Advantages of Express LPA Third-Party Beneficiary Provisions for Subscription Credit Facility Lenders
At A Glance
Background
Subscription credit facilities are extended to private equity, real estate, or similar investment funds (each, a “Fund”). This type of facility is secured by the capital commitments of the Fund’s investors, the rights of the Fund and its general partner (a “GP”) to call capital from the investors, receive capital contributions, and apply LPA remedies if investors default (collectively, the “Capital Call Rights”), and a collateral account into which capital contributions are required to be funded when called. A core right provided to a Subscription Lender under the facility’s loan documentation is to, in an enforcement scenario, call capital directly from the Fund’s investors to repay the facility without the need to first obtain further consent or cooperation from the Fund or its GP, or commence formal legal proceedings against the Fund, the GP, or the Fund’s investors.
A Fund’s and GP’s Capital Call Rights are set forth in the LPA and other fund documentation. They are the bedrock for a subscription credit facility’s underwriting and impact the strength of a Subscription Lender’s enforcement rights and remedies (as will the loan documentation).
When lenders first offered what would become widely known as subscription credit facilities, most LPAs did not contain fulsome provisions specific to such facilities. To mitigate the lack of robust LPA provisions and gain comfort and clarity on key points, it was customary for a Subscription Lender to obtain an investor letter directly from each (or each material) investor of a Fund, giving the Subscription Lender direct privity with the Fund’s investors. However, as this financing product evolved and market participants (including sponsors, lenders, and investors) became more experienced with the product, they brainstormed ways to streamline the process of entering into a subscription credit facility, reduce execution costs and timing, and minimize disruption to Funds’ investor relations. Accordingly, many lender safeguards that were historically addressed in investor letters are now instead directly incorporated in a Fund’s LPA at the outset via the inclusion of a standard set of subscription credit facility provisions for LPAs that the market developed.1 These provisions constitute contractual obligations of the Fund and its investors (since they are contained in the LPA). They support a Subscription Lender’s right to repayment and enhance a Subscription Lender’s ability to expediently enforce against its collateral if necessary.2 One such LPA provision that is commonly included is a designation of Subscription Lenders as third-party beneficiaries under the LPA.
What to Know About Subscription Lenders as Third-Party Beneficiaries
What Is a Third-Party Beneficiary? 3
Under general contract law, contracting parties can grant rights under a contract to a third-party beneficiary, which is a person or entity that is not itself a party to the contract but nonetheless benefits from the parties’ performance of the contract. To have standing to sue under and enforce the contract, the beneficiary must be intended (rather than incidental). One way to demonstrate intention is to specifically identify the beneficiary in the contract. The third-party beneficiary’s rights must also have vested (e.g., by the beneficiary manifesting its assent to the contract, suing to enforce the contract, or materially changing its position in justifiable reliance on the contract). Once vested, the contracting parties cannot modify or rescind the third-party beneficiary’s rights without the third party’s consent.
Advantages of a Subscription Lender’s LPA Third-Party Beneficiary Status
In an enforcement scenario under a defaulted subscription credit facility, the Subscription Lender’s efficient access to the collateral is vital. For this type of facility, the Fund and its GP collaterally assign certain of their rights under the LPA (i.e., the Capital Call Rights) to the Subscription Lender, giving it the right to, in an enforcement scenario, step into their shoes and exercise such rights. However, in addition to the collateral assignment, it is preferable to include express third-party beneficiary rights for Subscription Lenders in the LPA. This additional safeguard further enhances the ability of a Subscription Lender to independently enforce the collaterally assigned rights (e.g., to issue capital calls on the investors and receive payments) directly against the Fund, its GP, and the Fund’s investors. By virtue of this LPA provision, the Fund, the GP, and the investors have all agreed that the Subscription Lender has these rights. Thus, this LPA provision can benefit a Subscription Lender by helping to deter challenges (from the Fund, its GP, or the investors) to the Fund’s debt obligations and the security interests granted under the subscription credit facility, as well as the Subscription Lender’s collateral enforcement rights.
With LPA third-party beneficiary status and the accompanying direct and independent enforcement rights, a Subscription Lender is best positioned to, when exercising enforcement mechanisms, efficiently call capital from the investors, apply the capital contributions to repayment of the facility, and work to resolve the situation. This result benefits all parties. The market’s favorable pricing for subscription credit facilities is tied, in part, to the expected strength and efficiency of a Subscription Lender’s enforcement mechanisms if an event of default occurs; subscription credit facilities are not priced for the prospect of a downside scenario devolving into the parties battling in lengthy and costly litigation for the Subscription Lender’s recovery (which litigation, notably, could be disruptive to both a Fund’s and a Subscription Lender’s business). A Subscription Lender’s status as a third-party beneficiary of the LPA mitigates this risk and should promote expedient resolution of breaches, thereby helping to keep pricing for subscription credit facilities and legal costs for all parties down.
It is important to note that there are creditor-favorable statutory protections and case law in certain US (e.g., in Delaware and New York) and foreign jurisdictions that support a creditor’s enforcement of investors’ capital commitment obligations. Relevant statutory and case law has pointed to a “reasonable reliance” standard in upholding creditors’ rights to enforce capital commitment obligations—that is, a creditor that has reasonably relied upon investors’ capital contribution obligations under an LPA as a source of repayment for its facility has a legal basis to enforce such obligations.4 If a subscription credit facility’s enforcement journey does ultimately result in litigation, it is possible that the designation of a Subscription Lender as an express third-party beneficiary of the LPA may support the Subscription Lender’s claims by providing further evidence of its reasonable reliance on the investors’ obligation to fund capital.
How to Incorporate Subscription Lenders’ Third-Party Beneficiary Rights in an LPA
A Fund’s LPA customarily includes a “no third-party beneficiary” provision—this provision expressly prohibits non-parties to the LPA, such as creditors, from benefitting from or enforcing any provisions of the LPA. As a result, only LPA parties themselves (i.e., the Fund, its GP, and the investors) are entitled to enforce the LPA’s provisions unless otherwise noted.
Subscription Lenders may address this barrier in two ways. First, they often seek an explicit, affirmative statement designating them as third-party beneficiaries under the LPA, such as: “Notwithstanding anything herein to the contrary, including Section [Insert Third-Party Beneficiary Provision], each lender and other secured party under a [Insert Appropriate Defined Term, e.g., Subscription Facility] shall be an express and intended third-party beneficiary.” This statement is typically documented in the LPA provisions governing the Fund’s ability to enter into credit facilities. Second, to avoid internal discrepancies within the LPA, Subscription Lenders may also request a carve-out in the LPA’s separate “no third-party beneficiary” provision.
Key Takeaways
Establishing a Subscription Lender as an intended third-party beneficiary of a Fund’s LPA favorably positions the Subscription Lender in an enforcement scenario, providing it with additional evidence that it is authorized to exercise rights under the LPA to resolve the subscription credit facility’s underlying issues and facilitate its expedient recovery against the collateral. As extra protection on top of the standard collateral assignment of Capital Call Rights, holding the position of a third-party beneficiary of the LPA should help mitigate the risk of challenges to a Subscription Lender’s rights that may prolong its path to recovery. Finally, the inclusion of customary and robust subscription credit facility LPA provisions, including lender safeguards such as a third-party beneficiary designation, may result in a Fund obtaining better pricing and quicker execution for a subscription credit facility.
1 Investor letters are thus no longer common requirements for subscription credit facilities, except in the context of a fund of one, an SMA, or a Fund that otherwise has a fairly concentrated investor pool.
2 For model LPA language specific to subscription credit facilities, please consult our Legal Update: Model LPA Provisions for Subscription Credit Facilities.
3 This Legal Update is focused on certain US jurisdictions commonly applied in the fund finance sphere (e.g., Delaware and New York). With respect to fund vehicles organized in Cayman, Luxembourg, or other non-US jurisdictions, lenders should consult local counsel regarding any statutory provisions or other applicable law under those jurisdictions that may impact a lender’s third-party beneficiary status.
4 For more information on enforceability considerations for subscription credit facilities, please read our Legal Update: Enforceability of Capital Commitments in a Subscription Credit Facility.
