Table of Contents

About the Author...... vii Table of Chapters...... ix Preface ...... xxiii

Chapter 1 Introduction ...... 1 § 1:1 What Is Corporate Finance, and Why This Book...... 1 § 1:2 What This Book Covers...... 3 § 1:3 What This Book Doesn’t Cover...... 3 § 1:4 Caveat...... 4

Chapter 2 The Players ...... 7 § 2:1 The Company Perspective...... 8 § 2:1.1 Debt Versus Equity...... 8 § 2:1.2 Short-Term or Long-Term Debt...... 9 § 2:1.3 Illiquidity Versus Insolvency...... 10 § 2:1.4 Matching Liabilities to Assets; Managing Maturities .. 10 § 2:1.5 Market Conditions ...... 11 § 2:1.6 Fixed-Rate Financing and Call Protection...... 12 § 2:1.7 Short-Term Pricing with Medium-Term Assurance of Access to Funds Through a Backstop ...... 13 § 2:1.8 Nature of the Business...... 14 § 2:1.9 Maturity of the Business...... 16 § 2:1.10 Where Does the Company’s Cash Come From? ...... 17 § 2:1.11 Implications for Lawyers...... 18 § 2:2 Investors and Intermediaries...... 19 § 2:2.1 Individual and Institutional Investors in the Public or Quasi-Public Markets; Underwriters and Placement Agents ...... 19 § 2:2.2 Banks and Other Lenders in the Bank Loan and Private Placement Markets...... 21

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§ 2:2.3 Competition and Consolidation in the Banking Industry ...... 22 § 2:2.4 Implications for Lawyers ...... 23 § 2:3 Exchanges, Regulators and Industry Associations ...... 24 § 2:3.1 Another Kind of Liquidity; Trading and Exchanges....24 § 2:3.2 Primary Regulators and Self-Regulatory Organizations...... 26 § 2:3.3 Industry Associations ...... 26 § 2:3.4 Implications for Lawyers ...... 26 § 2:4 Ancillary Players...... 27 § 2:4.1 Providers of Trustee and Administrative Services...... 27 § 2:4.2 Rating Agencies...... 28 § 2:4.3 Accountants ...... 29 § 2:4.4 Financial Printers...... 30 § 2:4.5 Lawyers...... 31 § 2:5 The Evolving Market; Hedge Funds and Private Equity; Derivatives...... 31 § 2:5.1 The Status Quo Ante ...... 31 § 2:5.2 Change Happens...... 32 § 2:5.3 Private Equity and Leveraged Buyouts...... 33 § 2:5.4 Hedge Funds ...... 33 § 2:5.5 Derivatives, and Credit Derivatives in Particular ...... 34 § 2:5.6 Playing a Game of Catch-Up...... 35 § 2:6 The M&A Connection ...... 36 § 2:6.1 Financial Engineering and Financial Buyers...... 36 § 2:6.2 Assessment of the Target Company Debt ...... 37 § 2:6.3 The Acquisition Debt...... 38 § 2:6.4 Bridge Loans, PIK, Staple or Stapled Financing . . . Innovation Is the Rule ...... 39 § 2:6.5 Implications for Lawyers ...... 41

Chapter 3 The Instruments...... 43 § 3:1 Review of the Basic Terms ...... 43 § 3:1.1 Scheduled Maturity; Mandatory Repayment; Optional Repayment; and Call Versus Non-Call...... 43 § 3:1.2 Yield and Coupon; Yield and Price; Accrual; Fixed Rate Versus Floating Rate; Margin and Spread ...... 45

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§ 3:1.3 Rating...... 47 § 3:2 Plain Vanilla Finance...... 48 § 3:2.1 Common Stock...... 48 § 3:2.2 Preferred Stock ...... 48 § 3:2.3 Convertible Debt ...... 49 § 3:2.4 Commercial Paper...... 49 § 3:2.5 Bank Debt—Revolving Credits...... 51 § 3:2.6 Bank Debt—Letters of Credit ...... 52 § 3:2.7 Bank Debt—Term Loans ...... 55 § 3:2.8 Private Placement Debt ...... 55 § 3:2.9 Public or Rule 144A Debt...... 55 § 3:3 Complex Finance ...... 56 § 3:3.1 Structured Finance ...... 56 § 3:3.2 Derivatives ...... 60 § 3:3.3 Financial Engineering and Rule Arbitrage; Issues for Lawyers ...... 61

Chapter 4 Accounting Matters...... 63 § 4:1 Financial Statements...... 63 § 4:2 The Balance Sheet and What’s Not on It ...... 65 § 4:3 The Income Statement; LIFO and FIFO ...... 71 § 4:4 EBITDA...... 73 § 4:5 How the Financial Statements Fit Together...... 74 § 4:6 Consolidation; Minority Interests; Equity Accounting ...... 75 § 4:7 Interplay of Consolidation Concerns and Off-Balance-Sheet Financing...... 76 § 4:8 How Financial Statements and Financial Reality Can Diverge ...... 77

Chapter 5 Bankruptcy—Rules of the Endgame ...... 81 § 5:1 Priorities of Recovery ...... 81 § 5:2 Fraudulent Conveyance...... 83 § 5:3 Preference...... 85

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Chapter 6 The Issuer and the Obligation: Recourse, Ranking, Rights, and Remedies ...... 89 § 6:1 Identify the Obligor ...... 90 § 6:1.1 Who’s on the Hook? ...... 90 § 6:1.2 What’s in a Name? ...... 90 § 6:1.3 What Type of Legal Entity?...... 91 § 6:1.4 What Is Non-Recourse Financing?...... 92 § 6:2 Debt or Equity or Something Else?...... 92 § 6:3 Secured or Unsecured?...... 93 § 6:3.1 Benefits of Security ...... 93 § 6:3.2 Terminology; Negative Pledges; Equitable or Constructive Liens ...... 94 § 6:3.3 Nothing Short of Perfection Will Do ...... 94 § 6:3.4 Types of Collateral...... 95 § 6:3.5 Which Rules Apply?...... 96 § 6:3.6 Need for Careful Review; Key Defined Terms ...... 96 § 6:3.7 A Note on Stock Pledges...... 97 § 6:3.8 What About Proceeds?...... 97 § 6:3.9 Preference Risk ...... 98 § 6:3.10 In a Troubled Credit Situation...... 98 § 6:3.11 Roles of Collateral Trustee, Custodian, or Servicer.....99 § 6:3.12 Sharing Collateral ...... 99 § 6:3.13 Consistency with Debt Agreements; Release of Collateral...... 100 § 6:4 Senior or Subordinated? ...... 101 § 6:4.1 Subordination Is Contractual, Not an Absolute Priority...... 101 § 6:4.2 The Payover Provision; Obligations of the Issuer Unaffected...... 102 § 6:4.3 Definition of Senior Debt; Tiers of Subordinated Debt...... 103 § 6:4.4 The Credit Agreement Debt ...... 104 § 6:4.5 Designated Senior Debt, Payment Blockage and Delay on Acceleration...... 105 § 6:4.6 Anti-Layering...... 106 § 6:4.7 Terms That Can Frustrate Subordination ...... 106 § 6:4.8 Guarantees of Subordinated Debt...... 107 § 6:4.9 When Subordinated Debt Is Secured; Second Lien Debt...... 108 § 6:4.10 What Conclusions Can Be Drawn? ...... 110

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Chapter 7 Beyond the Issuer: Corporate Structure Issues...... 113 § 7:1 Structural Subordination and “Leakage”...... 113 § 7:1.1 Structural Subordination ...... 113 § 7:1.2 Pledge of Intercompany Loans; Upstream Guarantees...... 115 § 7:1.3 Stock and Debt of Subsidiaries...... 116 § 7:2 Subsidiaries—Presumptively Within the Credit Group... 117 § 7:2.1 Wholly Owned Versus Non-Wholly Owned Subsidiaries; Preferred Stock...... 117 § 7:2.2 Restricted Versus Unrestricted Subsidiaries...... 118 § 7:2.3 U.S. Versus Non-U.S. Subsidiaries ...... 119 § 7:2.4 Material or Significant Subsidiaries ...... 120 § 7:2.5 Single-Purpose or Special-Purpose Subsidiaries ...... 120 § 7:3 Non-Subsidiary Affiliates—Presumptively Outside the Credit Group ...... 121 § 7:3.1 Upstream Affiliates...... 121 § 7:3.2 Sisters ...... 122 § 7:3.3 Joint Ventures, Minority Interests, and the Like...... 123

Chapter 8 Commitments, Conditions, Pricing, and Risk; Liquidity Support and Credit Support; Credit Derivatives...... 125 § 8:1 Commitments, Conditions, Pricing, and Risk...... 125 § 8:2 Beyond the Issuer: Analyzing Levels of Credit Support ... 128 § 8:3 Liquidity Support...... 129 § 8:4 Credit Support and Credit Substitution ...... 130 § 8:4.1 Guarantees ...... 130 § 8:4.2 Non-Guarantee Credit Support?...... 130 § 8:4.3 Letters of Credit...... 132 § 8:4.4 Bond Insurance...... 132 § 8:4.5 Credit Derivatives? ...... 132

Chapter 9 A Deal in Time...... 133 § 9:1 The Deal Life Cycle and the Role of the Lawyer ...... 134 § 9:2 Understanding the Company and Its Financing Needs.... 134 § 9:3 Defining the Market and Instrument...... 134

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§ 9:4 Locating and Using Forms and Precedents...... 135 § 9:5 Preliminary Agreements—Term Sheets and Commitment Letters ...... 136 § 9:6 Due Diligence, Detail, and the Preliminary Agreement ...138 § 9:7 Drafting and Negotiation...... 139 § 9:7.1 The Drafting Process ...... 139 § 9:7.2 Golden Rules of Document Drafting and Negotiation ...... 139 § 9:7.3 How to Read a Contract ...... 140 § 9:7.4 Negotiation and the Lawyer’s Role ...... 141 § 9:7.5 Common Errors in Decision-Making ...... 142 § 9:8 Closings ...... 145 § 9:8.1 Good Closings...... 145 § 9:8.2 Typical Documentary Requirements ...... 147 § 9:8.3 Potential Documentation Problems...... 148 § 9:8.4 Requirements in the International Context...... 150 § 9:8.5 Related Transactions and Simultaneous Closings .....150 § 9:9 Opinions...... 151 § 9:9.1 Opinions are Hard; Not Just a Word-Processing Exercise ...... 151 § 9:9.2 The Basic Opinion ...... 153 § 9:9.3 Conclusions About Legal Facts ...... 154 § 9:9.4 Security Interest Opinions...... 155 § 9:9.5 True Sale and 10b-5 Opinions...... 155 § 9:9.6 Rules to Opine By ...... 155 § 9:10 Post-Closing ...... 158 § 9:10.1 Final Documents and Closing Sets...... 158 § 9:10.2 Post-Closing: Amendments, Waivers, and Questions of Interpretation (When to Call a Lawyer)...... 158

Chapter 10 Contract Structure and Key Elements ...... 161 § 10:1 Overview...... 162 § 10:2 Title, Date, and Parties; References to Other Contracts ...163 § 10:3 Successors and Assigns? ...... 164 § 10:4 Conditions Precedent ...... 165 § 10:5 The MAC Clause, Material Litigation, and Incipient Events of Default...... 166

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§ 10:6 Representations and Warranties ...... 169 § 10:6.1 Representations as “Hidden Covenants”...... 169 § 10:6.2 Representations About the Unknown: Who Bears the Risk? ...... 170 § 10:6.3 Misrepresentation Versus Inability to Make a Representation...... 171 § 10:7 Covenants...... 171 § 10:7.1 Affirmative Covenants, Negative Covenants, and Financial Covenants ...... 172 § 10:7.2 Maintenance Versus Incurrence Tests ...... 172 § 10:7.3 Principles of Covenant Design and Analysis ...... 173 § 10:7.4 Related Definitions: How Important Are They?...... 173 § 10:8 Defaults ...... 174 § 10:8.1 Default Versus Event of Default...... 174 § 10:8.2 Acceleration; The “Ipso Facto” Clause ...... 175 § 10:8.3 Cross-Defaults ...... 175 § 10:8.4 Judgment and Lien Defaults...... 176 § 10:9 General or “Miscellaneous” Terms ...... 177 § 10:10 Definitions ...... 177 § 10:11 Who’s Covered? ...... 178 § 10:12 How Do the Provisions Work Together?...... 179

Chapter 11 Housekeeping, Insurance, and Information Covenants ...... 181 § 11:1 Good Housekeeping ...... 181 § 11:2 Insurance Covenants ...... 182 § 11:3 Information Covenants ...... 183

Chapter 12 Debt and Liens (Negative Pledges)...... 185 § 12:1 The Negative Pledge (Restriction on Liens)...... 185 § 12:2 The Construction of Negative Covenants...... 186 § 12:3 Equal and Ratable Clauses...... 187 § 12:4 Restrictions on Sale-Leasebacks ...... 189 § 12:5 Restrictions on Negative Pledges...... 190 § 12:6 Debt Covenants...... 190 § 12:7 Restrictions on Debt of Subsidiaries ...... 191 § 12:8 The Priority Debt Package...... 192

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Chapter 13 General Business Covenants...... 193 § 13:1 Purposes ...... 193 § 13:1.1 Preserving the Identity of the Obligor and the Source of Repayment...... 194 § 13:1.2 Reducing Risk ...... 195 § 13:1.3 Controlling the Use of Cash ...... 195 § 13:2 By Type of Transaction or Activity...... 196 § 13:2.1 Mergers and Asset Sales...... 196 § 13:2.2 Restricted Payments...... 198 § 13:2.3 Investments...... 199 § 13:2.4 Line of Business ...... 200 § 13:2.5 Capital Expenditures ...... 200 § 13:2.6 Acquisitions?...... 201 § 13:2.7 Leases...... 202 § 13:2.8 Guarantees and Contingent Obligations ...... 202 § 13:2.9 Assignment of Receivables...... 203 § 13:2.10 Transactions with Affiliates...... 203 § 13:2.11 Other ...... 204 § 13:3 Constructing a Multi-Covenant Basket...... 205 § 13:4 Cross-References to Ensure Consistent Treatment ...... 205 § 13:5 Change of Control Provisions and Definitions...... 206

Chapter 14 Financial Covenants ...... 207 § 14:1 Lawyers Should Not Be Afraid of Financial Covenants....207 § 14:2 Correcting Toward Cash and Fair Value...... 208 § 14:3 Maintenance Versus Incurrence Tests (Again); Historical Versus Adjusted or Pro Forma ...... 208 § 14:4 Coverage Versus Balance Sheet Tests; Timing Questions.209 § 14:5 Coverage Tests...... 210 § 14:5.1 The Numerator ...... 210 § 14:5.2 EBIT and EBITDA ...... 211 § 14:5.3 The Denominator ...... 211 § 14:5.4 Depreciation and Capital Expenditures...... 212 § 14:6 Leverage Ratio of Debt to Cash Flow ...... 213 § 14:7 Balance Sheet Tests ...... 214 § 14:7.1 Net Worth ...... 214 § 14:7.2 Balance Sheet Leverage Test ...... 215

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§ 14:8 Minimum Operating Results...... 215 § 14:9 Liquidity and Working Capital Tests ...... 216 § 14:10 Excess Cash Flow Sweeps...... 216

Chapter 15 Amendments, Waivers, and Control Provisions...... 217 § 15:1 Amendments and Waivers ...... 217 § 15:1.1 Level of Consent Required ...... 217 § 15:1.2 Can the Obligor Vote?...... 219 § 15:1.3 Multi-Series or Multi-Tranche Agreements ...... 219 § 15:1.4 Banks and Bondholders That Do Not Go Along...... 221 § 15:2 Amendment Versus Waiver; Form of Amendment...... 222 § 15:3 Shared Collateral; Intercreditor Agreements; Standstill Agreements ...... 224 § 15:4 Analyzing Control Provisions ...... 225 § 15:4.1 A Common Apparent Anomaly...... 225 § 15:4.2 Trading of Loans and Bonds, and the Relevance to Control ...... 225 § 15:4.3 How to Review Control Provisions...... 226

Chapter 16 Risk-Based Review; Transactions Analysis ...... 229 § 16:1 Spend Your Time Wisely...... 230 § 16:2 How to Deal with Boilerplate and Other Standard Provisions...... 231 § 16:3 Recommendations and Questions for Risk-Based Review ...... 232 § 16:3.1 Party and Client Identification ...... 232 § 16:3.2 Correspondence to Term Sheet ...... 233 § 16:3.3 Closing Documents; Disclosure Schedules; Side Agreements; the Closing Set...... 233 § 16:3.4 Opinions ...... 234 § 16:3.5 Timing, Risk, Commitments, and Conditions; Continuing or Repeating Representations ...... 235 § 16:3.6 Complex Calculations and Tax Provisions...... 235 § 16:3.7 Security ...... 235 § 16:3.8 Interrelatedness and Consistency Generally Within the Financing ...... 236

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§ 16:3.9 How Different Financings Work Together ...... 237 § 16:3.10 Credit Support or Liquidity Support?...... 238 § 16:3.11 Covenants Dealing with Securitization and Derivatives ...... 238 § 16:3.12 Definition of the Corporate Group; Definitions of Affiliates and Control ...... 239 § 16:3.13 Adverse Developments—Stress Testing...... 239 § 16:3.14 M&A Scenarios ...... 240 § 16:3.15 Maintaining Flexibility: Amendments, Waivers, and Refinancing Options...... 240 § 16:4 Transactions Analysis at the Margin ...... 240

Chapter 17 Best Practices ...... 243 § 17:1 Drafting As a Professional Skill ...... 243 § 17:1.1 Cross-References...... 244 § 17:1.2 Consequential and Conforming Changes...... 244 § 17:1.3 Working with Precedent...... 245 § 17:1.4 Excessive Generality and Too Much Specificity; Over-Engineering ...... 246 § 17:1.5 Identifying and Correcting Ambiguity; Vagueness ...247 § 17:1.6 Logical Completeness and Correctness; Speculative Worlds?...... 248 § 17:1.7 Over-Drafting ...... 248 § 17:1.8 Too Many Words...... 249 § 17:1.9 Good Definitions ...... 249 § 17:1.10 Provisions in Related Documents ...... 251 § 17:1.11 Lists ...... 251 § 17:2 Drafting Disclosure of Contract Terms...... 251 § 17:2.1 Where the Contract Is Relevant but Is Not the Main Event...... 251 § 17:2.2 For the Selling Document for the Debt...... 252 § 17:2.3 In Regular Disclosure for Public Companies? ...... 252 § 17:3 Levering Technology—Possibilities and Pitfalls; Documents Handling and Retention ...... 252 § 17:4 Lessons of Enron...... 254 § 17:5 Stay Informed, Be Engaged, Live Long, and Prosper...... 257

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Appendix A Notes and Resources ...... 259 Appendix B Technical Drafting Checklist ...... 303 Appendix C Indicative Terms for Bank Debt and Public Debt, Investment Grade Versus Non-Investment Grade...... 307 Appendix D Newco Goes to Wall Street—8½ Balance Sheets .. 333 Appendix E Diary of a Liquidity Crisis: Enron’s Last Days ...... 343

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