Distressed and Par Trade Investments – a Case Study
Fieldfisher recently held a joint seminar with New York law firm Kramer Levin Natfalsis & Frankel LLP, which focused on a case study on the life cycle of a synthetic distressed Investment, comparing and contrasting the different issues and approaches we have seen on real transactions under both English and New York law. The talk focused both on the transfer of loan interests and related hedging agreements.
From a banking perspective, a number of interesting points were drawn from the discussions, of interest both to readers involved in the secondary debt markets, as well as those involved in loan origination, structuring and negotiation of loan documentation:
Obviously a review of the transfer clause of a facility agreement is essential and one of the first issues that should be undertaken as part of any due diligence exercise when reviewing such a document for a secondary market sale or purchase, to check to whom a loan or part of a loan can be transferred and if borrower consent is required.
There are clear differences between the New York and English markets as to what is acceptable or not acceptable when negotiating these clauses at loan origination stage.
English law loan documentation tends to be more restrictively drafted so that it will be very clear if consent is, or is not required for any transfer (which can result in protracted discussions at loan origination stage, and in some cases the creation of a "prohibited persons" list of non permitted transferees), whereas the practice in the US tends to allow more discretion to the borrower to withhold consent (including in some cases a consent "not to be unreasonably withheld" concept).
The practice of following a more precise approach under English law versus the consent "not be unreasonably withheld" approach is in part driven by the English courts allowing a commercial party to withhold consent if it can show that a reasonable commercial person in its position might have reached the same decision; but it does not need to show that the decision was justified. See for example Barclays Bank plc v UniCredit Bank AG and another  EWHC 3655 (Comm). Given this interpretation, the consent "not be unreasonably withheld" concept does not really provide any party under a facility agreement with much protection against another party withholding consent, thus alternative solutions are required. However, any consent mechanism whereby the borrower can withhold consent usually falls away following an event of default.
Predecessor-in-Title Representations v. Upstream Chain of Title
The major difference between the English (Loan Market Association or "LMA") approach to secondary trading versus New York (Loan Syndications and Trading Association or "LSTA") relates to the comfort and diligence a buyer of debt can expect from the seller of that debt with regard to title.
Both LMA standard terms and conditions for par and distressed trade transactions (bank debt/claims) (LMA documentation) and the LSTA equivalent contain a good title representation by the seller that it owns sole legal and beneficial title to the loans free and clear of lien, encumbrance or adverse claim against title of any kind.
Additionally, the LMA documentation will contain further representations and warranties by the seller to the buyer as compared to the LSTA equivalent (both in respect of par trades or distressed debt trades – although there are considerably more representations given for distressed debts). For example the following representations are given under the LMA documentation (both in respect of par trades and distressed debt trades), but not the LSTA par equivalent:
(i) neither seller nor any of its predecessors-in-title have executed any other documents which could materially and adversely affect the loans;
(ii) neither seller nor any predecessor-in-title is in default with respect to any of its obligations in relation to the loans and related rights being sold; and
(iii) in respect of the claims and ancillary rights being transferred to the buyer, none of these have been limited in any assignment/ transfer documentation between the seller and its immediate predecessor-in-title.
There are a number of other representations given which apply only to distressed debt trades under the LMA documentation, such as:
(i) neither the seller nor any of its predecessors-in-title have been "connected" with any obligor;
(ii) no predecessor-in-title has engaged in any acts or conduct or made any omissions that would result in the buyer receiving proportionately less payments or distributions or less favourable treatment in respect of the loans and other rights purchased than other lenders in the syndicate;
(iii) there are no rights of set-off or counterclaims against the seller or any of its predecessors-in-title;
(iv) neither the seller nor any of its predecessors-in-title have received any notice that the loans and related rights being sold are not impaired, invalid or void;
(v) no proceedings have been threatened against the seller or any of its predecessors-in-title, in certain circumstances the relevant representations, where they apply to the predecessors-in-title are subject to (to the best of the seller's knowledge).
The position changes under the LSTA distressed documentation, where most of the above representations are given, but in respect of seller only and not predecessors-in-title.
This results in a different risk framework under the LMA and LSTA documentation for buyers and sellers, a different due diligence and settlement process and different methods of recourse for buyers. The effect of the seller under the LMA based documentation making representations for itself and in respect of predecessors-in-title is that:
(i) the predecessor transfer agreements themselves are not transferred (although all claims, suits, causes of actions and other rights against any obligor transferred down the chain by predecessors-in-title will be transferred to the buyer), so no other predecessor transfer documents will be provided to the buyer for its review; and
(ii) the buyer’s recourse will be limited entirely to its immediate seller.
On the other hand, under LSTA documentation, where the seller makes representations in respect of itself only, distressed trades settle on the basis of the delivery of predecessor transfer agreements and the assignment to the buyer of all of the seller’s rights against prior sellers under such predecessor transfer agreements rather than the use of predecessor-in-title representations. It follows that a buyer under LSTA distressed documentation may be able to seek recourse not only against its immediate seller but against a prior seller. The above is a commentary on the approach taken under template documentation and may differ on a case by case basis.
Sub-participations and grantor credit risk
In most cases settlement of a loan trade will result in the buyer becoming the legal owner of the loan once any formalities required under the facility Agreement are complied with.
However, in the event that the loan trade is completed by sub-participation, there are differences between New York and English law.
Simplistically, under English law a sub-participant does not actually acquire any proprietary interest in the underlying loan, and the sub-participation agreement operates as a back to back financing agreement between buyer and seller under which buyer and seller enter into a debtor/creditor relationship, where the buyer is an unsecured creditor of the seller in respect of its rights under the participation agreement, thus taking double credit risk (on the borrower and on the seller).
There are various techniques employed to mitigate this double credit risk under English law, including:
(i) a declaration of trust by the seller in favour of the buyer over the loan and proceeds;
(ii) the grant of security by the seller in favour of the buyer over the loan and proceeds;
(iii) credit support (e.g. by way of security over certain collateral or a transfer of collateral with set-off rights);
(iv) creation of a bankruptcy remote SPV structure or a mechanic to elevate a participation to an outright transfer,
all of which have pros and cons (which are beyond the scope of this article but in respect of which we would be pleased to offer further detailed advice).
Another option, both in the New York and English markets, is for the participation to be documented under New York law and using the LTSA model participation agreement.
Under the LTSA model participation agreement, the seller holds the loans and other rights (including the right of repayment) for the benefit of the participant. The participant therefore obtains a beneficial interest in the loan and proceeds earmarked for them in the event of the insolvency of the seller.
Ultimately each par or distressed debt trade should be considered on a case by case basis and the above is only intended to make the reader aware of some potential differences between the approach taken in the US and English markets to such sales.
If you wish to obtain some further, more detailed advice, including in respect of a specific par or distressed debt sale, please do not hesitate to contact the author.