Regs On Debt Instrument Modification Need Major Changes, Attorney Says.

Richard Lipton of Sonnenschein Nath & Rosenthal, Chicago, has commented that the proposed regulations under section 1001 should be modified regarding the treatment of changes in collateral for a nonrecourse debt and the effect of a waiver of rights by a lender. Also, Lipton sees problems with the section relating to changes in the terms of a debt that do not affect the yield on the instrument.

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January 29, 1993

Internal Revenue Service

ATTN: CC:CORP:T:R (FI-31-92), Room 5228

Re: Proposed Regulations Under Section 1001

Dear Sirs:

This letter addresses the proposed regulations under Section 1001 concerning the tax effect of modifications of debt instruments. As set forth below, I believe that the proposed regulations should be substantially modified.

I find several aspects of the proposed regulations to be very troubling. The areas which are of particular concern to me are (i) the treatment of changes in collateral or security for a nonrecourse debt, (ii) the effect of a waiver of rights by a lender, and (iii) changes in the terms of a debt which do not affect the yield on the instrument. The approach adopted in the proposed regulations in all three of these areas is a significant (and, in my view, unwarranted) departure from current law. Moreover, these rules are the complete antithesis of what occurs in the "real world," in which the terms of a loan agreement (other than the yield on the instrument) are frequently changed by the parties. The proposed regulations will render taxable numerous transactions which have little, if any, effect on the economic income of the borrower and lender.

The modification of a debt instrument should be treated as an exchange only when there is a material change in the yield on the debt instrument. Any other rule will be a significant impediment to borrowers and lenders. Furthermore, the proposed regulations greatly complicate the law and would impose significant additional costs on all borrowers and lenders, who will need to draft for all potential contingencies in a loan agreement. (Indeed, the proposed regulations could require lawyers to re-draft the forms of loan agreements used for every loan.) Finally, if the Service decides to finalize the regulations in substantially their current form, the regulations should apply only to debt instruments issued after the regulations are finalized.

CHANGES IN COLLATERAL. Although current law is not completely clear, it appears fairly certain that a change in the collateral which secures a nonrecourse debt instrument, standing alone, does not result in an exchange under Section 1001. This result is reached no matter what the nature of the change in collateral (other than the addition of collateral to a recourse obligation), i.e., a change in collateral results in a significant modification when (i) recourse debt is changed to nonrecourse, (ii) nonrecourse debt becomes recourse, (iii) guarantees are added, eliminated or modified on nonrecourse debt or a recourse debt if the effect is to substitute obligers, (iv) credit enhancements are added, eliminated or modified on nonrecourse debt or a recourse debt if the effect is to substitute obligers, or (v) collateral is pledged or deleted from the security for repayment of a nonrecourse loan. All of these transactions are, from an economic standpoint, different ways of accomplishing the same thing, which is providing security to the lender for the repayment of a loan.

Current law makes more sense than the proposed regulations. After all, the collateral for a nonrecourse loan is only the last resort for a lender, who expects to receive interest and principal on the loan, resulting in an agreed internal rate of return to the lender. The parties are usually willing to adjust (increase or decrease) collateral as the lender's certainty of receiving this internal rate of return becomes less or more assured. Likewise, guarantees are added or eliminated, and debt is changed from nonrecourse to recourse, as additional ways to provide the lender with the assurance which the lender seeks of obtaining its desired yield on the loan made to the borrower.

The proposed regulations turn current law on its head. As a result, most changes in the security for a nonrecourse loan will give rise to an exchange, even though the amount received by the lender will not be changed unless there is a default by the borrower. It is virtually certain that tax considerations will now become paramount any time that the borrower and a lender wish to undertake a change in the security for repayment of a nonrecourse obligation, which could be a significant impediment to loan restructuring.

WAIVERS BY THE LENDER. It is often stated, only half- facetiously, that the borrower is always in default under a well- drafted loan document. Nonetheless, the proposed regulations provide an exception to modification treatment only in the case of a TEMPORARY failure of an issuer to perform its obligations. Indeed, the proposed regulations specifically state that, after a default by a borrower beyond a "temporary" period, the waiver of an acceleration clause by a lender can be treated as a modification. This provision does not distinguish between payment defaults and the mere failure of a borrower to satisfy a loan covenant (such as debt to equity ratio or interest coverage). Read literally, this provision would result in a modification any time that a borrower defaults on a loan covenant and the lender agrees to modify the covenant.

This provision is totally unworkable in the "real world". Borrowers frequently fail to satisfy all of the covenants in a loan, and lenders waive acceleration (and modify the covenants). Indeed, this event occurs annually for most loans. Surely the Service did not intend to require every issuer and every lender to treat the annual loan review, in which defaults are listed by borrowers and waived by lenders, and covenants are reworked, as constituting a modification. The answer to this concern may be that a modification must be "significant" to result in a deemed exchange. However, this determination is made on the basis of all of the tests and circumstances. Thus, until an audit is concluded, borrowers and lenders will not know with certainty whether the waiver of a default also has tax consequences.

NON-YIELD CHANGES. The fundamental flaw in the proposed regulations is that changes in the terms of a debt instrument which do not affect its yield or obligor can result in a taxable exchange. These "non-yield" events which are treated as modifications include the changes in collateral and waivers of defaults discussed above, as well as an extension of the maturity date of a loan, delayed payments (without any change in yield due to compounding of interest), a change in conversion rights and other changes in the nature of a debt instrument.

The proposed rules are not clearly required by current law (including Cottage Savings). Under existing law, primary emphasis is placed on the yield of a debt instrument, and secondary emphasis has traditionally been placed on who is the debtor; it is only changes in those items which result in a taxable exchange. (Indeed, even in Cottage Savings, which based its decision on "legal entitlements," the swap of loan portfolios resulted in a change in yield to the parties.) The proposed regulations would greatly expand the universe of transactions which result in taxable events.

In my opinion, the primary emphasis in current law on the yield of an obligation is correct. When a borrower and lender enter into a loan agreement, the primary concern to each party is the internal rate of return to the lender. This determination focuses on yield. The proposed regulations will make it necessary for every borrower and lender to determine, in advance, whether any other terms of a debt instrument can be changed in the future without potential tax consequences. (Failure to address such issues in a loan agreement could result in adverse tax consequences if changes must be made, and could expose lawyers to malpractice claims.) This will impose significant additional costs on all borrowers and lenders.

Indeed, it is reasonable to assume that the proposed regulations, if adopted in substantially their current form, will require changes to the forms utilized for every loan. Any lawyer who fails to take into account the tax consequences of potential changes, including waivers or changes in collateral, will have potentially harmed his or her clients. Thus, existing loan documents will need to be completely re-worked. I cannot believe that this result was intended by the Service.

EFFECTIVE DATE. The proposed regulations would apply to all modifications of a debt instrument after the regulations are finalized. If the regulations are adopted in substantially their current proposed form, this proposal is unfair to innumerable borrowers and lenders who relied upon current law in entering into loan agreements.

Under current law, only a change in yield (and, arguably, a change in the obligor) of a debt instrument results in an exchange under Section 1001. As a result, there was no need to draft provisions in existing debt instruments to permit changes in collateral, yield adjustments, etc. if certain events occur. The proposed regulations will require every borrower and lender to take such possibilities into account. Anyone who failed to anticipate this change in the law would effectively be "frozen" into their existing debt instruments.

As set forth above, I believe that the proposed regulations should be substantially modified. If the Service decides to finalize these regulations, recognition should be given to the fact that existing loan agreements were not drafted with these regulations in mind. Thus, a "grandfather clause" for all existing loan agreements would be appropriate.

Please call me if you have any question about these comments.

Sincerely,

By: Richard M. Lipton