What remedies should lenders, borrowers and opportunistic credit investors prescribe in light of current market practice and documentation?
This article examines some of the current issues arising in leverage finance agreements on defaults and the expansion of express remedy terms that can impact on debt transfers.
- Increased probability of default rates rising in European leverage financings should cause astute borrowers and lenders to re-assess very carefully exactly what specific defaults/events of default might be curable, when and how, in light of current market documentation and practice.
- Can lessons learned in recent US loan default cases be instructive to European credit investors, given the increased availability of cross-class cram-down restructurings in Europe?
- Can lenders who have suffered loss/harm pursue action for ostensibly cured defaults?
- Timing can be key when lenders seek to effect contractually compliant credit transfers.
A number of commentators have recently forecast a likely increase in default rates in the European leverage loan market in the coming 12 months, due to yet further macro-economic challenges impacting many borrowers’ ability to meet their performance and/or payment obligations. Such borrowers are often concerned that their credits might trade into the control of opportunistic/distressed credit funds, most of whom have had to wait impatiently to deploy their own “dry-powder”. These funds often seek to catalyse lender activism and/or take advantage of anticipated defaults in the credit market to generate equity-like returns. Restrictions on transfers to such funds typically cease to apply when an event of default has occurred and is continuing. So it is vital for current lenders (considering their recourse rights) and prospective lenders to understand just when and how transfers and sub-participations (where voting rights vest in the sub-participant) may, or may no longer, require borrower consent/ consultation to become effective based on the rights and remedies associated with defaults and events of default.
Many lenders have adopted a relatively benign attitude to a variety of defaults arising in the European credit market, not least because of regulatory expectations that lenders should be supportive of borrowers facing the recent pandemic’s “temporary” challenges. As formal support programs ended and the strictures of IFRS 9 cause many par lenders to seek to trade out of defaulting credits quite promptly many borrowers can face less indulgent creditors keen to exploit opportunities created by defaults.
Novel and bold High Yield bond restructuring techniques are increasingly being deployed in US loan default and restructuring situations. Some have questioned whether some elements of these aggressive tactics, driven by both sponsors and opportunistic lenders, aided by certain loan terms might gain traction in Europe, especially if facilitated by cross-class cram-down procedures.
- Prescribed Remedies
An important factor in opportunistic lenders’ calculations is the extent to which borrowers can remedy defaults/events of default, via express language in credit documentation, being additional to usual implied rights to remedy certain defaults within limited periods. These now include:
(a) “equity cures” of financial covenant breaches by the active infusion of new equity or subordinated debt capital, often within 20 business days of a testing date’s default, so the covenant is promptly retested on the basis of the additional capital deemed to reduce debt or increase EBITDA, with/ without an “over-cure” right that might disguise deeper performance issues within the borrower’s group, and with the cure amount being retained in the borrower’s group or prepaid to the lenders (by ensuring it is not permitted to be paid out by dividend/paid out under other permitted baskets);
(b) “cured defaults”, where various events of default outside the usual limited remedy periods (c3-14 business days, in many agreements) are expressed (along with consequential defaults) to be capable of being wholly cured (assuming they can be) by the obligors taking positive action to:
(i) reverse/unwind a prohibited defaulting action (eg an investment or dividend payment); or
(ii) undertake a previously unfulfilled required action (eg a positive reporting obligation);
(c) “deemed cures”, where a default in the compliance with a financial covenant can be deemed remedied by a reduction in the revolving outstandings to below the threshold for testing at the next testing date, provided the revolving lenders have not by then taken enforcement action; this introduces a “snooze and lose” timing type issue for lenders; and
(d) “auto-cures”, where a financial covenant default may be cured at any time (often by a simple retesting exercise based on updated figures rather than by any new capital injections), provided the lenders have not taken enforcement action, and which provide sponsors with considerable leeway to gauge how lenders are reacting to a continuing default and then move quickly if there is a risk of an enforcement.
Equity cures, after a rocky start well over a decade ago, should now be well understood by all parties but sponsors are increasingly negotiating a right to contribute cash or the monetary value of assets to the borrowing group (from outside that group) to effect the cure rather than:
- re-designating prior equity infusions; or
- freshly infusing funds from their own fund’s coffers.
In this way a sponsor counts previously committed funds to the cure rather than having to risk calling new fund-level capital. Sometimes such US aspects of equity cures feature in European credits but without equivalent attendant restrictive treatment of such cure amounts in financial statements.
The features (b)-(d) may be seen in larger leverage financings where the “originate and distribute” model prevails rather than in private credit funded structures where the original lender(s) will expect to remain with the credit for its duration. In view of current market sentiment, many market participants are now re-considering just how various issues in relation to events of default are presently addressed in the European loan market, including if, and when, they are actionable by lenders or remediable by borrowers, and how these issues impact the issue of loan transferability. A proactive borrower may seek a prospective waiver if it knows, or strongly believes, it will not meet a particular financial covenant rather than allow a default to arise which may require more involved action such as highly conditioned waiver terms from a higher threshold of supportive lenders. Such proactivity usually provides it and its shareholder(s) with an opportunity to take wider stock of its credit and perhaps also seek to push for other advisable waivers or amendments. However, as noted below many sponsors with deemed cures and auto-cures in their credit agreements are able to delay meaningful engagement (if they so choose) for a longer period to assess lender sentiment/tactics and dis-incentivise opportunists from circling their stressed credits.
- Clock running on events of default and cures
Many extant leverage loan agreements have been negotiated in an environment favouring the interests of borrowers and their sponsors in terms of how defaults/events of default arise and how flexibly they can be cured. Some deemed cures (absent any need to reduce revolver drawings) have been introduced in amendments on specific sectoral credits (eg casual-dining) suffering the effects of periodic pandemic lock-downs but they are expected to bounce-back once such restrictions are lifted nearly akin to “Mulligan clauses”. In this way a borrower will be deemed to return to full compliance on the next testing date without the need of further action (such as cure injections) being required. It has been noticeable that while a borrower may have a default or even an event of default outstanding for some time between a test date and the deemed cure date, sponsors have largely been content to use this time to assess the attitude of lenders. Lenders on such credits have had to bide their time rather than explore transfers to distressed or other opportunistic investors, absent other negative factors arising on the credit.
If market sentiment towards particular sectors turns more bearish and/or there is continuing underperformance in a borrower’s business then sponsors may have to make quicker decisions to actively inject funds via equity cures rather than risk losing support of lenders who may be quicker to trade out of the credit if an event of default is continuing, rather than wait for the next testing date, especially if a revolver is being heavily utilised. Auto-cures without any conditionality in their application will likely facilitate sponsors stymying potential trades to distressed funds who will be unwilling to trade into a credit which may return to compliance by a sponsor deploying a variety of creative methodologies.
- Are US case developments instructive to European credit markets?
A concern of certain minority par lenders is that a sufficient majority of opportunistic lenders might with the connivance/contrivance of the borrower’s sponsor engineer an “uptiering/priming” of the majority lenders’ claims, (ie to obtain superpriority status), effect a transfer of valuable assets out with the borrower’s recourse group, or enable credit lines to be drawn and applied in such a way as to be detrimental to the minority lenders. Such creative exercises have been known to occur in European loans see Redwood Master Fund Ltd and others v TD Bank Europe Ltd and others  1 BCLC 149, where majority lenders agreed to a minority-held facility being drawn and used to pay down their own under the same agreement.
The European Intralot matter has given rise to New York litigation on the “dropdown” technique first used in the US in 2016 by J Crew (see commentary (2022) 5 JIBFL 299). In the 2020/21 New York Trimark case (N.Y. Sup. Ct. August 16, 2021), aggrieved minority first-lien lenders challenged an uptiering of the majority lenders’ first-lien claims by a new debt issuance coupled with an exchange of debt for super-priority debt (under neither element were the minority lenders given an opportunity to participate). This resulted in more than US$420m of claims out-ranking the minority lenders’ claims with a variety of ancillary value-reducing elements (such as the removal of all covenants and undertakings, negatively modifying prepayment and indemnity clauses, etc) being imposed on the minority lenders’ debt. While the New York courts have largely rejected the claims of the plaintiffs in such matters (on lenders needing to act in good faith between themselves for example), it is likely that many European courts would take a different view.
Intercreditor agreements in many European credits ought, if properly drafted, to curb the worst of these contractual exercises by requiring the relevant impacted ranking lenders to agree separately unless the credit structure is amended via an EU/ UK cross-class cram-down restructuring procedure, which can override entrenched rights. Sponsors may increasingly work with senior lenders to adjust the interests of more junior ranking finance creditors and third-party unsecured creditors via such procedures. In many instances it could be expected that, unlike prior rounds of significant credit defaults, a relatively minor compromise in the claims of senior creditors can be used to deprive even more junior creditor classes of significant value.
- Can remedies cure all ills?
Where an event of default has purportedly been remedied by a borrower, a question arises whether any residual right exists for lenders to seek redress for loss or harm suffered by the remedy itself. Where an express “cured default” provision is included then it should largely prevent lenders from seeking to bring an action based on the original event of default and while it was continuing un-remedied. In most other credit agreements, concerns can arise in respect of remedial late payments or delayed provision of guarantees/security that might subsequently be at risk of challenge in a subsequent insolvency set-aside action against the obligors, which of course might only be actionable at a much later date. Similarly, a misrepresentation made in a drawdown/rollover request may not be remediable (absent express waivers) as it will also have propagated various crossdefaults. It is important that in considering any waiver request that lenders carefully consider what rights, of indemnification for any future cost, loss or liability they might incur as a result of the occurrence of the original event of fault, they might lose by a widely drafted set of irrevocable waivers. Lenders are increasingly seeking the preservation of such rights where losses might only arise at a later date, which in theory sponsors/borrowers might agree to as the rights may only preserve value in an insolvency when the loss or harm might be quantifiable.
Arguments of interpretation may arise where consequential defaults arise from an original default while other subsequent defaults also occur by reason of other action being taken when a remedy is undertaken by a borrower. The borrower may expect all consequential and related defaults to be remedied while lenders may rightly point to the independence of the secondary related but not consequential defaults. Unless they too are remedied by the borrower action, they will likely remain continuing. Case law on these issues only appears in the US such as Sara Lee Household & Personal Case, UK Ltd Almay, Inc. (2d Cir. 1993), where the company was required to return the claimant to the same position as if no default had occurred. Clearly, this may be impossible in many situations so an action may remain available to the lenders.
Cured default language should set out how a default may be cured, in what timeframe and that once remedied the original event of default (as well as consequential ones such as a repeating misrepresentation or failure to notify) will have ceased to apply, with no waiver required to be sought from, or provided by, the lenders. However, most loan agreements do not have such provisions, and so one must interpret the language in the context of the specific default and if remediable, eg late delivery of a certification but not a breach of a negative covenant even if the offending action is fully reversed with assets or other value being returned to the borrower for example. Many courts in civil law jurisdictions will not entertain current technical defaults to facilitate an enforcement, much less remedied events of default, even in the absence of an express right to do so.
- Timing Considerations
Most European credit agreements clearly set out how and when a default and an event of default will occur, on a set date or within a certain number of business days, so commencing the applicable remedy period. This may differ from certain US credit agreements where a notice of an event of default may be required to be served by the borrower to trigger the remedy period. Where there is a failure to give notice of the default this typically creates a further default which if the primary default is remedied will also be deemed to be remedied, or if the notice of default is eventually provided.
Restrictions on transfers (and applicable sub-participations) may fall away on the occurrence of an event of default only briefly, if at all, where borrowers have the use of some of the cure features described above. However, under European credit agreements an event of default may immediately arise such that quick acting opportunistic creditors may acquire an interest in the credit before a remedy can be undertaken by a borrower. It would be a poorly advised borrower that allowed the occurrence of an event of default if it had some indicative knowledge of its likely occurrence and simply failed to be proactive. As cure provisions have developed and become more sophisticated borrowers are more keenly aware of the need to ensure that a right to freely transfer a participation on an event of default is further circumscribed so it does not arise for a period where a cure may be undertaken. That said, a number of legacy credit agreements where certain US market concepts have been introduced into European credit agreements do not always address this issue adequately. Where lenders have obligations to deliver a direct participation in order to receive payment under a credit default swap it is likely that a non-payment or deeper restructuring must occur before they can effect a transfer, as it would be incapable of delivery earlier on the occurrence of other remediable events of default, which are unlikely to trigger a CDS payment in any event.
This article first appeared in the July/August issue of Butterworths Journal of International Banking and Financial Law.