By Howard Darmstadter

Some of my friends insist that you can’t write a securities prospectus in plain English unless the underlying documents are in plain English. On this view, when a prospectus describes a corporate bond, it is describing a set of legal relationships that are embodied in a separate legal agreement — usually called an indenture — between the issuer and a trustee for the bondholders.

This leaves us with two descriptions of the bonds: one in the indenture and one in the prospectus. This duality wasn’t a problem, however, until the SEC’s "plain English" rule came along. (It’s rule 421(b) and (d) under the Securities Act.) Before the plain English rule, a prospectus drafter would simply incorporate vast tracts of the indenture into the prospectus.

That solution may no longer be viable. A note to Rule 421(b) cautions us to avoid "complex information copied directly from legal documents without any clear and concise explanation of the provision(s)." Despite this, many prospectuses still incorporate goodly chunks of the indenture without any explanation, concise or otherwise. The SEC has apparently acquiesced in the view that prospectus recitals of indenture provisions are "magic words" that investors expect to see recited verbatim.

But even if you copy large chunks of the indenture word-for-word into the prospectus, you’re not going to copy the whole thing. Inevitably the description of the bonds in the indenture will differ from the description in the prospectus. What do you do about those differences? Most lawyers view the indenture as the key document. Accordingly, they tuck a sentence like the following into the prospectus:

The following summary describes certain terms of the bonds and is qualified in its entirety by reference to the indenture.

Here’s a charmingly in-your-face version of the same thought:

The following description is a summary of the material provisions of the indenture. We urge you to read the indenture because it, and not this description, define your rights as a holder of the bonds.

Really? I’m often the last to know anything, but did someone repeal the Securities Act when I wasn’t looking? The prospectus gives investors rights that the indenture can’t undo. How do I know? The Securities Act tells me so. See, especially, §§11, 12.

It’s tempting — and most lawyers yield to the temptation — to imagine that the indenture is the sole source of the bondholders’ rights, and that the prospectus description of the bonds is just a gloss on the indenture. The indenture is, after all, a legally binding agreement that describes how the bonds work, including the minute details of the actions the trustee must take for the bondholders to realize the benefits of their investment.

In a sense, the indenture is the bond issue. But that doesn’t mean that it’s the only, or even the best, description of the bonds. There is no single best description of the bonds. There are many descriptions, each serving different purposes. The indenture is one description, the prospectus another. And — stand back, I’m going to yell — for investors, the indenture description is the wrong description!

Let’s step back for a moment and consider a nonlegal example: My new word processing program arrived with a CD and a manual. The CD contained the program, which I installed on my computer. The manual told me how to use the program. The program itself was written in a programming language only comprehensible to a well-trained nerd. Which is the best description of the program: the program-in-programming-language or the manual?

It depends. For most of us, the manual is the only description we can understand. However, for a programmer who has to modify or debug the program, the programming language description is the only description that will serve.

What is the relationship between the two descriptions? Let’s suppose my new word processing program behaves differently from its description in the manual. Can Bill Gates argue that I don’t have a beef because the program ran exactly as the programmer wrote it? ("It’s not a bug, it’s a feature!") In most cases, No: The program will have to be modified to fit its description in the manual.

But not always. If my word processor seized on Jan. 1, 2000, could I have sued Bill? If I bought the program in December, Yes: My word processor is misprogrammed. But suppose I bought the program in 1980? It’s not clear that the programmer was negligent in assuming that no one would want to use the program 20 years later. Accordingly, he may have been justified in writing years using only two digits.

So if the manual misdescribes what happens, sometimes it’s actionable misprogramming and sometimes it’s tough noogies. There’s no clear line.

Now we have a way to think of the relation between the indenture and the prospectus: The indenture is the legal engineering for the bonds, and the prospectus is the owner’s manual. The indenture attempts to give the investor the benefits he reads about in the prospectus. If there’s an inconsistency between the description of the bonds in the prospectus and their description in the indenture, sometimes it’s the indenture that has to be modified, sometimes it’s the investor’s expectations. The dividing line is the difference between a prospectus misdescription that is "material" to the investor, and a misdescription that isn’t.

OK, so the traditional statement that "the following description is subject to the indenture" is out of bounds. What then should a prospectus say about the indenture?

In prospectuses my company has used for asset-backed securities, we tried to describe the securities as far as possible without reference to the underlying document. (In the asset-backed biz, the counterpart to the indenture is the pooling and servicing agreement, or P&S.) We do, of course, have a section on the P&S that covers matters, such as amendments, for which reference to the P&S is unavoidable. The lead-in to that section advises readers that:

The securities are complex instruments, and the P&S is a lengthy and complex document. The prospectus only discusses those aspects of the securities and the P&S that we believe are likely to be material to you. You should read the P&S for provisions that are important to you. The trustee will send a copy of the P&S to you on your written request.

There are aspects of this warning that I find unsatisfying. For one thing, saying the P&S is a complex document is a large understatement. The standard asset-backed prospectus is nearly impenetrable to anyone who doesn’t already know what it’s supposed to say. But next to the P&S, that prospectus reads like Pat the Bunny.

So cautioning an investor to read the P&S before investing might seem about as helpful as advising him or her to get an MBA. However, asset-backed securities are typically sold to a small number of institutional investors. (Issuers often print only a few hundred prospectuses.) A statement that would be ridiculous in a prospectus for a general audience — "read the P&S," for example — might be a useful warning in a prospectus for sophisticates — people who can understand, or employ people who can understand, the legal engineering.

Except that sophisticates already know to read the P&S. A more forthright (and useful) warning might go something like

"For sophisticated investors only! Don’t buy unless you have a lot of money and an MBA on call!"

The SEC’s official position, however, seems to be that a prospectus can not assume sophisticated investors. Rule 421(d)(2)(v) states that a prospectus must not contain any "legal jargon or highly technical business terms." Still, the commission in practice seems to realize that what’s highly technical in an IPO or a merger proxy might not be highly technical in an asset-backed securities prospectus.

At least I hope so. I still flog the P&S in my prospectuses for asset-backed securities. On the other hand, whenever they let me near a merger proxy, I try to delete all injunctions to read the merger agreement. One of these days I’ll get away with it.

Darmstadter is an assistant general counsel at Citigroup in New York City. You can e-mail him at darmstadte@citi.com.

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