Companies issuing high-yield bonds carefully draft the restrictive covenants in their indenture in order to protect investors and provide business flexibility. One important restrictive covenant is the limitation on affiliate transactions covenant. This covenant usually states that any transaction between the company and an affiliate must have terms no less favorable than those for a similar transaction between the company and an unrelated third party.

The purpose of the limitation on affiliate transactions covenant in high-yield bond indentures is to avoid leakage of value from the credit group and to discourage “self-dealing” transactions. The definition of “affiliate” usually matches the definition under federal securities law. Under Rule 405 of the Securities Act of 1933, an affiliate is a person that directly or indirectly controls, or is under common control with, the issuer. A holder of at least 10% of a company’s stock is generally considered an affiliate of the company.

The transactions with affiliates covenant often provides for a threshold amount above which affiliated transactions are not permitted. For example, the transactions with affiliates covenant might prohibit the issuer and its restricted subsidiaries from engaging in transactions, contracts, agreements, or loans with an affiliate in an aggregate amount exceeding $10 million.

The covenant provides for a de minimis exception that exempts transactions falling below a certain threshold from compliance with the covenant. Transactions that fall under this exception may include:

• Transactions between the issuer and its subsidiaries that are part of the credit group (known as “restricted subsidiaries”)
• Restricted payments that are covered by the restricted payments covenant in the indenture
• The payment of reasonable and customary fees to indemnify or reimburse officers, directors, or employees
• Transactions with customers, suppliers, or clients that are in the ordinary course of business and that the board of directors or senior management has determined is on fair terms to the issuer
• Payment of loans to officers, directors, or employees in the ordinary course
• Arrangements such as stock option plans, employee agreements, and compensation plans with officers, directors, or employees in the ordinary course
• Transactions with joint ventures that are in the ordinary course of business and that the board of directors or senior management has determined is on fair terms to the issuer

Like other covenants in the indenture, the transactions with affiliates covenants comes with a number of specified exceptions. One common exception to the affiliate transactions covenant is for certain “Permitted Investments” set forth in the indenture. “Permitted Investments” is defined to include:

• Any investment in the issuer or its subsidiaries that are part of the credit group
• Any investment in cash or investment grade securities
• Investments in joint ventures
• Investments consisting of purchases of inventory, supplies, or equipment
• Investments existing or contractually committed to prior to the bond issuance date

The exceptions to the transactions with affiliates covenant and the definition of “Permitted Investments” in the indenture should be carefully drafted. Attention to detail in the drafting can prevent future issues or inadvertently placing limitations on the company’s ordinary course business activities.