On March 26, 2012, just as we were submitting our last column for publication, three federal bank regulators—the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (collectively, the Agencies)—jointly proposed new guidelines (Proposed Guidance) for leveraged lending transactions conducted by the financial institutions subject to the Agencies' supervision.1 If and when adopted, the Proposed Guidance would update and replace guidance that has been in effect for more than a decade. Today we briefly summarize the Proposed Guidance's principal points and consider its potential effects on leveraged lending transactions.
In April 2001, the Agencies and the federal Office of Thrift Supervision issued guidance regarding sound practices for leveraged finance activities (2001 Guidance).2 The 2001 Guidance addressed expectations for the content of credit policies, the need for well-defined underwriting standards, the importance of defining an institution's risk appetite for leveraged transactions, and the importance of stress testing exposures and portfolios.
After the 2001 Guidance was issued, the Agencies observed tremendous growth in the volume of leveraged credit leading up to the 2008 financial crisis and in the involvement of non-regulated institutional investors in the market. Although there was a pull-back in leveraged lending during the crisis, volumes have since increased and, in the Agencies' view, prudent underwriting practices have again deteriorated. As the market has grown, loan arrangements have frequently incorporated features that the Agencies believe provide relatively limited lender protection. Examples of such features include 'covenant-lite' structures, which omit meaningful maintenance covenants in loan agreements, and payment-in-kind (PIK)-toggle terms in junior debt (i.e., features giving borrowers the option to pay interest either in kind, which thereby increases the principal owed by the amount of the unpaid interest, or in cash),3 both of which the Agencies say impair lender recourse if borrowers do not meet their projections.
In addition, the Agencies believe that the capital structures and repayment prospects for some transactions have been aggressive in light of the overall risk of the credit. Moreover, in the Agencies' view, management information systems (MIS) at some institutions have been unable to aggregate exposures accurately on a timely basis, and many institutions have been left holding large pipelines of higher-risk commitments when buyer demand for risky assets had fallen significantly.4 In light of these developments, the Agencies have decided to replace the 2001 Guidance with the Proposed Guidance.5 Comments on the Proposed Guidance may be submitted to the Agencies until June 8.
The Proposed Guidance covers dozens of items that could be the subject of regulatory supervision in eight broad areas that apply whether transactions are being underwritten to hold or to distribute:
Definition of Leveraged Finance. As a preliminary matter, it is necessary to define the kinds of transactions to which the Proposed Guidance would apply. Therefore, like the 2001 Guidance, the Proposed Guidance articulates the 'expectation'—an intentionally undefined and ambiguous concept that falls somewhere between a suggestion and a requirement—that institutions engaging in leveraged lending adopt a definition of leveraged finance.
Unlike the 2001 Guidance, however, the Proposed Guidance both states that an institution's definition should be sufficiently detailed to ensure consistent application across all of its business lines and specifies benchmarks that the Agencies expect the definition to incorporate. These criteria include, among other things, ratios that, if met, would automatically designate a credit as a leveraged finance transaction—total debt/EBITDA (earnings before interest, taxes, depreciation and amortization) exceeding 4:1, senior debt/EBITDA exceeding 3:1, or other defined ratios appropriate to the borrower's industry or sector, in all cases calculated without netting cash against debt. The Proposed Guidance further notes that the definition should include the institution's exposure to financial vehicles that engage in leveraged finance activities, whether or not the vehicles themselves are leveraged.
General Policy Expectations. The Proposed Guidance states that the Agencies expect management and the board to identify their institution's appetite for leveraged finance risk, establish minimum underwriting standards and appropriate credit limits, and ensure prudent oversight and approval processes. Presumably, although the Proposed Guidance does not expressly state this (except regarding underwriting standards), these items should be articulated formally in written credit policies and procedures that are available at least to the officers who bear responsibility for structuring, negotiating and approving leveraged lending transactions on behalf of the institution, as well, of course, to the institution's examiners.
Underwriting Standards. The Agencies expect institutions to adopt underwriting standards that are clear, written, measurable, and accurately reflect the institutions' risk appetite for leveraged finance transactions, including the size of deals they will arrange both individually and in the aggregate for distribution. The Proposed Guidance identifies numerous items the standards should consider that reflect the Agencies' expectations for borrower cash flow capacity, amortization, covenant protection and collateral controls.
The Agencies expect the standards to emphasize that the business premise for each transaction should be sound and the borrower's capital structure should be sustainable. Standards for asset-based loans should also outline expectations for the use of collateral controls (e.g., inspections, independent valuations, and lockboxes), other types of collateral and account maintenance agreements, and periodic reporting requirements. These are minimum standards, and the Proposed Guidance makes clear that institutions should also 'be mindful of reputational risks associated with poorly underwritten transactions, which may find their way into a wide variety of investment instruments and exacerbate systemic risks within the general economy.'6
Valuation Standards. These concentrate on the importance of sound methodologies in determining and periodically revalidating enterprise value and other intangibles, on which lenders often rely when underwriting, administering and working out transactions.
Pipeline Management. This is an entirely new subject, reflecting, no doubt, the painful experience of the credit crisis. Since market disruptions can substantially impair an institution's ability to consummate syndications or otherwise sell down exposures, institutions should have strong risk management and controls over transactions in their pipeline. Institutions should be able to differentiate transactions according to tenor, investor class, structure and key borrower characteristics (e.g., industry). The Proposed Guidance further identifies numerous items that should be covered by formal policies and procedures reflecting the Agencies' expectations for hedging pipeline exposures, accurately measuring exposures on a timely basis, addressing failed transactions and general market disruption, and periodically stress testing the pipeline.
Reporting and Analytics. This emphasizes the need for management information systems that accurately capture key obligor characteristics and aggregate them across business lines and legal entities on a timely basis. Reporting and analytics also reinforce the need for periodic portfolio stress testing.
Risk Rating Leveraged Loans. This reaffirms, and reapplies specifically to leveraged loans, the Agencies' previously-issued guidances7 on rating credit exposures and credit rating systems, which apply to all credit transactions generally.
Other Key Risk Management Components. The Agencies identify a laundry list of other considerations they expect institutions to address when engaging in leveraged lending. The list includes conducting high quality credit analysis; managing problem credits; avoiding conflicts of interest and violations of anti-tying regulations; complying with securities laws when equity interests and debt securities are involved in the transaction; developing guidelines for evaluating the qualifications of financial sponsors and implementing a process to monitor their performance regularly; and protecting the institution's reputation, which, if damaged, could 'impair' the institution's 'ability to compete.'8
As with the 2001 Guidance, much of the Proposed Guidance's substance is the province of bank regulatory professionals and affects operational matters rarely visible to transactional attorneys. Nevertheless, the potential indirect consequences of the Proposed Guidance on leveraged lending prompt several observations.
• The Agencies' supervisory concern with leveraged lending is nothing new. Readers of a certain vintage may recall that the Agencies first issued detailed joint guidance regarding so-called 'highly leveraged transactions' as long ago as 1989.9 The 1989 guidance caused institutions to fear being vulnerable to regulatory criticism if they held or booked highly leveraged transactions. It prompted an almost immediate shutoff of credit for leveraged transactions by lenders who feared receiving heightened scrutiny from regulators and being required to increase their regulatory capital base.
When they 'clarified' the 1989 guidance in 1991, even the Agencies acknowledged that 'some depository institutions may have become overly cautious in their lending practices' due to the regulatory focus. The clarifications did little to rekindle lending, so the Agencies declared victory and withdrew the 1989 guidance in 1992. When they revisited the subject with the 2001 Guidance, the Agencies did so in only a general and precatory manner that did not reduce the availability of credit for leveraged lending to the extent experienced in 1989. Perhaps because the 2001 Guidance was so non-specific, however, the Proposed Guidance articulates the Agencies' supervisory expectations in much greater detail.
• The Proposed Guidance states that leveraged finance is 'an important type of financing for the economy.' Banks play an integral role in making that credit available, but in the Agencies' view it is important that banks provide financing to creditworthy borrowers 'in a safe and sound manner.'10 Some lenders may feel that this is the regulatory equivalent of a baseball manager's telling the pitcher to throw strikes but not give the batter anything good to hit—a task that is easier to accomplish in theory than in practice since leveraged transactions are inherently risky. It is possible that some supervised institutions will react to the detailed Proposed Guidance as they did in 1989—by substantially reducing the credit they make available for leveraged financing transactions or by withdrawing from that product altogether.
• The 1989 guidance contained a definition of highly leveraged transactions that applied to all supervised institutions globally, whereas the 2001 Guidance requires merely that each institution adopt its own definition of leveraged finance. The Proposed Guidance would split the difference, requiring that each institution adopt its own definition but specifying certain benchmarks each bank's definition should cover. Accordingly, the definitions different institutions adopt should correlate more closely in the future than they do now under the 2001 Guidance. There will nevertheless continue to be differences, and thus some deals that must be considered leveraged transactions by some banks may not have to be so treated under the definition adopted by other institutions. This is an unfortunate result, and it may prompt disparate behavior from members of the same lending syndicate because the credit is categorized differently under their respective definitions.
• Much of the Proposed Guidance's focus boils down to requiring lenders to conduct good, old-fashioned credit analysis and to avoid structures that leave them effectively powerless if (as often happens with leveraged loans) the credit becomes distressed. Indeed, the supervisory expectations are a primer on prudent credit analysis.
For the institutions that allowed their credit analysis muscles to atrophy in the heady days leading up to the financial crisis, a significant investment in time, effort and expense will be necessary to upgrade their management information systems and to come into compliance with the Proposed Guidance. That cost may be greater than some institutions are prepared to bear, and they may vacate the leveraged lending space as a consequence. This could especially be the case for institutions that serve principally as co-lenders or participants, rather than as originators, of leveraged loans since the Proposed Guidance's requirements would apply equally to co-lenders and participants even though they have often tacitly relied on the originators' diligence and reputation when committing to co-lend or buy participations in a primary or secondary syndication.
Thus, the universe of potential co-lenders and participants may shrink, which in turn may make it harder for originators to syndicate loans and for borrowers to obtain credit. Conversely, lenders that are able to satisfy the Proposed Guidance's requirements may find it considerably easier to compete for business.
• Bankers seek to avoid regulatory criticism, and they occasionally pass on otherwise-creditworthy transactions because the deals might be subject to supervisory attention. The Proposed Guidance may thus make lenders less willing to underwrite loans having aggressive or non-traditional structures (such as the criticized 'covenant-lite' and 'PIK-toggle' features). This may force the prospective borrowers either to cancel the deals, to restructure them in a manner less likely to provoke regulatory criticism, or to seek financing from unregulated lenders. On the other hand, borrowers who are seeking financing with very conservative structures and relatively low leverage may be in a position to negotiate better terms and pricing than available now, if the Proposed Guidance induces banks to compete for such deals rather than higher-yielding but riskier ones.
• The Proposed Guidance repeatedly emphasizes that institutions focus on reputational risk. No doubt, as the Agencies point out, impairment of an institution's good name may have some impact on the institution's ability to syndicate loans it originates, especially if the reputational damage resulted from its 'apparent failure to meet its legal or fiduciary responsibilities in underwriting and distributing transactions' or by distributing transactions that 'over time have significantly higher default or loss rates and performance issues.'11 Nevertheless, the issue is not likely to affect borrowers or deal sponsors. In the final analysis, each lender's money is equally fungible. Credit takers can be expected to continue to evaluate competing loan proposals based much more on tangible factors, such as size, price and structure, than on a bank's intangible reputation.
Although the direct effect of the Proposed Guidance would be on the operations of the financial institutions subject to it, the guidance would inform how those institutions compete for and structure deals in the leveraged lending market. Accordingly, practitioners who advise lenders, borrowers and other parties in that market should familiarize themselves with the Proposed Guidance.
Alan M. Christenfeld is senior counsel at Clifford Chance. Barbara M. Goodstein is a partner at Mayer Brown.
1. Federal Reserve System Docket No. OP-1439, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency Docket ID OCC-2011-0028, 'Proposed Guidance on Leveraged Lending,' March 26, 2012, available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20120326a1.pdf.
2. SR 01-9, 'Interagency Guidance on Leveraged Financing,' April 17, 2001, OCC Bulletin 2001-8, FDIC Press Release PR-28- 2001.
3. PIK-toggles have also appeared in senior debt, but, for some reason, the Agencies specifically mentioned junior instruments.
4. These trends have also been noted in the financial press. See, e.g., G. Zuckerman and M. Wirz, 'There's Plenty of Money for Junk,' Wall Street Journal, May 1, 2012, at C1.
5. Id. at 4-5; Joint Press Release, "Agencies Propose Revisions to Leveraged Finance Guidance," March 26, 2012, available at http://www.federalreserve.gov/newsevents/press/bcreg/20120326a.htm.
6. Proposed Guidance at 12.
7. FRB SR 98-25 "Sound Credit Risk Management and the Use of Internal Credit Risk Ratings at Large Banking Organizations," Sept. 21, 1998; OCC Handbooks "Rating Credit Risk" and "Leveraged Lending"; FDIC Risk Management Manual of Examination Policies, "Loan Appraisal and Classification."
8. Proposed Guidance at 21.
9. OCC Banking Circular, "Definition of Highly Leveraged Transactions," Oct. 30, 1989.
10. Proposed Guidance at 22.
11. Id. at 21.
Reprinted with permission from the June 7, 2012 edition of New York Law Journal © 2012 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.