As the economic turbulence associated with the downturn in commodity prices and the outbreak of COVID-19 continues, many energy companies may find their debt trading at significant discounts. For companies trying to manage liability and liquidity, this presents an opportunity to selectively repurchase debt and de-lever at prices well below par. Energy companies that are well-situated to capitalize on this window should carefully consider the corporate and tax ramifications debt buybacks present.
While the appropriate debt repurchasing approach will vary by company, many of the basic considerations are universal:
Existing Debt Terms
Companies should review their existing debt contracts to determine if there are any terms precluding (or reducing the attractiveness of) a debt buyback. The terms of existing debt instruments could pose challenges by restricting or limiting debt repurchases themselves or the company’s capacity to re-incur the debt.
Securities Law and Disclosure Requirements
Buybacks of debt securities—like other securities transactions—subject companies to certain disclosure obligations under the federal securities laws. Importantly, a company contemplating a repurchase of its debt securities must consider whether it possesses any material non-public information (MNPI). If so, the issuer must disclose such information prior to repurchasing debt securities. Unless the company wants to issue a press release or a Form 8-K with the necessary disclosure, that may mean that the company may need to wait until it has released earnings or filed the next periodic report before repurchasing debt securities . Alternatively, a company making open market repurchases could consider entering into a Rule 10b5-1 repurchase plan during a time when it is not in possession of MNPI. Under such a plan, even if the company subsequently comes into possession of MNPI during the course of the plan, the automated repurchases would not be deemed to have been made on the basis of such information. Finally, the company should consider whether the adoption of the repurchase plan is itself MNPI that requires disclosure prior to the commencement of repurchases. Whether the repurchase plan itself constitutes MNPI ultimately depends on many factors, including the amount of debt being repurchased and the overall impact the repurchases will have on the company’s financial condition. Your legal counsel should be well-equipped to guide you through these regulatory obstacles and help you to determine what you need to disclose and when.
Tender Offer Rules (and How to Avoid Being Subjected to Them)
Companies should be mindful that debt buybacks, both privately negotiated ones and those conducted in the open market, could inadvertently trigger the tender offer rules. Companies will typically want to structure a debt buyback to avoid the tender offer rules, which reduce a company’s flexibility by imposing mandatory offering periods and extensions, payment terms, and disclosure obligations. At the same time, companies wishing to repurchase significant amounts of debt may instead choose to conduct a widespread offer in compliance with the tender offer rules. The traditional test to identify a tender offer weighs the presence of the eight “Wellman” factors (originally from Wellman v. Dickinson, 475 F. Supp. 783, 823-24 (S.D.N.Y. 1979)):
- The offer is actively and widely disseminated to the market.
- The offer is for a substantial percentage of the outstanding issue.
- The offer is at a premium to the market price.
- The terms of the offer are firm and not negotiable.
- The offer is contingent on a fixed principal amount being tendered.
- The offer is only open for a limited time period.
- The debt holders are pressured to sell.
- A public announcement of the buyback precedes or accompanies a rapid accumulation of large amounts of the target security.
Not all eight factors need to be present for a debt buyback to be deemed a tender offer, and the weighting of each factor will vary based on the facts and circumstances. Thus, would-be debt repurchasers wishing to avoid the tender offer rules should proceed with caution and consider the following guidelines when structuring a debt buyback program:
- Limit the number of securities repurchased. Repurchase efforts should not be aimed at an entire series of notes or a substantial portion of one series.
- Make offers only to a limited number of sophisticated holders. Even for bond series that are likely held only by institutional investors, limit your offers to a small number of institutions that are likely to be holding the bonds.
- Do not include a specified expiration time in your offers (ideally, the repurchases would occur over a meaningful period of time).
- Repurchase each holder’s debt securities on privately and individually negotiated prices and terms.
- Do not condition your offers on achieving the repurchase of a certain principal amount.
- Avoid advertisements or announcements relating to the repurchase.
Tax Consequences of Debt Buybacks
While a debt buyback can help a company de-lever its balance sheet, tax considerations must also be analyzed in order to address risks and to preserve the expected economic benefits. When a company buys back its debt in the market at a discount and such debt is thereafter effectively “cancelled” because the company would not have to repay the debt, the company generally is required to recognize cancellation of debt income (“CODI”) to the extent of the discount. The same CODI result occurs if the debt is repurchased by a “related person,” which generally speaking for a corporate issuer, is a person or entity that owns 50 percent or more of the equity in the corporation.
For corporate issuers, a deduction for the carryover of net operating losses (“NOLs”) can mitigate the tax consequences of CODI recognition. After the Tax Cuts and Jobs Act of 2017, a corporation can only use post-2017 NOLs carryforward to offset up to 80 percent of its taxable income (including CODI), leaving at least 20 percent of CODI subject to tax. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed into law and now allows NOLs generated in 2018, 2019 and 2020 to be carried back five years, as well as carried forward to offset 100 percent of taxable income (including CODI) without the 80 percent income limitation. For corporate issuers with 2018 and 2019 NOLs carryforward and considering debt buybacks, this new provision in the CARES Act can further reduce any potential CODI impact resulting from the debt buybacks.
Exceptions to the inclusion of CODI may be available to corporate issuers in certain circumstances. For example, a corporate issuer is not required to include CODI in its gross income if it is in bankruptcy or if the corporate issuer is insolvent. When a corporate issuer relies on the bankruptcy or insolvency exception, it must generally reduce their tax attributes (such as NOLs) or the tax basis in its assets by the amount of CODI excluded.
If the issuer of debt is classified as a partnership for U.S. federal income tax purposes, discharges of partnership debt give rise to CODI that is separately stated and allocated to each partner of the partnership. Given that partnerships do not generate NOLs, there is no mitigation of CODI at the partnership level. Further, any exclusions of CODI under the bankruptcy or insolvency exception are applied at the partner level by each partner, depending upon that partner’s particular circumstances. Thus, the bankruptcy or insolvency of the partnership is irrelevant for these purposes, and only partners that are bankrupt or insolvent may make use of those exclusions.
Companies considering debt repurchases should consult with their advisors regarding the risks and tax consequences associated with such transactions to preserve the intended economic benefits and avoid surprises.