It is my pleasure to introduce a new monthly contributor to Distressed Debt Investing: David Karp, partner at Schulte Roth & Zabel. David's practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. It is our pleasure to have him as a contributor.
For his entry, David discusses issues in buying and selling European distressed loans. This is an amazingly enlightening piece. I encourage all investors that are involved in Europe or are considering deploying capital to read. Enjoy!
Prospecting for European Distressed Loans
As reported throughout the financial trade press this past summer, many U.S. investors are prospecting for European distressed loans on the secondary market. While the game plan for some of these investors appears to be to invest in the fulcrum credit and implement one or more creative restructuring strategies that have been well honed by investing in the U.S., Europe is an altogether different playing field. Even as Germany, Spain, Italy and France have made recent changes to their insolvency regimes aimed at improving restructuring options — including out-of-court alternatives, debt-to-equity swaps and increased opportunities to provide debtor-in-possession financing — complex country-specific, and in many cases untested, insolvency laws and vast cultural distinctions will form the basis for a challenging recovery analysis. Before delving into recovery issues, investors must be well versed in the increased trade risks in the European market that can derail their active investment strategy just as they are getting started.
While pre-trade issues need to be vetted in numerous areas, including regulatory restrictions on lending, collateral perfection and withholding taxes, one area of great concern and complexity is whether or not the borrower’s door is even open for an investment fund to become a lender via secondary market purchase. Many European borrowers view the relationship with their lender group as a private and long-term membership club completely distinct from public bond issuances, and cringe at the thought of sharing proprietary information with investment funds pursuant to a credit agreement. As a result, when European borrowers receive a request for an investment fund to enter their lender group, they are increasingly using their consent rights to deny the request and maintain control of the make-up of the group. What constitutes “consent being unreasonably withheld” is an unsettled point of English contract law, which governs most bank debt trading agreements across Europe.
What happens when a fund confirms its purchase of bank debt and the borrower subsequently doesn’t provide consent for the fund to become a lender of record? The fund may be forced to settle by participation, which, in Europe, is structured as a derivative relationship. In this context, the seller is delivering an unsecured claim to a buyer referencing the underlying borrower and lender relationship. In contrast, the U.S. form of “true participation” is intended to vest the buyer with an ownership right in the proceeds the lender paid to the borrower and then passed to the participant. Loan traders entering the European secondary market need to be cautious as they are more likely to wind up as a participant due to consent being withheld by a borrower, which results in: (i) double credit risk (from the seller and the borrower), (ii) no privity with the borrower or ability to be active in a restructuring, and (iii) a less-liquid position than being in senior secured bonds or, for that matter, a lender of record. For many investors, this increased counterparty credit risk, decreased control and decreased liquidity is enough to ruin the investment — and the trade has not even yet settled. Investors should be especially cautious regarding this asset class because general practice in both the U.S. and U.K. secondary bank debt and claims trading markets is that a trade is binding upon oral or written agreement on material terms. (See N.Y. Gen. Oblig. Law § 5-701(b)(2)(i) and (ii), and the recent U.K. decision of Bear Stearns v. Forum Global Equity (2007), in which the court confirmed the binding nature of a telephone conversation between traders agreeing to terms of a purchase of Parmalat notes.) In other words, “a trade is a trade.”
Borrower Consent Pitfalls
Many loan agreements syndicated during the 2004–2007 high-liquidity period were drafted on “borrower-friendly,” “covenant light” terms that often included, among other things, secondary transfer provisions requiring the borrower to consent to any new lender under the agreement. Increasingly, borrowers with consent rights are exercising them as a strategic measure for controlling the composition of their lending syndicate. While many loan agreements stipulate that borrower consent cannot be “unreasonably withheld,” the historic lack of case law establishing what constitutes “unreasonable” behavior in a commercial context meant investors were left unsure as to whether they had legitimate grounds for challenging a borrower’s refusal of consent. A recent U.K. case — in which a potential borrower sued Terra Firma Capital Partners (the private equity owners of Tank & Rast Holding GmbH, a German infrastructure group) in the High Court of England for denying borrower consent to a competitor to whom Terra Firma did not want to provide access to syndicate confidential information — was unfortunately settled out of court without any guidance from the High Court on whether Terra Firma had legitimate grounds to withhold consent. However, in the recent decision of Porton Capital Technology Funds and others v. 3M UK Holdings Ltd. and 3M Company (2011), the High Court in England did set out certain guidelines (based in landlord-tenant case law) for determining whether consent was unreasonably withheld in the given circumstances. Applying these guidelines to secondary bank debt transactions, where borrower consent is withheld and subsequently challenged as being unreasonable, the following approach may be utilized by the courts when making a determination:
- The burden is on the proposed new lender to prove that withholding of consent by a borrower was unreasonable;
- A borrower does not need to show that its refusal of consent was right or justified, simply that it was reasonable in the given circumstances;
- In determining what is reasonable, the borrower may have regard to its own interests;
- A borrower with consent rights is not required to balance its own interests with those of the proposed new lender or to have regard to the costs that the proposed new lender might be incurring.
While there is still little case law on this approach, the findings in Porton merit attention from the bank debt community as to a rejected prospective lender’s uphill climb when disputing borrower consent refusals in the U.K. When a prospective assignee is unable to obtain the necessary borrower consent to become a lender under the loan agreement, it must often rely on settlement via participation, sub-participation or some other alternative mutually agreed-upon structure.
Status of Participations in U.K. v. U.S. (LMA v. LSTA)
The Loan Market Association (“LMA”) and Loan Syndication and Trading Association’s (“LSTA”) mandatory settlement provisions dictate that if a trade cannot settle by legal transfer, there will be an automatic “fall-back” to settlement via funded participation. The LMA form of funded participation is governed by English law and contemplates a debtor/creditor relationship between the seller (grantor) and buyer (participant). Under this type of arrangement, the buyer has no beneficial interest in the underlying credit agreement, nor any relationship with the borrower. Instead, the buyer has only a right to receive the economic equivalent of any payments made by the borrower under the credit agreement, with the seller passing on such amounts to the buyer pursuant to the terms of the participation agreement. As the participant has no interest in the underlying debt, it has no contractual standing against the borrower if the borrower defaults under any of its payments. Additionally, the buyer also bears credit risk exposure against the seller should the seller become insolvent during the life of the participation. In such a scenario, the buyer only has an unsecured claim against the seller under the funded participation and cannot claim a proprietary interest or entitlement in or to the underlying loan proceeds. The result of this structure for the buyer is a “double credit risk” scenario, placing the buyer in an inherently more risky position than if it were to acquire bank debt by way of an LSTA “true participation” arrangement.
The LSTA form of funded “true participation” is a New York law governed structure, intended to give the buyer an ownership interest in the actual proceeds paid by a borrower to the seller. Whether a participation constitutes a “true participation” under New York law is a fact-based analysis that takes into account various factors including, among others: (i) the relevant language of the underlying agreement, (ii) the amount of control the seller retains or is perceived to retain over the assets after the closing of the relevant transaction and (iii) whether the transaction shifts the risks of loss and/or benefits of ownership to the transferee. The LSTA form intends to meet this criteria and assign the participant all of the rights of grantor to payment under the loan agreement. In the event that the grantor becomes subject to insolvency proceedings, payments are intended to be isolated from its insolvency estate, resulting in more limited counterparty credit risk for a participant under a “true participation.” This structure was recently tested and proven effective in the Chapter 11 case of Lehman Brothers Commercial Paper when the Bankruptcy Court issued an order establishing that all “all cash, securities and other property distributed or payable in respect of true participations or sub-participations … are not property of the Debtor’s estate and shall be promptly turned over to the beneficial holders thereof.” (Emphasis added; see
In re: Lehman Commercial Paper Inc., 08-13900 (S.D.N.Y. Oct. 6, 2008) (Order Pursuant to Sections 105(a), 363(b), 363(c), and 541(d) of the Bankruptcy Code and Bankruptcy Rule 6004 Authorizing Debtor to (A) Continue to Utilize its Agency Bank Account, (B) Terminate Agency Relationships)).
There was some initial concern among investors that LMA-style participations would be subject to additional regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in the U.S. due to the derivative nature of such participations, which would have subjected loan participations even partially conducted in the U.S. to U.S. federal securities law including anti fraud and anti manipulation rules potentially rendering ineffective big boy provisions relied on by the market. However, carve-outs to Dodd-Frank for LMA-style loan participation were created by the Commodity Futures Trading Commission (“CFTC”) and the Securities Exchange Commission (“SEC”) (collectively, the “Commissions”) in response to lobbying efforts of the LMA and LSTA. While, initially, the Commissions provided a carve-out only for “true” participations, after an additional push from the LMA, they came back with a formulation that carved out all participations. The Commissions jointly adopted new rules and interpretations to define the terms “swap” and “security-based swap” found in Section 721 of Dodd-Frank, specifically excluding from these definitions certain contracts, including loan participations.
In order to qualify for this exclusion, a loan participation must “represent a current or future direct or indirect ownership interest in the loan or commitment that is the subject of the loan participation.” Per the final regulations, four characteristics must be present:
- The grantor of the loan participation is a lender under, or a participant or subparticipant in, the loan or commitment that is subject of the loan participation;
- The aggregate participation in the loan or commitment does not exceed the principal amount of such loan or commitment;
- The entire purchase price for the loan participation is paid in full when the loan participation is acquired and is not financed; and
- The loan participation provides the participant all of the economic benefit and risk of the whole or part of the loan or commitment that is the subject of the participation.
While this exclusion provides comfort to investors in loan participations that their investments will not be subject to Dodd-Frank, it serves to highlight the distinction between LMA-style participations and “true” participations.
Investor Take-aways
While investors can attempt to negotiate additional terms at the time of trade that enable them to walk away from a trade if legal transfer cannot be effected, the effort will likely be met with resistance and difficult to achieve as standard operating procedure. Alternatively, if the overall aim is to take on larger bank debt exposure against a particular borrower, it may be best to commit to a minimum threshold piece first as a way to discern how difficult the transfer process is going to be. However, it is important to note that in many European credit facilities, an existing purchase does not grant lenders an automatic right to increase their position and bypass borrower consent.
Ultimately, like many European trade issues, borrower consent risk needs to be actively managed on a case-by-case basis. It is crucial for investors to address this issue before saying “Done” or they will be fighting an even steeper uphill battle with both their counterparty and the borrower.
David J. Karp is a partner in the New York and London offices of Schulte Roth & Zabel, where his practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. David is an avid speaker and writer on distressed investing related issues, recently co-authoring “European Insolvency Claims Trading: Is Iceland the Paradigm?” for Butterworths Journal of International Banking and Financial Law and “Trade Risk in European Secondary Loans” for The Hedge Fund Law Report. David is an active member of the LMA, APLMA, INSOL Europe and the LSTA where he is a member of the Trade Practices and Forms Committee. Jamie Schwartz, an associate at SRZ, assisted in the preparation of this entry.
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