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

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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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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