- Economic uncertainty as a result of the COVID-19 pandemic has caused a decline in trading prices for debt and equity securities and liquidity and covenant compliance issues.
- BDCs and CEFs, and their affiliates, can repurchase shares of their securities at a discount to real value through tender offers or exchange offers, open-market purchases, privately negotiated transactions or contractual repurchase mechanisms to take advantage of lower trading prices or to restructure their liabilities.
- Issuers and their affiliates, should consider the potential pitfalls of repurchase transactions, including “creeping” tender offers and compliance with the 1940 Act and other securities laws, state laws, tax issues and contractual restrictions.
The uncertain economic environment surrounding the COVID-19 crisis has triggered a sharp decline in trading prices for the equity and debt securities of many business development companies (“BDCs”) and closed-end funds (“CEFs”). This decline in trading prices has created an opportunity for some issuers and their affiliates to repurchase the issuer’s securities at a discount to their real value or the necessity to restructure their liabilities. BDCs, CEFs and their affiliates should assess the following potential techniques and pitfalls of repurchase transactions when considering repurchases of equity or debt.
Potential techniques include:
- Tender Offers/Exchange Offers
- Open-Market Purchases and Privately Negotiated Transactions
- Contractual Mechanisms
Tender Offer/Exchange Offer
Tender offers provide BDCs and CEFs, and their affiliates, a means of repurchasing debt or equity directly from security holders in transactions designed to comply with the formal tender offer rules under the Securities Exchange Act of 1934 (the “Exchange Act”).
Issuers should be aware that the tender offer rules differ for purchases of non-public equity and purchases of debt versus purchases of public equity.
All tender offers are subject to the requirements of Regulation 14E under the Exchange Act, which include:1
- a minimum offer period of 20 business days (although, for tender offers for non-convertible debt securities that meet certain conditions, issuers may be able to reduce the offer period to as little as five business days);
- a prohibition on purchases outside the offer; and
- other antifraud and anti-manipulation provisions.2
All tender offers by funds are also subject to an all holders rule under Section 23(c)(2) of the Investment Company Act of 1940 (the “1940 Act”).
Tender offers for public equity, which generally include equity registered under Section 12 of the Exchange Act or issued by a closed-end investment company registered under the 1940 Act, are subject to additional requirements. An issuer selling public equity through a tender offer must:
- make the offer to all security holders at the same price;3
- file disclosure documents related to the tender offer with the Securities and Exchange Commission (the “SEC”);4 and
- disseminate certain documents related to the tender offer to stockholders.5
In addition, an issuer and its affiliates are restricted from purchasing or selling shares after the termination of a tender offer.6
Under certain circumstances, an issuer conducting a tender offer can solicit consent from its security holders to amend the terms of the outstanding securities involved in the tender offer to encourage security holders to tender into the offer. However, repurchases of debt usually do not provide any voting rights for the issuer or its affiliates as a result of neutering provisions under the debt agreements.
An exchange offer is a tender offer pursuant to which at least some of the consideration consists of other securities rather than cash. Because an exchange offer involves the issuance of new securities, exchange offers must be registered with the SEC, or meet the requirements of an applicable exemption from registration, in addition to complying with the tender offer rules.
Open-Market Purchases and Privately Negotiated Transactions
Open-market purchases and privately negotiated transactions are not subject to the Exchange Act rules for formal tender offers. Accordingly, an issuer can repurchase its securities directly or through a broker-dealer or other intermediary by making a bid to purchase or accepting a bid to sell securities on the open market or by negotiating privately with a security holder to repurchase its securities held by such security holder without being subjected to the Exchange Act tender offer rules. Issuers can also engage in an accelerated share repurchase program, pursuant to which an investment bank will sell a block of shares to the issuer that it has borrowed from investors and then cover its short position over time with purchases of the issuer’s securities on the open market. However, issuers and their affiliates that engage in open-market purchases or privately negotiated transactions must be careful to avoid an unintentional tender offer by inadvertently triggering the tender offer rules.
The contractual terms of a security may provide for a repurchase or retirement by the issuer. For example, an indenture often grants the issuer the right to redeem its securities by providing 30 to 60 days’ notice (often irrevocable and unconditional) to the holders. The redemption price often includes a make-whole payment or other premium to par, which is not useful for purchasing at a discount. However, contractual redemption may be useful as part of a refinancing effort, for example, to replace existing debt with longer-term maturities. Similarly, satisfaction and discharge or defeasance provisions can be used as part of a refinancing effort. Preferred equity securities may also have contractual redemption features.
Potential pitfalls include:
- Unintentional or “Creeping” Tender Offer
- Tax Issues
- Section 17 and Section 57 of the 1940 Act
- 1940 Act Rules Governing Repurchases
- Insider Trading/Rule 10b-5
- Disclosure and Reporting
- Market Manipulation
- State Law Issues
- Covenant Compliance
- Main Street Lending Program
Unintentional or “Creeping” Tender Offer
Issuers and their affiliates engaging in repurchases that are not intended to comply with the Exchange Act tender offer rules must avoid an unintentional or “creeping” tender offer. Any inadvertent triggering of the tender offer rules could potentially result in liability for failure to satisfy the securities law requirements for tender offers.
The term “tender offer” is not defined in federal securities statutes or regulations. To determine whether a repurchase transaction classifies as a formal tender offer, the Wellman case lays out an eight factor test. These factors include:
- Active and widespread solicitation of public security holders;
- Solicitation of the holders of a “substantial percentage” of the issuer's securities;
- An offer made at a premium over the prevailing market price;
- An offer containing terms that are firm, rather than negotiable;
- An offer contingent on the tender of a fixed number of securities, often subject to a fixed maximum number to be purchased;
- An offer open only for a limited period of time;
- Offerees being pressured to sell their securities; and
- A public announcement of a purchasing program precedes or accompanies rapid accumulations of large amounts of the target's securities.7
Not all factors must be satisfied for a repurchase to be considered a tender offer and the weight accorded to each factor is determined on a case-by-case basis. Although no bright line test for what constitutes a “substantial percentage” exists, some guidance indicates that a solicitation of holders owning less than 15% to 25% of the outstanding securities of a class will not cross the “substantial percentage” threshold.
In light of the Wellman factors, common practices that issuers and their affiliates implement to avoid an unintentional tender offer include:
- buying through brokers or dealers;
- keeping purchases independent of one another, including the separate negotiation and pricing of each purchase with no advance announcement of an intention to make the purchases;
- contacting only larger institutional holders to acquire the securities;
- determining in advance the security holders to be approached; and
- conducting the repurchases over a long period of time without a deadline (or any other form of pressure) for the holders to sell their securities.
Tax treatment can create another potential pitfall for repurchase transactions, in particular for repurchases of debt. As a general rule, the cancellation of a debt, including as a result of a repurchase transaction, creates taxable income (“COD Income”) to a debtor in an amount equal to the difference between the amount due on the debt and the amount (if any) paid (or deemed paid under tax rules) by the debtor. If the debt is cancelled without any payment by the debtor, the entire amount is treated as income. Generally, partners of a partnership must include in income their allocable share of the discharged debt of a partnership.
In addition to a straightforward reduction in an amount owed, repurchases of debt can result in COD Income in other ways. For example, a purchase by a debtor (or a party related to the debtor) of its own debt at a discount that includes certain modifications (referred to as “significant modifications”) to debt terms may result in a deemed payment and reissuance of the debt instrument. In addition, the issuance of a new debt security in exchange for existing debt will result in COD Income if there is a difference between the issue price of the existing debt and the issue price of the new debt. A “significant modification” (determined under tax rules) of existing debt is treated as a deemed payment and reissuance of the debt instrument, resulting in a debt-for-debt exchange.
Not every cancellation of debt results in COD Income. For example, the cancellation of a debt may be excluded from gross income if the discharge occurs in a bankruptcy case or at a time when the debtor is insolvent. If an amount is excluded from gross income as a result of a discharge in a bankruptcy case or insolvency, however, a taxpayer is required to reduce its tax attributes, including net operating loss carryovers and adjusted bases of property, to the extent of the amount excluded. This reduction results in the reduction of future tax benefits. Issuers should always consider any exceptions and limitations to these rules when evaluating the tax consequences of a repurchase transaction.
Section 17 and Section 57 of the 1940 Act
Issuers should also consider the affiliated-transaction provisions in Section 17 of the 1940 Act (if the issuer is a CEF) and Section 57 of the 1940 Act (if the issuer is a BDC) when evaluating repurchase transactions.8 Although these rules generally prohibit both CEFs and BDCs from engaging in transactions with affiliates, a carve-out to the general prohibition permits an affiliate to sell “securities of which the buyer is the issuer.”
Issuers should always be cognizant of their general fiduciary duties and any potential conflicts when considering transacting with affiliates. BDCs and CEFs should ensure that any purchase from an affiliate in connection with a repurchase transaction is conducted pursuant to terms that have been negotiated at arm’s length and that such purchase is in the best interest of the BDC or CEF.
1940 Act Rules Governing Repurchases
The 1940 Act sets forth additional restrictions for repurchases of securities by BDCs and CEFs in addition to the Exchange Act rules set forth above. Section 23 of the 1940 Act, which applies to both BDCs and CEFs, permits an issuer to repurchase shares in the open market or pursuant to a tender offer made to all holders of the issuer’s securities.9 In order to engage in an open-market purchase, the BDC or CEF is required to give notice to shareholders of its intention to repurchase stock within the 6-month period prior to the repurchase transaction. Many BDCs and CEFs include this disclosure as a routine matter in periodic reports to avoid additional notice requirements at the time of the transaction.
Rather than repurchase securities on an exchange or through a tender offer, a BDC or CEF may rely on Rule 23c-1, which permits a registered closed-end investment company to purchase its securities, subject to certain conditions. Most notably, Rule 23c-1 requires that:
- the purchase must be for cash;
- the purchase must not be from an affiliate;
- the BDC or CEF must maintain compliance with asset coverage requirements; and
- the price per security must be the lower of NAV or market price per security.10
BDCs can also rely on Rule 23c-2 to call or redeem preferred stock and debt instruments. Rule 23c-2 allows a CEF or BDC to call or repurchase securities in accordance with the terms of its organizational documents or an indenture. If an issuer relies on this rule to call or redeem preferred stock or debt, any redemption of less than all of the securities must be pro rata. Rule 23c-2 also requires that the issuer provide notice of its intention to call or redeem the securities at least 30 days in advance of such redemption.11 On March 13, 2020, the SEC issued an order temporarily relaxing the notice requirements provide that the issuer makes any required SEC filings prior to a call or redemption of securities.12
Insider Trading/Rule 10b-5
Issuers and their affiliates should also consider any potential liability for insider trading when conducting repurchases. Insider trading involves trading in securities while in possession of material non-public information in violation of Section 10(b) of the Exchange Act and Rule 10b-5.13 Information is considered “material” if a substantial likelihood exists that a reasonable investor would consider the information important in deciding whether to buy, hold or sell a security. Any information that could reasonably be expected to affect the price of the security is material. Material information may include information concerning developments in the issuer’s business or the repurchase transactions themselves. Issuers often try to address concerns surrounding disclosure of the repurchase transactions by including generic disclosure in their periodic filings that they may engage in repurchases from time to time. Information is considered non-public if the information has not been included in the company’s SEC filings. In some cases, website or press release disclosure can be sufficient to satisfy the public disclosure requirement if such practice has been previously well-established by the issuer.
Issuers can establish a defense (though not a complete safe harbor) against insider trading claims if the trades occur pursuant to a written plan that meets the requirements of Rule 10b5-1(c).14 A valid 10b5-1 trading plan can only be adopted when the issuer is not then in possession of material non-public information and typically is subject to a cooling-off period before trades begin under the plan. The plan must meet certain other requirements to ensure the issuer does not have discretion over the trades such that it could take advantage of material non-public information. Issuers should ensure that any plan suspensions and terminations do not undermine the effectiveness of the defense in connection with a repurchase transaction.
Disclosure and Reporting
Disclosure and reporting obligations may be applicable to repurchases, including general reporting requirements and, with respect to tender offers, specific reporting requirements related to the tender offer.
Regulation FD generally prohibits selective disclosure of material non-public information to securities market professionals, such as the issuer’s security holders, as well as broker-dealers, investment advisors and investment companies.15 In the context of a repurchase transaction, potential material non-public information that becomes known to potential and actual counterparties and intermediaries includes (a) the company’s engagement in a repurchase transaction and (b) information about the company’s business provided to ensure the company is not trading on the basis of material non-public information. In some cases, concern surrounding the disclosure of the repurchase transaction is mitigated by the issuer’s generic disclosure in its periodic reports that it may engage in repurchases from time to time. A company can also ensure compliance with Regulation FD by entering into a confidentiality agreement with recipients of material non-public information or by publicly disclosing such information.
Issuers also have an affirmative obligation under Item 703 of Regulation S-K to disclose repurchases of equity securities in their periodic reports on Form 10-K and Form 10-Q.16 MD&A and related party transaction disclosure may also be appropriate.17 Issuers entering into a material definitive contract in connection with a repurchase transaction must also consider whether disclosure on Form 8-K is necessary. In addition, pursuant to stock exchange rules, issuers must notify the exchange of material developments, including the implementation of repurchase plans, before making a public announcement of such developments.18 The NYSE requires reporting of repurchases booked as treasury stock, and Nasdaq requires reporting of repurchases that result in a greater than 5% decrease in outstanding shares.19
Trades of an issuer’s securities by affiliated purchasers (including officers, directors and owners of more than 10% of the issuer’s shares) involving a class of equity securities registered under the Exchange Act may be reportable on Forms 4 or 5 under Section 16 of the Exchange Act and may also impose short-swing liability for opposite-way transactions (a purchase and sale, or sale and purchase) that are fewer than six months apart.20 Additionally, Sections 13(d) and 13(g) of the Exchange Act require persons or groups who own or acquire beneficial ownership of more than 5% of an outstanding class of registered equity securities of an issuer to file a Schedule 13D or 13G with the SEC.21 The schedule must be amended upon any material change to the facts set out in a previously filed schedule, such as an acquisition or disposition of 1% or more of the class of equity securities owned by the filer.
Issuers should also be aware that the acquisition of voting securities by a person other than the issuer could require prior reporting under the Hart-Scott-Rodino Antitrust Improvements Act and, in certain circumstances, could implicate other investment laws such as review by the Committee on Foreign Investment in the United States (or CFIUS).
Sections 9(a)(2) and 10(b) of the Exchange Act impose additional restrictions on repurchase transactions.22 These restrictions prohibit (a) the manipulation of prices of a security by creating actual or apparent trading in such security or by raising or depressing the price of such security and (b) the use of any manipulative or deceptive device in contravention of SEC rules in connection with the purchase or sale of any security.
Rule 10b-18 provides issuers (and their affiliated purchasers) with a “safe harbor” from liability for manipulation under Sections 9(a)(2) and 10(b) of the Exchange Act solely by reason of the manner, timing, price, and volume of repurchases of the issuer’s common stock in the market.23 The repurchases must satisfy (on a daily basis) the following four conditions in order to take advantage of the safe harbor:
- All repurchases must be made in reliance on the safe harbor on any given day must be made by the same broker.
- The repurchase trades must not be the first opening (regular way) trade of the day, and must not be traded within 30 minutes of opening or closing of trading on the issuer’s principal market. This 30-minute restriction is reduced to 10 minutes from opening or closing for companies with a public float of $150 million and ADTV of $1 million. “ADTV” is defined in Rule 10b-18(a)(1) as “the average daily trading volume reported for the security during the four calendar weeks preceding the week in which the purchase is to be effected.”
- The price paid may not exceed (a) the highest independent bid or (b) the last independent transaction price, whichever is higher, quoted or reported at the time the purchase is made.
- The maximum aggregate amount that may be purchased by an issuer or any affiliated purchasers on any given day may not exceed 25% of the issuer’s ADTV. Once each week, in lieu of purchasing under the 25% of ADTV limit for that day, the issuer (or any affiliated purchaser) may make one block purchase.
Activities of “affiliated purchasers” will be aggregated with the issuer’s repurchases for purposes of Rule 10b-18’s single broker and volume requirements. An “affiliated purchaser” under Rule 10b-18 is a person acting in concert with the issuer for the purpose of acquiring the issuer’s securities, or is an affiliate that, directly or indirectly, controls the issuer’s purchases, or whose purchases are controlled by, or under common control with, those of the issuer.24
Issuers should consider that the Rule 10b-18 safe harbor only applies to repurchases of common stock. In addition, the safe harbor does not apply to tender offers and is not a defense for violations of the insider trading restrictions under Section 10(b) of the Exchange Act and Rule 10b-5.
In addition, Rule 10b-18 does not provide a safe harbor for violations of Regulation M. Generally, Regulation M prohibits an issuer, its selling security holders, offering participants and affiliated purchasers of offering participants from bidding for, purchasing or attempting to induce any person to bid for or purchase a covered security that is the subject of a “distribution.”25 These restrictions apply during a restricted period, which begins one to five business days before pricing of a distribution and ends on the completion of the distribution. Regulation M is intended to prevent an issuer and its underwriters from engaging in manipulative practices that would artificially inflate the price of a security, or create a false appearance of active trading in the security, during a distribution. A distribution is defined as an offering of securities distinguished from ordinary trading by the magnitude of the offering and the presence of special selling efforts and selling methods. An issuer that plans to conduct a distribution of its securities generally suspends any repurchase program, regardless of the method, for the duration of its distribution. Regulation M also prohibits an issuer from making a distribution of shares of the class involved in a tender offer for up to five business days after the tender offer closes.
State Law Issues
Issuers and their affiliates should also consider state law requirements in connection with repurchases by the issuer or its affiliates. The members of the issuer’s board of directors must satisfy statutory or fiduciary duties, which typically include the general duty to act on a fully informed basis, free from personal interests, and in furtherance of the best interests of the issuer and its shareholders. Issuers should also review their governing documents to ensure any specific requirements with respect to repurchases are met.
Additionally, many states have laws that apply specifically to repurchases, including the requirement that the issuer have a “surplus” sufficient to permit repurchases and that the repurchase does not render the company insolvent. Under Section 160 of the Delaware General Corporation Law, a company may not use cash or other property to repurchase its own shares if the issuer’s capital is impaired or if the repurchase would cause an impairment of the issuer’s capital.26 To avoid impairment, an issuer may use only “surplus” to purchase shares of its own stock. In Delaware, “surplus” is defined as the excess of net assets (total assets minus total liabilities) over the aggregate par value of the outstanding stock.27 With respect to repurchases by Delaware statutory trusts, the trust’s governing documents generally control and typically give the trust broad flexibility to repurchase securities of which it is the issuer, subject to the fiduciary principles imposed by state law.28
Most issuers are also subject to the Uniform Fraudulent Transfer Act, which prohibits the use of corporate cash or assets to repurchase stock if the repurchase would impair the ability of the issuer to pay its debts and liabilities or render the issuer with insufficient capital as a result of the repurchase.29 Some states, including Delaware and Maryland, impose personal liability on directors for violation of the statutory repurchase requirements. Importantly, this is one of the few areas in Delaware where a company is not permitted to exculpate its directors from personal liability for money damages.30
Issuers contemplating repurchase transactions should also consider contractual restrictions. For example, bond indentures and credit agreements often place restrictions on restricted payments, which can include repurchases of equity or debt securities prior to their scheduled maturity. In addition, financial covenants in these agreements may be impacted by repurchases. Issuers should carefully review contractual restrictions to ensure compliance.
Main Street Lending Program
Issuers eligible for the Main Street Lending Program should consider the program’s restrictions on repurchasing securities. The Federal Reserve issued guidance on April 30, 2020 with respect to the provisions of the Main Street Lending Program.31 The Federal Reserve established the program, which has not yet launched, to provide assistance to businesses of various sizes struggling with the COVID-19 pandemic’s economic impact by providing these businesses with access to credit on commercially reasonable terms. However, any issuer borrowing under the program may not repurchase the issuer’s or any parent company’s equity securities listed on a national securities exchange until twelve months after the loan is no longer outstanding, except to the extent required by a contractual obligation in effect prior to the enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act.32
1 Note that these are the general tender offer requirements and not the special requirements for funds conducting a “periodic” tender offer for common stock under Rule 23c-3 of the Investment Company Act of 1940.
2 17 CFR 240.14e-1 et seq.
3 17 CFR 240.14d-10
4 17 CFR 240. 13e-3; 17 CFR 240. 13e-4; 17 CFR 240. 14d-3
5 17 CFR 240. 13e-3; 17 CFR 240. 13e-4; 17 CFR 240. 14d-4
6 17 CFR 240. 13e-4; 17 CFR 242.100
7 Wellman v. Dickinson, 475 F.Supp. 783 (SDNY 1979).
8 15 U.S. Code § 80a–17; 15 U.S. Code § 80a–2
9 15 U.S. Code § 80a–23
10 15 U.S. Code § 80a–23(c)(1)
11 15 U.S. Code § 80a–23(c)(2)
12 Investment Company Act Release No. 33817 (Mar. 13, 2020), available at
13 15 U.S.C. § 78j; 17 CFR § 240.10b-5
14 17 CFR § 240.10b5-1(c)
15 17 CFR Part 243
16 17 CFR § 229.703
17 17 CFR § 229.303; 17 CFR § 229.404
18 NYSE Listed Company Manual § 202.5; NYSE Listed Company Manual § 202.6; Nasdaq Listing Rule 5250(b)
19 NYSE Listed Company Manual § 204.25; Nasdaq Listing Rule 5250(e)(1)
20 17 CFR § 240.16a-2
21 17 CFR § 240.13d; 17 CFR § 240.13g
22 17 CFR § 240.9a-2; 17 CFR § 240.10b
23 17 CFR § 240.19b-18
25 17 CFR 242.100 et seq.
26 8 Del C. § 160
27 8 Del C. § 154
28 12 Del C. § 3806(a)
29 E.g., Del. Code Ann. tit. 6, chapter 13; see also 11 U.S. Code § 548
30 5 Del. C. § 174; 5 Del. C. § 102(b)(7)
31 Press Release, Federal Reserve Board announces it is expanding the scope and eligibility for the Main Street Lending Program (April 30, 2020), available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20200430a.htm.
32 The Federal Reserve exercised its discretion to impose the repurchase restrictions applicable to direct loan programs under the CARES Act on the Main Street Lending Program in the program’s terms and conditions. See Frequently Asked Questions, Main Street Lending Program (April 30, 2020), available at https://www.federalreserve.gov/monetarypolicy/files/main-street-lending-faqs.pdf; Coronavirus Aid, Relief, and Economic Security Act, H.R. 748, 116th Cong. § 4003(c)(3)(A)(ii) (2020).