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Syndicated Lending Update: Defaulting Lender Issues
October 28, 2008
As the financial crisis has unfolded and a wide array of financial institutions have faced deteriorating financial stability, concern has increased that lenders participating in syndicated loans may become unable to honor their funding obligations. Most syndicated credit agreements contain some language dealing with the consequences of a lender's failure to fund. Until recently, however, defaulting lender provisions have not been the subject of much attention. Most syndicated credit agreements assume solvency of the lenders and their ability to fund. In the current market environment, borrowers and financial institutions that take on participation or funding risk from other lenders (such as administrative agents, issuing lenders and swing line lenders) have begun to focus serious attention on the risks imposed by defaulting lenders. The defaulting lender provisions typically found in syndicated credit agreements and risks faced by administrative agents, issuing banks, and swing line lenders are of particular importance during this time of increasing financial instability.
Definition of a Defaulting Lender
Most syndicated credit agreements define a "defaulting lender" as one that (a) fails to fund its portion of the loans to the borrower, (b) fails to pay any other amount required under the credit agreement or (c) has become insolvent. We are beginning to see in the marketplace an expansion of this definition to include lenders that have defaulted under other syndicated credit facilities and lenders whose holding companies or affiliates have become insolvent. The broadening of the definition allows the protections afforded by defaulting lender provisions to become effective when a lender's ability to meet its obligations is thrown into serious question, but before the lender actually fails to make payments required under the credit agreement.
Remedies Against a Defaulting Lender
A. Yank-a-Bank Clause; Assignment of Defaulting Lender's Interest
Syndicated credit agreements typically give the borrower the option to force a defaulting lender to assign its commitments and outstanding loans to another willing financial institution. This provision is often referred to as the "yank-a-bank" clause. There are three primary drawbacks of this remedy. First, and perhaps most importantly in the current market, the yanked lender is only required to sell at par. Second, if the defaulting lender is the subject of a bankruptcy proceeding, it may be necessary to seek bankruptcy court approval before the remedy of forced assignment can be exercised against the defaulting lender. Third, the remedy requires a financial institution willing to assume the defaulting lender's interest. As a result of the current conditions in the credit markets, the vast majority of loans are trading below par, and it may prove difficult to find a willing new participant or to convince an existing lender to take on a larger commitment. Negotiating the terms of an assignment of a defaulting lender's interest can also be challenging. The borrower, the administrative agent and the replacement lender would need to decide whether the replacement lender will be liable to fund advances that the defaulting lender previously failed to fund. The replacement lender will probably also request indemnification from the defaulting lender and assurances from the parties to the credit agreement that no claims will be asserted against the replacement lender as a result of the defaulting lender's failure to honor its obligations.
As an alternative to the traditional "yank-a-bank" remedy, there may be provisions added to syndicated credit agreements that permit the borrower to terminate a defaulting lender's existing commitments and repay its outstanding loans in lieu of finding a replacement lender. The reduction would be to the defaulting lender's commitment only, not a pro-rata reduction of each lender's commitment. This remedy would be appropriate in a situation where a borrower is unable to find a replacement lender, but still desires to remove a defaulting lender from the credit facility. The borrower would need to have sufficient availability to pay off any outstanding loans by the defaulting lender.
B. Voting Rights
Some syndicated credit agreements already provide that a defaulting lender forfeits its right to vote on amendments and waivers of the loan documentation. The voting rights that a defaulting lender loses can include issues that would otherwise require a unanimous vote of the lenders, such as reductions of principal, interest and fees. However, a defaulting lender generally retains its right to approve any increase in its commitment.
C. Payment of Commitment Fee
Most syndicated credit agreements do not expressly relieve the borrower or its obligation to pay commitment fees to a defaulting lender. Notwithstanding the contractual obligation to continue to pay commitment fees, a borrower might argue that under general contract law it should be relieved of its obligation to pay the commitment fee or should be able to set off the commitment fees it owes to a defaulting lender against the amount the defaulting lender has failed to fund. Most credit agreements, however, provide the borrower has no right of setoff. In jurisdictions where local law allows, the borrower could argue that a common law right of set off applies and that the borrower is relieved of its waiver of the right of setoff because of the defaulting lender's breach.
If the borrower desires to not pay the defaulted lender's commitment fee, it should enlist the support of the administrative agent. Some agents have been willing to allow the short paying of the commitment fees. If the credit agreement provides, as some do, that commitment fees are payable on the aggregate unused commitments, and the fees are to be divided pro rata to the lenders based on their individual commitments, the agent will be less likely to cooperate.
D. Breach of Contract
A borrower could elect to sue a defaulting lender on a breach of contract claim. In order to prevail, the borrower would need to demonstrate damages resulting from the defaulting lender's failure to fund, such as a higher cost of obtaining alternate financing. A borrower should consider that a suit for breach of contract can be costly and time-consuming and that it may be difficult to successfully enforce a monetary judgment against a defaulting lender that is on unsure financial footing or insolvent.
E. Payment of Loans; Pro Rata Sharing
Syndicated credit agreements generally provide that all repayments be applied pro rata to each lender's outstanding loans, regardless of whether any lender is a defaulting lender. Consequently, borrowers should consider rolling over any outstanding loans previously funded by a defaulting lender in lieu of repaying loans and subsequently requesting a new borrowing which the defaulting lender is unlikely to fund. Going forward, there likely will be provisions that offset a defaulting lender's right to share in a repayment of the loans prior to maturity against the amount that the defaulting lender has failed to fund.
Fronting Risk of Administrative Agents, Issuing Lender, and Swing Line Lenders
A. Administrative Agent
Syndicated credit agreements are structured so that the administrative agent funds requested borrowings on behalf of the bank group and looks to each individual lender to advance its pro rata share of borrowings to the administrative agent. Credit agreements usually contain provisions that allow the administrative agent to protect itself from the fronting risk imposed by this arrangement. Absent notice to the contrary, the administrative agent is permitted to advance funds to the borrower on the assumption that each lender will fund its pro-rata share of each borrowing. If the administrative agent makes a loan available to the borrower and a defaulting lender fails to provide its pro-rata share of the borrowing, the administrative agent can force the borrower to repay the defaulting lender's pro rata share of the borrowing to the administrative agent with interest at the base rate. The administrative agent would also have a right to set off amounts owed to it against amounts owed to the borrower, including proceeds of future borrowings.
B. Issuing Lender
Each lender acquires a pro-rata risk participation in each letter of credit issued under a syndicated credit agreement. After a draw on a letter of credit, each lender is responsible for reimbursing the issuing lender by making its pro-rata share of a revolving advance available or by funding its risk participation in respect of the letter of credit. The issuing lender faces the risk that a defaulting lender may fail to honor these obligations. Some credit agreements contain language providing that an issuing lender is not required to issue a letter of credit where a defaulting lender is participating in the facility unless cash collateral is provided to protect the issuing lender against the fronting risk imposed by the defaulting lender. This language is not standard in the marketplace, but issuing lenders are beginning to request it with more frequency. The provision can place significant hardship on the borrower, which would be forced to post cash collateral in order to have any letters of credit issued while a defaulting lender is participating in its credit facility. Another protection for issuing lenders that may be included more frequently in the marketplace is reducing letter of credit availability by the defaulting lender's pro rata share of the letter of credit sublimit. This would protect the issuing lender against fronting risk imposed by a defaulting lender, but would allow the borrower to continue to rely on the letter of credit facility to the extent of non-defaulting lenders' participation.
Issuing banks in synthetic letter of credit facilities also have been taking borrowers to task for exposure to defaulting lenders. Under a synthetic letter of credit facility, each lender prefunds its risk participation in the letters of credit and the issuing bank holds a deposit of the prefunded amounts in a deposit account in which the borrower and the lenders hold no claim or interest. These accounts were designed to be bankruptcy remote from the lenders and the borrowers, but we have experienced the issuing banks taking the conservative view that the defaulting lender may have a right to the deposit, notwithstanding the express terms of the documents. If the defaulting lender is in bankruptcy, these issuing banks also seem to believe the automatic stay would prevent the issuing bank from using the defaulting lender's share of the deposit to reimburse letter of credit draws. As with traditional letter of credit facilities, issuing lenders taking this position are attempting to require borrowers to cash secure the defaulting lender's share of the letters of credit if the credit agreement gives the ability to require the borrower. At some point the rights to these deposits will need to be addressed in the bankruptcy proceedings to validate whether the deposits are not property of the bankrupt lender's estate.
C. Swing Line Lender
Each lender also acquires a pro-rata risk participation in each swing line loan made under a syndicated credit agreement. Each lender is responsible for refinancing its pro-rata share of swing line loans with the proceeds from a revolving advance or for funding its risk participation in respect of swing line loans. The swing line lender therefore faces fronting risk similar to that of an issuing lender. Most credit agreements require swing line loans to be repaid within a few days or weeks after they are initially made, limiting the swing line lender's exposure. However, swing line lenders are typically required to fund swing line loans even when a defaulting lender is participating in the credit facility. In some instances, credit agreements provide that swing line loans are made at the swing line lender's discretion. This protects the swing line lender against fronting risk, but is burdensome to the borrower because the borrower cannot be certain that swing line loan requests will be honored. An alternative protection to the swing line lender that may emerge in the marketplace is reducing swing line availability by the defaulting lender's pro rata share of the swing line commitment. This solution would protect the swing line lender against the fronting risk imposed by a defaulting lender but would allow the borrower to continue to rely on the swing line facility to the extent of non-defaulting lenders' participation. This language has not traditionally been included in credit agreements but may begin to be more common going forward.
Where a defaulting lender is participating in a credit facility, the issuing lender and the swing line lender may attempt to resign to avoid taking on future fronting risk with respect to the defaulting lender. Although credit agreements generally contain language allowing an issuing lender and a swing line lender to resign their positions, it is typically necessary for a replacement issuing lender or swing line lender to be located before the retiring issuing lender or swing line lender is relieved of its obligations. Also, a retiring issuing lender is typically required to remain an issuing lender with respect to letters of credit issued before its resignation.
Defaulting Administrative Agent
Syndicated credit agreements typically do not contemplate the risk of an administrative agent defaulting on its obligations under the credit agreement or becoming insolvent. Consequently, although the administrative agent can resign, there is often no provision allowing the borrower or the lenders to remove an administrative agent, even when the administrative agent has defaulted on its obligations. Removal provisions may begin to become more common going forward if borrowers and participant lenders push for their inclusion.
The recent bankruptcy of Lehman Commercial Paper Inc. provides insight into how a bankruptcy of an administrative agent may be handled by the courts. The bankruptcy court stated that the funds in Lehman's agency account were not an asset of Lehman (except to the extent of Lehman's interest in the funds as a participating lender). The bankruptcy court also allowed but did not require Lehman to resign as administrative agent for more than one hundred credit facilities. The findings of the court should give borrowers and participant lenders some comfort that they can continue to make payments to an administrative agent as provided in the credit agreement without having those funds become a part of the administrative agent's estate in a bankruptcy.
As a result of recent events affecting the credit markets, there already are many instances of borrowers and financial institutions requesting changes to syndicated loan documentation to address issues related to defaulting lenders. Although no market standard for these provisions has emerged yet, future amendments to existing credit facilities and documentation for new credit facilities are likely to include language addressing these issues, and market standards for these provisions are likely to evolve.