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.