Practical Considerations for Secondary Loan Trades
Loan trades will typically be agreed on an over-the-counter basis either directly between buyer and seller, or through a broker-dealer or agent. Trades will usually be concluded by telephone, with contractual documentation negotiated and agreed post-trade. However, the contract between the buyer and the seller will have legal effect and be binding on the parties from the trade date, notwithstanding that the formal documentation of the contract may not be put in place for days, weeks, or, in some cases, months after the initial trade call. This approach was affirmed by the English courts in Bear Stearns Bank plc v. Forum Global Equity Limited.
It is, therefore, extremely important that any person wishing to enter into a trade takes care to ensure that all key terms are stated and agreed at the time of trade. While most trades will be carried out on phone lines, which will be recorded to preserve evidence of the trade terms, it is also good practice to ensure that all key trade terms are documented in a recap email sent immediately after a trade, where possible, to avoid misunderstandings.
Although parties are free to negotiate bespoke contractual documentation to document their trade, the vast majority of loan trades will be documented using a market-recognised form of standardised secondary trading documentation as a starting point. In Europe and Asia, trades are typically documented using the secondary trading documentation created and maintained by the Loan Market Association (LMA) as a starting point for negotiation.
By agreeing to expressly incorporate the LMA standard terms and conditions for par and distressed trade transactions (bank debt/claims) (the LMA Terms and Conditions), parties are able to incorporate a broad set of market standard terms and conditions, which will regulate the legal relationship between the buyer and the seller throughout the life of the trade and beyond.
A comprehensive review of every term of the LMA Terms and Conditions is beyond the scope of this chapter. Readers are referred to the LMA’s own user guide, which provides a detailed overview of the key provisions of each part of the LMA’s secondary trading documentation.
For the purposes of this chapter, we will focus on some of the key provisions of the LMA Terms and Conditions and concentrate on some practical considerations for parties to consider before agreeing to trade on LMA terms.
In particular, we will focus on:
- the practical implications of ‘a trade is trade’;
- restrictions on transferability;
- the allocation of payments made on or after the trade date; and
- dealing with undrawn commitments.
Finally, while this chapter covers points that will be of practical concern to an ad hoc committee member looking to either sell its interest, or acquire an additional interest, in the relevant underlying loan, it should also be noted that the ad hoc committee member may be in possession of private information that may not otherwise be available to the syndicate.
While possession of this information may not prima facie prevent an ad hoc committee member from entering into a trade, careful consideration will need to be given as to whether or not it is appropriate to do so in light of relevant market guidelines. This issue is discussed in greater detail in Chapter 10 on the Loan Market Association Transparency Guidelines.
The practical implications of ‘a trade is a trade’
‘A trade is a trade’
As with any traded instrument, the secondary market for loans is subject to material price volatility. On any given day, the price which a purchaser will be prepared to pay to purchase a loan will be driven by a wide variety of factors, including market liquidity (i.e., the number of potential buyers and sellers wishing to trade positions in the underlying loan) and the underlying financial performance of the relevant borrower.
Where the borrower of a loan is going through a period of financial distress, the impact of these factors can be particularly acute and significant swings in price can occur in a relatively short space of time. This volatility causes particular difficulties for parties to loan trade transactions, as the requirement to agree formal contractual documentation can lead to an extended period of time between trade and settlement.
Under the LMA Terms and Conditions, the target settlement date for a distressed trade transaction is T+20 (i.e., the date falling 20 business days after the trade date). It is not uncommon for the actual settlement date of the trade to fall well beyond this target settlement date. By contrast, trades in distressed bonds will typically still settle electronically on a T+2 basis.
Given the possibility of the time between trade date and settlement being measured in weeks or months rather than days, it is extremely important to both seller and buyer that both parties are ‘locked’ into a trade, so as to minimise their respective exposure to movements on price if their trade fails to settle for any reason.
For this reason, the LMA secondary trading documents are designed around the concept that ‘a trade is a trade’. Put simply, this means that, unless otherwise agreed at the time of trade, by agreeing orally to enter into a trade on LMA terms, parties will be bound into the transaction from the trade date and will be required to find an alternate means of concluding the transaction even if it cannot be settled as originally intended at the outset of the trade.
Mandatory settlement provisions
Parties will normally agree their preferred method for settling the trade on the initial trade call. Typically, parties will select either a legal transfer by novation, an assignment of rights and assumption of obligations, or a funded participation. However, it may not be clear at the time of trade whether it will be possible to settle the trade by the preferred method. For example, where parties cannot complete a legal transfer without obtaining prior borrower consent, the terms of trade will need to reflect what the consequences will be if that consent is not forthcoming.
The mandatory settlement provisions in the LMA Terms and Conditions address these concerns by requiring the parties to find an alternative means of settling the trade in line with the LMA’s broad ‘a trade is a trade’ approach.
The mandatory settlement provisions operate as follows:
- Where it has been agreed that the settlement of the trade is subject to the satisfaction of any condition, the buyer and the seller must each use their reasonable endeavours to ensure that any specified conditions are fulfilled on or before the settlement date. The seller is obliged to use its reasonable endeavours to obtain any third-party consents (e.g., borrower consent) in connection with the transaction.
- If (1) any condition specified in the agreed terms remains unfulfilled at the settlement date; or (2) any third-party consent has not been obtained or has not been granted, parties are required to settle the trade by way of a funded participation using the LMA recommended form with such changes as are mutually agreed between the parties.
- If settlement of the transaction cannot be effected by funded participation, or parties are unable to agree on the form of participation agreement itself, the transaction must be settled on the basis of an alternative structure or arrangement mutually acceptable to the seller and the buyer, which provides the seller and the buyer with the economic equivalent of the agreed-upon trade (which can include cash settlement). This alternate economic equivalent mechanism is referred to in the LMA Terms and Conditions as an alternative settlement.
Where parties do not wish to settle the transaction by way of a participation, they may elect to trade on a ‘legal transfer only’ basis. However, although the name would seem to imply that parties will be entitled to break the trade if it is not possible to settle by legal transfer, this is not the case. By selecting legal transfer only, parties are still bound to settle the trade with each other, but simply move straight to the alternative settlement route without attempting to agree a funded participation.
The mandatory settlement provisions also contain similar provisions requiring parties to use the alternative settlement route where they have elected to try to settle by funded participation in the first instance, but this has not been possible because of the failure to satisfy a condition to the trade or obtain a necessary consent.
While designed to try and minimise ongoing market risk on open trades, the mandatory settlement provisions can be something of a trap for the unwary. Often, when a lender has chosen to sell its interest in a loan, it is usually seeking a clean exit. It can, therefore, come as a surprise that there is a possibility that it may be required to remain as lender of record and administer the credit on a participant’s behalf.
As such, where a lender wants to have the option to break the trade if a clean exit is not possible, this will need to be expressly agreed at time of trade and documented in the subsequent trade confirmation.
Restrictions on transferability
One key point of pre-trade due diligence for both the buyer and seller – particularly in view of the mandatory settlement provisions referred to above – is to check what restrictions on transferability are contained in the underlying facility agreement.
While it has been fairly common to include some restrictions in facility documentation for some time, indications are that leveraged finance deals are becoming even more restrictive following the 2008 financial crisis, with private equity sponsors taking advantage of a borrower-friendly credit market to build in greater protections in their deals in response to losing control of portfolio companies to distressed investors during the downturn.
The first point to check is whether there is any restriction in the underlying credit documentation or arising at local law, which would restrict the ability of the potential buyer from becoming a permitted transferee.
Under the LMA standard facility documentation for leveraged and investment-grade deals, a lender is permitted (subject to any consent or consultation right – see below) to assign or transfer all or part of their rights and obligations to ‘another bank or financial institution or to a trust, fund or other entity that is regularly engaged in or established for the purpose of making, purchasing or investing in loans, securities or other financial assets’. This obviously provides for a broad class of potential transferees and should be sufficient to permit a transfer to most potential buyers.
Where the standard LMA language is pared back to simply cover another bank or financial institution, the English Court of Appeal has ruled that an entity can fall within the definition of ‘financial institution’ even if it is not a bank, akin to a bank, or carrying out bank-like activities, such as lending money, as long as it carrying on business in accordance with the laws of its place of creation and its business is concerned with commercial finance. As such, as a matter of English law, most distressed investment funds should still fall within this definition and be permitted transferees under the credit documentation.
It is also possible that the facility agreement may also restrict transfers to persons who are not on a ‘white list’ of approved transferees. This type of provision has grown in popularity since the 2008 financial downturn.
Finally, even where parties are satisfied that there is no restriction in the credit documentation itself, it is possible that there may be restrictions as a matter of local law, such as the requirement to hold an appropriate banking licence.
Borrower consent rights
One of the key diligence points to consider prior to entering into any trade is to determine whether or not the seller is under any obligation to obtain the borrower’s consent or to consult with the borrower prior to entering into any transfer.
Where borrower consent is required prior to transfer, it is common for this right to fall away following the occurrence of an event of default that is continuing. This is an area that sponsors have tried to make more restrictive following the 2008 financial crisis by limiting the necessary event of default to a payment or insolvency default.
Where consent is required, it is common for the facility agreement to provide that the consent is not to be unreasonably withheld and for consent to be deemed given if no rejection is made within a defined period (usually five business days). The question of when it is reasonable for a borrower to withhold consent in the context of a loan transfer has not been directly tested before an English court. In analogous situations where the court has had to consider reasonableness provisions in a commercial context, the courts have tended to interpret these clauses as permitting the party withholding its consent to act in accordance with its own commercial interests.
It is also increasingly common to see consent requirements extend beyond transfers and also include sub-participation and other synthetic arrangements. It remains to be seen how these increasingly restrictive transfer provisions will impact on restructurings in the coming years.
Borrower consultation rights
Where no express consent right has been granted to the borrower under a credit agreement, it is common to see borrowers instead be given a right to be consulted on a transfer instead.
While this is no doubt intended by lenders to be a lesser right than a full consent right, the right of a borrower to be consulted is somewhat problematic within the framework of the LMA Terms and Conditions.
Where a consent is required, the mandatory settlement provisions provide a clear route for lenders to follow. A trade is agreed and borrower consent is sought. If that consent is not given, parties default to a funded participation arrangement, or failing that, an alternative mutually agreeable settlement of the economic equivalent of the trade.
Where only a consultation is required, any consultation carried out post-trade will amount to a somewhat meaningless exchange for the borrower, as, at this stage, the seller is contractually committed under the ‘a trade is a trade’ principle to settle the trade with its buyer irrespective of the views of the borrower in any consultation. To date, this point remains untested before the English courts. However, a prudent seller may choose to consult with the borrower pre-trade, so as to avoid the possibility of a dispute.
Even where the potential buyer is a permitted transferee under the credit documentation and at local law, and no consent issues have arisen, difficulties may still arise where the credit agreement contains additional restrictions.
Common restrictions include:
- minimum transfer requirements, which will restrict transfers from being made where the amount being transferred is below the minimum amount permitted to be transferred under the credit agreement;
- minimum hold requirements, which will restrict transfers from being made where the seller’s holdings in the underlying loan would fall below a specified threshold as a result of the transfer (although sales of a seller’s entire position, which would reduce their holdings to zero are normally permitted); and
- pro rata transfer provisions, which will restrict transfers from being made unless the seller is also transferring a corresponding amount of other loans or facilities extended by it to the borrower.
The allocation of payments made on or after the trade date
As there is commonly a delay between the date on which a trade is agreed and the date on which the trade will be settled because of the need to agree and conclude the necessary trade documentation, the terms of the trade will need to reflect how the various sums payable by the borrower will be apportioned between the buyer and the seller during this period.
Careful consideration therefore needs to be given by the parties as to what entitlements are likely to arise during the life of a trade to ensure that these are apportioned between the parties in line with their expectations.
Broadly speaking, the main payments that are likely to arise will fall into one of six categories:
- repayments of principal;
- cash interest payments;
- payment-in-kind (PIK) interest payments;
- recurring fees;
- non-recurring fees; and
- non-cash distributions.
Repayments of principal
Where a borrower makes any repayment of principal to the seller prior to the settlement of an open trade, the buyer will be entitled to receive the benefit of this as a deduction from the purchase price payable by it on the settlement date. This allocation reflects the fact that the buyer has agreed to bear the risk of the underlying loan from the trade date onwards.
While the buyer’s entitlement to receive the benefit of any principal repayments should not be controversial, the seller should note that, under the standard terms, the buyer is entitled to receive all repayments made during the period from and including the trade date.
As such, where it is known at the time of trade that the borrower will make a repayment on the trade date itself or shortly thereafter, the seller may wish to seek to either exclude this repayment as an express term of trade, or ensure that the repayment is ‘priced in’ to the price agreed for the trade.
Payments of cash interest – performing borrowers
The LMA Terms and Conditions contain a number of options for parties to select to determine how interest should be allocated, which will need to to be considered and agreed at time of trade.
Where a borrower is expected to continue making interest payments throughout the life of the trade, the most common option for parties to select is ‘settled without accrued interest’ (SWOA). SWOA trades are also occasionally referred to in the market as ‘apportioned’ trades.
SWOA entitles the seller to retain its entitlement to receive payment of interest from the borrower for the period up to but excluding the settlement date of the trade. The buyer will then be entitled to receive all interest payable from the period of the settlement date onwards.
This apportionment of interest is not normally reflected in the purchase price payable on the settlement date. Instead, the seller will receive its share of interest when paid by the borrower on the next interest payment date. This payment will either be made by the facility agent to the seller directly, or, where the buyer receives the full coupon payment, the buyer.
However, the seller will lose its entitlement to any accrued but unpaid interest if the borrower repays the interest after:
- its due date and beyond any applicable grace period (each as specified in the credit documentation as in effect on the trade date) or, if no such grace period exists, the expiration of 30 days from such due date; or
- a default in connection with any other payment obligation of any obligor under the credit documentation (irrespective of whether such default is remedied or waived).
This provision is referred to colloquially by market participants as the ‘flip to flat’ provision.
Payments of cash interest – non-performing borrowers
Where a borrower is currently in payment default under the credit documentation, or it is considered likely that a payment default will occur on the next interest payment date, parties will normally agree to trade on a ‘trades flat’ basis. This entitles the buyer to receive all accrued and unpaid interest if and when paid by the borrower at no additional cost.
PIK interest will normally be rolled up and added to the existing capital of the loan under the terms of the credit agreement. Where this is the case, any PIK interest that has been capitalised prior to the trade date will form part of the principal amount of the loan, and the buyer will pay to acquire these amounts, together with the original principal amount, from the seller at the agreed purchase rate.
However, where PIK is capitalised on or after the trade date, these amounts will be for the account of the buyer and will be transferred at no additional cost. Where a lender is looking to sell its interest in a PIK facility, they will therefore need to be mindful of the PIK capitalisation date, as they may be giving up some additional value if they elect to sell when a capitalisation is imminent.
Recurring fees are fees that are expressed to accrue by reference to time elapsed in accordance with the credit documentation. As the name suggests, these are fees that are ongoing in nature and will normally be expressly provided for under the credit documentation, such as commitment fees, ticking fees, or facility or letter of credit fees or commissions.
The standard LMA position is for recurring fees to follow the interest treatment, so, for example, where a trade has been agreed on a SWOA basis, recurring fees will be apportioned around the settlement date as is the case with cash interest payments.
As is the case with cash interest payments, the seller’s right to claim its share of unpaid and accrued recurring fees will be lost if the borrower fails to pay the sums due within the relevant grace period or if a payment default otherwise occurs under the credit documentation.
Non-recurring fees are fees that typically arise as a one-off, usually in connection with a specified event. Examples of non-recurring fees include waiver fees, consent fees or prepayment fees.
Under the LMA Terms and Conditions, any fees that are paid on or after the trade date will be for the account of the buyer at no additional cost, irrespective of the period of accrual.
As such, where the seller wishes to retain a fee that remains unpaid as at the trade date, the seller will need to ensure that this is expressly agreed at the time of trade.
In distressed scenarios, the most likely scenario for a non-cash distribution to arise would be as a result of debt exchanges or debt-for-equity swaps.
Where a borrower or any obligor makes a payment of principal, interest or fees by way of a non-cash distribution, the seller and buyer will be entitled to a share of the non-cash proceeds that corresponds with their original entitlement to the underlying payment, in respect of which the non-cash distribution was issued in satisfaction. As such, where a non-cash distribution is made in respect of interest that has been subject to a ‘flip to flat’, the seller will forfeit its entitlement to the non-cash distribution in the same way that it has forfeited its right to the original underlying interest payment.
Where a party to the trade receives a non-cash distribution to which the other party is entitled, the recipient of the non-cash distribution is required as soon as is reasonably practicable after the receipt of the non-cash distribution to procure the transfer of the relevant portion of the non-cash distribution to, and the registration of the non-cash distribution into the name of, the other party, and, pending such transfer and registration, to account to the other party for any sums received or other sums yielded in respect of the non-cash distribution.
Dealing with undrawn commitments
Where the traded assets include a facility that is only partially funded at the time of settlement – for example, a revolving credit, letter of credit, guarantee or surety bond facility – the seller and buyer will need to consider whether it is appropriate to compensate the buyer for assuming the liability to fund and part of the undrawn commitment in the future.
The standard position under the LMA Terms and Conditions for dealing with undrawn commitment is for the buyer to be compensated by way of an adjustment to the purchase price. This adjustment is referred to in the secondary loan market as a ‘net-back’.
To demonstrate how the net-back operates in practice, it is perhaps easiest to use a few examples.
First, let us examine the position of the buyer and seller if no net-back were to be paid. In the following example, buyer and seller have agreed to trade a £1 million commitment under a revolving credit facility for an agreed purchase rate of 75 per cent (i.e, for every £1 originally lent by the seller, the buyer agrees to pay the seller 75 pence). At the time of settlement, the RCF is 50 per cent drawn, with 50 per cent of available undrawn commitment.
Example 1 – no ‘net-back’
Without a net-back mechanism, the payments to be made by the buyer to the seller and the borrower would operate as follows:
£500,000 @ 75%
Borrower utilisation of undrawn commitment
Total buyer funding requirement
The buyer has a £1 million claim against the borrower, for which it has advanced funds of £875,000 (i.e., an effective purchase rate of 87.5 per cent), rather than the agreed price of 75 per cent. Equally, by avoiding the requirement to fund the additional £500,000 to the borrower, the seller has received a total benefit of £875,000 as a result of the sale.
In order to put the buyer in the position that it would be in if it were purchasing a fully funded facility at the relevant purchase rate, it is necessary for the seller to pay to the buyer a net-back calculated as the difference between par (i.e., 100 per cent) and the agreed purchase rate. In our current example, the net-back would be 25 per cent (i.e., difference between 100 per cent and 75 per cent).
Example 2 – seller pays ‘net-back’ to buyer
By including a ‘net-back’ in the purchase price, the buyer is compensated by the seller for assuming the future funding obligation as follows:
£500,000 @ 75%
Undrawn commitment ‘net-back’
£500,000 @ –25%
Borrower utilisation of undrawn commitment
Total buyer funding requirement
As before, buyer has a £1 million claim against the borrower, but this time it has advanced funds of £750,000 (i.e., an effective purchase rate of 75 per cent).
There may be circumstances where it is appropriate for a seller to seek to exclude the net-back provisions. In distressed scenarios, it is often the case that undrawn commitment is ‘draw-stopped’ and is no longer capable of being utilised by the borrower as a result of the occurrence of an event of default, or the entry into standstill arrangements. Where it is unlikely that a facility will be capable of being drawn down in the future, it may be appropriate for the seller to seek to exclude the payment of a net-back as a condition of the trade.
In general, a buyer will always argue that it is appropriate for the net-back to be paid in circumstances where there is a possibility that any draw-stop is not permanent, and, in particular, in circumstances where a draw-stop could be lifted without the buyer’s consent (such as the waiver of an event of default by a majority lender decision).
As noted above, the mechanism for calculating the net-back applies to all LMA trades as standard. Where a party does not wish the net-back to apply, this will need to be expressly agreed at the time of trade and relevant sections of the LMA Terms and Conditions should be disapplied in the trade confirmation. The onus is, therefore, on the seller to address any concerns about the payment of a net-back at the time of trade.