Any capital-markets issue that is collateralized will tend to have an independent third-party trustee as holder of the security. This is a simple structure that originated in the common law (the Anglo-Saxon systems found in the UK, the former British Commonwealth and the US) and has been harnessed elsewhere, such as Scandinavia and the Middle East (see last month’s Financial Lawyer). But, hitherto, unsecured plain-vanilla issues have tended to be done without inserting a trustee structure, but with a fiscal agent instead. This has the merit of economy, since the fiscal agent tends to be the principal paying agent and the combined cost forms part of the pricing package put to the issuer. However, the benefits of using a trustee are being increasingly recognized, not least because of its legal standing within the issue structure.
Unlike a fiscal agent, which is the issuer’s agent and has no contractual duty to the bondholders, the trustee is appointed by the issuer but its principal duty is owed to the bondholders. The trust deed sets out the degree of discretion with which the trustee is vested. Clever borrowers will allow the trustee a wide discretion. This is because the trustee is able to deal with many of the issues that would otherwise require a meeting of the bondholders. These include minor and not so minor breaches of covenants.
These breaches occur not least because covenants from banking documents such as loan agreements still seem to be imported wholesale – and inappropriately – into capital-markets issues. An issuer faced with committing a technical breach can approach the trustee. The trustee, which is concerned to protect the interests of all bondholders over the full life of the issue, will waive the breach on their behalf if it believes that the breach will not “materially prejudice” (as the language of the trust deed usually puts it) their interests, ie, their receipt of interest and ultimately principal.
By contrast, the publicity attendant on the calling of a bondholders’ meeting is not only potentially embarrassing but can destroy confidence in an issuer and drive it over the brink, quite apart from the cost and the notice needed.
The appointment of a trustee will also prevent an individual bondholder from calling a default if the trustee does not believe that such a default would damage the interests of all bondholders: this ensures that a single holder – which may be pursuing its own agenda in seeking to put the issuer into default – cannot hold a gun to the rest. Normally, in the case of a fiscal agent, it has to notify the borrower if it receives written notice from any bondholder of an event of default and if the event is not cured the individual bondholder can take steps to enforce repayment.
Technical breaches can be prompted by changes in the issuer’s regulatory or legal environments. Examples of the former include utilities that cannot raise prices because of government-imposed restrictions. Examples of the latter include issuers with strong overseas cashflows that find themselves in default of ratios in their dollar-denominated debt following currency devaluations, as happened in Mexico. Asian issuers without trustees to consult are finding themselves in similar situations at the moment.
In the case of breaches that are waived by the trustee, the market may never know: the trustee may decide that it is not in anyone’s interest to publicise the fact of a technical breach.
This is what sovereigns should be waking up to: the use of the trustee in issues where the sovereign is guarantor. Where a sovereign acts as guarantor – indeed where a sovereign as issuer does not want to be at the mercy of each bondholder individually – it can benefit from inserting a trustee into the issuing structure. This way, as guarantor, it cannot be called upon to meet the guaranteed’s obligations to just one holder: its guarantee is either called in its entirety or not at all (and the use of the trustee makes the former less likely). The trustee’s discretion can extend to agreeing to the substitution of another entity in place of the original principal debtor. Any modifications, waivers, authorizations or substitutions agreed by the trustee are binding on all bondholders.
The trustee is not vouching for the issuer’s creditworthiness. Whereas a credit-rating agency is concerned with the issuer’s credit standing vis-à-vis the current investors, the trustee is concerned with the protection of the bondholders’ interests in the issue over the full life of the issue, whoever they may be and whatever the price they bought at. This is why a trustee will take the longer view.
The use of trustees is most developed in the US domestic bond market where it is a condition of SEC approval that issues are registered and have trustees. Ironically, registration removes much of the benefit of having a trustee since the fact of registration (quite apart from SEC requirements) probably implies a duty to notify bondholders of any technical breach. On top of that, fear of litigation US-style means that trustees in that market are unlikely to be prepared to exercise any degree of discretion without a specific indemnity from bondholders, which makes a nonsense of giving the trustee any freedom of discretion in the first place: sued if they do and sued if they don’t.
Two other advantages of trustees concern the detail of the bond covenants. The first is that issuers can be prepared to accept more stringent covenants, knowing that the exercise of the trustee’s discretion will prevent technical breaches being used as an excuse to accelerate repayment opportunistically. The second is that trustees will not accept discretion in the case of covenants the materiality of which cannot be objectively tested.
So, for example, if it is a condition of the issue that the state retains a 75% holding in the issuer, there is no way of knowing whether a reduction in the state’s shareholding by, say, 10% would have a material adverse effect as it has no impact on the state’s willingness to support the issue – and a trustee will reject it accordingly.
The real issue is that such “keep well” agreements are of doubtful benefit. Calling upon a trustee to agree to exercise its discretion over such clauses will smoke out which are actually worthwhile at all.
Although most jurisdictions are waking up to the benefits of the trustee, it is salutary that some civil-law jurisdictions lack the language to accommodate the concept. In one significant issue under French law where a trustee-type entity was inserted into the structure, it took the assembled bankers and lawyers half a day of head-scratching to come up with “le trustee”.
