Although there are many potential threats to secured lenders’ interests, the Roundtable has taken note, at this time, of three major issues in particular:
- the now common ability of borrowers to issue unlimited amounts of equivalently secured debt in the context of ostensible “hedging” transactions, potentially diluting existing lenders’ financial protection significantly,
- the now common ability of borrowers to essentially churn their asset base in such a way so as to render the specific identity of lenders’ collateral uncertain, and
- the now common ability of borrowers to sell, release, or freely substitute the collateral that lenders are relying upon to safeguard their loans
Since the legal provisions granting such broad powers to borrowers often go unnoticed in hundreds of pages of densely written loan documentation, the Roundtable has extracted some illustrative examples from loans currently in the market.
A leading area of concern relates to the expanding number of parties that may be (inconspicuously) granted equivalent security in the secured lender’s collateral – parties in no meaningful sense part of the original lending syndicate.
In the following example, the definition of “Permitted Liens” is drafted to include:
…Liens securing Debt permitted to be Incurred with respect to Hedging Obligations
which has the effect of making an unknown, merely prospective hedging counterparty a fully co-extensive secured lender even though the borrower’s “hedging” activities are permitted to range rather broadly,
“Hedging Obligation” of any Person means any obligation of such Person pursuant to any Interest Rate Agreement, Currency Exchange Protection Agreement or any other similar agreement or arrangement.
If an unknown hedge counterparty can become a secured party by simply participating in “any other similar agreement or arrangement,” the moat surrounding traditional secured lenders’ collateral has been drained indeed.
Further, perhaps such hedge counterparty provisions would be less egregious were the loan arrangers drafting the loan documents not infrequently themselves the hedging counterparties – potentially profiting from their own authorship of the loan documentation.
Borrower asset churning, if left unchecked, also holds the real potential to substantially alter the secured lending relationship. If a secured lender can never be assured as to the specific identity of his collateral, the initial loan underwriting process (heavily reliant as it is upon the careful valuation of collateral) becomes a useless exercise and one that may cause lenders to either a) blindly “assume” the intrinsic value of their collateral will not change dramatically downward in value or b) exit the syndicated loan market entirely.
Here, a borrower is casually authorized to use the proceeds from any asset sale to reinvest in the benignly named “Additional Assets”:
“The Net Available Cash (or any portion thereof) from Asset Sales may be applied by the Borrower to…reinvest in Additional Assets”
But benign becomes potentially malign when the definition of Additional Assets is seen to include,
“…any property…to be owned by the Issuer…and used in a Related Business...”
which itself is defined as broadly as,
“…any business that is related, ancillary or complementary to the businesses of the Borrower...”
In sum, the borrower is authorized (by means of an extensive series of cross-references) to sell lenders’ collateral and use the proceeds to invest in items as indeterminate as “any property used…in any business” that is merely “complementary” to the borrower’s existing business. The borrower is even, therefore, empowered to convert a loan secured by tangible assets into one secured only by stock.
Finally, in the following example, the borrower is inconspicuously granted the authority (by a bare majority of lenders – although all lenders’ collateral protection is thereby threatened) to release a minimum of 49% of all loan collateral and potentially as much as 80% (depending upon one’s interpretation of the nebulous phrase “substantially all”).
“provided, however, that no such waiver and no such amendment, supplement or modification shall: … release all or substantially all of the Collateral… of the Obligations, in each case without the consent of all Lenders”
It is important to note that the borrowers’ and/or loan arrangers’ legal team has couched this borrower-friendly collateral release provision in language that certainly sounds lender protective (“no such waiver…shall”, “without the consent of all Lenders”). However, the true legal import of this sentence actually turns upon the more subtle implications of the phrase “release all or substantially all of the Collateral”.
The main issue remains: Should 50.1% of the lenders have the power to release up to 80% (or possibly more) of the collateral?
The preceding excerpts illustrate just how fraught with risk buying syndicated loans in the secondary market has become for lenders with traditional notions of secured credit.
At least upon primary issuance potential buyers can theoretically insist upon better terms and conditions.
In the secondary market they can, at best, merely be aware that they are entering a minefield.