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SYNDICATED LENDING UPDATE:
DEFAULTING LENDER ISSUES
ROBIN J. MILES, M. CATHERINE OZDOGAN, STEPHANIE KOO SONG AND
CHRISTOPHER D. HEARD
The authors examine the defaulting lender provisions typically found in syndicated credit agreements and risks faced by administrative agents, issuing banks,
and swing line lenders, which are becoming of particular importance during
this time of increasing financial instability.
A
s 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.
Robin J. Miles, M. Catherine Ozdogan, Stephanie Koo Song and Christopher D.
Heard are energy finance attorneys with Bracewell & Giuliani LLP.
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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
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 replace166
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SYNDICATED LENDING UPDATE
ment 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.
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.
Payment of Commitment Fee
Most syndicated credit agreements do not expressly relieve the borrower of 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
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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.
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.
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.
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SYNDICATED LENDING UPDATE
FRONTING RISK OF ADMINISTRATIVE AGENTS, ISSUING
LENDER, AND SWING LINE LENDERS
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.
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
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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.
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
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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.
Resignation
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.
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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.
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