Current Issues in Syndicated Lending: Defaulting Lenders and the Failure to Fund

The adverse impact of the current market disruption on many financial institutions has given rise to an increased risk of the occurrence of lenders defaulting on lending obligations. This, in turn, has placed unexpected focus both on the effectiveness of defaulting lender provisions and certain other funding and management mechanics of many syndicated credit agreements. In particular, the typical remedy that allows the borrower to replace a defaulting lender at par has proven to be inadequate due to the current lack of liquidity in the market and the trading levels of most syndicated loans at well below par.

Most current syndicated credit agreements include a concept of a defaulting lender to address situations where a lender fails to fund its pro rata share of an advance, reimbursement, or participation under a syndicated credit agreement (any such lender, a “Defaulting Lender”). For example, the Model Credit Agreement Provisions (Effective May 2005, the “Model Provisions”) for syndicated credit agreements published by the Loan Syndications and Trading Association expressly give a borrower the right to require any Defaulting Lender “to assign and delegate, without recourse (in accordance with and subject to the [applicable assignment terms and conditions], all of its interests, rights and obligations under this Agreement and the related Loan Documents ' to an assignee” at par. (See, Model Provisions, Yield Protection, Section 3(b) Mitigation of Obligations; Replacement of Lenders) Notably, the Model Provisions do not include a formal definition of “Defaulting Lender,” and except as described above, the Model Provisions do not address Defaulting Lender issues. Unlike the Model Provisions, most syndicated credit agreements do include a formal definition of “Defaulting Lender,” and this definition frequently includes any Lender that is deemed insolvent or is in receivership within the definition. As evidenced by the Model Provisions, defaulting lender terms were typically drafted with the expectation that a Defaulting Lender would be a rare and isolated occurrence, and could be readily replaced by an assignment at par.

The differences between the obligations of a Defaulting Lender with an outstanding revolving credit commitment (or other unfunded commitment such as a delayed draw term loan commitment) and a Defaulting Lender holding a fully funded term loan have revealed other weaknesses with typical Defaulting Lender provisions. As discussed more fully below, a Defaulting Lender with an unfunded commitment presents credit risks to the borrower, the administrative agent, and the other lenders. A Defaulting Lender holding a fully funded term loan, however, presents no credit risk to the borrower. With respect to the administrative agent and lenders, the only credit risk presented by a Defaulting Lender that has fully funded its term loan obligations relates to indemnification obligations (which typically only arise in the event that the borrower has breached its indemnification obligations) and obligations to share amounts recovered by such Defaulting Lender on account of the exercise of set-off rights or otherwise in excess of its pro rata share of such recoveries.

Credit Risks Resulting from a Defaulting Lender

The borrower's liquidity is directly and adversely affected by the existence of a Defaulting Lender with an unfunded revolving credit commitment. To manage this liquidity problem is for the borrower to increase borrowing requests by the amount necessary to cover any expected shortfall attributable to a Defaulting Lender. Although the obligations of the lenders under a syndicated credit agreement are several and not joint, the existence of a Defaulting Lender nevertheless creates credit risk for the other members of the bank group. For example, to the extent that a borrower increases its borrowing requests, the loans outstanding from the non-Defaulting Lenders will be higher than would have been the case if there had not been a Defaulting Lender.

According to the Model Provisions, the administrative agent under a syndicated credit agreement has the right, but not the obligation, to pre-fund on behalf of the other lenders any loan requested by the borrower. (See, Model Provisions, Administrative Agent's Clawback, Section (a), Funding of Lenders; Presumption by Administrative Agent). In the current market, most administrative agents have ceased to pre-fund loans on behalf of the other lenders as a matter of policy. This avoids any credit risk to the administrative agent resulting from pre-funding the portion of a loan that should have been funded by a Defaulting Lender.

To the extent the lender responsible for issuing letters of credit is not fully reimbursed by the borrower for letter of credit drawings, such issuing lender has credit exposure to the other lenders that are obligated to purchase risk participations in any such unreimbursed letters of credit. However, a Defaulting Lender will not fund its portion of the reimbursement. Although this credit risk has not been treated consistently, the issuing lender typically has the discretion to refuse to issue a letter of credit if there is a Defaulting Lender in the bank group. If a credit agreement does not give the issuing lender this discretion, the issuing lender should consider requesting an amendment to the credit agreement to address that issue. The borrower will likely object to new limitations on the issuing lender's obligation to issue letters of credit.

Remedies

As discussed above, a borrower has the right to replace a Defaulting Lender. Unfortunately, it is presently virtually impossible to locate a replacement lender that is willing to pay anything close to par to purchase a loan and commitment from a Defaulting Lender. Further, to replace a Defaulting Lender, the borrower must typically replace all of a Defaulting Lender's obligations (funded term loans and revolving credit commitments). Therefore, the borrower must obtain new loan commitments for the full amount of all of the Defaulting Lender's obligations (revolving credit commitments and funded term loans) even if the borrower only wants to replace the Defaulting Lender's revolving credit commitment and leave the funded term loan obligations of the Defaulting Lender outstanding. In addition to the borrower's replacement right, a Defaulting Lender is typically stripped of virtually all voting rights. This is usually accomplished by excluding Defaulting Lenders from the calculation of “Required Lenders” or by a blanket elimination of a Defaulting Lender's voting rights, except with respect to increases or extensions of such lender's commitment. Finally, a Defaulting Lender will lose certain economic rights, such as the right to receive payment of commitment fees on unfunded commitments.

Defaulting Administrative Agent

An administrative agent that is a Defaulting Lender (especially if such Defaulting Lender is in bankruptcy) creates a number of issues, such as:

• Funding issues ' Are loans funded by the lenders but held by the administrative agent prior to disbursement to the borrower the property of the bankrupt debtor's ( i.e., the administrative agent's) estate?
• Payment issues ' Are loan payments from the borrower but held by the administrative agent prior to distribution to the lenders property of the bankrupt debtor's ( i.e., the administrative agent's) estate?
• Ongoing loan administration issues ' Will the administrative agent be able to carry out its administrative obligations under the credit agreement (including consenting to assignments by other lenders) without the approval of the bankruptcy court?

In the bankruptcy case of In re Lehman Commercial Paper Inc., certain of these issues were addressed with respect to Lehman Commercial Paper Inc., the debtor in bankruptcy, by an order of the Bankruptcy Court stating “that the funds in the Agency Account are not property of the Debtor's estate, except to the extent of the Debtor's proportional share of such funds as lender.” In re Lehman Commercial Paper Inc., (U.S. Bankruptcy Court, SDNY, Chapter 11 Case No. 08-13900 (JMP)) ORDER PURSUANT TO SECTIONS 105(a), 363(b), 363(c), AND 541(d) OF THE BANKRUPTCY CODE AND BANKRUPTCY RULE 6004 AUTHORIZING DEBTOR TO (A) CONTINUE TO UTILIZE ITS AGENCY BANK ACCOUNT, (B) TERMINATE AGENCY RELATIONSHIPS, AND (C) ELEVATE LOAN PARTICIPATIONS, Oct. 6, 2008 (hereinafter, the “Oct. 6 Order”).

The uncertainty caused by an administrative agent that is a Defaulting Lender creates significant pressure to replace such administrative agent. The Model Provisions permit the administrative agent the right to resign for any reason upon notice to the borrower and required lenders. (See, Model Provisions, Agency, Section 6, Resignation of the Administrative Agent). In the case of In re Lehman Commercial Paper Inc., the Bankruptcy Court authorized Lehman Commercial Paper to exercise its business judgment to determine which agency relationships (if any) to terminate. (Oct. 6 Order) The Model Provisions do not provide for a forced removal of the administrative agent by the borrower or the required lenders. Although such a right could be added to a credit agreement by amendment, as a practical matter, if the administrative agent is in bankruptcy, the automatic stay may prevent such an amendment (see Bankruptcy Issues below).

Assignments and Participations

A Defaulting Lender may have sold participations to third parties pursuant to the terms of the credit agreement prior to becoming a Defaulting Lender. Any such participations should be identified as quickly as possible to determine how best to handle it going forward. In the case of In re Lehman Commercial Paper Inc., the Bankruptcy Court forced the conversion of all outstanding participations to assignments. (Oct. 6 Order). Requiring such a conversion, however, should be evaluated on a case-by-case basis to determine the best approach under the given facts and circumstances. A Defaulting Lender also may be party to pending assignment transactions. To resolve open trades pending at the time of the Lehman bankruptcy, the Bankruptcy Court heard arguments from both Lehman and the assignment counterparties before ruling on which assignments would be rejected and which trades would be completed on amended terms.

Bankruptcy Issues

If a Defaulting Lender is in bankruptcy, it will have the benefit of the automatic stay under the Bankruptcy Code. It is important to note that the exercise of remedies against a Defaulting Lender in bankruptcy may be prohibited by the automatic stay even if those remedies were included in the applicable credit agreement prior to bankruptcy filing. Although there are no “bright line” tests for determining if actions taken against a Defaulting Lender violate the automatic stay, any action or amendment which has a negative impact on the economic right of the Defaulting Lender may implicate the stay. Therefore, bankruptcy counsel should be consulted prior to taking any actions against, or proposing any amendments that could affect the existing contract rights of, a Defaulting Lender in bankruptcy.

Conclusions

Because the Model Provisions do not include robust Defaulting Lender provisions, various administrative agents have developed, and are developing, different Defaulting Lender provisions. Because of the lack of clear market trends in this area, many of the approaches taken to deal with Defaulting Lenders may meet with market resistance or may otherwise prove impractical when viewed in light of the specific facts and circumstances of a given transaction. For example, a solution that works for an asset based credit may not be appropriate for an investment grade credit. In particular, the typical remedy of allowing the borrower to replace a Defaulting Lender at par has proven to be inadequate in the current market. Any proposed modification to existing Defaulting Lender definitions, mechanics, and related provisions to address these shortcomings will require the approval of the borrower and the applicable percentage of lenders (required lenders, all lenders or “affected lenders” (in each case, generally exclusive of the Defaulting Lenders)) as determined under the terms of the applicable credit agreement, and such modifications may be blocked by applicable bankruptcy laws.

David L. Batty is a partner in Winston & Strawn LLP's finance practice group who concentrates on corporate lending. Batty focuses his practice on the representation of financial institutions in syndicated credit facilities, including first and second lien loan transactions, as well as mezzanine financings. He has served as counsel to the administrative agent and lead arranger in syndicated credit facilities ranging in size from $100 million to more than $1 billion extended to companies in the media, telecommunications, consumer, defense technology, and other sectors.

The adverse impact of the current market disruption on many financial institutions has given rise to an increased risk of the occurrence of lenders defaulting on lending obligations. This, in turn, has placed unexpected focus both on the effectiveness of defaulting lender provisions and certain other funding and management mechanics of many syndicated credit agreements. In particular, the typical remedy that allows the borrower to replace a defaulting lender at par has proven to be inadequate due to the current lack of liquidity in the market and the trading levels of most syndicated loans at well below par.

Most current syndicated credit agreements include a concept of a defaulting lender to address situations where a lender fails to fund its pro rata share of an advance, reimbursement, or participation under a syndicated credit agreement (any such lender, a “Defaulting Lender”). For example, the Model Credit Agreement Provisions (Effective May 2005, the “Model Provisions”) for syndicated credit agreements published by the Loan Syndications and Trading Association expressly give a borrower the right to require any Defaulting Lender “to assign and delegate, without recourse (in accordance with and subject to the [applicable assignment terms and conditions], all of its interests, rights and obligations under this Agreement and the related Loan Documents ' to an assignee” at par. (See, Model Provisions, Yield Protection, Section 3(b) Mitigation of Obligations; Replacement of Lenders) Notably, the Model Provisions do not include a formal definition of “Defaulting Lender,” and except as described above, the Model Provisions do not address Defaulting Lender issues. Unlike the Model Provisions, most syndicated credit agreements do include a formal definition of “Defaulting Lender,” and this definition frequently includes any Lender that is deemed insolvent or is in receivership within the definition. As evidenced by the Model Provisions, defaulting lender terms were typically drafted with the expectation that a Defaulting Lender would be a rare and isolated occurrence, and could be readily replaced by an assignment at par.

The differences between the obligations of a Defaulting Lender with an outstanding revolving credit commitment (or other unfunded commitment such as a delayed draw term loan commitment) and a Defaulting Lender holding a fully funded term loan have revealed other weaknesses with typical Defaulting Lender provisions. As discussed more fully below, a Defaulting Lender with an unfunded commitment presents credit risks to the borrower, the administrative agent, and the other lenders. A Defaulting Lender holding a fully funded term loan, however, presents no credit risk to the borrower. With respect to the administrative agent and lenders, the only credit risk presented by a Defaulting Lender that has fully funded its term loan obligations relates to indemnification obligations (which typically only arise in the event that the borrower has breached its indemnification obligations) and obligations to share amounts recovered by such Defaulting Lender on account of the exercise of set-off rights or otherwise in excess of its pro rata share of such recoveries.

Credit Risks Resulting from a Defaulting Lender

The borrower's liquidity is directly and adversely affected by the existence of a Defaulting Lender with an unfunded revolving credit commitment. To manage this liquidity problem is for the borrower to increase borrowing requests by the amount necessary to cover any expected shortfall attributable to a Defaulting Lender. Although the obligations of the lenders under a syndicated credit agreement are several and not joint, the existence of a Defaulting Lender nevertheless creates credit risk for the other members of the bank group. For example, to the extent that a borrower increases its borrowing requests, the loans outstanding from the non-Defaulting Lenders will be higher than would have been the case if there had not been a Defaulting Lender.

According to the Model Provisions, the administrative agent under a syndicated credit agreement has the right, but not the obligation, to pre-fund on behalf of the other lenders any loan requested by the borrower. (See, Model Provisions, Administrative Agent's Clawback, Section (a), Funding of Lenders; Presumption by Administrative Agent). In the current market, most administrative agents have ceased to pre-fund loans on behalf of the other lenders as a matter of policy. This avoids any credit risk to the administrative agent resulting from pre-funding the portion of a loan that should have been funded by a Defaulting Lender.

To the extent the lender responsible for issuing letters of credit is not fully reimbursed by the borrower for letter of credit drawings, such issuing lender has credit exposure to the other lenders that are obligated to purchase risk participations in any such unreimbursed letters of credit. However, a Defaulting Lender will not fund its portion of the reimbursement. Although this credit risk has not been treated consistently, the issuing lender typically has the discretion to refuse to issue a letter of credit if there is a Defaulting Lender in the bank group. If a credit agreement does not give the issuing lender this discretion, the issuing lender should consider requesting an amendment to the credit agreement to address that issue. The borrower will likely object to new limitations on the issuing lender's obligation to issue letters of credit.

Remedies

As discussed above, a borrower has the right to replace a Defaulting Lender. Unfortunately, it is presently virtually impossible to locate a replacement lender that is willing to pay anything close to par to purchase a loan and commitment from a Defaulting Lender. Further, to replace a Defaulting Lender, the borrower must typically replace all of a Defaulting Lender's obligations (funded term loans and revolving credit commitments). Therefore, the borrower must obtain new loan commitments for the full amount of all of the Defaulting Lender's obligations (revolving credit commitments and funded term loans) even if the borrower only wants to replace the Defaulting Lender's revolving credit commitment and leave the funded term loan obligations of the Defaulting Lender outstanding. In addition to the borrower's replacement right, a Defaulting Lender is typically stripped of virtually all voting rights. This is usually accomplished by excluding Defaulting Lenders from the calculation of “Required Lenders” or by a blanket elimination of a Defaulting Lender's voting rights, except with respect to increases or extensions of such lender's commitment. Finally, a Defaulting Lender will lose certain economic rights, such as the right to receive payment of commitment fees on unfunded commitments.

Defaulting Administrative Agent

An administrative agent that is a Defaulting Lender (especially if such Defaulting Lender is in bankruptcy) creates a number of issues, such as:

• Funding issues ' Are loans funded by the lenders but held by the administrative agent prior to disbursement to the borrower the property of the bankrupt debtor's ( i.e., the administrative agent's) estate?
• Payment issues ' Are loan payments from the borrower but held by the administrative agent prior to distribution to the lenders property of the bankrupt debtor's ( i.e., the administrative agent's) estate?
• Ongoing loan administration issues ' Will the administrative agent be able to carry out its administrative obligations under the credit agreement (including consenting to assignments by other lenders) without the approval of the bankruptcy court?

In the bankruptcy case of In re Lehman Commercial Paper Inc., certain of these issues were addressed with respect to Lehman Commercial Paper Inc., the debtor in bankruptcy, by an order of the Bankruptcy Court stating “that the funds in the Agency Account are not property of the Debtor's estate, except to the extent of the Debtor's proportional share of such funds as lender.” In re Lehman Commercial Paper Inc., (U.S. Bankruptcy Court, SDNY, Chapter 11 Case No. 08-13900 (JMP)) ORDER PURSUANT TO SECTIONS 105(a), 363(b), 363(c), AND 541(d) OF THE BANKRUPTCY CODE AND BANKRUPTCY RULE 6004 AUTHORIZING DEBTOR TO (A) CONTINUE TO UTILIZE ITS AGENCY BANK ACCOUNT, (B) TERMINATE AGENCY RELATIONSHIPS, AND (C) ELEVATE LOAN PARTICIPATIONS, Oct. 6, 2008 (hereinafter, the “Oct. 6 Order”).

The uncertainty caused by an administrative agent that is a Defaulting Lender creates significant pressure to replace such administrative agent. The Model Provisions permit the administrative agent the right to resign for any reason upon notice to the borrower and required lenders. (See, Model Provisions, Agency, Section 6, Resignation of the Administrative Agent). In the case of In re Lehman Commercial Paper Inc., the Bankruptcy Court authorized Lehman Commercial Paper to exercise its business judgment to determine which agency relationships (if any) to terminate. (Oct. 6 Order) The Model Provisions do not provide for a forced removal of the administrative agent by the borrower or the required lenders. Although such a right could be added to a credit agreement by amendment, as a practical matter, if the administrative agent is in bankruptcy, the automatic stay may prevent such an amendment (see Bankruptcy Issues below).

Assignments and Participations

A Defaulting Lender may have sold participations to third parties pursuant to the terms of the credit agreement prior to becoming a Defaulting Lender. Any such participations should be identified as quickly as possible to determine how best to handle it going forward. In the case of In re Lehman Commercial Paper Inc., the Bankruptcy Court forced the conversion of all outstanding participations to assignments. (Oct. 6 Order). Requiring such a conversion, however, should be evaluated on a case-by-case basis to determine the best approach under the given facts and circumstances. A Defaulting Lender also may be party to pending assignment transactions. To resolve open trades pending at the time of the Lehman bankruptcy, the Bankruptcy Court heard arguments from both Lehman and the assignment counterparties before ruling on which assignments would be rejected and which trades would be completed on amended terms.

Bankruptcy Issues

If a Defaulting Lender is in bankruptcy, it will have the benefit of the automatic stay under the Bankruptcy Code. It is important to note that the exercise of remedies against a Defaulting Lender in bankruptcy may be prohibited by the automatic stay even if those remedies were included in the applicable credit agreement prior to bankruptcy filing. Although there are no “bright line” tests for determining if actions taken against a Defaulting Lender violate the automatic stay, any action or amendment which has a negative impact on the economic right of the Defaulting Lender may implicate the stay. Therefore, bankruptcy counsel should be consulted prior to taking any actions against, or proposing any amendments that could affect the existing contract rights of, a Defaulting Lender in bankruptcy.

Conclusions

Because the Model Provisions do not include robust Defaulting Lender provisions, various administrative agents have developed, and are developing, different Defaulting Lender provisions. Because of the lack of clear market trends in this area, many of the approaches taken to deal with Defaulting Lenders may meet with market resistance or may otherwise prove impractical when viewed in light of the specific facts and circumstances of a given transaction. For example, a solution that works for an asset based credit may not be appropriate for an investment grade credit. In particular, the typical remedy of allowing the borrower to replace a Defaulting Lender at par has proven to be inadequate in the current market. Any proposed modification to existing Defaulting Lender definitions, mechanics, and related provisions to address these shortcomings will require the approval of the borrower and the applicable percentage of lenders (required lenders, all lenders or “affected lenders” (in each case, generally exclusive of the Defaulting Lenders)) as determined under the terms of the applicable credit agreement, and such modifications may be blocked by applicable bankruptcy laws.

David L. Batty is a partner in Winston & Strawn LLP's finance practice group who concentrates on corporate lending. Batty focuses his practice on the representation of financial institutions in syndicated credit facilities, including first and second lien loan transactions, as well as mezzanine financings. He has served as counsel to the administrative agent and lead arranger in syndicated credit facilities ranging in size from $100 million to more than $1 billion extended to companies in the media, telecommunications, consumer, defense technology, and other sectors.