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

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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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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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 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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