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

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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On Wednesday, I spoke at an international conference on microfinance.   The conference was a veritable United Nations, with representatives from the microfinance community around the world in attendance.   We even had those little earpieces for language translation.  My role at the conference was to discuss how loans and workouts are done in corporate finance, and whether there are differences in lending to microfinance institutions (covering just the institutional loans this time, not the microloans the institution makes to its individual clients).   I was surprised to find many similar issues, despite the sometimes vastly differing circumstances.  

Is there anything that we, in the corporate finance world, can learn from microfinance lending?  

1.  Use intercreditor agreements.   Workouts involving microfinance institutions highlight the  importance of using intercreditor agreements among lenders.   It's very common for a microfinance institution to have received loans from several different creditors, some domestic and some international, but all without any intercreditor arrangements in place.   One person I met was from a microfinance institution in Eastern Europe that is running into some financial issues.  She's trying to address those issues with ten lenders who each have differing views and approaches.  The lack of a common understanding among the lenders as to what to do in this situation creates problems for the lenders themselves, as well as for the borrower institution. 

2.  Use similar loan documents whenever possible.   When several lenders make loans to a single borrower, it becomes all the more vital that the terms of the loans match up.  Borrowers and senior secured lenders sometimes insist on this approach in corporate lending, but this hasn't happened much (yet) in microfinance.  Microfinance institutions often find themselves with loan documents that contain a wide variety of covenants and terms - each one different from the last.   Several institutional borrowers at the conference mentioned that keeping track of (and complying with) eight or ten different sets of reporting requirements takes up time and resources that would be better spent serving the institution's clients.  Trends toward standardization of loan documents and the increased use of syndicated loan structures may help with this issue over time.

3.  Defined legal structures make a big difference.  Microfinance loan workouts can be significantly complicated by absence of the legal structures that we take for granted in the US and Western Europe.  Several countries don't have Chapter 11-like procedures for bankruptcy -- or if they do, the process isn't always available to microfinance institutions, especially nonprofits.  In many places, it isn't legally possible to obtain a perfected security interest in accounts, which are the primary assets a microfinance institution is likely to have.  Even if you do have a security interest, your priority over other creditors isn't assured.   Also, the entire process can be affected in unexpected ways by local political events and regulatory changes.  Though we are occasionally surprised by bankruptcy court decisions in the US, we benefit from relative certainty as to who has priority and how the legal process will treat our claims.

Borrowers and creditors all over the world, in microfinance and in corporate finance, share many of the same concerns.   We have much to learn from each other.

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This week I am delighted to be in New York attending the WWB Microfinance and Capital Markets Conference. 

For those of us who normally spend our time on corporate lending and workouts, microfinance offers a rare opportunity to use our skills to improve the lives of people who are truly in need.  Micro loans have helped thousands of families around the world to build up small enterprises, move out of poverty, and be able to afford food, education and healthcare for their children.  Because these loans have a remarkably low default rate (often less than 2%), the funds provided to a microfinance institution are returned to be loaned out again and again -- to help even more people. 

Many institutions that make loans to the poor are backed by loans or other types of investments from other entities -- from commercial banks and financial institutions, microfinance investors, donors, and others.  Tomorrow I will be speaking on a panel of commercial lenders and microfinance institutions, discussing the issues that arise when a microfinance institution defaults on a loan.   As you can imagine, workouts in this context are quite different from those we usually see in corporate America.   There are some interesting lessons we can learn from this; I'll have more to say on this topic in my next post.

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This post was written by my partner Ben Brimeyer, a member of the Financial Industry Group in Reed Smith's Chicago office.

In today's challenging economic climate, private equity sponsors are trying to figure out how to fill funding gaps in acquisition financings -- and how to provide additional capital to their troubled portfolio companies.  In lieu of providing additional equity, some sponsors are requesting the ability to participate as a lender in the senior debt facilities of the portfolio company.  Also, on occasion, it's the lenders who need to find someone to take a piece of a new loan, and the equity sponsor is the only one standing by ready to do so.

If the lenders decide to allow the sponsor to become a lender in their debt facilities, what steps should they take to best protect themselves, given the different hats this new lender will be wearing?

Voting rights. Given the sponsor's ability to control the borrower, the sponsor should not have the same set of voting rights available to the other lenders.  The sponsor should have the ability to protect its investment, but should generally be a silent participant, without the ability to interfere with actions the lenders may need to take.  The sponsor’s commitment should be removed from the calculation of required lenders, and the voting terms should provide that the vote of the sponsor won’t be required other than for a very specific set of items (typically 100% vote issues):

• Increase the commitment of the sponsor-lender
• Reduce the interest rate on the sponsor-lender's loans
• Reduce the principal amount owing to the sponsor-lender
• Change the pro rata treatment of the loans
• Subordinate the loans

Information/Meetings. It is important to ensure that the sponsor, as both the equity owner and a lender, does not have the same access to information, rights to attend bank group meetings and ability to require action by the agent as the other lenders have.  In this regard, the sponsor-lender should not be allowed to:

• Require the agent or any lender to take any action or exercise any remedy
• Attend any meeting between the agent and the lenders to which the borrower is not invited
• Receive any information or communication from the agent or any lender that is not sent to or by the borrower (i.e., shared among the lenders only) 
• Provide information obtained in its capacity as a lender to any member of management of the borrower

Bankruptcy. In a bankruptcy, the sponsor-lender’s interests differ significantly from the rest of the lenders, since the sponsor as equity owner receives a different set of rights. To protect the lenders from actions which may be taken by the sponsor-lender in a bankruptcy, the sponsor should agree not to impede any actions being taken by the agent, so long as the sponsor-lender is being treated equally with the other lenders.  The sponsor-lender should also agree that its vote in bankruptcy shall be cast in the same proportion as that by the other lenders, which results in the sponsor essentially being dragged along proportionally to the votes of the other lenders. This is particularly important if the sponsor-lender will hold more than one third of the debt, providing a potential blocking position on issues requiring a lender vote in a bankruptcy.

Allowing the sponsor to participate in the senior loans may be essential to completing a transaction or providing a portfolio company with additional liquidity.  It can be done, but with careful consideration of the challenges it presents to the rest of the lender group.
 

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In my last post, I gave some suggestions for reducing the risk of lender liability in a workout situation.  This time, let's talk some more about what to do when you're working through a workout, and focus on what happens when you're getting ready to seek remedies.  

As a general rule, it is a good idea to act "reasonably" in a default situation.  

There is usually an implied requirement of "good faith and fair dealing" in a contract-based relationship, whether under general state contract law or under the UCC.  Good faith and fair dealing essentially requires that you follow commercially reasonable standards of behavior and be fair to the borrower.  In some states it means that you have to act "honestly" (the definition varies).   This concept is applied to your agreement regardless of what the contract otherwise appears to say.   And this is true all the time, of course, not just after a default. 

Here's an example of how this plays out in a loan agreement.  Secured loan agreements usually say that any kind of default gives the lender the right to terminate the loan and foreclose on all the assets.  In practice, however, even though the agreement would appear to permit a lender to foreclose on assets if (for example) the borrower is just five days late in delivering its financial statements, it would be unusual for a lender to do so.  Indeed, many courts would find that type of action to violate the implied covenant of good faith and fair dealing, as the remedy would appear to the court to be out of proportion to the harm suffered by the lender.  That said, the law does respect your right to negotiate your own terms, and a judge won't normally rewrite the terms you agreed to.  You shouldn't be asked to do more than what you agreed to, but you will be required to do what you agreed to do fairly and in good faith. 

What else can you do to reduce the risk of lender liability when seeking remedies after a default?

• Give notice.  Even though notice may not be required under your loan agreement, in some situations it may be wise to give the borrower some notice before taking any action.  This is especially true if you are contemplating actions like foreclosure, that have harsh results.  Depending on the situation (and this does differ from case to case), giving notice may be fairly easy and may not do any harm to the lender's position -- and it may help demonstrate to a court later that the lender acted reasonably, giving the borrower a chance to explore alternatives.
   
•  Follow a consistent procedure.  It helps if you have established policies and procedures for seeking remedies and for the decision process to get there.  This seems like a good business practice generally, as it not only establishes consistency in dealing with borrowers, but it also helps to ensure that the options you want to have considered are actually considered -- and that a measured and appropriate response is given.  Also, be aware that if your normal practice is to ignore defaults of the type at issue and then you suddenly deviate from that practice and terminate the loan, some courts have found this behavior objectionable.
   
• Figure out what the assets are worth, and what you're likely to be paid.  If you have sufficient security and you are unlikely to lose anything if you forbear or take lesser steps against he borrower, you might want to consider these other options.  Some courts may find your exercise of remedies inappropriate if it can be shown that you would've had full recovery by forbearing on the default; similarly, your exercise of remedies can be called into question if you recover more than the loan agreement would've given you otherewise.   In these situations, you might do some clever thinking to see if you can get an appropriate result with less harm to the borrower.  For example, maybe forbearance makes sense, or maybe you can do things over a longer period of time, foreclose on only certain types of assets, or seek other types of remedies, while otherwise allowing the business (or portions of it) to continue.  Lots of options here.

There's no way to completely eliminate the risk of liability, but taking careful action can help mitigate this risk.  Applying principles of "good faith and fair dealing" will help.

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