid contaminating the original CUSIP (with the consequence that the initial bonds and additional bonds will trade separately until the restricted legend has been removed from both tranches). If you are working on a tack-on offering for 144A-for-life bonds, you should surface this issue for discussion with the deal team.
1 We do note that any bonds issued to non-U.S. investors in the tack-on offering pursuant to Reg. S may temporarily bear a different CUSIP number, but that is not a big deal for purposes of this discussion.
2 As described above, there will always be only a single holder of record for bonds settled through DTC’s electronic book-entry system. Under DTC’s interim accounting procedures, DTC will allocate interest payments amonthe DTC participants consistent with DTC’s position listings as of the business day prior to the interest payment date, rather than as of the “special record date” (or the record date specified in the indenture or the note itself).
3 In some cases, Rule 144 permits a shorter six-month holding period.