In recent years the European direct lending market has grown dramatically. Such expansion can be attributed to a number of factors, including (i) a sizeable jump in the number of private equity firms with direct lending operations, and (ii) institutional investors allocating more of their fixed income portfolios to higher-yielding (but more illiquid) private debt strategies. Whilst European direct lenders have traditionally focused on investing in European term loan B loans governed by English law (“European TLB”), they are increasingly looking to invest in non-European products through their European investment vehicles, especially U.S. term loan B loans governed by New York law (“U.S. TLB”). As European direct lenders venture into the U.S. TLB market the need to understand the differences between European TLB and U.S. TLB is increasingly apparent. Although there has been significant convergence in loan documentation terms between European and U.S. TLB, especially with respect to covenants, there remain key differences between the two products that European direct lenders should be mindful of when considering U.S. TLB investments. This article provides an overview of those key differences from a legal standpoint, and highlights common concerns for European direct lenders when investing in U.S. TLB.

Simultaneous signing and closing

European TLB loan agreements typically have an “Availability Period” construct under which borrowers can draw-down the TLB within a period of circa six months from signing, the result being that it is common for there to be a delay between signing and closing/funding. Conversely, under U.S. TLB signing and closing/funding typically take place simultaneously (other than in cases of delayed draw facilities). When participating in U.S. TLB deals, European direct lenders need to be prepared to fund earlier than they may be accustomed to in European deals. Additionally, if there will be a simultaneous signing-funding then consideration should also be given to the timing of capital drawings from limited partners – this is discussed further below.

Capital draws from limited partners

An issue of particular concern to direct lenders is the availability of funds for drawing. Direct lenders will likely require several days’ notice of any intended drawing due to the need to make capital calls from limited partners to make funds available (unless, of course, capital call credit facility is in place, which often provides for same day access to funds). To avoid any mismatch in borrower funding requirements and lender funding availability it is advisable to discuss borrowing notice requirements early in the negotiation process. Further, if the lender will make arrangements to fund itself ahead of the U.S. TLB credit agreement being signed, it should also consider requiring the borrower to sign a break funding indemnity.

Repetition of Representations and Warranties

Unlike in Europe, U.S. TLB loan documents do not contain repeating representations and warranties; rather, representations and warranties are typically only given (i) at closing (when the initial funding takes place), and (ii) on the date of any subsequent borrowing (if any). It is arguable that the absence of repeating representations and warranties from U.S. TLB means lenders have weaker protections compared to European TLB where certain representations and warranties tend to be repeated at the beginning of each Interest Period. Despite this, the absence of repeating representations and warranties in U.S. TLB is unlikely to be of material significance to European direct lenders provided that adequate undertakings are included in the relevant credit agreement.

Transferability of Loans

The European and U.S. TLB markets take opposing positions on the transfer of TLB commitments. In the European market the convention is for there to be an Approved Lender List detailing the organisations to which the lenders can transfer their commitments, whereas the U.S. convention is to have a Disqualified Lender List of organisations to which TLB commitments cannot be transferred. In some ways the U.S. approach is better for lenders than the European position in that the pool to whom such debt can be transferred should, in theory, be larger. Nonetheless, European direct lenders will need to be careful to ensure that Disqualified Lender Lists (also referred to as DQ Lists) are not drafted so widely that in reality the pool of transferees is unduly restricted.

In addition, in U.S. deals it is typical for the agent to be paid a fee when a lender transfers their commitments to another lender. The MoFo team’s experience indicates that European direct lenders prefer that such a fee is not payable (or at the very least that a reduced fee is payable) when a transfer is to an affiliate of that lender. Agents often are amenable to modifying this fee, either by adjusting quantum or removal altogether.

U.S. Withholding Tax

Although there is no economic difference between OID and upfront fees - in both cases the lender effectively transfers to the borrower less than par for a loan resulting to an increase in such lender’s overall economic return - the two ‘charges’ may, in certain instances, be subject to different tax treatment. For example, many foreign lenders buying U.S. loans try to avoid receiving anything called a “fee” to avoid withholding tax charges, and therefore prefer OID over upfront fees (sometimes also referred to as closing payments).

U.S. withholding tax is also of concern to direct lenders in the context of ordinary course interest payments. Double-taxation treaties can provide relief against U.S. withholding tax that would otherwise be applicable to interest payments, however European direct lenders must be conscious that in many instances double-taxation treaties may not apply to their benefit. Additionally, many double-taxation treaties with the U.S. do not eliminate withholding tax entirely but only reduce the applicable withholding tax rate. To address this issue, many direct lenders rely on the so-called ‘portfolio interest exemption’ to avoid U.S. withholding tax. European direct lenders seeking to to rely on this exemption should, with the assistance of their legal and tax advisors, undertake a detailed analysis to determine whether a loan qualifies for the exemption. In general terms, to qualify for the portfolio interest exemption the following criteria must be satisfied: (i) the lender (a) does not own 10% or more of the borrower’s equity, (b) is not a bank lending in the ordinary course, and (c) is not a ‘controlled foreign corporation’,[1] and (ii) the underlying debt is issued in ‘registered form’ (i.e., only transferrable by delivering notes or by notations in a register).

Distress and Insolvency

In European TLB deals the absence of a uniform European code on bankruptcy means that in distress situations, lenders’ first ports-of-call are the mechanics and protections incorporated into loan and security documents (and intercreditor agreements, if any). This has resulted in European TLB documentation containing comprehensive provisions relating to the enforcement and restructuring of debt; provisions which, fundamentally, are based on Loan Market Association standard forms albeit that these forms do get negotiated especially, in the direct lending market, with respect to payment blocking provisions and price protection clauses.[2] In contrast, by and large the U.S. restructuring process and the rights of creditors are codified in ‘Chapter 11’ of the U.S. Bankruptcy Code, meaning that U.S. documentation is significantly thinner with respect to the rights and liabilities of creditors on enforcement and during restructurings.

Some of the key differences between the Chapter 11 and English approaches to restructuring and enforcement are as follow:

• Intercreditor agreements (“ICAs”) are significantly different. ICAs supporting European TLB typically contain considerably greater controls on enforcement, and facilitate restructurings through distressed disposal provisions. Additionally, the treatment of the receipt of proceeds differs significantly between U.S. TLB ICAs and European TLB ICAs.
• The worldwide effect of the automatic stay arising from debtors commencing Chapter 11 cases, and the sanctions arising from a breach thereof, serve as a significant deterrent to enforcement action for U.S. and non-U.S. debtors. This is not replicated in European jurisdictions.
• U.S. restructurings are predominantly conducted in-court through Chapter 11 cases supervised by the U.S. Bankruptcy Court. In Europe, restructurings tend to be negotiated (and in many cases, implemented) outside of a court process. The availability of court-supervised processes varies depending on the jurisdiction of incorporation of the obligors. European TLB will usually be governed by English law, and so the English scheme of arrangement tends to be the in-court restructuring tool of choice.
• The broader powers and flexibility afforded to U.S. debtors in Chapter 11 cases are vastly more successful than the European models in rescuing businesses where restructurings are not agreed in advance of bankruptcy filings. That said, the availability of DIP financing and the risk of DIP priming unsecured TLB indebtedness is significantly greater in the U.S. than in Europe.

Reliance Letters vs. Non-reliance letters

The U.S. and European TLB markets adopt divergent approaches to reports and reliance by lenders. In the U.S. the common practice is for report providers to request non-reliance letters from recipients of their reports that contain a waiver and release of any and all claims a report recipient may have against the report provider. Put simply, a recipient uses the report at their own risk with no recourse to the report provider. The opposite approach is adopted in Europe, where the norm is for report providers to issue reliance letters stating that lenders (and sometimes their affiliates or transferees) may rely on the relevant report in connection with the financing.[3] European lenders should not, however, expect to obtain reliance on a report that is prepared by a U.S. report provider. In most cases the divergence in market practice between the U.S. and Europe will be of little consequence; however, the U.S. approach does narrow a lender’s potential avenues of recourse in the event that reliance on a report causes loss to a lender.

[1] I.e., a foreign corporation owned 50% or more by 5 or fewer U.S. shareholders.

[2] These are provisions that provide safeguards with respect to the realisation amount on a restructuring before the target group can be sold “debt free”.

[3] It is notable, however, that liability is usually capped. Particular attention should be paid to any liability caps and any carve-outs that limit a report provider’s liability in certain circumstances.

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