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

The New York Court of Appeals has decided (pdf) that under New York law, buyers of debt in the secondary market can also assert claims related to the loans they purchase.   As you might imagine, it's important that lenders who acquire loans know that they will not just be passive holders of the loans, but that they also will be able to take steps to enforce those loans if necessary.   In keeping with this concept, the Loan Syndications and Trading Association's standard form for assignment has long provided that both the debt and the related claims are assigned to the buyer.

At issue in this case was application of the centuries-old doctrine of champerty.   Not to be confused with "champignon" (a mushroom), "champing" (as in, "at the bit"), or "championship" (as in, "Will the Phillies beat the Yankees?"), this rather arcane legal doctrine was intended to prohibit attorneys from purchasing claims for the purpose of collecting the costs of litigating the claims.  Of course, that situation seems to bear little resemblance to a lender buying a loan and then asserting its right to collect the loan.

If you'd like to know more about this case, my colleagues Jordan Siev and David Kochman, both litigators in Reed Smith's New York office, have prepared a write-up of the details, including a brief but interesting history of the doctrine of champerty. 

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The U.S. Department of Energy has a new program to guarantee loans to support the development of renewable energy projects.   Lenders who meet the DOE's requirements for eligibility have been invited to submit applications for partial guarantees from the DOE for the financing of projects that will generate electricity or thermal energy, using commercial technology.   The loans must be structured as traditional senior secured indebtedness, and the guaranteed amount will vary but is capped at 80% of the principal amount of the loan.   The guarantees offered by the DOE are expected to support up to as much as $4-8 billion in lending to eligible projects.   If you'd like to learn more about this program, my partners Ellen Bastier and Ferd Convery from Reed Smith's energy practice group have written a helpful summary of the program.   

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In our last post on this topic, we discussed some basic provisions that provide protection for the bank group if a lender in a syndicated loan deal defaults.   Now let's take it to the next level.  What kinds of things could you add to your loan agreements that would give you even more protection, and better rights, if a lender defaults?

• Expanded Definition of Defaulting Lender.  Rather than narrowly defining a "Defaulting Lender" as one that fails to fund a loan or make a payment to the agent when required, consider adding insolvency, receivership, bankruptcy, liquidation, and takeover by the FDIC to the list of defaults.  These types of events, whether affecting the lender or its parent company, will often lead to a full-stop in lending activity and can create significant problems for the borrower and the rest of the bank group, even if no loan request is pending at the time.  You might also consider using an "impacted lender" standard to set the trigger for certain things (like the ability to remove or replace a lender) even earlier -- for example, upon the failure of the lender to adequately demonstrate that it is not going to become a defaulting lender.
   
• Payment Priority.  Instead of providing that all lenders always share pro rata in payments made by the borrower, you can include a provision that overrides pro rata sharing as to defaulted lenders, in the event there are any prepayments of the loan.  In this case, all the non-defaulting lenders would share (pro rata as among themselves) any prepayments made on the loan, up to the amount of the defaulted portion of the loan.  Or, as in some agreements, the defaulting lender's pro rata portion of the payment could be held by the agent as cash collateral for the obligations that lender owes to the agent, and could be applied to all funding and payment shortfalls until the lender's default is cured.
   
• Non-Ratable Reduction of Commitments.  Consider giving the borrower the right to non-ratably reduce and terminate the undrawn commitments of the defaulting lender.  On an undrawn revolving line of credit, this would effectively eliminate the defaulting lender from the group without having to find a replacement lender willing to purchase the commitment.  One downside  to this approach is that the size of the credit facility will be reduced by the amount of the terminated commitment, which could pose a problem for some borrowers.   Also note that if any loans are outstanding, the other lenders probably won't be willing to agree up front that the defaulting lender can be paid back in full on a non-pro rata basis, as this could be a significant, and unfair, windfall for the defaulting lender (particularly in workout situations).  Outstanding loans would still need to be paid down pro rata as among all lenders, unless the lenders agreed to waive this at the time.
   

• Permit the Other Lenders to Fund the Defaulted Piece.  You might consider adding provisions to the loan agreement to allow the non-defaulting lenders to step in and fund the loans that the defaulting lender failed to make.   This is very helpful to the borrower, as otherwise it will receive less money than it actually needs each time it requests a borrowing and the defaulting lender fails to fund.   The decision as to whether or not to fund any of these additional loans is left to the discretion of each lender, as no one is ever required to exceed their original commitment amount.  Funding can be pro rata or not, if not everyone chooses to participate.   It is very helpful to permit the lenders who decide to fund the defaulted portion of the loan to be paid a higher rate of interest (perhaps at the default rate) and to receive priority in right of payment as to these additional loan amounts, resulting in that the additional loans being paid back first and carrying a higher rate of return than the rest of the loans under the facility.

We've seen variations of all of these in loan agreements recently.  Many lenders and agents are requiring that some form of enhanced defaulting lender terms be added when amending their existing loan agreements, as the current market continues to increase the potential for lender defaults.

Next up, we'll explain what to do when the defaulting lender has been taken over by the FDIC.  Lots of special rules apply in that case; we'll tell you what they are and how to work within them.

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This post was written by Joel Schaider, a partner in the Financial Industry Group here at Reed Smith.

With failed financial institutions approaching record numbers, the Federal Deposit Insurance Corporation (“FDIC”) has been required to step in and seize the assets of these institutions.  The single largest categories of assets held by a failed financial institution are its performing and non-performing loans.  These loans are in the process of being sold to the public in bulk through a sealed bid process.

How to Find Information on Loan Sales  

The FDIC’s website contains information on current loans which are available for bid.  The loans of each failed institution are grouped into pools by loan type (e.g. commercial and industrial, consumer, residential, agriculture).  The website contains a list of offering announcements which are currently available for bid including the name of the financial institution which originally held the loans, the number of loans in each pool, a general description of the loan type, a description of the nature of the collateral securing the loans, the location of the collateral and the percentages of seasoned performing and non-performing loans in each group.  There are also key dates listed for the commencement of due diligence and the due date for the submission of a bid.

Additional information on loan sales may be obtained from two loan sales advisors (First Financial Network and DebtX) who the FDIC has retained to manage the sales process. The offering announcement for each loan sale will identify the sales advisor who has been assigned to manage the particular sale. 

How the Sale Process Works

• Purchaser Qualification.   The first step in the sale process to for the purchaser to become qualified.  First Financial and DebtX have established similar qualification requirements, however, it is advisable for the purchaser to qualify with both advisors.  Once the qualification requirements have been met, purchasers will be given passwords and access instructions to the loan due diligence and other information pertaining to a particular loan sale.
   
• Timing.  Generally, the period of time involved in bidding and purchasing a group of loans from the FDIC is approximately 6 to 8 weeks from the time the offering is first announced. The initial period of due diligence is typically 4 to 5 weeks in length with the bids to be submitted on a specified date after the expiration of the due diligence period. Generally, it takes two weeks for the bid to be awarded. The closing would then occur within a short period after the bid is awarded.
   
• Due Diligence.   The FDIC makes no representations or warranties in connection with the purchase of any loans and all of the risk of loss associated with the loans are passed to the purchaser upon closing.  The rights and remedies available to the purchaser are solely contained in the underlying loan documents and the associated collateral.  Therefore, a review of the loan files including the collateral is a critical element which must be completed prior to the submission of a bid. 
  
  The due diligence process may vary depending on the size and characteristic of the loans contained in each portfolio. Larger-sized commercial loans may require greater scrutiny than smaller consumer loans. However, a large number of consumer loans, for example, may contain defective terms which could affect the enforceability of all the loans in the portfolio. The loan files may be missing signed documents or important pieces of collateral. Experienced counsel needs to be involved in order to conduct due diligence in an efficient and effective manner.
  
  The due diligence files are obtained through the financial advisor assigned to the particular sale. The files are typically available on a secured website, on a separate hard drive (which may be purchased) or in a physical location.
   
• Bid Submission.  Upon completion of due diligence, an interested purchaser needs to submit a bid.  An initial deposit of $100,000 is required from each bidder to be sent by wire transfer at the time of bid submission.  The deposit is fully refundable, without interest, if the purchaser’s bid is not accepted.  If the purchaser’s bid is accepted, a final deposit equal to 10% of the purchase price of the loan portfolio, less the amount of the initial deposit, is required to be deposited within one business day following the bid award.
   
• Closing.  Closing occurs on a specified date within a short period of time after the bid is accepted by mail or in person at a place designated by the sales advisor.  The balance of the purchase price is due at the time of closing. All loan documentation such as notes, collateral documents and loan files will be delivered to the purchaser within a reasonable time after closing.

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Lenders often express concern about potential defaults under their loan agreements – but it’s usually default by the borrower that they’re concerned about, not default by the lenders.  It's a sign of the times that this has now become a significant issue.  With an increase in the number of bank failures and FDIC receiverships over the past year, we’ve begun to see an increase in the number of lender defaults in syndicated loan deals.  If you're a lender (or a borrower) in a syndicated credit facility, you might well find yourself facing this situation.

If a lender in your bank group defaults, what can you do – and what can’t you do?

As an initial matter, it’s important to keep in mind that default by a lender does not excuse anyone else from performance.  The remaining lenders still have to fund loans when requested, and the borrower still has to make payments and comply with all the covenants.  However, depending on what your loan agreement says, you may be able to mitigate the effects of the default.  Here are some typical provisions that many loan agreements already contain:

1. Limitation on Voting Rights.  Many loan agreements provide that a defaulting lender’s commitment is not counted when determining whether a required/majority lender vote has been achieved.  Some loan agreements also provide that the defaulting lender simply does not have the right to vote on any issue – even issues otherwise requiring a 100% vote (perhaps with some very limited exceptions such as for increases of that lender’s commitment).  This is extremely helpful, because if the lender has gone into bankruptcy or has been taken over by the FDIC, it will be very difficult, if not impossible, to get that lender to vote on even the simplest of amendments.
    
2. Replacement of Lenders.  Most syndicated credit agreements permit the borrower to remove a defaulting lender from the credit facility, under so-called “yank-a-bank” provisions. Removal of the lender would be accomplished through a forced assignment of its commitments and outstanding loans to another lender.  Taking the defaulting lender out of the deal would certainly solve a lot of problems.  However, the practical reality is that it can be difficult to find another lender willing to purchase the commitment at par as required – and this is particularly true when the loan is trading at a large discount in the secondary market (whether due to market conditions, as has been true recently, or due to a decline in the borrower’s performance).
    
3. Commitment Fees.   Though some agreements are silent on this point, several credit agreements include provisions permitting the borrower to stop paying a commitment fee to the defaulting lender. This seems appropriate, as borrowers otherwise find it rather unfair to have to pay a fee for a commitment that the lender has demonstrated it will not honor.  A few loan agreements provide instead for the fee to be paid in the same amount as always, but for it to be shared only among the non-defaulting lenders.  This provides something of a windfall for the non-defaulting lenders - which may be why this formula is less popular.  
    
4. Letters of Credit and Swingline Loans.  It is relatively common to require the borrower to cash collateralize the portion of an outstanding letter of credit or swingline loan that would otherwise have been backed by the defaulting lender’s commitment.  This protects the issuing bank or swingline lender from having to bear additional risk for that portion of the loan/commitment, beyond its pro rata share.  Some agreements provide that letters of credit cannot be issued at all (and swingline loans cannot be made) if there are any lender defaults, but this approach is used less frequently these days, as losing access to letters of credit can make things very difficult for certain types of borrowers.

At a minimum, you’ll want to make sure your loan agreements cover these important topics.  If these provisions aren't already in an existing agreement, you might consider taking the opportunity to add them the next time there is an amendment. 

In our next post, we’ll offer some suggestions for how to further improve protections for the bank group and the borrower in the event of a lender default, beyond these basic provisions.
 

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