Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

Now that the Dodd Frank Act is expected to be enacted, attention turns to how this legislation will affect the financial services industry.  Will it fundamentally change the industry in the same way that Glass-Steagall, the FDIC Act, and the groundbreaking securities laws did during the Depression era?  With more than 200 rulemakings still to be issued, countless research studies to be conducted, and a Financial Stability Oversight Council to be formed, the bill’s enactment alone will not provide all of the answers.  

Reed Smith is planning to conduct a series of teleseminars about the new bill, with the first session on Tuesday, July 20, at 12 pm Eastern.  A panel of regulatory authorities and former general counsel will provide a summary of the legislation and discuss the following topics: 

• Will this law be the game-changer everyone expects?  What will the impact be for the financial services industry?
• What impact will the financial reform legislation have on banks and investors outside the United States?
• Who will be the new regulators?  Who will be among the newly regulated?
• Has the legislation addressed the issue of "too big to fail"?

Michael Bleier, former general counsel of Mellon and now a partner in our regulatory practice, will moderate the panel.  Panelists will include William Mutterperl, former vice chairman of PNC, Jacqui Hatfield, a partner in Reed Smith's financial services regulatory practice, and Reed Smith partners Stephen Keen and Andrew Cross from our investment management practice. 

If you'd like to attend this program, just click here to register. 

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I was talking with a client the other day, and a good question came up.  Since this question has been raised a few times recently, I thought I'd share it with you here.   This is the story:  The lender wants to refinance a loan made by another bank, and the other bank has provided an interest rate swap to the borrower.  The problem is that the swap is "out of the money" -- meaning that, in this case, the borrower would owe the bank about $20 million if the swap were terminated today.  As is typical, termination of the credit facility will cause the swap agreement to terminate too, so, unless we can come up with another option, the swap will terminate and the $20 million will be owed on the day the loan is refinanced. 

If the dollar amount owed is small, or the borrower is a very large company easily able to pay the amount, this isn't a problem.  But what can we do if the borrower can't afford to pay the termination amount?

Here are some options you might consider for how to deal with a swap when terminating a loan agreement:

1.  Novate the swap, so that the new lender replaces the old lender as the swap provider and can keep the existing swap open in support of the new loan.  My partner Andrew Cross, who specializes in dealing with all kinds of unusual issues that come up the derivatives world, says that this is legally possible but has found that it's not practical in many situations.  If the swap is out of the money, as in our case, the existing lender is still going to insist (rightfully) on being covered for the losses in connection with the novation -- so somebody still has to come up with $20 million.  As a practical matter, this option is best reserved for swaps on which nothing (or very little) is owed at the time.

2.  Give the existing lender some collateral, and ask them to agree to waive the termination event and keep the swap open.   This requires the existing lender to agree to preserve the existence of the swap, which isn't always possible if they aren't continuing to be the lender for the company.  It also requires the borrower to come up with sufficient collateral to cover the loss amount, which would require both that the borrower has enough assets to do this and that the new lender(s) agree that those assets can be carved out of their own collateral pool and given to that institution for that single purpose.  If there's a lot of money involved, it is unlikely that the borrower will have sufficient assets available to put up the required collateral, and even if they do, the new lender(s) may not want to permit it.

3.  Bring the lender into the new deal.  If the existing lender agrees to join in as a lender in the new loan, the swap can continue to be supported by a lien on all the borrower's assets, and there will be no need to make the $20 million termination payment or provide separate collateral.  It is standard for the security agreement in a syndicated loan deal to say that any swaps or hedges provided by the lenders and their affiliates are also  "secured obligations" and are covered by the collateral in exactly the same way as the loans.  

Option 3 might offer the best outcome for all involved, If the existing lender can be convinced to participate in the new deal.  Under Option 3, the original lender remains fully protected by a security interest in all the borrower's assets, the borrower's resources don't have to be applied to pay for (or collateralize) temporary losses that might have been nothing more than the result of a market shift (that might later shift back again), the borrower doesn't have to try to get a new interest rate swap in connection with the new loan, and the new lenders are able to close their refinancing. 

These are options that I've seen work in the past, but I'd be interested to know if any of you have seen any other options work successfully when a swap is out of the money.  Let me know! 

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When you want to make a loan, you probably get copies of the borrower's recent financial statements, and you probably take a pretty close look at them as part of your credit process.  You might even ask for more information about certain items that you see on the financial statements.  But how often do you dig deeply behind the financial statements and conduct your own audit?  Probably never, right?

Unless you have reason to think otherwise, it's likely that you take the financial statements largely at face value and rely on representations from the borrower as to their accuracy.  Indeed, nearly every loan agreement contains a representation that the financial statements "fairly present, in all material respects, the financial position of the Borrower" as of the date of the statements and that the statements "were prepared in accordance with generally accepted accounting principles" (or words to that effect).  But what if the representation isn't true?  

In a case decided just yesterday in New York, the lenders alleged that the borrower's representations about its financial statements were false in many important respects.  At issue in the case was the question of whether the lenders should have looked behind the numbers, undertaking a review of the borrower's books and records to discover the alleged inaccuracies.  The court in this case said no.  Even though the court thought there were some "hints" that could have suggested that the financial condition of the borrower wasn't all that it appeared to be, and that the lenders might have been "put on their guard" by some of the facts, the court nonetheless found that the lenders had done enough to protect themselves by requiring the borrower to give representations and warranties as to the accuracy of the statements.  The court specifically stated that the lenders were not required to conduct their own audit or even engage in detailed questioning of the preparers, so long as they included appropriate representations in the loan agreement.  It's possible for inaccuracies in financial statements to be so obvious that the lenders really should question things further up front, but absent those kinds of facts, we wouldn't expect more to be required.

The Loan Syndications and Trading Association (LSTA) noted in a publication sent to its membership today that requiring lenders to conduct an independent examination of borrowers' financial statements could have resulted in a "material disruption" in the commercial lending market.   It's certainly nice to have avoided such an outcome.

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In recent months, there have been several bankruptcy court decisions that are significant to secured lenders.  Here's a write-up of some of them, prepared by my bankruptcy colleagues here at Reed Smith.  Some of the issues addressed in these cases include proper perfection of security interests, the rights of second lien holders (also covered in this prior post), the role of stalking horse bidders, and a situation where a 363 asset sale didn't work out as planned for the secured lender.  Happy reading!

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The last two weeks have brought new plans for regulation of financial institutions and financial markets, in both the US and the UK.   The global trend toward increased regulation of finance is bound to have significant effects on lending institutions over the next few months and years.

On May 20, the US Senate passed S. 3217, an extensive set of banking and financial regulatory reform legislation.   This bill covers such areas as proprietary trading by banks, enhanced consumer protection (including creation of a new consumer financial protection agency), trading of over-the-counter derivatives, and many other things.  Next steps will include trying to reconcile the content of this bill with the somewhat different version of a financial reform bill passed earlier by the House of Representatives, before the legislation moves forward to be signed by the President.  To find out more about how this legislation might affect you, take a look at this summary of the Senate bill's contents prepared by my partner Christopher Rissetto and others.

Meanwhile, across the pond, UK regulators are gearing up to further tighten the rules affecting financial markets.  Similar to some initiatives in the US, the focus in the UK is on reforming over-the-counter derivative markets, strengthening global standards for clearing houses (including improving handling of defaults in the clearing and settlement system), increased transparency in non-equity markets, and oversight of credit rating agencies.  Here's a helpful guide to the UK proposals, along with some commentary from my partner Jacqui Hatfield, who leads Reed Smith's Financial Services Advisory Group from our office in London.

For those in the US, enjoy the Memorial Day weekend and the unofficial start of summer!

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Credit bidding has become a really hot issue recently.   For those of us who don't normally work on bankruptcy matters, the right to credit bid is an important right that secured lenders usually have in a bankruptcy proceeding.  If you're the senior secured lender and you want to buy the company's assets in a bankruptcy sale, you can show up at the auction and, instead of bidding cash, you can place credit bids.  A credit bid is basically an offer to give up part (or all) of the secured claim you have against the company -- i.e., amounts the company borrowed from you and didn't pay back -- in exchange for the assets.  

The senior secured lender's right to credit bid in an asset sale has come under question recently.  In the well-publicized Philadelphia Newspapers (pdf) case, the secured lenders were actually prohibited from credit bidding in the asset sale.  Last week, the lenders bought the company's assets anyway, by paying cash. 

The Philadelphia Newspapers case is significant because it seems to be the first time an appellate court has decided that secured lenders don't have a right to credit bid the amount of their loans in a sale under a Chapter 11 plan of reorganization.  It's important to note that this case was from the Third Circuit, which includes Delaware -- where a lot of companies choose to file for bankruptcy.  That said, it's also important to note that this case applies only to sales under plans of reorganization, and not to "363 sales" (under Section 363 of the bankruptcy code) or UCC Article 9 asset sales outside of bankruptcy.  Still, this changes the game for secured lenders, at least in that part of the country.  A right you would have expected to have in bankruptcy appears to be gone, at least for now.

Several suggestions have been offered for what to do about this.  For example, if you have a borrower in bankruptcy (and if it's not too late), you can try to include provisions in a DIP financing order (or in a cash collateral order) requiring that the secured lenders be given the right to credit bid.  You can also try to require that an asset sale be conducted as a 363 sale and not under a plan of reorganization.   For more details about the Philadelphia Newspapers case (and a longer list of suggestions for what to do), take a look at this summary.

Since credit bidding has been the subject of so many recent bankruptcy cases, we'll continue this thread next time, talking about issues that come up when you have a syndicated loan and want to credit bid for the assets, but not all the lenders agree. 

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With the increase in corporate bankruptcy filings over the past year, there have been some interesting bankruptcy court decisions that affect those of us on the front end in corporate lending.  One recent case took up the question of whether a second lien is truly second -- and whether it is safe to expect that the terms of your intercreditor agreement will be enforced.  

In an intercreditor agreement, the senior lender will usually require that the junior lender waive several of its rights, including

• the right to challenge the validity or priority of the senior lender's liens, and
• the right to oppose a plan of reorganization supported by the senior lender. 

The intercreditor agreement in the ION Media case, as is common for an agreement of this type, included a broad waiver of these and other rights.  In the agreement, the junior creditor agreed that its rights to the company's assets would be junior, and the relative priorities of the lenders' claims would not be affected or impaired by "any nonperfection of any lien purportedly securing" any of the senior obligations.  However, in the bankruptcy case, the junior creditor took issue with these terms, and argued that some of the assets weren't "collateral" as defined in the intercreditor agreement -- so the waiver should not apply.  The bankruptcy court disagreed, deciding instead to enforce the waiver as written. 

When we draft these kinds of waivers in intercreditor agreements, this is exactly the type of situation we are trying to address:  if it turns out that there's a problem with the senior lender's lien (perhaps liens as to some of the collateral don't appear to have been properly perfected, for example), the junior lender is still supposed to remain in the junior position.  These terms help  ensure that the senior lender actually receives the benefit of its senior position.  And this agreed-upon allocation of risk affects many other elements of the lending relationship for both creditors -- including loan pricing.  Junior creditors typically receive significantly higher rates of return than senior lenders, due to the higher level of risk they take on.

Until now, we were pretty sure that all these provisions worked, but we didn't have the benefit of a published case on point.  It is helpful for both junior and senior creditors to have more certainty here.

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In response to my post yesterday on a recent New York case prohibiting a participation without borrower consent, my partner Lucy Newcomb from Reed Smith's London office provides a UK-law perspective on the case below.  It is interesting to note that there is no such thing as the doctrine of good faith and fair dealing in the UK, so we could expect a similar case to have a different outcome in a UK court.  Lucy writes:

Although the judgement in the Cablevisión case is unlikely to be repeated in an English court, the case will have implications for the negotiation of lender transfer provisions going forward.

We have already shared our general thoughts on this case in a prior post, so I won't get into all the details again here.  What is most important to note from a UK-law perspective is that there is no general doctrine of good faith in English common law. This difference has important implications in terms of the enforcement of contracts, since the English common law is biased in favour of predictability of commercial transactions and certainty of common law.  This means that parties contracting under English law can specify rights and obligations in some detail and be confident that they will be enforced as stated.

Therefore, as the law currently stands, any similar dispute under an English law governed credit agreement would have to be decided solely on the grounds that the participation agreement was for all relevant purposes a disguised but un-consented to assignment that breached the credit agreement, and not that it violates concepts of good faith and fair dealing. 

On this point, it is worth noting that, as described in the court's decision, as a result of the would-be participant's requested changes to the participation agreement, and in particular after the lender rejected a request to enter into side letters empowering the participant to direct any lender decisions regarding amendments and waivers to the credit agreement, the lender amended the recitals to the participation agreement to explicitly refer to the lender's direct relationship with the borrower and to reaffirm its sole discretion with respect of amendments and waivers under the credit agreement. These amendments indicated to the court that the lender had attempted to ensure that the participation agreement was consistent with the credit agreement -- and indeed believed it to be consistent.   

No ruling on the point was made in this case, but Judge Rakoff's comment (in response to the lender's claim that the participation agreement was technically consistent with the credit agreement) that “[s]uperficially, this may be correct” suggests it is possible that an injunction application made on these grounds only -- absent application of the doctrine of good faith and fair dealing -- would have been unsuccessful.  Without seeing the actual text of the credit agreement, it is not possible to give a definitive view on the point. However, it is our view that careful drafting of the relevant provisions of participation agreements should ensure that the risk of a successful challenge by a borrower on these grounds is remote.

Moreover, this case has highlighted a weakness, from the borrower’s perspective, of the transfer provisions in the UK Loan Market Association (‘LMA’) standard form documents.  Namely, that any protection that a borrower is able to persuade a lender to grant in the form of consent rights to certain assignments can be circumvented by the lender entering into a participation agreement instead.  Historically, lenders have been extremely reluctant to accept any changes to the LMA transfer provisions – consent rights are viewed as a “top of the market” term by most lenders active in the UK market, and fettered rights to sub-participate are rarer still.  However, with the risk this poses to the borrower being so starkly exposed by this recent New York case, this is likely to be an area of hot debate in the future.
 

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Here's an easy one for you:  How many of you (lenders) think that you should have to get consent from the borrower to sell a participation in a loan?  I'll take the safe bet and guess "none" -- since it's such standard practice for lenders to sell participations to other lenders without borrower consent.  Really, you'd be hard pressed to find a credit agreement that said otherwise.

With that in mind, let's take a quick look at a recent case from a federal court in Manhattan that said just the opposite.  The Cablevisión case, reported on by the Wall Street Journal last month, says that despite the fact that the loan agreement plainly stated that the lenders could sell participations without consent from the borrower, the lender did in fact need borrower consent and was prohibited from selling a participation without it.

How can this be?  On the surface, this decision is surprising and a bit disturbing, since it seems to cut against both the specific terms the parties agreed to and the common market practice in this area.  To be fair, though, the participation in this case was not an ordinary loan participation, and the court was heavily influenced by the facts.  Much can be said about this case, but let's just focus in on a couple of issues that are particularly important for us here.

First, it turns out that the would-be participant was a major competitor of the borrower.  This topic isn't often addressed in loan agreements, and I think that's because it isn't a practical concern in most cases.  Unless the borrower's competitors (or their affiliates, as in this case) are in the lending business, negotiating limits on assignments or participations to competitors won't be high on the borrower's issues list.  Also, the lenders themselves generally aren't interested in participating the loan to a competitor of the borrower, as in some cases this could undercut the borrower's business (and the lenders' ability to get repaid).  Because the borrower's confidential information can be freely shared with participants and lenders alike, allowing a competitor into this group could be a bit like inviting the fox into the henhouse.  We all need to know who we're dealing with -- and what each person's affiliations are.

Second, we learn from the court's comments in this case that the lender had originally planned to do a full assignment of the loan, and, as required under the loan agreement, had asked for the borrower's consent to the assignment.  (In contrast to participations, where the lender remains party to the loan agreement and the participants just share risk behind the scenes among themselves, an assignment substitutes a new party to the loan agreement in place of the original lender and typically requires borrower consent.)  Not surprisingly, the borrower declined to consent to this proposed assignment to its competitor.

The lender then decided to sell the competitor a participation, which didn't require consent.  It seems clear that the lender in this case thought and fully intended that its participation would comply with the terms of the loan agreement -- and indeed the participation appeared to do so.  This participation was a bit unusual, though, since it was for 90% of the loan amount.  Also, the participation agreement included some very favorable terms for the participant.  Two terms in particular -- automatic assignment of the entire loan to the participant upon an event of default, and a very broad right to demand that the lender obtain and deliver additional confidential information from the borrower -- led the court to believe that this participation was really intended to be an "end-run" around the consent requirements applicable to assignments.

As mentioned in a prior post, loan agreements in the United States include an implied covenant of "good faith and fair dealing" which is deemed to be part of the loan terms regardless of what the agreement actually says.  Since there was nothing stated in the loan agreement that would prohibit the participation, the court instead based its decision on this implied covenant of good faith and fair dealing.  The court thought the lender's actions were unfair and granted a preliminary injunction against the participation. 

Though the facts of this case are unusual, the outcome is instructive.  Similar to the increase in lender liabililty cases that we're already seeing, we may start to see more judges applying the doctrine of good faith and fair dealing with a broader brush, as here.  And, yes, there might be some participations that require consent.

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