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

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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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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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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When closing a leveraged buyout, if the buyer makes its payments to the company’s shareholders through a financial institution - even in an acquisition of a privately held company - those payments may be protected from being clawed back in a bankruptcy. 

The Quality Stores Case

A recent federal case involving Quality Stores Inc. was decided in favor of the shareholders on appeal, permitting them to keep the payments they received for their shares when the company was acquired.  This has long been the case for public company acquisitions, but now the rule has been extended to private companies as well.

The sale price for the Quality Stores acquisition was paid to the shareholders through a financial intermediary, who distributed the cash to the shareholders in exchange for their shares. The court found that use of the financial intermediary for payment and settlement was sufficient to entitle the shareholders to the protections of Section 546(e) of the Bankruptcy Code. This means that the payments cannot be unwound, and the cash cannot be pulled back into the company to be accessed by the company’s creditors.

What This Means For Financial Institutions

On one hand, it seems odd that the mere use of an intermediary would create such a result, when there is nothing else different about this transaction from most others.  Steve Bobo, who is one of my bankruptcy partners here at Reed Smith, has been watching this case for some time.  He recently explained that the exemption exists to protect financial institutions (i.e., the intermediaries) from instability and risk.  But, as Steve also points out, this particular transaction had no economic or substantive difference from any other private LBO.  The shareholders got paid for their stock just like in any other acquisition.

For financial institutions that act as intermediaries in settlements like these, this is good news. There is additional certainty that once you’ve transferred the funds to the shareholders, they can stay there.  However, for financial institutions that act as senior creditors, the fact that these funds cannot be brought back into the bankruptcy estate means there may be less cash from which you can have your loan repaid, and you have less likelihood of recovery.  Whether you cheer or decry this decision depends which side of the table you’re on in any particular deal.

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