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!