Similarities and distinctions are already being drawn between the impact on our economy of the 2008 sub-prime mortgage-induced financial crisis and today’s global pandemic of COVID-19. With the shutdown of non-essential businesses, social distancing and a resulting volatile market, it is unclear how COVID-19 will scar our economy. Secondary loan market participants are simultaneously battling to maintain their health and the health of their families all the while working to keep the company lights on with work-from-home mandates. Lessons learned from 2008 may help us weather this storm and navigate these unprecedented times. Since the secondary loan market intersects bankruptcy and corporate issues, it is important to be mindful of the following key legal issues that were tested in 2008 that are likely to be tested again in the coming weeks and months ahead.
Counterparty Risk: In secondary loan market transactions, secondary loan market participants (“MPs”) should consider the possibility and implications of the insolvency of the seller or buyer. In June of 2008, the Loan Syndication and Trading Association (the “LSTA”) issued a LSTA Legal Advisory, Assessing Counterparty Credit Risk in the U.S. Secondary Loan Market[1]. Lessons learned from 2008 and summarized in the LSTA’s advisory highlight the importance of being mindful of counterparty risk. Unlike transactions for real estate, for instance, a transaction to buy or sell bank loans is enforceable as an oral agreement, provided the material terms of the trade are evident. The requirement to reduce the transaction to writing is carved out of the New York Statute of Frauds[2] but best practices dictate to reduce an oral agreement to writing in a trade confirmation (“Confirm”). MPs that just have an executed Confirm are in a precarious position in the event their seller files for bankruptcy. Section 365 of the Bankruptcy Code treats a Confirm as an executory contract which then can be rejected, assumed or assigned by the debtor. MPs are already considering how a borrower’s business is affected by the pandemic, but MPs should also evaluate how the pandemic is affecting their counterparty’s operations.
Par Versus Distressed Trading Documentation: The stress of the global pandemic on borrowers will impact whether or not a credit will trade in the secondary market on the LSTA’s par or distressed trading documents[3]. With looming default rates, MPs should consider the advantages of closing on distressed trading documents at this time. The decision to trade on par or distressed trading documents is made by MPs at the time of trade[4]. In an LSTA par transaction, there is a Confirm, the credit agreement’s form of assignment agreement (“AA”) and a funding memo. The AA transfers legal title to the loan from seller to buyer and contains standard representations and warranties. These are basic protections afforded to the buyer in a credit that is trading at or near par. Trades are expected to settle within 7 days of a trade date (T + 7). There’s less risk when a borrower is performing its obligations under the credit agreement and the credit is trading at or near par. In an LSTA distressed transaction, there is a Confirm, the AA, a purchase and sale agreement (the “PSA”) and a funding memo. In a distressed transaction, risk is naturally greater because the borrower is restructuring or in a bankruptcy proceeding. Trades are expected to settle within 20 days of a trade date (T+20). There are key differences between the LSTA’s par and distressed trading documents. The distressed trading documents include an additional agreement, the PSA. The PSA contains robust representations and warranties from the seller to buyer. These additional protections address predecessors-in-title, prior holders of the bank loans, and actions of the seller while it held the bank loans. This means that the seller is transferring additional rights to the buyer that enable the buyer to seek recourse against prior owners. The buyer is able to identify and diligence the prior owners because the chain of title is provided in a schedule to the PSA. The seller is also providing the buyer with copies of the predecessor transfer documents (the AAs and PSAs) that track the loans up the chain of title. The established chain of title, along with certain representations like the “no bad acts representation”, where the seller represents that it hasn’t engaged in any acts or conduct that would cause the buyer to be treated differently from other lenders, offer additional protections to a buyer[5]. The PSA also contains enhanced indemnifications and one of the indemnifications is tied to the seller’s no bad acts representation. Overall, distressed trading transactions provide recourse to the buyer to proceed against its immediate seller and those parties up the chain of title. Issues arise for MPs when loans were purchased on par trading documents and then are sold on distressed trading documents. Not all transactions, however, settle on distressed documents. This is because some credits are trading par and some are trading distressed. The LSTA uses a market consensus among dealer banks, buyers and sellers to determine whether a credit has shifted from par to distressed. MPs can request that the LSTA publish a shift date for a specific credit. Liquidity in the marketplace is key to MPs. Whether a credit is trading par or distressed, loan transactions are continuing electronically on platforms like ClearPar and with document electronic signing. MPs should continue to evaluate their positions and proceed to close trades with the assistance of counsel.
Assignments and Participations: The transfer clauses and eligibility criteria for new lenders and participants are critical even as a borrower’s creditworthiness declines. Whether or not an MP can enter into a credit as a new lender is a threshold matter and key diligence item. MPs should pay close attention to issues of new lender requirements, borrower consent, transfer minimums and withholding tax issues.
Material Adverse Effect Clauses: Material adverse effect provisions may be considered in light of this global pandemic. If tripped, these clauses can trigger an event of default under a credit agreement and impact a borrower’s ability to borrow money. However, as we are in the midst of this storm, it is too soon to tell how successful any such claims will be. What constitutes a material adverse effect is often a carefully crafted and highly negotiated provision, most typically designed to be triggered in response to an event that causes a material adverse effect to the business or operations of a company, except for events that impact the economy as a whole. There are exceptions to that exception that permit claimant to assert that a material adverse effect has occurred, however, it then becomes an exercise in careful examination of facts and circumstances. Delaware and New York law call upon a company asserting this claim to show that a material adverse effect has substantially threatened its overall earnings in a durationally-significant way (i.e., a company would have to show that it has suffered years – and not months – of consequential impact). With this type of information required to be able to assert such a claim, it is difficult (at least as of today) to evaluate COVID-19 through that lens.
Events of Default and Cross-Defaults: Credit agreements provide detailed event of default provisions that identify how the borrower can cause an event of default and cure an event of default. With decreased earnings, a borrower is exposed to breaching certain financial covenants which are most often calculated using EBIDTA. The pandemic is causing borrowers to face unprecedented costs. These new costs include increased cleaning costs to ensure employee safety and costs related to the closing and re-opening of business operations. Because cross-defaults can occur among financial documents, it is imperative to review the suite of documents in a transaction.
On the Horizon: Looking ahead, borrowers will be negotiating forbearance agreements and defaults will continue to rise. MPs should also pay close attention to provisions in credit agreements that permit borrowers to buy back debt as company bank debt continues to trade below par. Helpful analysis has been provided on the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) which is available here.
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In these uncertain times, it is helpful to understand the mechanics of the trading documents, key provisions in credit agreements and lessons of the past financial crisis.
[1] LSTA Legal Advisory. Assessing Counterparty Credit Risk in the U.S. Secondary Loan Market, June 6, 2008.
[2] Section 5-701 of the General Obligations Law of the State of New York.
[3] Most of the secondary loan market uses the LSTA’s form documents to settle transactions.
[4] LSTA: The Use of Par or Distressed Documentation, August 16, 2007.
[5] LSTA Purchase and Sale Agreement for Distressed Trades – Standard Terms and Condiitions, March 16, 2020.
