Timely Reporting – It’s Not A Job, It’s A Debenture

“George, that’s the first time anyone ever thought enough of you to call you a shark. If you were a good lawyer, you’d be flattered.”

There are so many companies behind on their SEC filings, it’s a good idea to review what happens when you forget about your reporting obligations. There are at least 105 separate entries in Compliance Week’s database, based on Edgar filings, in the “Restatements and Delays” category alone, and that doesn’t include investigations and other potential problem situations such as “going concern,” “qualified opinion,” or “disclaimer of opinion” entries.

Breaching loan covenants means losing access to lines of credit and other forms of liquidity and then it’s just a hop, skip and a jump into bankruptcy. It’s not the economy, stupid, it’s the lousy way they managed the business.

When you run into these kinds of issues, that’s often the time when your auditor finally resigns or you realize that you have to kick him out, to ring-fence both of you in the coming litigation.

I was reminded of this because I happen to be working some days in close proximity to a real shark. I had thought that the Bank of New York v. BearingPoint decision was the last word on what happens when a company fails to make timely SEC filings and, therefore, risks being in breach of loan covenants. But by being close to greatness, I found out that there is a new case in town, Cyberonics v. Wells Fargo.

For those who are interested in the BearingPoint details, here’s a good non-legal summary of the case from late 2006.

“A hedge fund strategy criticized for being a muscle-bound way of extracting returns from underperforming investments just got an injection of validity. Now, some investors are scouring bond indentures looking for the next windfall, while others are seeking ways to protect themselves against the next possible shakedown.

The Supreme Court of New York released its opinion Tuesday evening, detailing its decision last week to side with the Bank of New York (BONY) as trustee for the holders of BearingPoint’s (BE) $225 million, 2.75% convertible bonds. The holders had alleged that the company defaulted on its indenture. The consulting company failed to file its annual report, or 10-K, for the year ended Dec. 31, 2004. BearingPoint also failed to file other reports throughout 2005.

BearingPoint was claiming it did not violate the indenture, and that sharing financial statements with the bondholders was dependent on its choosing to file financial statements with the Securities and Exchange Commission.

The McLean, Va., technology consultant said in an SEC filing Monday that it would appeal the ruling, which it said could cause it to have to place a “going concern” statement in its yet-to-be-filed 2005 annual report. The company said it will defer making that filing beyond Sept. 30, “until these uncertainties are addressed.” BearingPoint said it targets late spring 2007 for when it will be up to date with all of its SEC filings.

The company came under investigation by the SEC last year for its internal control deficiencies, which led to its delayed filings…In this latest version of what many call a type of hedge fund activism, hedge funds holding bonds of companies that fail to file or delay filing financial statements with the SEC allege the bond issuer has defaulted on debt — regardless of the rationale for such delays.

The New York court’s decision draws a line in the sand regarding the legality of these default claims, regardless of how “technical” they may be. For a bond issuer such as BearingPoint, such a claim of default usually means the company would have to repay the bondholders the par value, or $1,000 per bond, of the notes plus accrued interest within a certain period of time. The declaration also could mean the investors could declare the bonds convertible into the issuer’s stock.

There has been an increase in delayed filings due to companies’ coming up to speed with new accounting requirements under the Sarbanes Oxley Act, and more recently, issues with accounting for stock options. Some companies have argued that these defaults are technicalities, and that more long-term-oriented lenders like mutual funds or bank lenders have given companies some leeway regarding these so-called “technical” defaults when they are due to special circumstances. ”

Interestingly, a recent decision came to the exact opposite opinion even though the covenant language was substantially similar. I like this analyst’s comments because they remind us that delayed filings are not a “technicality” but usually a sign of grave issues that only now are investors, rating agencies and other stakeholders actually taking seriously.

Financial Reporting Covenants in the Era of “Covenant Lite”…

“The unprecedented level of liquidity in the financial markets has permitted companies to issue public debt securities utilizing “covenant lite” indentures…

One consequence of the current indenture environment is that financially troubled issuers can defer default situations for a long time either by staying in compliance with the few remaining covenants in the indenture and/or making coupon payments in new debt instruments to postpone (but seldom to overcome) a liquidity crunch. In this environment, investors are forced to pay even greater attention to the few covenant protections that they have, such as the financial reporting covenant that obligates the issuer to deliver copies of its SEC filings to the indenture trustee pursuant to the terms of the indenture and § 314 of the Trust Indenture Act (the “TIA”).

As an initial matter, we reject the notion that a breach of the reporting covenant is a “mere” technical breach. Covenants are either complied with or they are breached and there is nothing “mere” about the breach of any covenant. Further, reporting requirements are close to sacred for investors in public companies, and when an issuer misses an SEC filing deadline there is often the possibility that something serious may be occurring behind the scenes. Why won’t the auditors sign off? What might the “minor internal investigation” or the “routine SEC inquiry” reveal? How significant, and for how many years, will the need to restate prior financials extend? There may not always be fire where there is smoke and in the current environment of increased scrutiny of back-dated stock options, investors should exercise prudence. Sometimes, however, there really is a fire, and the failure to make a timely SEC filing should always be taken as a potentially serious matter by investors and issuers alike.

Interestingly, not all financial reporting covenants are alike, even though one would think that they should be “boilerplate.” Some specifically mandate that the company must make all SEC filings on a timely basis and then provide copies thereof to the indenture trustee. Others, however, only require the issuer to provide copies of the SEC filings to the indenture trustee. And there are other variations in between.

If the foregoing language variations sound like semantics, they are not—the difference could be quite substantive. In 2006, a New York court issued a significant decision in The Bank of New York v. BearingPoint, 2006 N.Y. Misc. LEXIS 2448 (N.Y. Sup. Ct. 2006), finding that an issuer’s failure to make its SEC filings was an indenture default. The decision provides two significant holdings. First, the court held that, as a matter of New York contract law (which governs most indentures), the indenture’s language contractually obligated the issuer to make such filings. Second, the court held that TIA § 314, which was expressly incorporated into the indenture, similarly obligated the issuer to make such filings. This was the first decision on this issue and it was a significant development for distressed investors seeking a seat at the table when an issuer displays signs of financial distress by failing to make its SEC filings.

On June 14, 2007, in Cyberonics v. Wells Fargo Bank Nat’l Assoc., Civ. Act. No. H-070121 (S.D. Tex. June 14, 2007), a Texas court came to the opposite conclusion in a case involving an indenture with language that was very similar to the BearingPoint indenture.

Thus, there is now a split of authority with respect to whether a covenant default arises when an issuer fails to make its SEC filings, at least in the context of the specific indenture language that was at issue in these two cases. Issuers can find some comfort in the Cyberonics decision, but it is by no means clear that it will have widespread applicability…