The effect of the current financial market conditions is having a significant impact on corporate borrowing including: (a) some lenders are reportedly finding the London Interbank Offered Rate (“LIBOR”) does not represent their true cost of funds and are seeking to pass on their higher costs to borrowers; (b) some lenders are seeking to terminate facilities by calling events of default so as to reduce the number of loans on their books and so reduce their credit exposure and capital reserve requirements; and (c) some lenders (e.g. Lehman Brothers and several Icelandic banks and their UK subsidiaries) are in financial difficulty and are being placed into administration (or are subject to other insolvency procedures, such as Chapter 11 in the United States).
This article seeks to assist corporate borrowers who have facilities with lenders (or who are in the process of entering into them) in which they are experiencing some or all of the above effects. It assumes facilities are documented on the basis of the Loan Market Association’s (“LMA”) standard forms and so focuses primarily on syndicated facilities, but many of the issues are equally relevant to bilateral facilities.
The article considers: (a) the mechanism lenders may use to require borrowers to meet their higher funding costs; (b) the possible events of default lenders may call to cease further funding and accelerate outstanding loans; (c) lenders’ ability to transfer loans; and (d) issues arising where a lender is placed into an insolvency procedure such as administration.
Cost of funds - market disruption clauses
The interest rate on loans is comprised of: (a) a margin plus; (b) mandatory costs (essentially FSA fees and certain deposits required by the Bank of England) plus; and (c) LIBOR (or for euros, the European Interbank Offer Rate). LIBOR is intended to represent the lenders’ cost of funds. It is defined as the rate shown on the Reuters screen for the relevant currency and interest period or, if no rate is available, the average of rates supplied to the facility agent quoted by specified reference banks to leading banks in the relevant interbank market.
It has been reported in the media, and we have found in practice, that some lenders who find LIBOR does not represent their cost of funds, are considering invoking market disruption clauses. This is despite requests from the Association of Corporate Treasurers (who represent corporate borrowers) and the British Bankers’ Association for lenders not to invoke such provisions except as a last resort.
Market disruption clauses may be invoked if either (a) LIBOR is not available on the Reuters screen; or (b) enough lenders (usually 33% or 50%) notify the facility agent that the cost to them of obtaining matching deposits in the relevant interbank market for an interest period would exceed LIBOR. If invoked, the interest rate for each affected lender’s participation in the relevant loan (for that interest period) is based not on LIBOR but on a rate which expresses the cost of funding its participation from whatever source it may reasonably select. The problems for borrowers are: (a) the transparency of the displayed screen rate is lost; (b) the borrower has no say in what source is selected (in fact the lender is not even obliged to reveal the source it selects); and (c) the interest charge becomes more complex as the borrower will be charged different interest rates on each affected lender’s share of the loan.
If market disruption provisions are invoked, the only assistance available to borrowers is that they can require the facility agent to negotiate with them in good faith (for up to 30 days) with a view to agreeing a substitute basis for determining the interest rate. Any agreed substitute basis is then binding on all parties. But if not agreed within this time then the cost of funds rates are determined as above.
When negotiating new facilities, lenders may try to amend market disruption clauses so as to make them easier to invoke and/or to ensure they always recover their higher cost of funds. Examples we are aware of include: omitting the screen rate in the definition of LIBOR or defining LIBOR as the higher of the screen rate and the average of the reference banks’ rates. Borrowers should resist any amendments especially where facilities are likely to outlast the current financial market conditions.
We are also aware that participants in the syndicated loan market are considering other methods by which loans may be priced, including calculating the margin by reference to credit default swap (“CDS”) rates. Under this method the CDS rate margin is determined by reference to rates published by Markit for the senior unsecured debt of the borrower on the five immediately preceding business days to the Quotation Date (the CDS rate margin is determined by taking the average of the CDS rates over these days). Whether this method of pricing the margin on a given loan will catch on has yet to be seen; it clearly does not address the issues surrounding LIBOR not accurately reflecting lenders’ costs of funds. In any event, this method of setting the margin will not be practical or appropriate in all cases.
Events of default
Breach of financial covenants: Lenders may take the opportunity to call a default because borrowers are in breach of their financial covenants. For example, with property valuations falling, loan-to-value (“LTV”) ratios may be breached. Borrowers should notify lenders as soon as they become aware that they may be about to breach a financial covenant. They should request a grace period (e.g. for LTV ratios, 21-30 days) to allow them to inject equity to remedy the breach before being in actual default (assuming there are no equity cure restrictions). For new facilities borrowers should request a grace period be included from the outset and require adequate headroom in financial covenants based on their financial model.
Material Adverse Effect (“MAE”): Many representations, undertakings and events of default are qualified by MAE. The LMA investment grade documents leave the definition blank, leaving it for the parties to agree a suitable definition. But the LMA leveraged document defines MAE as:
“a material adverse effect on:
the business, operations, property, condition (financial or otherwise) or prospects of the borrower’s group taken as a whole; or
the ability of the borrower [or other obligor, e.g. a guarantor] to perform its obligations under the facility; or
the validity or enforceability of, or the effectiveness or ranking of any security granted … under the finance documents or the rights or remedies of any lender under any finance document.”
“Finance document” includes the facility agreement and related security documents e.g. a debenture and/or legal mortgage or charge.
The first bullet point is particularly widely drafted and, for new facilities, borrowers should try to remove it or at least modify it to remove some of its limbs in particular “prospects”. They could also try to restrict the second point to “payment obligations”.
Material Adverse Change (“MAC clauses”): Facilities commonly include MAC clauses. Under these, loans may be accelerated and further funding stopped if “any event or circumstance occurs which the “Majority Lenders” (usually 66%) reasonably believe has or is reasonably likely to have a Material Adverse Effect”. If lenders try to invoke this clause, borrowers should consider challenging it on the basis that “materiality” is ambiguous and subjective. Borrowers can take some comfort from (and could remind lenders of) the fact that (a) the courts have tended to be reluctant to give any guidance on enforcing MAC clauses as each case will depend on the particular facts and the wording of the MAC clause in question; and (b) it is generally accepted that, if lenders mistakenly accelerate debts thinking an event of default has occurred (e.g. a MAC) when in fact it has not, they will be liable to the borrower for damages. A 2005 House of Lords case (Concord Trust v The Law Debenture Trust Corporation plc  UKHL 27) serves as a reminder that often the only way to establish for certain whether an event of default has arisen, and if so whether it is materially prejudicial, is to apply to the courts for a ruling. This will rarely be practical for lenders because of time constraints. Given the risks, it is likely lenders will only use a MAC clause (if at all) to stop further drawings rather than accelerate loans. For new facilities borrowers should try to limit the subjective nature of the clause by defining what is meant by “material” and by removing the subjectivity of it being in the lenders’ opinion or belief.
Lenders may want to sell or sub-participate loans so as to remove them from their balance sheet and so free up capital reserves. Borrowers may wish to maintain their facilities with their relationship banks and not want to find that a lender is one they do not know or, possibly worse, is a hedge, private equity or even vulture, fund. For existing facilities there may be nothing a borrower can do about this; the documentation will dictate whether their consent is required to transfers or participations. For new facilities borrowers should resist attempts to avoid requiring their consent or for deemed consent to be given. Another issue for borrowers is that, as a result of the transfer, the borrower may have to make a payment or increased payment to the new or existing lender under the increased costs and/or tax gross-up clauses. These are excluded in LMA facilities but in new facilities, lenders may try to include them. Borrowers should resist this.
Lenders in administration
Drawdown under committed facilities: A lender being placed into administration (or other insolvency procedure) does not entitle any party to terminate the facility. The administrator must continue to perform the lender’s obligations if the borrower does not default. If a lender (whether or not in administration) does not fund its participation in a loan, the other lenders are not relieved of their obligations to fund. They are not, however, obliged to make up any shortfall because one of the lenders fails to fund its share of the loan. Borrowers could consider increasing the amount of future drawdown requests to compensate for possible failures to fund if a lender is, or is about to be, in administration, although this may not always be possible or practical.
On demand and overdraft facilities: The administrator could demand immediate repayment of on demand and overdraft facilities and not fund further advances.
Revolving facilities and rollover loans: Under revolving facilities the administrator could insist on strict compliance with the terms on which rollover loans are made. Revolving loans must be repaid at the end of each interest period and, if the borrower requests, a new “rollover” loan drawn if the borrower is not in default. Borrowers therefore risk not receiving the full amount if a lender fails to fund because it is in administration. However, market practice is such that a rollover rarely happens this way. Instead the loan is simply deemed to be repaid and re-drawn on the rollover date and the lender makes a book entry showing the repayment and the terms on which the loan has been re-borrowed. Borrowers could try relying on a “course of dealings” argument to avoid actually having to repay.
Set-off: Borrowers’ set-off rights are usually excluded under the facility agreement. However on the occurrence of administration there is an automatic set-off of mutual debts (rule 2.85 Insolvency Rules 1986). Although this has not been tested in the courts, a borrower could sue for damages it suffers on a lender’s failure to fund (e.g. on a rollover) and argue that the judgement debt could be set off against the amount of the borrower’s debt repayment obligation. Damages claims must be reasonable and reflect the borrower’s true cost and loss. The set-off under rule 2.85 only applies where the lender is in administration and the obligation to repay under the loan does not take place before the date when the administrator is ready to distribute funds to creditors.
Facility agents: It is unlikely to be appropriate or possible for a bank in administration to carry out the role of facility agent. Borrowers should consider contacting the syndicate lenders who constitute Majority Lenders (see above) to use their powers under the facility to require the facility agent to resign and to replace it with another (solvent) lender. If, however, an administrator continues to act as facility agent, it is in the interests of borrowers (and the other syndicate banks) that steps are taken to ensure funds paid to the facility agent (in its role as payment conduit) are kept separate for the benefit of the relevant parties. Another role of facility agents is to pass drawdown requests to the other lenders. Borrowers should consider sending copies directly to the lenders to ensure they are aware of the request and are able to meet it. While not strictly in compliance with the facility agreement, it seems a commercial and sensible way to assist all parties.
The current financial market conditions are unprecedented, requiring borrowers to consider new approaches to documenting facilities and to dealing with issues arising under existing ones. Some of the issues outlined in this article have not been tested or at least are not current market practice. Where borrowers find themselves facing these or other issues arising from the current market conditions they should contact a member of Berwin Leighton Paisner’s Finance Department at the earliest opportunity.