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

This post was written by Svetlana Attestatova, a member of Reed Smith's financial industry practice group, addressing several intellectual property issues that have come up in our deals recently.  

Sometimes we get rather technical questions, and this post responds to one of those: if the collateral for your loan includes patents, trademarks or copyrights ("IP"), read on.

Searches.  In addition to regular lien searches, you may want to run specific IP searches on your borrower and guarantors, especially if valuable IP is part of your collateral.  A search will confirm who the owner of the IP is, and will reveal the existence of other liens.  If IP is central to your deal, beware of the timing gap issues discussed below and consider running some additional post-filing searches after the applicable time period lapses.

Disclosure Schedules.  Accurate schedules listing the IP are important -- and sometimes difficult to obtain.  The underlying representations in the credit and security agreements will determine what should be disclosed on the schedules.  Sometimes the list is limited to registered U.S. IP; other times, it is limited to material IP.  The schedules and your search results should be reconciled.

How to Perfect.  The steps required to perfect your security interest in IP vary for different types of IP.  We will spare you the extensive legal explanation here and just say that the preferred practice is to file a UCC-1 financing statement (as you typically would for most other collateral) and also to file a short-form security agreement with the U.S. Patent and Trademark Office for patents and trademarks, and with the U.S. Copyright Office for registered copyrights.  The short-form agreement is prepared solely for the purpose of making these filings and does not include the covenants and other detailed terms that would appear in the more comprehensive security agreement for the deal.  Even though a PTO filing may not be absolutely required for perfection of patents or trademarks, it is advisable in order to help protect your interests against a good faith purchaser of a patent or trademark.  However, please note that unlike patents and trademarks, a Copyright Office filing is required for perfection of your interest in registered copyrights.  As always, it is critical to get the collateral description, the IP identifying marks and other necessary  information right on these filings.

Timing Gap Issues. One potential timing gap issue arises when there is a discrepancy between the closing date and the date through which the searches have been run.  This is purely an issue of the PTO and Copyright Office records being up to date.  A longer gap in time here increases the likelihood of things being missing from the search results.  A second timing gap issue is the grace period provided by both the PTO and Copyright Office that permits an assignment that was signed before your security agreement filing but unrecorded at the timing of your filing to trump priority of your recorded filing, as long as the competing assignment is recorded within the grace period (even if recorded after your filing). This grace period is three months for patents and trademarks and one month for copyrights.  To help with this issue, the lender would usually receive representations from the borrower that  no competing assignments have been granted.  Post-closing searches should reveal the existence of any of these filings.

Other IP; Special Cases. “Intent-to-use” trademarks deserve a special mention.  Although a security interest can be taken in this type of IP, you should be aware that foreclosure may be problematic until the mark has been put to use in commerce and there is goodwill associated with it.  If the collateral includes mask works, you'll want to make both Copyright Office and UCC filings.  For trade secrets, UCC filings are advisable.  And, generally, if you have other unusual (and valuable) IP collateral -- for a company that develops software, or where software is embedded into machinery with accompanying accounts receivable, for example -- consult with counsel to be sure you are properly perfected.

After-Acquired IP. The credit or security agreement will usually require the borrower to deliver periodic updates listing any newly acquired or registered IP (including a requirement to inform the lender as soon as an unregistered copyright became registered).  UCC-1 filings can be structured to effectively cover after-acquired assets in the initial filing, but new filings with the PTO or the Copyright Office will be needed to cover each additional IP item.

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By now many of you will have heard about the recent decisions in the TOUSA (pdf) bankruptcy case.  There are several other write-ups out there that cover the many important elements of this case in detail, but here I wanted to just say a few words about one issue of significance to senior secured lenders.  The question of whether subsidiaries can properly guarantee a loan made to the parent company (without it being a fraudulent conveyance) sometimes comes up in loan transactions, and having an understanding of the issues here can be really helpful. 

You'll recall that the TOUSA case is about fraudulent conveyances.  As explained in our last post, in simple terms, a bankruptcy court can void (and claw back) payments made if the debtor was insolvent at the time of the transaction and if it received less than "reasonably equivalent value" for what it gave up in the deal.  Setting aside the question of solvency, then, here's our issue:

QUESTION:  If a subsidiary of the borrower guarantees the loan (and/or provides a lien or other support), do you have to show that the subsidiary received some of the proceeds of the loan in order to demonstrate that it got "reasonably equivalent value" in the transaction? 

SHORT ANSWER:  No.  Reasonably equivalent value can be received through intangible and indirect benefits as well as by direct benefits such as cash proceeds.  

The court in the TOUSA case explained that you can take a relatively broad view of what constitutes "value."   In TOUSA, the company's subsidiaries became co-borrowers on the loan and provided liens on their assets.  The loan proceeds were used to pay off a significant liability.  The court found that the subsidiaries had received value in exchange for this because they had received "indirect economic benefits" from the loan.  The benefits were, among other things, "the opportunity to avoid default, to facilitate the enterprise's rehabilitation, and to avoid bankruptcy, even if it proved to be short lived" (here, the companies ended up in bankruptcy anyway).  The court clarified that it is not just cash, but all kinds of interests in property -- including intangible things like "promises to act or forbear to act" and indirect or contingent benefits -- that can be considered.  

But was the value "reasonably equivalent" to the property rights that were transferred?  In this case, yes.  A "legitimate and reasonable" expectation that default could be avoided and the enterprise strengthened by the transaction can be enough value.  For the TOUSA subsidiaries, absent the loan transaction, there was a realistic risk that the companies would not have been able to continue to survive.  The value to the companies was their ongoing existence, and the court found that this met the standard for being reasonably equivalent to what they gave up in the deal.  It was not necessary to quantify the benefits and determine a precise dollar valuation in order to come to this conclusion. 

Of course, as with all things legal, the analysis can get rather complex and the conclusions will vary depending on the facts at hand (full disclaimers, no promises, your results may vary, don't try this at home, etc.).  A takeaway from the TOUSA case is that you can look at a lot of different things when considering if there was value received -- and showing that there was "reasonably equivalent value" may not be quite as difficult as it sometimes seems.

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Like the New York Giants, equity cures have made a comeback here in the fourth quarter -- even without the help of Eli Manning. 

Source

An equity cure right is a provision that's included in the loan agreement for a sponsor finance deal, giving the private equity sponsor that owns the borrower the right to put in additional cash to cure a default under a financial covenant.  So, for example, if the company breaches its leverage ratio for the quarter (either because it has too much debt or too little EBITDA), the sponsor can make a cash contribution to the company after the quarter-end, and that cash will be added to the company's EBITDA number for that quarter (as if it represented actual earnings), to put the company back into compliance with the covenant.  Once the cash is contributed, the financial covenant default is considered cured.

Back in the day (remember 2006, anyone?) an equity cure right might have contained relatively few limitations on the sponsor's ability to exercise it.  It was not unusual for there to be a very large cap (or sometimes none at all) on the amount that could be contributed, with relatively long periods of time in which to put in the money.  Though there were often restrictions on the number of cures that could be made (both in the aggregate and the number per year), these were often negotiated to permit very frequent cures.  We also sometimes saw permission to put the cash in as subordinated debt rather than equity, and other bells and whistles, depending on the size and type of the sponsor.  All of this was heavily negotiated.

When the credit markets tightened up, we didn't see equity cure provisions in new deals very often.  Now we're seeing them again all over the place -- but with somewhat more restraint in what's permitted.  Though there are a few outliers, it's often the case that the cash must be contributed as equity, within a few days of the quarter-end financials being produced.   There is almost always a cap on the number of cures permitted -- often one per fiscal year and/or three over the life of the deal.   There may sometimes even be a requirement that the cash be used to pay down the amounts outstanding under the loan, rather than just treating the cash as additional EBITDA and keeping it on the books.  Though there's definitely willingness to allow equity cures again, lenders seem to be a bit less eager to permit very broad rights.

I'd be interested to know if any of you are seeing even more flexibility in equity cure provisions these days, and whether you think we'll end up with similar terms to what we saw in 2005-2006.  Email me or post  a comment here with your thoughts. 

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I'm delighted to announce the publication of my book Corporate Credit -- A CFO's Guide to Bank Debt and Loan Agreements.  

First of all, let me just say that after many months of preparation, it sure feels good to finally have it in print!   Becoming a published author was both more fun and more difficult than I thought it would be -- especially while working (more than) full time on other things, as those of you whose deals I worked on during the last year can attest.  (And if you're ever thinking of writing a book yourself, let me know, as I've got a whole lot of advice to offer on this topic now too.)

Anyway, if you enjoy reading this blog, you'll probably enjoy the book too.  In many ways, the book is an extension of the blog, covering some of the same kinds of topics in a different format.  

The book is intended to be a helpful guide for corporate borrowers and lenders alike, explaining in plain and easy-to-understand language what the terms of a corporate loan agreement mean.   There are chapters on things like representations and warranties, interest rates, financial covenants, events of default, reporting requirements, syndication, security interests, guarantees, and how to get ready for a closing.   Pretty much all the basics you'll need to know to understand your loan agreement and work your way through the loan process.

For those of you on the lender side, don't let the title throw you off -- this is not a how-to manual for CFO's to learn to beat up on lenders in tough negotiations!   (Sorry, CFO's.)  Instead, there are explanations about why certain provisions of a loan agreement are important for both sides, to help everyone have a better understanding of the terms and how to consider negotiating them.  Both lenders and borrowers will find this useful.

Corporate Credit was published on October 1, 2010 and is available for purchase on Amazon.com.

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What issues have you faced most often when trying to negotiate covenants in a loan agreement?  Do you find that many of your negotiations are about the tension between maintaining appropriate limits vs. providing sufficient flexibility for the business?  Do specific issues arise in setting baskets for other debt, liens and investments?    Permitting acquisitions?   Dealing with subsidiaries?   Agreeing on appropriate levels for financial covenants? 

For the borrower, it's often the case that a large part of the process involves thinking through what the company needs in order to maintain and grow its business.  This includes figuring out what the company will need during the entire life of the loan - looking ahead up to three or even five years and taking an educated guess. 

On the other side of the table, the lenders need to know that things at the company won't change in a way that adds an unacceptable level of risk - for example, that the company will maintain reasonable financial performance and won't get rid of revenue producing assets (well, at least without paying down the loan). 

If, for example, the borrower wants the ability to make significant acquisitions during the term of the loan, but the lenders think that for this company the acquisitions would create an unacceptable level of risk, these two differing viewpoints can lead to lengthy discussions.  If all goes well (as is often the case), these negotiations result in creative solutions being crafted that meet the needs of all the parties.  At the end of the day, there may be a few things can't be determined in advance that are set aside for later, with the lenders saying that the borrower should request consent if the anticipated event ever does occur.  But usually the parties try to keep as many items off this list as possible.

On October 6, I'll be speaking on the topic of negotiating covenants in this program.  Agreeing on the covenants is one of the most important - but also one of the most difficult - parts of a loan transaction.   If you let me know what issues you've faced, I'll try to cover those in the October 6 program and in future blog posts.  As always, you can post responses in the comments below or email me at salker@reedsmith.com.  Thanks for your input!

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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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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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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. 

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