Subscription Finance: Fraud as an Exclusion Event

Executive Summary

In the evolving landscape of the subscription credit facility market, the introduction of fraud allegations by an investor against a fund as a new exclusion event marks a pivotal shift. This Legal Update explores this recent development, its basis in the changing dynamics of the post-2023 banking crisis, and its broader implications for risk management in fund finance. By analyzing the rationale behind this new exclusion event and the reception by market participants, we provide insights into their expected impact on the market’s stability and integrity.

Background

Subscription credit facilities, much like other asset-backed loans, traditionally use a borrowing base concept to govern the maximum amount of loans the borrower can have outstanding. Similar to other asset-based loans, the “borrowing base” is composed of eligible assets pledged as collateral – which in the case of a subscription credit facility are the capital commitments of the fund-borrower’s investors. Key to this underwriting method is that the borrowing base will change over time to adapt to negative credit events – often referred to as “exclusion events”. An exclusion event removes the value of an asset (i.e., the uncalled capital) from the calculation of the borrowing base.

A Fresh Look at the Market Standard

Post-2023 banking crisis, new entrants in the subscription facility market have reevaluated the product and its historical performance. This reassessment has focused on, among other things, whether standard “market” exclusion events provide adequate protection.

A New Exclusion Event

This scrutiny has led to the adoption of a new exclusion event – namely that an investor will be excluded from the borrowing base if it alleges the fund has breached its fiduciary duty or engaged in fraud or similar events. An example is as follows:

“Such Investor (or its Credit Provider, Sponsor or Responsible Party, as applicable) or any affiliate thereof alleges that any Credit Party, the Investment Manager or any affiliate thereof has breached any fiduciary duty or has acted in any manner constituting fraud, embezzlement or misappropriation of funds.”

Despite initial pushback —largely predicated on the belief that allegations should not undermine the obligation to fund capital— most sponsors and their counsel have eventually agreed to the provision as a sensible addition. Most agree that this addition aligns with existing market-standard exclusion events, e.g., an investor repudiating its capital commitment. Put differently, although the enforceability of the capital commitment is not impacted in either scenario (i.e., neither a mere allegation of fraud nor a mere repudiation renders the capital commitment unenforceable), it is widely accepted that the credit profile of the investor has changed. The general consensus is that this scenario alters the traditional investor credit profile, justifying exclusion from the borrowing base.

Key Takeaways

The initial hesitation towards adopting fraud allegations as an exclusion event largely stemmed from its novelty, and not a flaw in logic. As the market adapts, such provisions are expected to gain acceptance, reflecting a deeper understanding of risk in the evolving landscape of fund finance.