The top five points for corporate borrowers to protect themselves against bank insolvency in Europe and elsewhere
Following a number of recent high-profile collapses of banks in Europe and the United States (notably, Credit Suisse, Silicon Valley Bank, Silvergate Bank and Signature Bank), not only their investors but also their clients may be considering their position under financing arrangements and applicable insolvency law.
Here are five steps that corporate borrowers can take to protect themselves against the fall-out of their financing banks’ insolvency:
- check existing finance documents for provisions dealing with lenders and agents that are in default;
- check the possibilities for setoff and discharge of payment obligations under existing finance documents and applicable law;
- consider a transfer of the defaulting lender’s or agent’s position to others;
- consider diversification of funding sources in addition to existing finance documents; and
- consider entering into stand-by arrangements in addition to existing finance documents.
If a corporate borrower also has claims against the insolvent bank, such as credit positions on bank accounts, investments in regulatory capital or other securities issued by the bank, or in-the-money positions under derivatives with the insolvent bank as the counterparty, additional steps would need to be assessed and taken to protect the value of the corporation’s claims. These steps include assessing deposit guarantees, bank parent guarantees, creditor hierarchy provisions under insolvency laws, and collateral positions under derivatives. In this blog, we will focus on the corporate borrower’s position under its own financing arrangements with an insolvent bank.
1. What do finance documents generally provide about a lender or facility agent being in default?
In the wake of the 2008 financial crisis, the LMA introduced “Defaulting Lender” and “Impaired Agent” provisions in its standard leveraged finance documentation. Under these provisions, a Defaulting Lender or an Impaired Agent is, in short, a lender or facility agent (as applicable) that (i) has failed (as lender) to fund a loan, (as issuing bank) to issue a letter of credit or (as agent) to make a payment that it is required to fund, issue or pay; (ii) rescinds or repudiates a finance document; or (iii) is subject to an insolvency event (with this insolvency trigger being optional for the designation of a Defaulting Lender).
If a lender becomes a Defaulting Lender
Defaulting Lender provisions may be particularly relevant in the context of working capital facilities, where a borrower is continuously relying on its counterparties to fund its working capital requirements.
Working capital funding is often provided in the form a revolving credit facility. If at any time a lender becomes a Defaulting Lender, the maturity date of each of its participations in outstanding revolving credit facility loans will be extended to either the last day of the availability period of that facility or its termination date. Revolving facility loans are typically short-term loans that need to be repaid or refinanced by the end of the relevant interest period (typically between one to six months). By extending the maturity of revolving facility loans provided by a Defaulting Lender, or parts of those loans, the borrower will create some breathing room for itself while it searches for a long-term solution to refinance amounts provided by that lender.
Issues neverthel4ss remain, because as a borrower may not be able to rely on a Defaulting Lender to provide future funding under its undrawn commitments. Longer-term solutions for dealing with a Defaulting Lender, as contemplated by LMA standard finance documentation, are either:
(a) cancelling the commitments of the Defaulting Lender on all facilities that have not been fully drawn and subsequently finding another lender or financial institution to assume the cancelled position through the LMA’s increase provisions (which need to be invoked within a specific period after cancelation); or
(b) forcing the Defaulting Lender to transfer its participations and commitments to another financial institution at par (or, with the Defaulting Lender’s consent, below par).
Through these steps, a borrower may isolate its financing arrangements from further fall-out of the Defaulting Lender, but a major practical limitation remains that it may prove difficult to transfer the position of the Defaulting Lender to others, in particular in the wake of a major bank failure or adverse market circumstances. Under such circumstances, it may be more feasible to find such solutions in large multibank syndicates, rather than in smaller club deals.
Other consequences of a lender becoming a Defaulting Lender under the LMA’s Defaulting Lender provisions include:
(i) (optionally) that Defaulting Lender no longer being entitled to commitment fees;
(ii) that lender becoming subject to stricter “you snooze you lose” type of provisions; and
(iii) that Defaulting Lender being disenfranchised for its undrawn commitments in the context of any majority lender voting matters.
If a facility agent becomes an Impaired Agent
Another concern for a borrower may be that the facility agent becomes insolvent or defaults on its obligations. This is particularly relevant, as under the LMA’s form of documentation all information and cash flows from and to the lenders are routed through the facility agent. A borrower will not want such funds to become trapped in the facility agent’s insolvency estate.
If a facility agent becomes an Impaired Agent, the LMA’s Impaired Agent provisions provide that that facility agent may be circumvented by the borrower and the lenders forming the syndicate. This means that, for example, instead of making payments of interest and principal to the facility agent (for distribution to the lenders), the borrower will instead make such payments directly to the lenders in the syndicate or into a designated account maintained for the benefit of the lenders. Similarly, payments from the lenders to the borrowers (for example on a drawdown of a facility) can be made directly by the lenders to the borrower in a similar fashion. Similar provisions apply to the provision of information and notices.
If the finance documents do not include Defaulting Lender and Impaired Agent provisions
The Defaulting Lender and Impaired Agent provisions referred to above are included as standard provisions in the LMA’s leveraged finance documentation, but are not included in the LMA’s other forms of documentation (such as the LMA’s investment grade and real estate investment documentation). In addition, in the context of so-called LMA-light documentation, such provisions may have been deleted by market participants in an effort to make the size of the facility agreement more manageable.
Consequently, there will be a significant number of facility agreements without Defaulting Lender and Impaired Agent provisions. Accordingly, a borrower would need to rely on applicable laws to assess what should and can be done to isolate the finance arrangements from the lender’s or facility agent’s insolvency. In particular, the borrower should ensure that payments of principal and/or interest after insolvency of the relevant lender/agent would still be recorded as properly discharged to prevent any insolvency trustee from making claims that such payments are not.
2. Is setoff of liabilities and claims against the insolvent bank possible?
In the context of (syndicated) lending arrangements, it is not unusual for lenders to reserve their rights of setoff against the borrower, whereas the borrower is not entitled to invoke rights of setoff against the lenders.
In light of recent developments, and concerns about the stability of the banking system generally, borrowers may wish to reconsider the market position and may consider reserving their rights to invoke setoff against Defaulting Lenders. If a borrower does not reserve these rights, it may be left claiming the balance of any claim against the Defaulting Lender in that Defaulting Lender’s insolvency whilst having to continue to make payments under its loans to that party.
Whether such reservation is feasible will depend on the particular circumstances of the case. For example, certain lenders may reject the borrower’s right of setoff, as it may adversely impact their ability to use the loans as collateral for other purposes.
Generally, the ability of borrowers to set off claims may also be provided for, or limited, under applicable insolvency law.
3. Can the insolvent bank’s position be transferred to others?
Borrowers may seek protection against defaulting counterparties by relying on transfer restrictions in their facility agreements. In particular, borrowers may require that their working capital facilities can be transferred to robust financial institutions with a particular credit rating or appearing on a list of approved transferees.
In the context of such lists of approved transferees, borrowers should consider reserving the right to amend this list, as the recent bank insolvencies have shown that even large reputable banks may deteriorate quickly.
If the facility agreement does not provide for restrictions on transfers of the lender’s position, discussions about a transfer of contract or specific rights and obligations would have to be conducted with the insolvency trustee.
4. My banks are all based in the EU. Am I at risk?
Several EU authorities, including the ECB, have swiftly reacted to the Swiss and American bank insolvencies by stating that the European banking sector is resilient with robust liquidity levels.
It is true that the framework for EU banks (in the form of the Capital Requirements Directive and Regulation and the Bank Recovery and Resolution Directive) includes provisions in relation to the financial robustness of EU banks and the steps to be taken if EU banks are in financial difficulty. However, the mere fact that such provisions exist are evidence of the fact that EU Banks also run the risk of insolvency and are not immune to the effects of international adverse market conditions. Accordingly, the steps above also apply to corporate borrowers of EU banks.
If you have any questions on these or other matters, please do not hesitate to contact the Stibbe Banking & Finance team.