June 22, 2007

Bond Defaults and Late SEC Filings: New Court Decision Contrary to BearingPoint

Last year, I blogged about late SEC filings serving as bond defaults and, more specifically, a New York decision in BearingPoint. Now, a recent decision in Texas – Cyberonics, Inc. v. Wells Fargo – seems to have come to a contrary conclusion. Cyberonics recently filed a Form 8-K about this case – and both of these court opinions are posted in our “Late SEC Filings” Practice Area.

Here is some analysis about Cyberonics from Davis Polk: As a result of the large number of delayed SEC filings in the last several years due to option back-dating and other accounting problems, investors and companies have focused significant attention on whether a failure to file SEC reports will trigger a default under a company’s indenture that will permit acceleration of the Company’s debt. Last year, a New York state court, in a decision regarding BearingPoint, Inc., interpreted standard indenture language to require the timely filing of SEC reports and held that a failure to file was a default. Recently, a U.S. District Court in Texas held, contrary to the New York court, that similar language did not impose such an obligation.

In the BearingPoint case decided by the Supreme Court of New York, New York County, on September 18, 2006, the covenant in the indenture called for reports to be filed with the trustee by the company “15 days after it files such annual and quarterly reports, information, documents and other reports with the SEC.” BearingPoint argued that, so long as the documents were not filed with the SEC, there was no obligation to provide them to the trustee and hence no default. However, the court ruled that the company’s failure to file reports with the trustee when such reports were required to be filed with the SEC constituted an event of default under the indenture.

The court also found that, aside from the language in the indenture itself, the language in Section 314(a) of the Trust Indenture Act “specifically obligates” an issuer of bonds to provide the trustee with “current filings,” meaning filings made in accordance with the time frames prescribed by the SEC. Section 314(a) of the TIA provides that an issuer must “file with the indenture trustee copies of the annual reports and of the information, documents, and other reports (or copies of such portion of any of the foregoing as the Commission may by rules and regulations prescribe), which such obligor is required to file with the Commission pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934.”

Last week, the U.S. District Court for the Southern District of Texas, in litigation brought by the trustee for bonds issued by Cyberonics, Inc., took the opposite view of the BearingPoint court. First, the Cyberonics court held that the language of the reporting covenant itself (which was substantially identical to the language in the Bearingpoint indenture) clearly only required Cyberonics to file Exchange Act reports with the Trustee 15 days after actually filing them with the SEC (not 15 days after when they were due).

Second, the court rejected the trustee’s argument that Section 314(a) of the TIA required the reports to be filed with the trustee in accordance with the SEC’s deadlines. The Cyberonics court stated that Section 314(a)(1) is virtually identical to the reporting covenant itself but is “less stringent” because it does not specify a time frame for providing the reports to the Trustee.

The opinion is a significant victory for Cyberonics and for other issuers that are subject to indentures with similar reporting covenants (the opinion is largely irrelevant to issuers with reporting covenants that provide explicit SEC filing deadlines).

By interpreting the Cyberonics reporting covenant to require that Exchange Act reports be filed with the trustee only after being filed with the SEC and stating that Section 314(a) of the TIA does not provide a deadline for filing such reports with the SEC, the Cyberonics opinion provides issuers that are facing restatements or are otherwise delinquent in their SEC filings a bit more leverage against bondholders threatening default or acceleration as a result of such delinquency. The Cyberonics court emphasized, however, that during the period that Cyberonics was delinquent in filing its Form 10-K, Cyberonics kept “the trustee informed of company developments” by filing Form 8-Ks containing information about its operations.

Accordingly, we recommend that delinquent issuers continue to provide as much operating information to bondholders and the trustee as possible. Issuers should also take note that this opinion, like the BearingPoint opinion, is by a single trial court and is not binding on other courts.

[Cowabunga! These big wave videos get me antzy. 100 foot waves!]

Tellabs: Another Blow to Securities Fraud Lawsuits

Yesterday, the US Supreme Court – in Tellabs, Inc. v. Makor Issues & Rights, Ltd. – enforced a strict pleading standard for private securities actions. This case dealt with the issue of what a plaintiff is required to plead under the Private Securities Litigation Reform Act in order to establish a “strong inference” that the defendant acted with the requisite mental state. This issue has long split the lower courts.

In a 8-1 decision (Justice Stevens dissenting), the Court found that to qualify as a strong inference of scienter within the meaning of the PSLRA, the inference must be more than merely plausible or reasonable – it must be “cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” The Court found that when determining whether a Rule 10b-5 claim meets that requirement, a court must consider plausible opposing inferences – although the inference of scienter need not be irrefutable.

Yesterday’s WSJ’s Law Blog included some interesting commentary from participants in the case. This case comes on the heels of another important Supreme Court case dealing with private lawsuits: Credit Suisse Securities (USA) LLC v. Billing. A copy of the opinion – and a bunch of related memos – are posted in our “Securities Litigation” Practice Area.

Opening Up the Shelf: The SEC’s Proposals to Benefit Smaller Public Companies

From Dave: On Wednesday, the SEC published its proposed amendments to Forms S-3 and F-3, seeking to open up those forms for primary offerings (on a limited basis) by companies with less than $75 million of public float. Under the proposals, these smaller companies (as well as companies selling below-investment grade debt) could sell securities off the shelf in an amount up to 20% of their public float over any 12 calendar month period. The proposed limited primary offering provisions would be available to companies quoted on the OTCBB and Pink Sheets.

For the purposes of calculating whether an issuer could do a takedown under this proposed new instruction, you would compute 20% of the public float immediately prior to the intended sale, and compare that number to the aggregate amount (gross proceeds) of sales of securities in primary offerings under the S-3 instruction over the past 12 calendar months, including the amount of the intended sale. The SEC’s rationale for limiting sales to 20% of public float is to strike a balance between the issuers’ need to raise capital with the potential effect of primary offerings on the markets in relatively thinly-traded securities.

In the proposals, the SEC specifies that, for convertible securities, the amount that could be sold off the shelf would be based on the aggregate market value of the maximum amount of underlying securities, rather than the market value of the convertible securities themselves. The proposals would specifically prohibit otherwise S-3 eligible shell companies from utilizing the new shelf flexibility – until 12 calendar months after it ceases to be a shell company, the shell company has filed all of the Form 10-like information required and the shell company has been timely reporting for 12 calendar months.

One of the nice features in these proposals is that the 20% threshold is calculated by reference to public float just before the contemplated takedown (rather than, say, at the time of filing the registration statement), so the amount of securities that an issuer is able to sell increases if the issuer’s public float increases. Further, the 20% restriction on sales goes away if an issuer crosses the $75 million public float threshold and reaches the promised land of unlimited shelf offerings. When the Section 10(a)(3) update time next rolls around, the issuer would then have to re-evaluate its public float and, if the float is less than $75 million, the issuer would drop back into the 20%-limited shelf offering instruction.

While these proposals don’t go as far as the Advisory Committee on Smaller Public Companies had hoped, they do go a long way toward improving the capital formation picture for smaller companies. With the prospect of at-the-market direct public offerings done off the shelf, issuers may be less inclined to seek financing through the PIPEs and equity lines markets, where terms may not be as advantageous for the issuers.

Corp Fin No-Action Letter: A New 409A Option Repricing Twist

For those with 409A option repricing exchanges on the brain, I blogged about a new Corp Fin no-action letter yesterday on the Blog

– Broc Romanek