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! 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

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.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Tough times bring all sorts of things out of the woodwork.  Some of you will remember that back in the 80's and early 90's there was a flurry of "lender liability" lawsuits, with lenders being sued when they exercised remedies after a default on a loan.  There were a lot of these cases filed across the country during that time.  But by the mid 90's, these lawsuits appeared to have gone the way of the dinosaur.  Times were good and defaults were few.  Well, guess what . . . they're back.   We shouldn't be surprised, given the increase in the number of loan defaults.  In fact, we probably should expect to see more of these cases in the coming months.

How can you protect yourself against lender liability claims?  

One common basis for a lender liability lawsuit is what the lender did after the borrower defaulted on the loan.   If the lender behaves in a manner that later appears to have been unfair or inappropriate (perhaps "not in good faith", coercive, or in breach of a promise - more on this in future posts), a claim can result.   So, what types of things should you do after a default or in a workout situation?

• Engage in discussions.   When a borrower goes into default on a loan, what is your typical response?   With many lenders, the first thing that happens is a conversation with the borrower.  Sometimes this turns into a long series of discussions, followed by forbearances or partial waivers, as the lender and borrower attempt to sort things out and avoid a negative outcome.   And repeated defaults add pressure to subsequent discussions.   Regardless of how things go, it is often a good idea to engage in at least some discussion with the borrower.   For one thing, a discussion might actually result in the situation being "worked out" to a solution that's reasonably satisfactory to both parties.  Of course, this is usually the goal!   But even if the situation can't be worked out, engaging in negotiation and talking through the options can help you demonstrate later that your response to the default was reasonable and appropriate under the circumstances.
   
• Consider a prenegotiation agreement.   Not all defaults will require prenegotiation agreements, but in some cases you'll find it helpful to document what your understanding is before entering into workout discussions.   As discussions proceed, sometimes misunderstandings can result -- the borrower might think that the lender has promised something when that isn't the case, or may think the lender has agreed to waive the default when the lender thinks it hasn't.  Among other things, prenegotiation agreements help establish the scope of the discussions and what (if anything) can be agreed to orally vs. in a formal waiver document.   A prenegotiation agreement can also clarify who is authorized to make promises on behalf of the lender.   
   
• Speak carefully.  Sometimes lender liability cases arise from things the lender's representative said in the course of workout negotiations.  It can come down to just being careful not to speak in broad terms, avoiding over-promising or over-stating what you are actually willing to do.  In this regard, it is often helpful to establish (perhaps in a prenegotiation agreement) that nothing is considered agreed to or binding until it is in writing.   
   
• Write it down.  If you decide to forbear from exercising remedies for a period of time while trying to work things out, it's a good idea to put the forbearance in writing and include an express reservation of your rights in connection with the default.  Sometimes the argument is made that the lender gave tacit consent to ongoing defaults -- by ignoring them repeatedly, or by doing nothing about new defaults -- and that this action (or inaction) was effectively a waiver.  You can help avoid this by recognizing in writing the ongoing existence of defaults and stating that you're reserving all your rights under the loan documents.

These are just a few suggestions -- hardly an exhaustive list.  And, as we know, not every default can be worked out.  Next up, we'll explain more about lender liability cases and get into how to mitigate the risk when you've decided to accelerate the loan, foreclose or seek other remedies. 

• Email This
• Print
• Comments
• Trackbacks
• Share Link