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

Do you require a promissory note from the borrower when you make a loan under a syndicated credit facility? In syndicated deals, promissory notes -- like bell-bottom pants and polyester suits with wide lapels -- really seem to have gone out of style.

In a syndicated loan deal, the note is often just a very simple document with one or two paragraphs. It says what the amount of the lender's loan is and that it is payable by the borrower “as set forth in the loan agreement” -- meaning, go look at the loan agreement for all the actual deal terms, because you sure won't find any of them here.

Though this was not the case a few years ago, these days issuance of notes in a syndicated loan deal is almost always optional, at the request of the lenders. Some lenders still request notes for their records, but most lenders don't require them anymore. Instead, they rely on the loan agreement itself as sufficient evidence of the debt. Certainly, not having to keep track of notes (issuing new ones whenever new lenders come into the deal, making sure old ones are found and returned for cancellation, exchanging old for new when commitments are increased or decreased, etc.) is easier, saving time and money.

The role of a promissory note varies depending on what type of deal it is, though.

In smaller, simple deals, a promissory note itself might constitute the entire loan documentation, containing all of the deal terms. This is often the case with unsecured loans made by early-stage investors, and it's particularly common if the note is supposed to be freely transferable to others. Bank loans, by contrast, would rarely be documented with a promissory note alone. In a deal involving a bank or other institutional lender, there is almost always a loan agreement that contains covenants, events of default and other terms generally applicable to the loan, regardless of how small the loan amount may be.

On occasion, you’ll see a hybrid approach, with some of the loan terms stated in a loan agreement and some in an accompanying note. This is an alternative method for drafting loan documents that is sometimes used in deals involving a single lender, if the lender prefers this form of documentation. In this case, the loan agreement will contain the representations and warranties, covenants, and defaults, and other general terms relating to the borrower, and the note will contain the loan amount, borrowing and repayment terms, interest rate information, and other terms specifically relating to the loan itself.

But in syndicated deals, where the note contains nothing new that the loan agreement does not already say, promissory notes are uncommon.
 

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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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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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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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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 our prior posts on this topic, we focused on what your loan agreements might say about how to deal with a defaulting lender.  In this post,  we'll talk about what happens when a member of your bank group goes into default because it is taken over by the FDIC.  Special rules apply in that case.

Automatic Stay.  The Federal Deposit Insurance Act  provides for an "automatic stay" whenever a lender is taken over by the FDIC.  In part, the statute says that no one may "exercise any right or power to terminate, accelerate, or declare a default under any contract" that the failed institution is a party to, for a period of 90 days after appointment of the FDIC as receiver (45 days, if it is a conservatorship).  

My colleagues Colleen McDonald and Nikki Kolhoff have explained (pdf) that this means you can't do anything that would affect the contractual rights of the defaulting lender, if such action is based solely on the insolvency or FDIC takeover.  So, for example, you can still amend your loan documents, but you have to invite the defaulting lender to vote, and the amendment can't affect the rights of the defaulting lender without that lender's consent.  According to McDonald, the bottom line here is "if you are going to amend your loan agreement, make sure you do it correctly."  She points out that both the "D'Oench Dhume doctrine" (D'Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942)) and 12 U.S.C. Section 1823(e) impose specific requirements on modifications of loans involving financial institutions taken over by the FDIC.  Contracts that don't meet the requirements can be avoided altogether by the FDIC - so it's worth taking the time to make sure those requirements are met.

In addition, even if the loan agreement would otherwise permit you to stop sharing payments with a defaulting lender, if the lender is taken over by the FDIC, you'll still have to share all principal and interest payments with it -- at least, to the extent of the obligations it has previously funded.  (As discussed in our prior post, the loan documents should ordinarily prohibit the defaulting lender from sharing in principal and interest payments relating to advances it did not fund.) 

As a practical matter, the automatic stay can create significant problems for a bank group, particularly if the defaulting lender is the administrative agent for the credit facility.  Since the agent manages the funding and payment processes, and often holds the borrower's bank accounts and controls other collateral for the loan, an FDIC takeover could bring everything to a halt - at least temporarily.  

McDonald recommends that to help protect against these problems, the loan agreement should include the right to declare the lender in default early -- before FDIC takeover.  This would allow the bank group to take action before the automatic stay kicks in.  For example, if the agent in a syndicated loan goes into default (pre-FDIC takeover), its rights as agent could be terminated and assigned to a successor, and all the collateral could be transferred to the new agent -- thus permitting the credit facility to function pretty much as usual through the FDIC takeover.  McDonald suggests including a definition of  "Impaired Agent" in the loan agreement that would include an agent that fails to make payments or fund loans required under the loan documents, or that rescinds or repudiates a loan document.

Exceptions.  There are other sections of the Federal Deposit Insurance Act that provide exceptions to the automatic stay, including an exception for when the FDIC as conservator/receiver fails to comply with otherwise enforceable provisions in the loan agreement.  Sometimes these exceptions can provide relief for the bank group, though their full effect is as yet untested.   I have a feeling we'll get the chance to test some of these provisions over the next few months.

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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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In our last post on this topic, we discussed some basic provisions that provide protection for the bank group if a lender in a syndicated loan deal defaults.   Now let's take it to the next level.  What kinds of things could you add to your loan agreements that would give you even more protection, and better rights, if a lender defaults?

• Expanded Definition of Defaulting Lender.  Rather than narrowly defining a "Defaulting Lender" as one that fails to fund a loan or make a payment to the agent when required, consider adding insolvency, receivership, bankruptcy, liquidation, and takeover by the FDIC to the list of defaults.  These types of events, whether affecting the lender or its parent company, will often lead to a full-stop in lending activity and can create significant problems for the borrower and the rest of the bank group, even if no loan request is pending at the time.  You might also consider using an "impacted lender" standard to set the trigger for certain things (like the ability to remove or replace a lender) even earlier -- for example, upon the failure of the lender to adequately demonstrate that it is not going to become a defaulting lender.
   
• Payment Priority.  Instead of providing that all lenders always share pro rata in payments made by the borrower, you can include a provision that overrides pro rata sharing as to defaulted lenders, in the event there are any prepayments of the loan.  In this case, all the non-defaulting lenders would share (pro rata as among themselves) any prepayments made on the loan, up to the amount of the defaulted portion of the loan.  Or, as in some agreements, the defaulting lender's pro rata portion of the payment could be held by the agent as cash collateral for the obligations that lender owes to the agent, and could be applied to all funding and payment shortfalls until the lender's default is cured.
   
• Non-Ratable Reduction of Commitments.  Consider giving the borrower the right to non-ratably reduce and terminate the undrawn commitments of the defaulting lender.  On an undrawn revolving line of credit, this would effectively eliminate the defaulting lender from the group without having to find a replacement lender willing to purchase the commitment.  One downside  to this approach is that the size of the credit facility will be reduced by the amount of the terminated commitment, which could pose a problem for some borrowers.   Also note that if any loans are outstanding, the other lenders probably won't be willing to agree up front that the defaulting lender can be paid back in full on a non-pro rata basis, as this could be a significant, and unfair, windfall for the defaulting lender (particularly in workout situations).  Outstanding loans would still need to be paid down pro rata as among all lenders, unless the lenders agreed to waive this at the time.
   

• Permit the Other Lenders to Fund the Defaulted Piece.  You might consider adding provisions to the loan agreement to allow the non-defaulting lenders to step in and fund the loans that the defaulting lender failed to make.   This is very helpful to the borrower, as otherwise it will receive less money than it actually needs each time it requests a borrowing and the defaulting lender fails to fund.   The decision as to whether or not to fund any of these additional loans is left to the discretion of each lender, as no one is ever required to exceed their original commitment amount.  Funding can be pro rata or not, if not everyone chooses to participate.   It is very helpful to permit the lenders who decide to fund the defaulted portion of the loan to be paid a higher rate of interest (perhaps at the default rate) and to receive priority in right of payment as to these additional loan amounts, resulting in that the additional loans being paid back first and carrying a higher rate of return than the rest of the loans under the facility.

We've seen variations of all of these in loan agreements recently.  Many lenders and agents are requiring that some form of enhanced defaulting lender terms be added when amending their existing loan agreements, as the current market continues to increase the potential for lender defaults.

Next up, we'll explain what to do when the defaulting lender has been taken over by the FDIC.  Lots of special rules apply in that case; we'll tell you what they are and how to work within them.

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Lenders often express concern about potential defaults under their loan agreements – but it’s usually default by the borrower that they’re concerned about, not default by the lenders.  It's a sign of the times that this has now become a significant issue.  With an increase in the number of bank failures and FDIC receiverships over the past year, we’ve begun to see an increase in the number of lender defaults in syndicated loan deals.  If you're a lender (or a borrower) in a syndicated credit facility, you might well find yourself facing this situation.

If a lender in your bank group defaults, what can you do – and what can’t you do?

As an initial matter, it’s important to keep in mind that default by a lender does not excuse anyone else from performance.  The remaining lenders still have to fund loans when requested, and the borrower still has to make payments and comply with all the covenants.  However, depending on what your loan agreement says, you may be able to mitigate the effects of the default.  Here are some typical provisions that many loan agreements already contain:

1. Limitation on Voting Rights.  Many loan agreements provide that a defaulting lender’s commitment is not counted when determining whether a required/majority lender vote has been achieved.  Some loan agreements also provide that the defaulting lender simply does not have the right to vote on any issue – even issues otherwise requiring a 100% vote (perhaps with some very limited exceptions such as for increases of that lender’s commitment).  This is extremely helpful, because if the lender has gone into bankruptcy or has been taken over by the FDIC, it will be very difficult, if not impossible, to get that lender to vote on even the simplest of amendments.
    
2. Replacement of Lenders.  Most syndicated credit agreements permit the borrower to remove a defaulting lender from the credit facility, under so-called “yank-a-bank” provisions. Removal of the lender would be accomplished through a forced assignment of its commitments and outstanding loans to another lender.  Taking the defaulting lender out of the deal would certainly solve a lot of problems.  However, the practical reality is that it can be difficult to find another lender willing to purchase the commitment at par as required – and this is particularly true when the loan is trading at a large discount in the secondary market (whether due to market conditions, as has been true recently, or due to a decline in the borrower’s performance).
    
3. Commitment Fees.   Though some agreements are silent on this point, several credit agreements include provisions permitting the borrower to stop paying a commitment fee to the defaulting lender. This seems appropriate, as borrowers otherwise find it rather unfair to have to pay a fee for a commitment that the lender has demonstrated it will not honor.  A few loan agreements provide instead for the fee to be paid in the same amount as always, but for it to be shared only among the non-defaulting lenders.  This provides something of a windfall for the non-defaulting lenders - which may be why this formula is less popular.  
    
4. Letters of Credit and Swingline Loans.  It is relatively common to require the borrower to cash collateralize the portion of an outstanding letter of credit or swingline loan that would otherwise have been backed by the defaulting lender’s commitment.  This protects the issuing bank or swingline lender from having to bear additional risk for that portion of the loan/commitment, beyond its pro rata share.  Some agreements provide that letters of credit cannot be issued at all (and swingline loans cannot be made) if there are any lender defaults, but this approach is used less frequently these days, as losing access to letters of credit can make things very difficult for certain types of borrowers.

At a minimum, you’ll want to make sure your loan agreements cover these important topics.  If these provisions aren't already in an existing agreement, you might consider taking the opportunity to add them the next time there is an amendment. 

In our next post, we’ll offer some suggestions for how to further improve protections for the bank group and the borrower in the event of a lender default, beyond these basic provisions.
 

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In the past year, we’ve seen many changes in how interest rates are calculated. Volatility in the quoted rates for LIBOR created problems for several lenders, who suddenly found that the interest rates they were earning on some of their outstanding loans didn’t cover their cost of funds.

There are many possible ways to remedy this problem, most of which I’m sure you’re all familiar with by now.   For example:

• You can set a rate floor for both LIBOR and base rate loans, to protect against significant decreases in the quoted rates. 
• You can require that the interest rate be based on “the higher of” LIBOR or the base rate. 
• You can use the rates quoted to a few carefully chosen reference banks as the basis for calculating LIBOR, rather than the typical published rates. 
• You can require one-month LIBOR rather than offering longer interest periods.
• For larger companies, you can calculate the margin based on the credit default swap rate for that company – or you can use a credit default swap index rate. 

There are deals out there containing all of these and more.  And these approaches work equally well in single-lender deals as in syndicated deals.

However, in a syndicated loan, there is additional tension between the need for each of the lenders to have its own cost of funds covered, and the problem that would be created for the borrower (and perhaps other lenders) if a situation affecting only one member of the bank group could be used to drive the interest rate up on the entire credit facility.   The “market disruption” clauses in a few older deals are not entirely clear on this point, but the current standard is to provide for some consensus that the problem affects many of the lenders in the group before taking action.  

One fairly common way to address this issue is to include a provision like the following, which appears in the Alliance Data Systems Corporation credit agreement.  This provision requires a majority of the lenders to share the problem before triggering a switch from LIBOR to the base rate.

Alternate Rate of Interest.  If before the beginning of any Interest Period for a Eurodollar Borrowing:
(i) the Administrative Agent determines (which determination shall be conclusive absent manifest error) that adequate and reasonable means do not exist for ascertaining the Adjusted LIBO Rate for such Interest Period; or
(ii) Lenders having 50% or more of the aggregate principal amount of the Loans to be included in such Borrowing advise the Administrative Agent that the Adjusted LIBO Rate for such Interest Period will not adequately and fairly reflect the cost to such Lenders of making or maintaining such Loans for such Interest Period;
the Administrative Agent shall promptly give notice thereof to the Borrower and the Lenders, and, until the Administrative Agent notifies the Borrower that the circumstances giving rise to such suspension no longer exist, (a) the obligations of the Lenders to make Eurodollar Loans, or to continue to convert outstanding Loans as or into Eurodollar Loans shall be suspended and (b) each outstanding Eurodollar Loan shall be converted into a Base Rate Loan on the last day of the then current Interest Period applicable thereto. Unless the Borrower notifies the Administrative Agent at least three Business Days before the date of any affected Borrowing for which a Notice of Borrowing has previously been given that it elects not to borrow on such date, such Borrowing shall instead be made as a Base Rate Borrowing.

The Alliance Data Systems agreement is from May of 2009; another recent example with similar provisions is the Tyson Foods credit agreement  from the first quarter of 2009 (and there are many more).  It can be helpful to include a provision like this in a syndicated loan agreement, so that the lenders in the bank group are protected from receiving yields below their cost of funds, in a way that makes sense for the entire group.

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One question we hear a lot these days is whether a syndicated loan agreement can be amended to do certain things without consent of all of the lenders. 

Several kinds of changes that may be made to a loan agreement, such as reducing the principal amount, decreasing the interest rate, postponing payment dates and the like, typically will require all of the lenders affected by the change to approve.  With more borrowers in financial trouble, it has become increasingly important - and sometimes necessary for the borrower’s survival - to get amendments passed quickly.  But it can be difficult, if not impossible, to get all of the lenders to agree.

This is part one of a series of posts about what to do when this issue comes up.

When the borrower asks for relief on some of its obligations, and the agent and majority lenders are willing to agree to what the borrower has requested, in many deals there will be strong incentive to take a narrow view of the other lenders’ voting rights in order to get the amendment passed.  Agents are analyzing amendment provisions very carefully to determine precisely what is and is not required in terms of lender voting.  If there are ways to get the amendment passed without triggering the other lenders’ voting rights, then that can end up being the desired course.

For example, we know we can’t extend an interest payment date without a 100% vote, but there is no such prohibition on amending events of default.  So, the agent and majority lenders may start thinking about whether they can lengthen the cure period for payment defaults by a few days, which could have the effect of permitting the borrower to pay later without changing the date the payment is due.  This type of amendment would have other consequences, of course, and it may not be a good idea for a number of reasons.  Whether changes like this can even be considered will depend on the circumstances, and on the terms of the loan agreement.

In any event, these situations call for some clever thinking on the part of the agent and its counsel.  And they call for careful consideration of how the non-consenting lenders will view the amendment.  Elevating form over substance (i.e. “we know we can’t amend section 2.04 without consent, so we’ll add a new section 2.05”) is likely to result in objections from the non-consenting lenders – and rightfully so.  Finding alternative types of amendments that can properly be made, and other substantive provisions to amend, is a safer course.

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At long last, the Huntsman case has settled.  As recently reported, the banks providing the commitment for the acquisition financing have agreed to pay $1.7 billion (in a combination of cash and debt) to end the litigation. 

This case provides a good reminder of the need to be careful when issuing commitment letters.  Even though your commitment is conditioned on many things, and even though there are significant events that would appear to trigger a condition that lets you out of the commitment, you can still find yourself out of pocket.

In the Huntsman case, the commitment letter provided by the lenders included a typical condition that the borrower not be insolvent at the time the loan was to be made.  When it came time to fund, the banks thought the borrower was in fact insolvent, and refused to fund.  Regardless, these lenders have now spent significant time in litigation over this matter, and ended up settling for a not inconsequential sum.

Lenders, like all contracting parties, should be able to rely on the language of their commitment letters.  If the commitment letter provides the lender a right to refuse to fund under certain circumstances, and those circumstances come to pass, that right should be given effect.  Conditions on the obligation to fund are a necessary part of a commitment, particularly in an acquisition financing where the letter is usually issued in the early stages of the deal - at a time when there are still many unknowns.  Including a very clearly worded set of conditions, with strong language that makes the lender's intentions plain, can help protect the lender.

Of course, most lenders understand that they need to take litigation risk into account, especially when providing commitments for significant acquisitions.  It's part of the cost of doing business.  And, any time a very large dollar amount is at stake, the risk of litigation will increase.  As the Huntsman case illustrates, nothing is ever certain when litigation is involved. There are costs associated with defending the case even if you ultimately win.  Even with a strong case, you may find it advantageous to settle - sometimes for a rather large sum.

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