The Banking Law JournaL - Reed Smith...tHe bANKINg lAW JourNAl 644 assessing these potential issues...

The Banking Law JournaL

Volume 127 Number 7 July/August 2010

Headnote: Is HIstory repeatIng Itself?steven A. meyerowitz 579

HIstory repeats Itself: WHy Interest rate Caps pave tHe Way for tHe return of tHe loan sHarksJustice David baker and macKenzie breitenstein 581

fdIC open Bank assIstanCe: doa or ready for revIval?lorraine m. buerger 604

seCurItIzatIon safe HarBor: fdIC’s revIsed proposal refleCts some Industry Comments, But proposed restrICtIons remaIn largely IntaCtedward m. De sear and David J. Zawitz 610

tHe uIgea’s fInal rule BeComes laW: WHat does It mean for non-u.s. fInanCIal InstItutIons?Wendy Wysong, megan gordon, and Inna Dexter 624

tHe proposed unIted states Covered Bond aCt of 2010michael Durrer, theresa Kradjian, Joseph mclaughlin, and Daniel rossner 632

a sWap provIder’s guIde to syndICated loan doCuments tHat InCorporate BIlateral sWap faCIlItIesWilliam l. Harvey and svetlana g. Attestatova 642

Investments In u.s. fInanCIal InstItutIons By BusIness enterprIses domICIled In IndIaFrank A. mayer, III and travis P. Nelson 663

edItor-In-CHIefSteven A. Meyerowitz

President, Meyerowitz Communications Inc.

Board of edItors

Paul BarronProfessor of LawTulane Univ. School of Law

George BrandonPartner, Squire, Sanders & Dempsey

LLP

Barkley ClarkPartner, Stinson Morrison Hecker

LLP

John F. DolanProfessor of LawWayne State Univ. Law School

Stephanie E. KalahurkaHunton & Williams, LLP

Thomas J. Hall Partner, Chadbourne & Parke LLP

Michael HoganAshelford Management Serv. Ltd.

Mark Alan KantorWashington, D.C.

Satish M. KiniPartner, Debevoise & Plimpton LLP

Paul L. LeePartner, Debevoise & Plimpton LLP

Jonathan R. Macey Professor of Law Yale Law School

Martin MayerThe Brookings Institution

Julia B. StricklandPartner, Stroock & Stroock & Lavan

LLP

Marshall E. Tracht Professor of LawNew York Law School

Stephen B. Weissman Partner, Rivkin Radler LLP

Elizabeth C. YenPartner, Hudson Cook, LLP

Bankruptcy for BankersHoward SeifePartner, Chadbourne & Parke LLP

Regional Banking OutlookJames F. BauerleKeevican Weiss Bauerle & Hirsch

LLC

Directors’ PerspectiveChristopher J. ZinskiPartner, Schiff Hardin LLP

Banking BriefsDonald R. CasslingPartner, Quarles & Brady LLP

Intellectual PropertyStephen T. SchreinerPartner, Goodwin Procter LLP

The Banking Law JournaL (ISSN 0005 5506) is published ten times a year by A.S. Pratt & Sons, 805 Fifteenth Street, NW., Third Floor, Washington, DC 20005-2207. Application to mail at Periodicals postage rates is pending at Washington, D.C. and at additional mailing offices. Copyright © 2010 ALEX eSOLUTIONS, INC. All rights reserved. No part of this journal may be reproduced in any form—by microfilm, xerography, or otherwise—or in-corporated into any information retrieval system without the written permission of the copyright owner. Requests to reproduce material contained in this publication should be addressed to A.S. Pratt & Sons, 805 Fifteenth Street, NW., Third Floor, Washington, DC 20005-2207, fax: 703-528-1736. For subscription information and custom-er service, call 1-800-572-2797. Direct any editorial inquires and send any material for publication to Steven A. Meyerowitz, Editor-in-Chief, Meyerowitz Communications Inc., 10 Crinkle Court, Northport, New York 11768, [email protected], 631-261-9476 (phone), 631-261-3847 (fax). Material for publication is welcomed—ar-ticles, decisions, or other items of interest to bankers, officers of financial institutions, and their attorneys. This pub-lication is designed to be accurate and authoritative, but neither the publisher nor the authors are rendering legal, accounting, or other professional services in this publication. If legal or other expert advice is desired, retain the services of an appropriate professional. The articles and columns reflect only the present considerations and views of the authors and do not necessarily reflect those of the firms or organizations with which they are affiliated, any of the former or present clients of the authors or their firms or organizations, or the editors or publisher.POSTMASTER: Send address changes to The Banking Law JournaL, A.S. Pratt & Sons, 805 Fifteenth Street, NW., Third Floor, Washington, DC 20005-2207.

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Published in the July/August 2010 issue of The Banking Law Journal.

Copyright 2010 AleXesolutIoNs, INC. 1-800-572-2797.

A SwAp provider’S Guide to SyndicAted LoAn documentS thAt incorporAte

BiLAterAL SwAp FAciLitieS

WIllIAm l. HArVey AND sVetlANA g. AttestAtoVA

The authors analyze six of the most important issues in syndicated loan docu-mentation that are of potential concern to swap providers.

Syndicated credit agreements often provide that syndicate member banks may enter into bilateral swaps and derivatives transactions with the borrower, and that any resulting credit exposure will be secured by

the collateral and backed by the guaranties supporting the credit agreement.1 The swaps extended to the borrower may include interest rate hedges in re-spect of the syndicated loan itself, foreign exchange hedges relating either to the loan facility or generally to the borrower’s business, or commodity hedges protecting the borrower from fluctuations in commodity-related expenses or revenues, among others. Ordinarily, the resulting swaps will be governed by the ISDA Master Agreement, as modified by an agreed form of ISDA Schedule. The interests of the lenders providing such hedging products or swaps (re-ferred to herein as “swap providers”) will often differ from those of the admin-istrative agent and the other lenders who are not providing swaps to the bor-

William Harvey is vice president and senior counsel at union bank, N.A., and svetlana Attestatova is a senior associate in the san Francisco office of reed smith llP. the authors, who gratefully acknowledge the helpful comments pro-vided by mark guinn, Assistant general Counsel of bank of America, N.A., can be reached at [email protected] and [email protected], respectively.

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A sWAP ProVIDer’s guIDe to syNDICAteD loAN DoCumeNts

rower, sometimes in material ways, giving rise to a variety of intercreditor issues under the syndicated loan documentation. Indeed, syndicated loan documents are often not especially “friendly” to swap providers. Among other issues, the credit agreement may interfere with the swap provider’s ability to administer, close out and enforce its swaps, or the desired collateral position in favor of the swap providers may be conditioned or may inadvertently become impaired or forfeited after the loan closing, or the loan documents may conflict with or override certain provisions in the ISDA Master Agreement and swap confirma-tions, potentially rendering the latter ambiguous and open to dispute.2 In addi-tion, swap providers are rarely accorded voting rights under the loan agreement (apart from whatever vote they may have as and while they are lenders) and so have no say as to credit document amendments and default waivers, regardless of the size of their swaps positions with the borrower.3 Finally, swap providers whose swap documents are linked in certain respects to syndicated loan facili-ties may lose or suffer impairment of statutory safe-harbor rights they would otherwise have under the U.S. Bankruptcy Code that would permit swap en-forcement during a borrower bankruptcy.4

Syndicated credit documentation, especially for leveraged, secured deals, and project financings, is lengthy and complex. Unlike the ISDA Master Agreement, it is decidedly not standardized.5 As with the ISDA Master Agreements, however, it takes time to master the intricacies and nuances of syndicated credit documents, and swaps personnel may find that they are ill-equipped to fend for themselves in this new and different world.6 Among the many areas in syndicated loan documentation that are of potential concern to swap providers, six items are perhaps the most impor-tant: (1) whether the swap provider’s fundamental rights to terminate trades, effectuate close-out netting, and set off against deposit accounts and similar property are impaired by the credit documents; (2) whether the swaps are secured and guarantied by the loan document collateral and guaranties; (3) whether the swaps are collateralized ratably with the loans; (4) whether the swap provider’s collateral and guaranty rights could be impaired or lost for reasons that are outside the swap provider’s control; (5) whether a swap de-fault or early termination causes a credit agreement default; and (6) whether the credit agreement conflicts with the swap documentation.7 This article is intended to assist swaps personnel of syndicated lenders, and their counsel, in

tHe bANKINg lAW JourNAl

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assessing these potential issues in syndicated loan documentation. Where se-rious issues exist with the loan documents that cannot be addressed by modi-fication of those documents, provisions are suggested for inclusion in the swap provider’s ISDA Schedule that may mitigate the swap provider’s risk.8

WHetHer tHe CredIt agreement Interferes WItH Close-out nettIng, set-off or otHer admInIstratIve rIgHts of tHe sWap provIder

There exists a fundamental tension in most syndicated loan documents surrounding the extent to which individual syndicate members may avail them-selves independently of creditor rights and privileges against the borrower and guarantors, rather than acting on a forced, collective basis through the adminis-trative agent.9 This tension is perhaps even greater with regard to swap provid-ers operating within a syndicated credit framework, since the swap relationship is ostensibly a bilateral one. Examples of syndicated credit agreement provi-sions that may interfere to an unacceptable extent with the swap administration rights of swap providers include:

• provisions that prohibit or restrict the swap provider’s ability to declare an Early Termination Date (as defined in the ISDA Master Agreement), to close out swaps upon certain events, and to undertake close-out net-ting (“swap remedies restrictions”);

• payment or setoff sharing provisions (“sharing provisions”) that require swap providers to share ratably with other lenders (i) ordinary course swap payments received by them or (ii) setoff proceeds from deposit ac-counts or similar property applied to closed out swap positions; and

• provisions that require that the majority lenders (or administrative agent) approve any amendments to the swap provider’s swap confirmations or ISDA Master Agreement (“swap amendment restrictions”).

As a rule, a swap provider should be very reluctant to agree to swap rem-edies restrictions that would cause it to relinquish its rights under the ISDA Master Agreement to (i) suspend its further payment or performance under

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the ISDA Master Agreement by virtue of the borrower’s default under the swap documents,10 (ii) declare an Early Termination Date, close out all relevant swap trades, and calculate a net settlement or termination amount, and (iii) bring suit against the borrower for swap payment amounts. Certain syndicated credit agreements, however, contain “exclusive remedy” provisions that would prevent swap providers from enforcing some or all of the foregoing rights and remedies independently from the administrative agent or the majority lenders. Where such provisions exist in the credit documents (and cannot be removed), the swap provider should determine whether it is willing to forego those rights, in view of the collateral and guaranty benefits provided under the credit docu-mentation.11

Swap providers should also rarely, if ever, agree to sharing provisions in respect of scheduled, or ordinary course, swap payments. However, such shar-ing requirements may arise (perhaps inadvertently) where the swap obligations are included within the definition of “Obligations” (or similar term) under the credit agreement. Close-out payments received by the swap provider, however, may reasonably be shared when the loans have been accelerated and there is a general sharing of enforcement proceeds by the syndicate group.12 Otherwise, swap close-out payment proceeds should generally inure solely to the benefit of the specific swap provider. Swap providers who are also depository institutions where the borrow-er maintains deposit balances will also wish to ensure that they may set off against such deposits if the borrower fails to make a swap payment. Un-like loan creditors, swap providers are permitted to make such setoffs even if the borrower counterparty is a debtor under the U.S. Bankruptcy Code, by virtue of certain Bankruptcy Code swap safe harbors.13 However, the credit document may require that the proceeds of such setoffs be shared with the syndicated lender group (who are not eligible for such safe harbors)14, thereby effectively preventing the swap provider from setting off against such deposit accounts post-bankruptcy.15

Swap amendment restrictions should also, as a rule, be resisted by swap providers, save perhaps in instances where the form of ISDA Schedule is at-tached as an exhibit to the credit agreement, and it is a requirement that all lender swap providers enter into precisely that document. In that event, it is assumedly important to ensure that all swap providers operate under exactly


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the same swap agreement terms, and it therefore may be appropriate to con-trol the post-closing modification of that agreement.16

WHetHer tHe sWaps are supported By loan doCument Collateral and guarantIes

The credit agreement collateral and guaranty package is usually the main reason for a swap provider to sign on to a syndicated credit structure. In order to confirm that it in fact receives such credit support, the swap pro-vider will need to review appropriate provisions in the collateral and guaranty documents, as well as the credit agreement. Often, there are restrictions, based upon the identity of the swap parties or the nature of the swap trades or swap documentation, which determine whether the swaps will be eligible to share the benefit of the syndicated credit collateral and guaranties (referred to in this article as “eligible swaps”).17

Identity of the swap parties

It is not uncommon for syndicated loan documents to restrict collateral and guaranty rights to swap provider entities that are (or as of the trade date were) “lenders” under the credit facility. Thus, if the swap provider is, for example, an affiliate of the lender bank (instead of the lender bank itself ), it should ascertain that such affiliates may also be included.18 Similarly, the loan documentation will usually specify the borrower-related entity that may enter into eligible swaps with swap providers, which may or may not include subsidiaries or affiliates of the borrower. Each swap provider should therefore determine that it is trading with the appropriate borrower-related entity. As a related matter, care should be taken to confirm that the swap provid-er, as such, is expressly identified as a “secured party” and “guarantied party” (or equivalent terms) for purposes of all collateral and guaranty documents (or that the administrative agent, who is the secured and guarantied party, is expressly representing the swap provider in its capacity as such).19 Otherwise, the collateral grant or guaranty may fail altogether as to the swap provider.

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swap types or Circumstances

Eligible swap criteria going to the nature or circumstances of the deriva-tives trades are often troublesome from the swap provider’s standpoint. For example, it is not uncommon to encounter any one or more of the following restrictions or conditions to swap eligibility:

• that the swap be limited to a specific type or category (e.g., interest rate or commodity derivatives);

• that the swap be undertaken by the borrower for hedging (and not specu-lative) purposes, or that it be an effective hedge;

• that the swap be entered into by the borrower in compliance with all (or certain) affirmative and negative covenants in the credit agreement; and

• that the trade terms or documentation (including any Schedule) governing the swap be notified to or approved in advance by the administrative agent.

Limitations based on swap type (the first item above) and advance notice or approval (the fourth item above) may be addressed readily enough by the swap provider, through internal controls that permit only the specified types of trades to occur and that require such advance notice or approval. However, hedging and covenant compliance conditions (the second and third items above) tend to raise greater concerns. First, these restrictions are often drafted in ambigu-ous fashion (e.g., what is a “hedge”?), such that no one may be absolutely cer-tain whether a given swap would be in compliance. Even where the terms are reasonably explicit, the conditions may be such that only the borrower may know whether they are in fact being complied with. Nevertheless, a mistake would penalize not only the borrower (by creating an event of default under the credit agreement), but also, and to a disproportionate extent, the swap provider, who would potentially forego all of its collateral and guaranty rights.20 Where hedging or covenant compliance eligibility conditions do exist in the credit agreement, the swap provider should ensure that the ISDA Schedule includes a specific representation by the borrower stating that all trades entered into with that swap provider will satisfy the relevant eligible swap criteria.21


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WHetHer tHe sWaps Have approprIate Collateral and payment prIorIty

Having confirmed that the swap obligations will indeed be supported by the syndicated loan collateral and guaranties, it should then be determined whether those obligations are accorded ratable, pari passu, collateral and pay-ment priority vis-à-vis other credit agreement obligations. This item will in-volve a review of the credit agreement and collateral and guaranty documents (and, if any exists, the intercreditor agreement). The credit agreement typically contains a payment waterfall (or payment allocation) provision, which applies during periods of borrower distress or rem-edies enforcement. It specifies, with regard to payments received by the admin-istrative agent upon the enforcement of certain remedies, the order in which the resulting payment proceeds will be allocated to the lender group in satisfaction of various claims (e.g., expenses, loan interest, loan principal, swap termination payments, etc.).22 Enforcement payments received directly by individual lend-ers or swap providers outside of this waterfall must usually be turned over to the administrative agent for ratable sharing with the syndicate group.23 The swap provider should determine that the waterfall provision specifically references all varieties of swap payments, and that the priority that is granted to swap pay-ments (including close-out payments) in such waterfall is not lower (worse) than the position accorded loan principal.24

WHetHer tHe sWaps may suffer loss of lIen and guaranty entItlements

There are several ways by which swap providers, who are initially (as of the credit agreement closing) entitled to ratable, pari passu lien and guaranty positions under the syndicated loan documents, may come to lose such enti-tlements. Swap providers should ensure that they have “enduring collateral,” which will be available when and if needed, regardless of circumstances.

Ceasing to Be a lender

Unfortunately, under many syndicated credit documents, a swap pro-

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vider ceasing to be a lender (or an affiliate of a lender) under the credit agree-ment will automatically and immediately forfeit its swap collateral and guar-anties.25 Such provisions should be resisted by swap providers as a rule, but when they do exist, swap providers should be mindful of the fact that they (or their affiliated lender entities) may cease to be lenders under a syndicated credit facility for any of the following reasons:26

• the lender may voluntarily assign its entire loan position and loan com-mitments to another entity under the assignment provision of the credit agreement (“voluntary assignment”);27

• the lender may be compelled by the borrower to assign its entire loan po-sition and commitments to a replacement lender (“forced assignment”), as a result of (x) the lender availing itself of certain tax gross-up or regula-tory expense indemnification rights granted to it under the credit agree-ment, (y) the lender becoming insolvent or breaching or repudiating its loan commitment obligations under the credit agreement (i.e., becoming a “defaulting lender”), or (z) in connection with certain revolving credit facilities, the lender not agreeing to extend its revolving commitment termination date when a majority of the other lenders is agreeing to do so;28 or

• the syndicated credit facility may be terminated upon its early cancel-lation by the borrower, or the maturity date being reached, and the full repayment of the loans (“credit facility termination”).

Loss of swap collateral or guaranties due to voluntary assignment would seem to be an unwarranted interference with the swap provider’s right to sell its loan position, but it is at least manageable from an operational stand-point, since such assignments are presumably within the control of the swap provider.29 As a partial mitigant, the swap provider may include a provision in its ISDA Schedule modifying the transfer provision in the ISDA Master Agreement30 to provide that the swap provider may, without the consent of the borrower, transfer any swap trades to any entity that purchases its loans under the credit agreement. This will permit the initial swap provider to exit the swaps once it has located a buyer for its loans, assuming the buyer is also


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willing to take on the swap position.31

Losing lender status as a result of a forced assignment is more complex and difficult to address. Most swap providers would take the view that if they (or their affiliated lenders) are being forced out of the loan syndicate for any reason other than perhaps their own failure to perform under the credit agree-ment, then they should (1) be able to close out all of their swaps immediately, and (2) retain their collateral and guaranty positions pending final payment. The former can be achieved by including the appropriate forced assignment event as an “Additional Termination Event” in the ISDA Schedule, but the latter will usually require specific modification to the credit agreement itself.32

Similarly, protecting the swap provider from loss of collateral or guaran-ties in the event of credit facility termination suggests both (1) the prompt close out of the swaps through inclusion of an Additional Termination Event in the ISDA Schedule, and (2) confirming that the collateral and guaranty grants to the swap provider under the credit documentation do not lapse im-mediately upon such credit facility termination, but only after full payment of all obligations, including swap obligations.33

adverse amendments to loan documents

In addition to ceasing to be a lender, a swap provider’s collateral and guar-anty positions might also be lost through adverse amendments of the loan doc-uments, undertaken by the majority lenders, presumably without the consent or vote of the swap provider as lender.34 Here, the “amendments” section of the credit agreement should be inspected to confirm that (i) the payment waterfall provision, (ii) any provisions containing swap eligibility criteria, and (iii) any definitions and provisions relating to the description of “secured indebtedness” or “secured parties” (or similar terms, establishing which entities are able to share in the collateral and guaranty package) may not be amended in a manner that may deprive the swap providers of their security (or guaranties) without their express consent. In addition, the swap provider should consider including in the ISDA Schedule an Additional Termination Event, triggered by any such adverse amendment to the credit documents.35

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loss of eligible swap status

Finally, under certain credit agreements, if the swap eligibility criteria cease to be satisfied with regard to then-existing swaps, the collateral and guaranty support may be forfeited or cancelled even as to those swaps. For example, where the swap eligibility criteria includes the borrower’s on-going compliance with a hedging covenant (against holding speculative swaps), and the borrower leaves swap trades in place after the underlying asset or liability has been disposed of, it has arguably ceased to comply with that covenant (and is now speculating), with the possible result that those swaps may no longer be secured under the credit documents.36 Where such forfeiture pro-visions exist (and cannot be excised), swap providers should take care to see that the terms of their ISDA Schedule or confirmation contain an Additional Termination Event or covenant, permitting early close-out by the swap pro-vider immediately upon the occurrence of any such circumstance. In sum, it is important from the standpoint of the swap provider for the syndicated credit agreement to provide clearly for “enduring collateral” sup-porting the swaps, by (i) specifying that swap providers ceasing to be lenders will still be entitled to the benefit of credit agreement collateral and guaran-ties,37 (ii) including “lock-in” provisions in the amendments section of the credit agreement that bar amendments that would deprive swap providers of their collateral or guaranty support without their consent, and (iii) avoiding swap eligibility requirements that would apply in retroactive fashion to ne-gate collateral support as to a swap that had previously become effective and been deemed eligible for such collateral support.

WHetHer a sWap default or early termInatIon Causes a CredIt agreement default

If the borrower defaults under an ISDA Master Agreement that is linked to a syndicated credit agreement, the enforcement options available to the swap provider, in the absence of action by the administrative agent, are gener-ally limited. Since the swap provider’s credit exposure is secured by a com-mon collateral and guaranty structure, it usually cannot independently com-mence collateral foreclosure or bring action against guarantors. Only the


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administrative agent may do this, under the instruction of the majority lend-ers, which must be preceded by an “Event of Default” arising under the credit agreement. Thus, in order for there to be any chance of the administrative agent enforcing remedies on account of a swap default (or early termination), the swap default (or early termination) must give rise to an “Event of Default” under the credit agreement.38

There are two alternative means by which credit agreement defaults that are based upon a swap default or condition may occur — either (1) directly, as a covenant breach or default by the borrower under a “Loan Document” (which generally will exist only if the swap documents are included within the credit agreement definition of “Loan Documents”), or (2) indirectly, through the cross-default provision in the credit agreement. Where the cross-default provision is being relied upon, notice should be taken, first, to see that swap obligations are included within the credit agreement’s definition of “Debt” or “Indebtedness” (as used in this connection), and second, to see what thresh-old amount applies in respect of the cross-default provision. In many cases, that threshold may be too high to be useful for many swap close-outs, with the result that swap defaults or terminations may not always translate into credit agreement events of default.39

WHetHer tHe CredIt agreement ConflICts WItH tHe Isda master agreement

Finally, the credit agreement may contain provisions that intentionally or unintentionally override or conflict with certain aspects of the ISDA Mas-ter Agreement, particularly “boilerplate” provisions. This tends to occur es-pecially (although not exclusively) where the credit agreement definition of “Loan Documents” includes the swap documents. In that event, the credit agreement’s provisions relating to (i) choice of law, (ii) submission to jurisdic-tion and venue, and (iii) jury trial waiver and related dispute resolution mat-ters, among others, which frequently apply to all “Loan Documents,” may be deemed to supersede (or conflict with) the counterpart provisions in the ISDA Master Agreement. Generally, swap providers will wish to resist this result, in order to avoid ambiguity and possible enforcement impediments as to their swap documentation.40 This is best accomplished by modification

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of the credit documents themselves in order to remove any conflict, but if that is not feasible, in most instances a satisfactory resolution can be achieved through a specific counter-override provision placed in the ISDA Schedule.

ConClusIon

In conclusion, working within the confines of a syndicated credit agree-ment is sometimes the only way that a swap provider can engage in deriva-tives activity with certain corporate counterparties, and most likely the only way it can do so while receiving security for the resulting credit exposure.41 However, such arrangements often present traps for the unwary swap pro-vider, which are best recognized, and potentially avoided, at the outset of the relationship through a careful, focused review of the credit documentation and the inclusion of appropriate provisions in the ISDA Schedule.42

notes1 For ease of reference, this article will use the term “swaps” as being synonymous with over-the-counter (“OTC”) “derivatives.” This article assumes general familiarity on the part of the reader with the basic structure of standard derivatives documents, particularly the 1992 and 2002 versions of the Master Agreements published by the International Swaps and Derivatives Association (“ISDA”). Readers wishing to learn more about basic ISDA documents may consult with, among other sources, anThony C. gooCh & Linda B. kLein, doCumenTaTion for derivaTives (4th ed. 2002); PauL C. harding, masTering The isda masTer agreemenTs (1992 and 2002): a PraCTiCaL guide for negoTiaTion (3d ed. 2010); and ChrisTian a. Johnson, The guide To using and negoTiaTing oTC derivaTives doCumenTaTion (2d ed. 2005). Unless otherwise indicated, references herein to the “ISDA Master Agreement” are to both the 1992 and 2002 versions of that agreement. 2 Each of these potential issues is discussed in greater detail below. In addition, the negative pledge or secured debt covenant in the credit agreement will often prohibit swap providers from obtaining independent collateral from the borrower securing their swap exposure, including through the ISDA Credit Support Annex. As a result, in most instances, the swap provider will be forced to rely solely upon the loan document collateral and guaranties.3 The implicit assumption is that lenders who are swap providers will overlook these


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disadvantages and view the overall credit relationship with the borrower as a whole, finding ways to express their needs relating to swaps through their rights as lenders under the credit agreement. Whether this assumption is realistic will depend on the specific facts and circumstances of the credit facility and its lender group, including the proportion of lenders that are ultimately also swap providers. For example, syndicated credit facilities are administered on behalf of the lenders by administrative agents, but such agents are for most purposes instructed by a vote of the “required lenders” (or “majority lenders”), which typically requires action by lenders representing 51 percent (or sometimes 66-2/3percent) of the total loan facility. Certain issues — such as a maturity extension or loan interest or loan fee decreases, for example — require the vote of each affected lender or all lenders. However, most issues of import to swap providers will be “majority lender” issues. The parties do not often know the identity of swap providers until after the loan closes, and the borrower’s choice of a swap provider will usually be determined by the swap pricing offered to the borrower. As a result, it is difficult or impossible for a potential swap provider to know in advance whether it will be a swap provider in the end, and whether the swap providers will in the aggregate reach the “majority lender” threshold. This uncertainty complicates the process of negotiating various loan document provisions that affect swap provider rights.4 Such bankruptcy swap agreement safe harbor rights are codified, inter alia, at Sections 362(b)(17) (exemption from automatic stay), 546(g) (exemption from certain avoiding powers), and 560 (preserving rights of termination (including by virtue of an ipso facto clause), close-out netting and swap enforcement) of the U.S. Bankruptcy Code (11 U.S.C. §101, et seq.). See also note 15, infra.5 While syndicated loan documents vary substantially across the different banking institutions that frequently serve as administrative agents (and across different counsel that such institutions engage to prepare those loan documents), certain common themes and provisions do occur, some of which are addressed in this article.6 Since most swap trades are not entered into until some weeks or even months after the syndicated credit agreement has become effective, the credit documents are often not shared with swaps personnel until after the closing, when ISDA Schedules and confirmations need to be prepared to document the swap relationship. Swaps personnel and their counsel, therefore, are frequently not afforded a chance to review the syndicated loan documents while they are still in draft form, nor do they always have a meaningful opportunity to comment before the credit documents are finalized.7 These six issues are not necessarily an exhaustive listing of all areas within the syndicated credit documents that may have a material bearing on the position of swap providers. Swaps personnel, or appropriate counsel, should undertake a full review of all aspects of the credit documentation that are potentially relevant to swap

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providers’ rights.8 The swap provider does not always prepare the ISDA Schedule to document the swap relationship in syndicated loan arrangements. In some (relatively infrequent) cases, borrowers (or the administrative agent) insist that a single, uniform version of the Schedule be used by all swap providers. See note 16, infra. Swaps personnel will then be expected to review that form document provided by the administrative agent, to confirm that it satisfactorily addresses their institution’s credit and operations requirements. In most instances, however, the swap provider will prepare and negotiate its individual form of Schedule, which should be appropriately linked to the credit documentation. For a helpful outline of issues to be considered when preparing a loan-linked ISDA Schedule, see Paul Harding, Loan-Linked ISDA Master Agreements: A Primer, derivaTives wk., Apr. 7, 2008. 9 See, e.g., A. Christenfeld and S. Melzer, ‘Beal’: Syndicated Loans and Individual Remedies, 238 N.Y.L.J. 5 (2007). 10 This particular variety of remedies impairment is relatively uncommon in syndicated credit agreements, but swap providers should nevertheless be alert to the possibility. Such right typically exists under Section 2(a)(iii) of the ISDA Master Agreement. 11 Exclusive remedy provisions are generally difficult to countenance even for swap providers who are lenders. They would almost certainly be unacceptable for non-lender assignees of such swap providers, a fact that should be taken into account when deciding whether to agree to such restrictions. Exclusive remedies provisions may also impair the ability of a swap provider that is a depository institution to report swaps exposures on a net basis for capital reserve purposes, if such provisions prevent prompt close out and netting of swap trades upon borrower default. See 72 Fed. Reg. 69403 (Basel II definition of “qualifying master netting agreement”). It should also be borne in mind that a swap provider’s continuous failure to enforce a default or Additional Termination Event under an ISDA Master Agreement (including as a result of credit agreement restrictions on such enforcement), may at some point cause the default or event to be deemed waived or, if the borrower is in bankruptcy, cause relevant safe harbor rights to be deemed waived or exceeded. See, e.g., In re Lehman Brothers Holdings Inc., Case No. 08-13555 (JMP) (Bankr. S.D.N.Y. Sept. 15, 2009) (R. at 100-13) (“Metavante Corp. v. Lehman” — bench ruling, finding swap safe harbor no longer applicable, and compelling swap counterparty to continue to perform, pending debtor’s decision to assume or reject contract). But see Enron Australia v. TXU Electricity Ltd. [2003] NSWSC 1169 (finding no waiver).12 Typically, this sharing would occur under the credit agreement’s payment waterfall provision relating to allocation of remedies enforcement proceeds. See text accompanying note 22, infra.


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13 See note 4, supra.14 While credit documents often require swap providers to waive (or agree to share) rights of setoff, care should be taken to ensure that such provisions do not inadvertently preclude swap close-out netting (such netting being closely related to setoff ), as the setoff language is sometimes drafted overly-broadly.15 Even if the syndicated credit agreement is deemed a “master netting agreement” under the Bankruptcy Code (11 U.S.C. §101(38A)), the safe harbor benefits of Section 561, among others, will only extend to those transactions that are “swap agreements” as defined in the Bankruptcy Code (11 U.S.C. §101(53B)). Since the credit agreement will likely prohibit the swap provider from taking and retaining setoff proceeds without sharing with the lenders (who are not entitled to the swaps safe harbors), the swap provider is potentially precluded from undertaking any setoff whatsoever during a bankruptcy. See also In re Lehman Brothers Holdings Inc., 422 B.R. 407, 421 (Bankr. S.D.N.Y. 2010) (holding that payment priority provisions set forth in trust deeds governing the notes secured by collateral, which also supported swap obligations of a Lehman Brothers affiliated entity, did not comprise “swap agreements” themselves, and as a result, such payment priority provisions were not protected by the Bankruptcy Code safe harbors); In re SemCrude, L.P., 399 B.R. 388, 396-99 (Bankr. D. Del. 2009) (denying triangular setoff in bankruptcy). A related issue is whether the swap provider may set off upon swap close-out its own (out of the money) swap payment obligations against loan amounts owing to it by the borrower. Frequently, this will be captured by the credit agreement’s setoff sharing provision. Other times, such swap positions, which are “in the money” (and therefore assets) as to the borrower, will be subject to the collateral grant to the administrative agent, setting up a potential conflict between the swap provider’s setoff rights and the rights of the administrative agent as secured party under Article 9 of the Uniform Commercial Code. See U.C.C. § 9-340 (priority of depository bank right of setoff vs. Article 9 security interest). See generally Mark Guinn & William Harvey, Taking OTC Derivatives Contracts as Collateral, 57 Bus. Lawyer 1127 (May 2002).16 Such standardized ISDA Schedules tend to occur more frequently in project financing transactions, where the lenders wish to control the extent, nature and terms of material indebtedness and other obligations of their special-purpose borrower entities. See also note 8, supra. In some cases, the swap provider may be told that all other swap providers are agreeing to a common set of master agreement terms, but there is no written evidence of such fact. In such instances, the swap provider may wish to insist that a “most favored nations” clause be included in its ISDA Schedule, confirming that no other swap provider’s master agreement is materially more favorable than its own.

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17 The prospect of both eligible and ineligible swaps being included, intentionally or unintentionally, under a single ISDA Master Agreement, and being subject to close-out netting on a combined basis, raises certain interesting issues that may affect the swap provider’s rights under the syndicated loan documentation. Perhaps the best way for the swap provider to avoid such issues and uncertainties is to place ineligible swaps (if the swap provider knows at the outset that they are ineligible) under a separate master agreement from the one containing the eligible swaps, coupled with a push-out provision in the eligible swap Schedule, to expel swaps later determined to be ineligible.18 Most syndicated credit agreements do expressly permit affiliates of syndicate lenders to act as swap providers. A primary reason for limiting the role of a swap provider to syndicate lenders (and their affiliates) is that of avoiding complex intercreditor issues (including allocation of voting rights) that exist where unrelated entities share in a common collateral and guaranty pool.19 In other words, whether the collateral security and guaranties are granted to the secured parties directly or to the administrative agent for the benefit of listed beneficiaries, the secured parties or such beneficiaries should include not just lenders (as such) but also swap providers. 20 Generally, such forfeiture would be viewed as an unreasonable penalty to exact on swap providers. In addition, these provisions, by virtue of their factual uncertainty, provide ammunition for after the fact disputes among the parties (and the borrower’s bankruptcy trustee) as to their relative secured positions at prior points in time. However, in certain instances, the combination of large “out of the money” swap obligations owed by the borrower, together with the loan obligations, may cause the total secured indebtedness of the borrower to exceed the value of the syndicate collateral supporting it. The result of such partial insecurity is that certain payments made by the borrower in close proximity to its bankruptcy may constitute preferential payments under Section 547 of the Bankruptcy Code and become subject to recoupment by the bankruptcy trustee. 11 U.S.C. §547. Due to the swap provider’s anti-avoidance safe harbor right (at 11 U.S.C. §546(g)), such recoupment would likely affect only payments received by lenders. Thus, lenders may in certain instances have an interest in limiting the total secured indebtedness (including swap obligations) to a level below the total collateral value, and for this reason may argue to maintain some limitation on the incurrence of eligible swaps. However, the hedging and similar covenant restrictions commonly encountered as conditions to swap eligibility in credit agreements are not especially useful for this purpose.21 Unfortunately, if such representation should prove incorrect, it is likely that the swap provider would still be deprived of any collateral and guaranty entitlements,


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although it would have a basis to declare a default under the ISDA Master Agreement. For this reason, it is important from the swap provider’s standpoint that such provisions operate solely as borrower covenants (as to which the only remedy for breach is an event of default under the credit agreement), and not as eligibility criteria for swap collateral and guaranties.22 A key variable in this regard is the precise event that triggers the waterfall allocation scheme under the credit agreement. Where such sharing arises upon the mere occurrence of an event of default under the credit agreement, swap providers may find that they are obligated to share swap payment proceeds at an unduly (and unexpectedly) early stage. Among other things, such payment capture may cause the swap provider to go out of pocket as to transactions entered into by it in order to hedge its exposure under that swap arrangement. It is therefore preferable for swap providers that such payment allocation provisions only apply when the loans have been accelerated, collateral is being foreclosed upon, or there has been a bankruptcy or similar event.23 Such provisions may cause the swap provider to lose entitlement to the Bankruptcy Code swap safe harbor sheltering such payment transfers from the avoiding powers of the borrower’s bankruptcy trustee. See 11 U.S.C. §546(g); see also note 15, supra. 24 There are several distinct swap payment types possible under the ISDA Master Agreement, including (i) Settlement Amounts (as defined in the 1992 ISDA Master Agreement) or Close-out Amounts (as defined in the ISDA 2002 Master Agreement), (ii) Unpaid Amounts (as defined in the ISDA Master Agreement), (iii) interest on deferred or defaulted payments, (iv) expenses, (v) tax indemnities, (vi) currency indemnities, and (vii) miscellaneous or general indemnities. Swap providers may wish to argue that Unpaid Amounts (as well as default interest) should be entitled to a preferred payment priority in the waterfall, commensurate with that of loan interest, since such amounts, as ordinary course payments, may be viewed as equivalent to unpaid loan interest. Payment waterfall arrangements that are linked to the payer’s insolvency or bankruptcy may, under certain circumstances, be set aside under the U.S. Bankruptcy Code. See In re Lehman Brothers Holdings Inc., 422 B.R. 407, 411 (Bankr. S.D.N.Y. 2010).25 Provisions limiting collateral rights to lenders also mean that assignees taking an assignment of a swap provider’s swaps position will not be secured unless they too are lenders. As a result, such swaps positions will tend to be less marketable, if not altogether unmarketable. 26 These examples are most commonly encountered in practice, in the authors’ experience. The credit documentation should be examined for any others.27 Borrowers often seek to discourage their lenders from selling down their loan positions and typically negotiate assignment provisions in the credit agreement

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prohibiting such loan and commitment assignments without their consent, absent an event of default. See also note 29, infra.28 Usually, such forced assignment provisions do not require that the assignee also take assignment of any swap position of the assignor lender. As a result, a lender being forced out of a syndicate may find itself with swap exposure without any loan exposure under the credit agreement, which, particularly in view of absent voting rights, is generally not a desirable outcome, even apart from possible loss of collateral and guaranties. In those unusual instances where the credit agreement’s forced assignment provision does provide for the transfer of swaps exposures to a replacing lender, it often does not adequately address the manner of determining the transfer price that would apply to the swaps assignment.29 Although the assignment process can be controlled internally, to preserve asset liquidity, lenders (and swap providers who are lenders) are interested in as few assignment restrictions as possible. In contrast, as noted above, borrowers typically wish to place impediments in the way of lenders seeking to exit the facility. Such impediments can be in the form of narrow categorizations of eligible assignees, blacklisting certain lenders who may assign their positions (or their assignees), increasing the minimum dollar amount that can be assigned in the event of a partial assignment, or simply withholding borrower consent to an assignment (where such consent is required).30 The ISDA Master Agreement generally prohibits any transfer by a party of its interests or obligations under the Master Agreement, or any swap transaction, without the other party’s consent. There are two exceptions to this rule, when no consent is required: (1) upon the occurrence of a merger or similar corporate event, and (2) upon default or early termination, for transfers of interests (but not obligations) (a) in close-out payments and (b) under the 2002 Master Agreement only, in other payments related to early termination (such as currency conversion, default rate interest, Unpaid Amounts, default interest on swap payment amounts, and out-of-pocket expenses).31 The swap provider should also consider including as an “Additional Termination Event” in the ISDA Schedule the assignment by the swap provider of its entire loan position, to ensure that it can close out all of its swaps immediately upon the effectiveness of the assignment if the buyer of the loans is not interested in acquiring the swaps as well.32 Because the defaulting lender scenario is attributable to the swap provider’s own failure to perform under the credit agreement (or its insolvency), it may be argued that it is fair that item (ii)(y) in the second preceding paragraph should be excluded from the credit agreement modifications permitting the swap provider to retain collateral and guaranty entitlements pending final payment. In opposition to this


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position, however, it should also be noted that such a draconian penalty does not occur on the loan side — i.e., defaulting lenders do not, as a rule, lose their loan collateral or guaranties as a result of becoming defaulting lenders. In addition, it is doubtful whether a provision causing forfeiture of the collateral position of a swap provider upon such swap provider’s insolvency would be enforceable against such swap provider in a bankruptcy or bank insolvency proceeding involving such entity. See 11 U.S.C. §365(3); 12 U.S.C. §1821(e)(12).33 The swap provider should consider whether there exists any scenario under the credit documentation and the ISDA Master Agreement whereby the syndicate loans may be repaid in full, yet swaps may remain outstanding. Typically, when the credit facility is fully repaid, the administrative agent’s role is completed, and it may or will resign. However, with the administrative agent absent, the collateral and guaranty package previously supporting the swap obligations (and granted to the administrative agent) may no longer inure to the benefit of any swap providers whose swaps remain in place after the pay-off. Even where the administrative agent does remain in place after repayment of all loans, swap providers will need to be accorded voting rights, in order to be able to instruct it (i.e., have “springing” voting rights).34 This scenario is of particular concern where only a minority of the lenders consists of swap providers. See note 3. supra.35 The inclusion of such an Additional Termination Event may not preclude the effectiveness of the adverse amendment to the credit documents, but it will, at a minimum, permit an immediate close-out of swap trades and may induce the borrower not to agree to such an amendment. 36 An interesting attribution issue may arise where a covenant breach by the borrower results from swaps activity with several swap providers. For example, if the credit agreement requires that more than 50 percent but less than 75 percent of the term loan exposure be covered by hedges, and the borrower enters into hedges for the entire 100 percent of the term loan exposure, does it mean that all of the swaps related to the 100 percent exposure become ineligible because the covenant has been breached? Or, is the penalty allocated only to the swap providers whose trades became effective later in time, and who were the most direct cause of the covenant breach? In either event, such covenants and eligibility conditions suggest the need for swap providers to closely monitor, and perhaps restrict, the borrower’s overall swaps activity through provisions in the ISDA Schedule. Better yet, from the swap provider’s standpoint, would be to avoid such eligibility criteria altogether. See text accompanying note 20, supra.37 Again, a separate issue is whether non-lenders who take, by way of assignment from lender swap providers, will be entitled to the benefit of collateral. See note 25, supra.

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38 However, it is probably unlikely that the majority lenders would elect to instruct the administrative agent to take action, based solely upon a default under a swap document, unless the majority lenders were also swap providers and the default was shared directly or indirectly by each. See Section (1), supra, and note 39, infra..39 The credit agreement cross-default threshold as applied to swaps should also be inspected to see if it relates to swap close-out or termination amount, notional amount, or some other amount. Oftentimes, there appears only an ambiguous reference to “principal amount.” Where the cross-default is based on a mark-to-market or swap termination threshold amount, issues may arise as to which entity is responsible for reporting the relevant amount, and subject to what methodology or assumptions. Unless a formal Close-out Amount or Settlement Amount has been determined by the swap parties under the relevant ISDA Master Agreement, any quantity determined for this purpose will be an informal or indicative amount, and potentially subject to dispute or second-guessing. It is recommended, where possible, that each swap provider’s ISDA Schedule contain a cross-default (or Specified Transaction default) provision that would result in the various swap documents across the several lender swap providers being cross-defaulted. In such event, the aggregate default amount for all of the lenders’ swap agreements will more likely reach the required cross-default threshold in the credit agreement. It may also make it more likely that the swap providers as a group will have sufficient interest and ability to instruct the administrative agent to take enforcement steps on their behalf as a result of swap default conditions. See notes 3 and 38, supra. It is obviously a particularly undesirable circumstance for swap providers to be unable to act, due to the existence of an “exclusive remedies” provision in the credit agreement, while the administrative agent is also unable to act on account of the swap default, because of the absence of any Event of Default under the credit agreement. See text accompanying note 11, supra.40 Alteration of the ISDA (usually New York) choice of law provision can be particularly disadvantageous to the swap provider. Among other considerations, while the laws of New York, California and certain other states contain exceptions to their statute of frauds, upholding the validity of derivatives contracts arranged by telephone, other states may not have such exceptions and the relevant swaps could be subject to attack under such laws. See CaL. Civ. Code § 1624(b); n.y. gen. oBLig. Law § 5-701(b).41 Where the credit agreement and other loan documents in the end lack sufficient clarity as to the basic rights of swap providers, the latter may wish to require that a separate intercreditor agreement be entered into by all of the secured parties.42 As this article was going to print, the U.S. Congress was in the apparent final stages of considering the Dodd-Frank Wall Street Reform and Consumer Protection


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Act, which included comprehensive revision and expansion of regulations governing over-the-counter derivatives. Among other possible areas of impact, the legislation’s mandatory clearing provisions (with the accompanying margin requirements) for non-exempt OTC derivatives may further complicate syndicated loan-linked swap arrangements.

The Banking Law JournaL - Reed Smith...tHe bANKINg lAW JourNAl 644 assessing these potential issues...

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Transcript of The Banking Law JournaL - Reed Smith...tHe bANKINg lAW JourNAl 644 assessing these potential issues...