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

In response to my post yesterday on a recent New York case prohibiting a participation without borrower consent, my partner Lucy Newcomb from Reed Smith's London office provides a UK-law perspective on the case below.  It is interesting to note that there is no such thing as the doctrine of good faith and fair dealing in the UK, so we could expect a similar case to have a different outcome in a UK court.  Lucy writes:

Although the judgement in the Cablevisión case is unlikely to be repeated in an English court, the case will have implications for the negotiation of lender transfer provisions going forward.

We have already shared our general thoughts on this case in a prior post, so I won't get into all the details again here.  What is most important to note from a UK-law perspective is that there is no general doctrine of good faith in English common law. This difference has important implications in terms of the enforcement of contracts, since the English common law is biased in favour of predictability of commercial transactions and certainty of common law.  This means that parties contracting under English law can specify rights and obligations in some detail and be confident that they will be enforced as stated.

Therefore, as the law currently stands, any similar dispute under an English law governed credit agreement would have to be decided solely on the grounds that the participation agreement was for all relevant purposes a disguised but un-consented to assignment that breached the credit agreement, and not that it violates concepts of good faith and fair dealing. 

On this point, it is worth noting that, as described in the court's decision, as a result of the would-be participant's requested changes to the participation agreement, and in particular after the lender rejected a request to enter into side letters empowering the participant to direct any lender decisions regarding amendments and waivers to the credit agreement, the lender amended the recitals to the participation agreement to explicitly refer to the lender's direct relationship with the borrower and to reaffirm its sole discretion with respect of amendments and waivers under the credit agreement. These amendments indicated to the court that the lender had attempted to ensure that the participation agreement was consistent with the credit agreement -- and indeed believed it to be consistent.   

No ruling on the point was made in this case, but Judge Rakoff's comment (in response to the lender's claim that the participation agreement was technically consistent with the credit agreement) that “[s]uperficially, this may be correct” suggests it is possible that an injunction application made on these grounds only -- absent application of the doctrine of good faith and fair dealing -- would have been unsuccessful.  Without seeing the actual text of the credit agreement, it is not possible to give a definitive view on the point. However, it is our view that careful drafting of the relevant provisions of participation agreements should ensure that the risk of a successful challenge by a borrower on these grounds is remote.

Moreover, this case has highlighted a weakness, from the borrower’s perspective, of the transfer provisions in the UK Loan Market Association (‘LMA’) standard form documents.  Namely, that any protection that a borrower is able to persuade a lender to grant in the form of consent rights to certain assignments can be circumvented by the lender entering into a participation agreement instead.  Historically, lenders have been extremely reluctant to accept any changes to the LMA transfer provisions – consent rights are viewed as a “top of the market” term by most lenders active in the UK market, and fettered rights to sub-participate are rarer still.  However, with the risk this poses to the borrower being so starkly exposed by this recent New York case, this is likely to be an area of hot debate in the future.
 

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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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In my last post, I gave some suggestions for reducing the risk of lender liability in a workout situation.  This time, let's talk some more about what to do when you're working through a workout, and focus on what happens when you're getting ready to seek remedies.  

As a general rule, it is a good idea to act "reasonably" in a default situation.  

There is usually an implied requirement of "good faith and fair dealing" in a contract-based relationship, whether under general state contract law or under the UCC.  Good faith and fair dealing essentially requires that you follow commercially reasonable standards of behavior and be fair to the borrower.  In some states it means that you have to act "honestly" (the definition varies).   This concept is applied to your agreement regardless of what the contract otherwise appears to say.   And this is true all the time, of course, not just after a default. 

Here's an example of how this plays out in a loan agreement.  Secured loan agreements usually say that any kind of default gives the lender the right to terminate the loan and foreclose on all the assets.  In practice, however, even though the agreement would appear to permit a lender to foreclose on assets if (for example) the borrower is just five days late in delivering its financial statements, it would be unusual for a lender to do so.  Indeed, many courts would find that type of action to violate the implied covenant of good faith and fair dealing, as the remedy would appear to the court to be out of proportion to the harm suffered by the lender.  That said, the law does respect your right to negotiate your own terms, and a judge won't normally rewrite the terms you agreed to.  You shouldn't be asked to do more than what you agreed to, but you will be required to do what you agreed to do fairly and in good faith. 

What else can you do to reduce the risk of lender liability when seeking remedies after a default?

• Give notice.  Even though notice may not be required under your loan agreement, in some situations it may be wise to give the borrower some notice before taking any action.  This is especially true if you are contemplating actions like foreclosure, that have harsh results.  Depending on the situation (and this does differ from case to case), giving notice may be fairly easy and may not do any harm to the lender's position -- and it may help demonstrate to a court later that the lender acted reasonably, giving the borrower a chance to explore alternatives.
   
•  Follow a consistent procedure.  It helps if you have established policies and procedures for seeking remedies and for the decision process to get there.  This seems like a good business practice generally, as it not only establishes consistency in dealing with borrowers, but it also helps to ensure that the options you want to have considered are actually considered -- and that a measured and appropriate response is given.  Also, be aware that if your normal practice is to ignore defaults of the type at issue and then you suddenly deviate from that practice and terminate the loan, some courts have found this behavior objectionable.
   
• Figure out what the assets are worth, and what you're likely to be paid.  If you have sufficient security and you are unlikely to lose anything if you forbear or take lesser steps against he borrower, you might want to consider these other options.  Some courts may find your exercise of remedies inappropriate if it can be shown that you would've had full recovery by forbearing on the default; similarly, your exercise of remedies can be called into question if you recover more than the loan agreement would've given you otherewise.   In these situations, you might do some clever thinking to see if you can get an appropriate result with less harm to the borrower.  For example, maybe forbearance makes sense, or maybe you can do things over a longer period of time, foreclose on only certain types of assets, or seek other types of remedies, while otherwise allowing the business (or portions of it) to continue.  Lots of options here.

There's no way to completely eliminate the risk of liability, but taking careful action can help mitigate this risk.  Applying principles of "good faith and fair dealing" will help.

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