Covenant to pay
|
The Law and Lore of Repackaging
|
You might wonder what on Earth this is all about, especially if you encounter it cast in wrought iron with that impenetrable prose that the School Matron beats into Linklaters trainees with her rolling pin, during their Debt Capital Markets seat. You know it is true, Linklaters people.
So, in brief:
What the covenant to pay is all about
The note is a unilateral, bearer instrument. Holders appoint a trustee to represent their interests as creditors — somewhat interesting — but also to hold security interests for them and the other Secured Parties.
As the security trustee does not hold the Notes themselves, otherwise it would have no rights under it. This covenant gives the trustee legal standing to sue/act for noteholders.
Also, the Issuer makes its payments to noteholders via a paying agent (normally, a bank). There is an odd interregnum between the Issuer paying its agent, and the Paying Agent paying the Noteholders, which it does through clearing systems.
There are fun recent cases about this — in the context of a loan agency arrangement, about what happens if an agent pays money away before the debtor pays it — especially when it then turns out that the debtor can’t pay it.
The Issuer’s covenant is discharged by paying the principal it owes to its agent. At that point it has done everything it can do.
But if the agent then fails before paying noteholders — it can happen — the Issuer should not be discharged from its obligation to the noteholders. One cannot escape liability to a principal by giving money to your own agent.
At this point, the noteholders have a claim for default against the Issuer, and the Issuer has a claim against its (insolvent) paying agent.
The security trustee holds the covenant on trust for noteholders, other secured parties (and itself to the extent of its own fees) to defend against trustee running off with the money: under the trust noteholders can trace their claims in the trustee’s hands if the trustee does a bolter.
Why have separate covenants to the Trustee, if they are direct covenants under the Notes?
Privity
As described above. it establishes a direct contractual relationship between the Issuer/chargor and Trustee for the main indebtedness, which there would otherwise not be (albeit that the Trustee holds this obligation on trust for the Secured Parties)
Limitation period
There are some more ninjery reasons relating to the statutory limitation of claims.
A covenant under the debt instrument itself is only a simple contract to which the usual six-year period in the Limitation Act 1980 applies. A covenant under a security arrangement is a specialty, to which a longer 12 years limitation period applies under pursuant to s 20 of the Limitation Act 1980.
You can also buy a few more days with security covenant. Per the Limitation Act, again, no action can be brought of 12 years from the date on which the right to receive the money accrued.
There will generally be a due date — the scheduled maturity date, for example — and this is undoubtedly the point from which the Noteholder’s simple contract[ 6-year limitation period runs, but the ninja wizardry is to buy the secured “specialty” covenant a few more precious days (you know, should 12 years’ worth of days not be quite enough) by making the security covenant bite “when demanded on or after the due date” — the italicised reference to the due date being there so as not to convert a term loan into a demand loan. (I know what you are thinking, and you’re right: lawyers sometimes need a slap).
That weird “pro tanto” discharge
...provided that payment of any sum due in respect of the Notes made to the Principal Paying Agent shall, pro tanto, satisfy such obligation except to the extent that there is failure in its subsequent payment to the Noteholders under the Conditions.
This such standardised boilerplate in repack trust deeds that trustee counsel will ask that it is included as some kind of Pavlovian, behavioural response. We are not sure what it is meant to do, but we are actively trying to find out and will let you know if we find out.
What is going on here? Firstly, bear in mind that the convoluted nature of debt securities means the note issuer — the legal entity that owes noteholders the debt represented by the Notes — cannot discharge its debt but through its paying agents. In the old world, the bond conditions mandate payment by paying agents on the issuer’s behalf, against presentation to those agents of the notes and coupons in preparation for the mythical annual Balearic bender.
The issuer cannot discharge its debt directly. What it can do is pre-fund its agents — well, in point of fact, the principal paying agent — in preparation for the swamping tide of Belgian dentists rocking up toting battered suitcases full of coupons and EasyJet tickets to Ibiza.
The issuer says, “since my payment to my bankers is the last point at which I can influence the payment to bondholders, I should like the Trustee to acknowledge that, by that payment, my covenant is discharged. I should not be held liable for double counting. I have done my bit.”
“Fair enough,” says the Trustee. “But, by the same token, the noteholders are taking your credit, not the paying agent’s. So we cannot have it that you can avoid liability for your own debt by paying money to your own agent, who then goes and loses it. A principal remains liable for a disclosed agent’s performance. Everyone knows that.”
The ingenious compromise is to discharge the Issuer “pro tanto” — by payment to its agent, but only to the extent the paying agent then makes payment to the noteholders.
That, of course, is no different than only discharging noteholders when they are actually paid, of course.
See also
References
- ↑ We bracket this bit because it is common, but we think, a bit stupid.