History Repeating Itself
Defaulting lender provisions have long existed in U.S. syndicated credit agreements as a protection for borrowers against lenders who fail to follow through on their funding commitments. These provisions gained attention from borrowers and lenders alike during the financial crisis of 2008, which resulted in the bankruptcies of numerous financial institutions. At that time, borrowers were particularly concerned about the liquidity of their lenders and wanted to make sure they were able to exercise remedies against any lender unable to honor its funding commitments – while also having the ability to replace such a lender. Following the financial crisis, borrowers sought additional protections from defaulting lenders, and these terms have since become almost universal across syndicated credit documentation. In the last decade the defaulting lender provisions have become more or less “boilerplate” – rarely negotiated, exercised or litigated.
Since the onset of the COVID-19 pandemic, there has been a dramatic increase in the number of borrowers drawing down on their revolving credit facilities, including many which were previously undrawn, as borrowers attempt to support their balance sheets and protect against anticipated adverse earnings. Many borrowers fear that current market conditions may result in events of default materializing under their credit facilities which would prevent them from drawing in the future. In light of this, many lenders are questioning their desire to fund a previously creditworthy borrower who may soon be on the verge of a restructuring. Lenders are increasingly looking to the defaulting lender provisions within their credit documentation to better understand the consequences which would flow from a decision not to fund – beyond any reputational or commercial repercussions.
Outlined below are the typical defaulting lender terms, including the protections afforded to borrowers against defaulting lenders, as well as the areas in which borrowers and lenders may wish to improve their positions in any future negotiations.
What is a Defaulting Lender?
The definition of “Defaulting Lender” in the credit documentation will typically capture any lender who becomes subject to any bankruptcy or insolvency proceeding or who fails to fund (or gives notice of its intention not to fund) any loans required under the credit agreement - unless such lender believes in good faith that the borrower has not satisfied all of its conditions precedent to such funding.
Consequences of Becoming a Defaulting Lender
Replacement of Defaulting Lender. The primary recourse a borrower has in its credit documentation with respect to a defaulting lender is the ability to replace any such defaulting lender – the so-called “yank-a-bank” provisions. These terms give a borrower the right to force a defaulting lender to assign its interests to a new, replacement lender. Any replacement lender must otherwise be an eligible assignee under the credit documentation and able to assume the loans and commitments of the defaulting lender. The borrower is responsible for finding such replacement lender and for any costs associated with replacing the defaulting lender. In a difficult credit environment and uncertain market, however, it may not necessarily be easy for a borrower to find a new lender willing to replace a defaulting lender – especially as most yank-a-bank provisions require that the defaulting lender be taken out at par.
Exclusion from Voting. Upon becoming a defaulting lender, such lender will become largely disenfranchised within the credit documentation and lose its ability to vote on most amendments, waivers and consents. Commitments of defaulting lenders become disregarded in the calculation of “Required Lenders” – typically comprised of over 50 percent of commitments by all lenders – whose consent is generally necessary to make any changes to the credit documentation. Defaulting lenders are also excluded from almost all decisions that require unanimous lender consent.
Fees. While a lender remains a defaulting lender, it will no longer be entitled to receive any commitment fees that would have otherwise been payable under the credit documentation.
Defaulting Lender Waterfall. Payments made by a borrower and received by an agent, which would otherwise have been payable to the defaulting lender, will be subject to a waterfall. Before a defaulting lender may receive any amount, the agent will apply the proceeds as prescribed in the credit documentation, which includes a set off against any amount owing to the agent or any lender, funding the portion of any loan that a defaulting lender fails to fund, and being held in a deposit account in order to satisfy a defaulting lender’s potential future funding obligations.
Repayment and Termination. Some credit facilities permit a borrower to repay outstanding amounts owed to any defaulting lender and terminate the commitments of such defaulting lender.
What Can Lenders and Borrowers Negotiate?
Good Faith Determination. If a lender has made a good faith determination that the borrower has failed to fulfill any condition precedent to funding, such lender’s refusal to, or intention not to, fund will typically not render it a defaulting lender. A borrower may wish to remove this stipulation in order to create an automatic designation of a defaulting lender upon the failure to fund or notice of its intention not to fund, regardless of the reason.
Cross-Default. Lenders typically are only at risk of becoming a defaulting lender as a result of actions or inactions under that particular credit facility. Borrowers may consider adding a cross-default trigger to capture lenders who have failed to fulfill their obligations under other similar financing agreements or made a public statement that they do not generally intend to fulfill such obligations in their loan agreements. If a lender has been unable or unwilling to fund its other loans, it may be in a borrower’s interest to have the ability to preemptively replace such lender or apply other protective measures that may be available.
Funding Grace Period. A lender will only be classified as a defaulting lender after a prescribed grace period has passed following their failure to fund – typically, two business days. Borrowers may desire to reduce this to one business day, while lenders may look to extend this to three business days or beyond.
Notice Requirements. A lender will usually become a defaulting lender if it has failed to respond affirmatively, within three business days, to a request from an agent or a borrower to confirm its intention to comply with a funding. Lenders may wish to remove the ability of a borrower to make this request, leaving it only as a right of an agent. A lender may also attempt to negotiate a longer period to respond to any such request, if, at the very least, only in order to avoid unintentionally becoming a defaulting lender due to a failure to provide a timely response.
Replacement by Agent. While a lender will become a defaulting lender following its failure to pay any amount owed to an agent or any other lender, typically a borrower would be the only party with the right to replace such defaulting lender. An agent, or syndicate lender, may want to expand the replacement terms in order to have the ability to replace a fellow lender themselves if that lender becomes a defaulting lender as a result of failing to make such a payment.
Governmental Ownership. Defaulting lender provisions usually include a proviso specifying that a lender shall not become a defaulting lender solely by virtue of the ownership of any equity in that lender by a governmental authority (so long as such ownership does not provide the lender with any immunity from enforcement action). A borrower may wish to remove this language in order to avoid having a creditor owned by or affiliated with a governmental entity – which may, for instance, result from a government bailout of a lender. Any lender with a pre-existing governmental affiliation should ensure that this language remains in place or is expanded to take into consideration its particular circumstance.
Bankruptcy Limitation. A lender will normally become a defaulting lender in the event of its bankruptcy. A lender may wish to add a carve-out to the bankruptcy requirements that, under such circumstances, it will not become a defaulting lender if it intends to, and has approval to, continue to perform its obligations under the credit documentation.
Interest Bearing Account. Upon a lender becoming a defaulting lender, any funds owed to such defaulting lender are generally required to be held by an agent in a deposit account. The parties may wish to specify whether such account shall be an interest bearing or non-interest bearing account. Most syndicated credit documents are silent on the point.
Removal of Waterfall. As lenders will see amounts owed applied in accordance with the applicable waterfall once they become defaulting lenders, lenders may wish to remove the application of proceeds provisions in their entirety.
Syndicate lenders are required to act quickly once they receive a funding request, and it would be wise for such lenders to fully understand the defaulting lender terms in their credit agreements in advance of any such requests. A lender should be cautious to avoid any potential lender liability for breach of contract if it decides not to honor a draw request, especially if such lender is relying on a belief that the conditions precedent to funding have not been met. Likewise, borrowers who may wish to draw upon their facilities should ensure that they are in complete compliance with the terms of the credit documentation and able to fulfill all conditions precedent to funding. They should proactively anticipate the possibility of existing lenders refusing to fund and have a strategy in place in the event they find themselves underfunded. In better times, lenders may have been willing to turn a blind eye to minor or “technical” defaults, but in the current environment borrowers should not give lenders a reason not to fund.
It remains to be seen what changes, if any, the COVID-19 pandemic will bring to the current settled defaulting lender provisions. The defaulting lender provisions found in many documents today were largely a reaction to the last financial crisis and were not designed in contemplation of this current market situation. In the weeks, months and years to come we may see these provisions begin to again evolve to take into account the realities of new market conditions.
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