Lending Law Report

Promissory Notes

Susan Alker — Wed, 28 Jul 2010 10:11:29 -0800

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.

Regulatory Reform - Upcoming Seminar on How It Affects the Financial Services Industry

Susan Alker — Wed, 14 Jul 2010 13:04:02 -0800

Now that the Dodd Frank Act is expected to be enacted, attention turns to how this legislation will affect the financial services industry. Will it fundamentally change the industry in the same way that Glass-Steagall, the FDIC Act, and the groundbreaking securities laws did during the Depression era? With more than 200 rulemakings still to be issued, countless research studies to be conducted, and a Financial Stability Oversight Council to be formed, the bill’s enactment alone will not provide all of the answers.

Reed Smith is planning to conduct a series of teleseminars about the new bill, with the first session on Tuesday, July 20, at 12 pm Eastern. A panel of regulatory authorities and former general counsel will provide a summary of the legislation and discuss the following topics:

Will this law be the game-changer everyone expects? What will the impact be for the financial services industry?
What impact will the financial reform legislation have on banks and investors outside the United States?
Who will be the new regulators? Who will be among the newly regulated?
Has the legislation addressed the issue of "too big to fail"?

Michael Bleier, former general counsel of Mellon and now a partner in our regulatory practice, will moderate the panel. Panelists will include William Mutterperl, former vice chairman of PNC, Jacqui Hatfield, a partner in Reed Smith's financial services regulatory practice, and Reed Smith partners Stephen Keen and Andrew Cross from our investment management practice.

If you'd like to attend this program, just click here to register.

Interest Rate Swaps: What to do When the Loan Agreement Terminates

Susan Alker — Thu, 01 Jul 2010 09:21:50 -0800

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!

False Financial Statements -- Can You Rely on Representations from Your Borrower?

Susan Alker — Fri, 25 Jun 2010 10:24:02 -0800

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.

Bankruptcy Roundup - Recent Cases Affecting Secured Lenders

Susan Alker — Tue, 22 Jun 2010 09:37:22 -0800

In recent months, there have been several bankruptcy court decisions that are significant to secured lenders. Here's a write-up of some of them, prepared by my bankruptcy colleagues here at Reed Smith. Some of the issues addressed in these cases include proper perfection of security interests, the rights of second lien holders (also covered in this prior post), the role of stalking horse bidders, and a situation where a 363 asset sale didn't work out as planned for the secured lender. Happy reading!

Regulatory Updates for the Holiday Weekend

Susan Alker — Fri, 28 May 2010 09:00:29 -0800

The last two weeks have brought new plans for regulation of financial institutions and financial markets, in both the US and the UK. The global trend toward increased regulation of finance is bound to have significant effects on lending institutions over the next few months and years.

On May 20, the US Senate passed S. 3217, an extensive set of banking and financial regulatory reform legislation. This bill covers such areas as proprietary trading by banks, enhanced consumer protection (including creation of a new consumer financial protection agency), trading of over-the-counter derivatives, and many other things. Next steps will include trying to reconcile the content of this bill with the somewhat different version of a financial reform bill passed earlier by the House of Representatives, before the legislation moves forward to be signed by the President. To find out more about how this legislation might affect you, take a look at this summary of the Senate bill's contents prepared by my partner Christopher Rissetto and others.

Meanwhile, across the pond, UK regulators are gearing up to further tighten the rules affecting financial markets. Similar to some initiatives in the US, the focus in the UK is on reforming over-the-counter derivative markets, strengthening global standards for clearing houses (including improving handling of defaults in the clearing and settlement system), increased transparency in non-equity markets, and oversight of credit rating agencies. Here's a helpful guide to the UK proposals, along with some commentary from my partner Jacqui Hatfield, who leads Reed Smith's Financial Services Advisory Group from our office in London.

For those in the US, enjoy the Memorial Day weekend and the unofficial start of summer!

Can We Credit Bid Or Not?

Susan Alker — Fri, 07 May 2010 10:05:01 -0800

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.

Second Liens Really are Second

Susan Alker — Tue, 13 Apr 2010 10:00:11 -0800

With the increase in corporate bankruptcy filings over the past year, there have been some interesting bankruptcy court decisions that affect those of us on the front end in corporate lending. One recent case took up the question of whether a second lien is truly second -- and whether it is safe to expect that the terms of your intercreditor agreement will be enforced.

In an intercreditor agreement, the senior lender will usually require that the junior lender waive several of its rights, including

the right to challenge the validity or priority of the senior lender's liens, and
the right to oppose a plan of reorganization supported by the senior lender.

The intercreditor agreement in the ION Media case, as is common for an agreement of this type, included a broad waiver of these and other rights. In the agreement, the junior creditor agreed that its rights to the company's assets would be junior, and the relative priorities of the lenders' claims would not be affected or impaired by "any nonperfection of any lien purportedly securing" any of the senior obligations. However, in the bankruptcy case, the junior creditor took issue with these terms, and argued that some of the assets weren't "collateral" as defined in the intercreditor agreement -- so the waiver should not apply. The bankruptcy court disagreed, deciding instead to enforce the waiver as written.

When we draft these kinds of waivers in intercreditor agreements, this is exactly the type of situation we are trying to address: if it turns out that there's a problem with the senior lender's lien (perhaps liens as to some of the collateral don't appear to have been properly perfected, for example), the junior lender is still supposed to remain in the junior position. These terms help ensure that the senior lender actually receives the benefit of its senior position. And this agreed-upon allocation of risk affects many other elements of the lending relationship for both creditors -- including loan pricing. Junior creditors typically receive significantly higher rates of return than senior lenders, due to the higher level of risk they take on.

Until now, we were pretty sure that all these provisions worked, but we didn't have the benefit of a published case on point. It is helpful for both junior and senior creditors to have more certainty here.

And Now, Loan Participations from a UK Perspective

Susan Alker — Wed, 31 Mar 2010 09:34:31 -0800

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.

Loan Participations - To Consent or Not To Consent?

Susan Alker — Tue, 30 Mar 2010 12:21:58 -0800

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.

Lessons We Can Learn from Microfinance

Susan Alker — Fri, 26 Mar 2010 01:20:07 -0800

On Wednesday, I spoke at an international conference on microfinance. The conference was a veritable United Nations, with representatives from the microfinance community around the world in attendance. We even had those little earpieces for language translation. My role at the conference was to discuss how loans and workouts are done in corporate finance, and whether there are differences in lending to microfinance institutions (covering just the institutional loans this time, not the microloans the institution makes to its individual clients). I was surprised to find many similar issues, despite the sometimes vastly differing circumstances.

Is there anything that we, in the corporate finance world, can learn from microfinance lending?

1. Use intercreditor agreements. Workouts involving microfinance institutions highlight the importance of using intercreditor agreements among lenders. It's very common for a microfinance institution to have received loans from several different creditors, some domestic and some international, but all without any intercreditor arrangements in place. One person I met was from a microfinance institution in Eastern Europe that is running into some financial issues. She's trying to address those issues with ten lenders who each have differing views and approaches. The lack of a common understanding among the lenders as to what to do in this situation creates problems for the lenders themselves, as well as for the borrower institution.

2. Use similar loan documents whenever possible. When several lenders make loans to a single borrower, it becomes all the more vital that the terms of the loans match up. Borrowers and senior secured lenders sometimes insist on this approach in corporate lending, but this hasn't happened much (yet) in microfinance. Microfinance institutions often find themselves with loan documents that contain a wide variety of covenants and terms - each one different from the last. Several institutional borrowers at the conference mentioned that keeping track of (and complying with) eight or ten different sets of reporting requirements takes up time and resources that would be better spent serving the institution's clients. Trends toward standardization of loan documents and the increased use of syndicated loan structures may help with this issue over time.

3. Defined legal structures make a big difference. Microfinance loan workouts can be significantly complicated by absence of the legal structures that we take for granted in the US and Western Europe. Several countries don't have Chapter 11-like procedures for bankruptcy -- or if they do, the process isn't always available to microfinance institutions, especially nonprofits. In many places, it isn't legally possible to obtain a perfected security interest in accounts, which are the primary assets a microfinance institution is likely to have. Even if you do have a security interest, your priority over other creditors isn't assured. Also, the entire process can be affected in unexpected ways by local political events and regulatory changes. Though we are occasionally surprised by bankruptcy court decisions in the US, we benefit from relative certainty as to who has priority and how the legal process will treat our claims.

Borrowers and creditors all over the world, in microfinance and in corporate finance, share many of the same concerns. We have much to learn from each other.

Microfinance - Making a Difference

Susan Alker — Tue, 23 Mar 2010 06:38:38 -0800

This week I am delighted to be in New York attending the WWB Microfinance and Capital Markets Conference.

For those of us who normally spend our time on corporate lending and workouts, microfinance offers a rare opportunity to use our skills to improve the lives of people who are truly in need. Micro loans have helped thousands of families around the world to build up small enterprises, move out of poverty, and be able to afford food, education and healthcare for their children. Because these loans have a remarkably low default rate (often less than 2%), the funds provided to a microfinance institution are returned to be loaned out again and again -- to help even more people.

Many institutions that make loans to the poor are backed by loans or other types of investments from other entities -- from commercial banks and financial institutions, microfinance investors, donors, and others. Tomorrow I will be speaking on a panel of commercial lenders and microfinance institutions, discussing the issues that arise when a microfinance institution defaults on a loan. As you can imagine, workouts in this context are quite different from those we usually see in corporate America. There are some interesting lessons we can learn from this; I'll have more to say on this topic in my next post.

What if an Equity Sponsor is also a Lender in your Bank Group?

Susan Alker — Mon, 08 Mar 2010 11:05:50 -0800

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.

How to Avoid Lender Liability - Part 2

Susan Alker — Tue, 02 Mar 2010 10:45:41 -0800

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.

How to Avoid Lender Liability - Part 1

Susan Alker — Wed, 17 Feb 2010 10:09:38 -0800

Tough times bring all sorts of things out of the woodwork. Some of you will remember that back in the 80's and early 90's there was a flurry of "lender liability" lawsuits, with lenders being sued when they exercised remedies after a default on a loan. There were a lot of these cases filed across the country during that time. But by the mid 90's, these lawsuits appeared to have gone the way of the dinosaur. Times were good and defaults were few. Well, guess what . . . they're back. We shouldn't be surprised, given the increase in the number of loan defaults. In fact, we probably should expect to see more of these cases in the coming months.

How can you protect yourself against lender liability claims?

One common basis for a lender liability lawsuit is what the lender did after the borrower defaulted on the loan. If the lender behaves in a manner that later appears to have been unfair or inappropriate (perhaps "not in good faith", coercive, or in breach of a promise - more on this in future posts), a claim can result. So, what types of things should you do after a default or in a workout situation?

Engage in discussions. When a borrower goes into default on a loan, what is your typical response? With many lenders, the first thing that happens is a conversation with the borrower. Sometimes this turns into a long series of discussions, followed by forbearances or partial waivers, as the lender and borrower attempt to sort things out and avoid a negative outcome. And repeated defaults add pressure to subsequent discussions. Regardless of how things go, it is often a good idea to engage in at least some discussion with the borrower. For one thing, a discussion might actually result in the situation being "worked out" to a solution that's reasonably satisfactory to both parties. Of course, this is usually the goal! But even if the situation can't be worked out, engaging in negotiation and talking through the options can help you demonstrate later that your response to the default was reasonable and appropriate under the circumstances.
Consider a prenegotiation agreement. Not all defaults will require prenegotiation agreements, but in some cases you'll find it helpful to document what your understanding is before entering into workout discussions. As discussions proceed, sometimes misunderstandings can result -- the borrower might think that the lender has promised something when that isn't the case, or may think the lender has agreed to waive the default when the lender thinks it hasn't. Among other things, prenegotiation agreements help establish the scope of the discussions and what (if anything) can be agreed to orally vs. in a formal waiver document. A prenegotiation agreement can also clarify who is authorized to make promises on behalf of the lender.
Speak carefully. Sometimes lender liability cases arise from things the lender's representative said in the course of workout negotiations. It can come down to just being careful not to speak in broad terms, avoiding over-promising or over-stating what you are actually willing to do. In this regard, it is often helpful to establish (perhaps in a prenegotiation agreement) that nothing is considered agreed to or binding until it is in writing.
Write it down. If you decide to forbear from exercising remedies for a period of time while trying to work things out, it's a good idea to put the forbearance in writing and include an express reservation of your rights in connection with the default. Sometimes the argument is made that the lender gave tacit consent to ongoing defaults -- by ignoring them repeatedly, or by doing nothing about new defaults -- and that this action (or inaction) was effectively a waiver. You can help avoid this by recognizing in writing the ongoing existence of defaults and stating that you're reserving all your rights under the loan documents.

These are just a few suggestions -- hardly an exhaustive list. And, as we know, not every default can be worked out. Next up, we'll explain more about lender liability cases and get into how to mitigate the risk when you've decided to accelerate the loan, foreclose or seek other remedies.

Financial Firms and Social Media - New Rules for New Times

Susan Alker — Fri, 05 Feb 2010 09:01:05 -0800

Are you using social media? I'd be surprised if you weren't . . . and if you're part of a financial institution subject to FINRA (the Financial Industry Regulatory Authority), you'll want to know about a new notice that just went into effect about use of social media.

On January 25, 2010, FINRA issued a regulatory notice (pdf download) giving guidance on how the FINRA rules apply to social media sites that are sponsored by financial firms and their registered representatives. My partners Chris Bennett and Amy Greer have written a report summarizing the relevant parts of the notice and explaining how the rules can affect you. For example, you still have to comply with the normal recordkeeping requirements when using social media -- and this can be a real challenge, since the requirements were set up before social media gained widespread use. The FINRA notice includes a dicussion of some requirements for adopting a system for supervision and review of social media communications. And there is new guidance about how the rules apply to the content that you post.

To learn more about the issues you can encounter when using social media for business - in any industry - take a look at this full-length write-up (pdf download).

Derivatives Market Reform - Where Are We Headed?

Susan Alker — Mon, 07 Dec 2009 11:04:32 -0800

What's going on in the derivatives market these days? There's lots of talk about regulation -- who, how, when, and what.

My partners in our derivatives practice have written a summary of the three proposals for regulatory reform of the OTC derivatives market that are currently under consideration by Congress. Key themes of these proposals include mandatory clearing, exchange trading, capital requirements, margin requirements, position limits, and disclosure and reporting obligations. The Commodities and Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) will be required to establish the specific rules.

If you're a swap dealer or "major swap participant" (as defined in the proposals), you'll want to watch these developments closely.

The FDIC's Interim Rule for Securitizations

Susan Alker — Tue, 24 Nov 2009 10:28:16 -0800

This post was written by Colleen McDonald, a partner in the Financial Industry Group here at Reed Smith.

The FDIC has given banks a temporary reprieve from the impact on their securitizations of the recent changes in GAAP, until March 31, 2010. By then, the FDIC has promised new securitization rules.

The FDIC has stated (pdf) that it will issue new rules for bank securitizations in December 2009, which rules will likely impose mandatory structural changes to bank securitizations including credit risk retention, increased disclosures to investors, and more flexibility for servicers of securitized debt. There will be a comment period before the revised rules go into effect, during which time interested parties will be invited to provide comments and feedback to the FDIC on the proposals.

The FDIC's action under the Interim Rule (Fed. Reg. Vol. 74. No. 220, Nov. 17, 2209) extends the current safe harbor for bank securitizations contained in the "Securitization Rule" (12 CFR 360.0) until March 31, 2010, thereby giving banks the ability to securitize without considering whether the recent GAAP accounting changes in FAS 166 and 167 (the "New GAAP Rules") affect their securitizations during the interim period. We've prepared a separate report on the content of these recent changes to GAAP.

Under the "Securitization Rule", the FDIC clarified its authority as receiver or conservator to reclaim as property of a bank any financial assets transferred by the bank in connection with a securitization did not apply to a sale which met all conditions for sale accounting treatment under GAAP. The New GAAP Rules may affect whether an issuing entity has to be consolidated on the bank's balance sheet for financial reporting purposes. Given the changes in the accounting treatment, securitizations would not likely meet all conditions for sale accounting treatment. As a result, the safe harbor provision of the Securitization Rule may not apply to the transfer.

The Interim Rule provides that for securitizations and participations for which transfers were made or interests were issued before March 31, 2010, the FDIC will not exercise its statutory authority and reclaim as property of the institution any transferred financial assets notwithstanding that such transfer does not satisfy all conditions for sale accounting treatment under the New GAAP Rules for reporting periods after November 15, 2009, if such transfer satisfied the conditions for sale accounting treatment set forth by GAAP in effect for reporting periods before November 15, 2009. The FDIC has requested comments on all aspects of the Interim Rule, which must be received by January 4, 2010.

Of course, not all issuers are banks. Non-depository institutions will continue to have to deal with the impact of the GAAP changes on their securitization structures.

New Rules for Securitization

Susan Alker — Fri, 20 Nov 2009 11:40:31 -0800

A new set of FASB rules may impact whether a securitization is treated as a "true sale" and whether companies with financial assets will have to consolidate their special purpose entities on their balance sheets. For banks, the new rules may also mean that there will be additional capital requirements, to cover their conduits. The Wall Street Journal has reported (subscription-based content) that the cost of securitization will likely go up as a result of this change, and that it could create a "logjam" in the securitization market, further slowing market recovery. My partners Michael Brown and Colleen McDonald have written a report on the proposed changes -- if the securitization market affects you, you'll want to check it out.

What To Do When a Lender Defaults - Part Three

Susan Alker — Wed, 11 Nov 2009 10:08:27 -0800

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.