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Law360 (May 11, 2020, 6:03 PM EDT) --
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| Raniero D’Aversa |
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| Anthony Kay |
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| Amy Pasacreta |
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| Matthew Fechik |
Fitch Ratings recently forecast a 4% default rate for European leveraged loans in 2020 and a 7% default rate in 2020.[2] In a severe downside scenario, Fitch projected that default rates could reach as high as 14% next year. In some European leveraged loan deals, the transfer restrictions that have kept distressed investors out of lending syndicates may fall away if events of default (or certain specific events of default) occur and continue.
When Problems Create Opportunities
While transfer restrictions vary from deal to deal, a typical European leveraged loan deal will include several transfer restrictions.
Generally, the prior written consent of the borrower is required for any assignment, transfer or subparticipation unless: (1) the buyer is a lender or an affiliate or related fund of a lender; (2) the buyer is included on a list of approved lenders; or (3) the transaction occurs at a time when a borrower or guarantor has defaulted on its payment obligations or has entered insolvency or insolvency proceedings (or similar events), also known as a "material event of default."
Further restrictions are often placed on top of the basic ones discussed above. These can include prohibitions on transactions involving industry competitors, hedge funds, private equity funds, loan to own funds and distressed investors.
In some deals, these prohibitions may also fall away, along with the borrower consent requirement, if a material event of default is continuing (or, in certain deals, if an event of default is continuing). Such scenarios could create openings for distressed investors to participate in European leveraged loan deals that were inaccessible to them just a few weeks ago.
Not all deals eliminate or relax transfer restrictions when a material event of default (or an event of default) occurs and continues. According to Reorg Debt Explained, 58% of loans sold in 2019 imposed restrictions on selling to distressed funds even after certain types of default, compared with just 14% in 2017.[3]
Additionally, there are other jurisdiction-specific restrictions to be aware of. For example, in deals with Swiss borrowers, credit agreements typically cap the number of nonbank lenders under that credit agreement at 10 and the aggregate number of nonbank lenders under all outstanding debt at 20 in order to avoid withholding tax on interest payments. These restrictions will very likely stay in place, regardless of whether a default occurs.
When Opportunities Create Problems
As discussed above, it's imperative to thoroughly review the applicable credit documents before entering a trade in which the buyer is a distressed investor that isn't already a lender. Parties to a trade shouldn't assume that settlement by subparticipation will be an option if the buyer cannot become a lender of record. European leveraged finance deals frequently apply the same transfer restrictions to subparticipations that apply to assignments and transfers.[4]
Even if subparticipation is an option, parties who check the "legal transfer only" box in a Loan Market Association trade confirmation could inhibit their own ability to settle via subparticipation.
There is a common misconception that selecting "legal transfer only" means that the trade will go away if the buyer cannot become a lender of record. In fact, when parties check the box, they're agreeing not to settle the trade by subparticipation if assignment or transfer is not possible, but instead, they're electing to settle "on the basis of an alternative structure or arrangement mutually acceptable to the seller and the buyer that provides the seller and the buyer with the economic equivalent of the agreed-upon trade."[5] There is no standard form for this type of agreement.
If settlement by subparticipation is an option, the parties should consider settling the trade on a participation agreement adapted from the Loan Syndications and Trading Association form rather than a Loan Market Association participation agreement. Under English law, a participation agreement doesn't effect a true sale of beneficial ownership and the grantor and participant have a debtor and creditor relationship. Under New York law, a participation agreement is viewed to transfer beneficial ownership from the grantor to the participant.
This distinction is important because if the grantor becomes insolvent under English law, the participant would only be an unsecured creditor in the insolvency proceedings. Under New York law, the participant would have a property interest in the loans and should not be adversely affected by the grantor's insolvency proceedings.
Parties wishing to have a New York law participation as a settlement option should include it as a term of trade and make sure that the trade confirmation is drafted accordingly. But before doing so, the parties should first confirm that such a transaction is permitted under the credit documents. European credit agreements often require that the relationship between the existing lender and the proposed subparticipant is that of a contractual debtor and creditor (including in the bankruptcy or similar event of the lender or a borrower).
Conclusion
The COVID-19 pandemic may, for the first time in years, allow distressed investors to meaningfully return to the European leveraged loan syndication market. As many par investors look to offload credit risk at the same time, distressed investors could provide an important source of liquidity for collateralized loan obligations, debt funds and banks.
Par investors and distressed investors alike should carefully review credit documents before trading and, when they do trade, they should make sure that the trade documentation provides for an acceptable form of settlement if the buyer is unable to become a lender of record.
Raniero D'Aversa is a partner at Orrick Herrington & Sutcliffe LLP and chair of the firm's restructuring group.
Anthony Kay is a partner at Orrick.
Amy Pasacreta is of counsel at the firm.
Matthew Fechik is senior distressed trade career associate at the firm.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] "PE Firms Race to Block the Exits to Ward Off Vulture Funds," Bloomberg June 12, 2019, https://www.bloomberg.com/news/articles/2019-06-12/pe-firms-race-to-block-exit-doors-to-ward-off-vulture-funds
[2] "Europe's High-Yield Default Rates Rise as Credit Cycle Turns," Fitch Ratings Mar. 30, 2020, https://www.fitchratings.com/research/corporate-finance/europe-high-yield-default-rates-rise-as-credit-cycle-turns-30-03-2020.
[3] "PE Firms Race to Block the Exits to Ward Off Vulture Funds," Bloomberg June 12, 2019, https://www.bloomberg.com/news/articles/2019-06-12/pe-firms-race-to-block-exit-doors-to-ward-off-vulture-funds
[4] "PE Firms Race to Block the Exits to Ward Off Vulture Funds," Bloomberg June 12, 2019, https://www.bloomberg.com/news/articles/2019-06-12/pe-firms-race-to-block-exit-doors-to-ward-off-vulture-funds
[5] See Condition 6.2(c) of the LMA Standard Terms and Conditions for Par and Distressed Trade Transactions (Bank Debt/Claims).
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