As a response to concerns about hedge funds who operate as ‘loan to own’ or distressed asset investors joining their syndicates, many borrowers have carefully re-examined the terms of their credit documents to find strategies that will protect them and limit the leverage that such hedge fund lenders could otherwise exercise in any future restructuring.
Such terms, which were often negotiated at a time when investment capital was cheap and lender protections were scarce, may include equity cures and mulligan clauses which limit the value of financial covenants (if any).
Similarly, there was the inclusion of “yank-a-bank” and “snooze-you-lose” provisions that enable the borrower to influence and control votes, and stricter eligibility criteria for new lenders to control the composition of the lending syndicate. But the simplest and often cheapest defensiveapproach is for a borrower to simply refuse to give its consent to a transfer.
How strong a borrower’s position is to refuse consent to a transfer is usually determined by the relative bargaining positions between a borrower and its syndicate when the consent provisions were negotiated prior to the loan being issued. When investment capital is readily available and deals are routinely over-subscribed, as was often the case between 2005 and 2007, loans would include many borrower-friendly provisions, whereas the reverse is true when investment capital is scarce.
Historically, it was unusual for borrowers to refuse consent but in recent months it is becoming more common as an increasing number of borrowers are looking to utilise such consent rights to retain their relationship with banks who, they hope, will be supportive in any future restructuring, rather than with hedge fund lenders who may be approached with suspicion in this regard.
In the past, failure to obtain borrower consent for a transfer was not overly problematic for secondary market participants such as hedge funds. In such a situation, the seller and the buyer would normally agree for the seller to grant a sub-participation in favour of the buyer and thereby provide both parties with the desired economic exposure to the loan. Increasingly, however, sellers of loans lack the balance sheet appetite for the credit risk intrinsic to sub-participations.
Putting aside the disconnect that until recently existed between the Loan Market Association par and distressed documentation (i.e., that there was no automatic fall back to sub-participation in pre-January 2010 par loan trading documentation) should the trend of borrowers refusing consent to the transfer continue, it will be interesting to see whether the automatic fall back to sub-participation language that has now been hardwired into both par and secondary trades remains or whether it will be (as is becoming increasingly common) expressly excluded by sellers of loans.
Turning to the specifics of a borrower refusing consent, most syndicated loan agreements require a transferring lender to either consult with the borrower about such transfer or obtain its consent to the transfer. Whilst many borrowers (and indeed agents) are confused by the distinction between the two terms, the general consensus from market practitioners is that consultation does not give a borrower a right to block a transfer. In contrast, a contractual requirement to obtain the borrower’s prior consent to a transfer would give it a veto right. However, where a credit agreement includes such a provision, it is usually limited in scope.
In practice, it is common to require the consent of the borrower to such transfers whilst the syndication process is ongoing, and thereafter, save where there is a continuing event of default or it would constitute a transfer to an affiliate, the borrower cannot usually withhold consent to a transfer unless it has reasonable grounds.
This begs the question: when can consent be reasonably withheld? The principles governing the refusal of consent are clearly established in English law and provide that a party is not entitled to refuse consent without having a proper and legitimate reason and any refusal on grounds that are not objectively justifiable would not be valid. Ultimately, it becomes a question of fact as to whether in the circumstances the refusal to grant consent was reasonable or whether it was for a collateral purpose.
Whilst there has been little guidance from the courts in the context of syndicated loans, there is a difference between fully funded loans (e.g. funded term loans) and loans where there continues to be a funding commitment (e.g. delayed draw term loans or revolving loans). Clearly, where there continues to be a funding commitment, a borrower could reasonably withhold consent to a transfer, if there were legitimate grounds for questioning the buyer’s ability to meet its funding requirements. If the loan was already funded, however, then the creditworthiness of the buyer is no longer relevant and there is a strong argument to say that any attempt to withhold consent on these grounds would be invalid.
Another possible reason to avoid consent would be to prevent the disclosure of commercially sensitive information to a competitor. That said, whilst this may in itself appear to be a legitimate and proper reason, one must consider what information is actually being disclosed to the lenders and whether it would it be detrimental to the business and operations of the borrower. Normally, a borrower would only disclose limited financial information to its syndicate (e.g. audited annual accounts and unaudited quarterly accounts) and would not commonly disclose industrial processes or trade secrets. Indeed, such financial information is often disclosed to the market in any event, either by virtue of statutory filing requirements or under the rules of an exchange if the borrower group has listed securities.
Whilst there has been little guidance from the courts in this respect, there was the recent case of Tank & Rast, a German highway services operator. This case highlights the line of tension that can arise between borrower and lender. In this case, the borrower blocked sales by an existing lender to certain infrastructure funds that specialised in investing in similar types of investments. The credit agreement provided that consent could not be unreasonably withheld and proceedings were issued against the borrower seeking, inter alia, a declaration that the borrower was in breach of contract for unreasonably withholding consent.
Unfortunately, whilst the court’s decision in this matter would have served as useful guidance to the secondary loan trading community, the case ultimately settled out of court and the borrower gave its consent. Whilst it is always dangerous to speculate on the reasons for why a case settles, especially when it settles out of court, one could nonetheless speculate that the consent from the borrower that the settlement provided for was brought about because the borrower’s argument that refusal was reasonable lacked strength.
The more recent, and in some respects, more challenging development is, however, where borrowers refuse consent in the belief that the proposed new lender does not fit the traditional lender stereotype and their interests may not therefore be as aligned with the borrower’s as a traditional lender’s would be. In such circumstances, the concern is that the new lender would be less willing to provide the same level of support that a more traditional bank lender may have done, for example, by agreeing to extend the maturity of the loans or reset covenant levels.
Previously, a borrower’s refusal of consent simply because the new lender would not vote in accordance with its wishes was not in itself generally considered to be a reasonable basis to refuse consent but given the uncertainty of the current climate, this would be an interesting question to pose before a court, namely: is it a legitimate and proper reason to refuse consent to a transfer simply because the proposed transferee may not agree to the borrower’s proposals for a restructuring, in particular if such proposals had not even been put before the syndicate? In recent months we have seen borrowers argue, in hung loan situations, that the syndication process has not closed, in some cases, years after the loans were issued, and should therefore be able to rely upon the more liberal pre-syndication rule regarding consent.
Clearly, private equity sponsors have little appetite for ceding their portfolio investments (often sustaining significant losses in the process) to hedge fund distressed asset investors whose underlying strategy involves acquiring the borrower’s assets at a substantial discount to par through the debt structure. But is this a legitimate and proper reason or a collateral purpose?
The refusal to give consent seems to be going largely unchallenged perhaps because the banks are facing a fundamental conflict between the desire of their investment banking businesses to obtain new client mandates and the needs of their secondary trading desks to pursue the interests of their clients. It is therefore necessary to ask oneself whether the concept of ‘a trade is a trade’ still holds true if the borrower refuses to grant consent and the seller has no appetite for granting sub-participations since in many cases the only practical alternative is to unwind the trade which may mean a loss for the buyer if the price of the asset has shifted.
How the market responds will be interesting, in particular given the number of hedge fund investors that have recently expressed a preference for the high yield market in contrast to trading loans. Clearly the gaining of borrower consent in loan trades has lead to increased settlement times, but it may also have a more fundamental impact on pricing and liquidity, not only as hedge fund buyers respond to the inherent uncertainty that this trend creates but also as arrangers try to place new loans into the market and are met with a lukewarm reception.