The recession has highlighted a new risk for borrowers – the risk that a lender will be insolvent and default on its obligation to fund loans under the credit agreement. This has created unexpected issues under credit agreements, which were written at a time when lender insolvency was not a perceived risk.”34
The risks raised by lender failure to fund were highlighted when Lehman Brothers Holdings Inc. and Lehman Commercial Paper Inc. (“LCPI”) filed for bankruptcy in the fall of 2008. According to its petition, at the time it filed for bankruptcy protection LCPI acted as a lender, administrative agent or syndication agent in hundreds of commercial loans, had billions of dollars of unfunded commitments and had stopped funding its commitments to lend at the time that the parent company filed for bankruptcy. In addition, some of Holdings’ other subsidiaries, even though not in bankruptcy themselves, stopped funding their loan commitments.
Another Lehman subsidiary that was a lender in multiple syndicated revolvers, Lehman Brothers Bank FSB, was the subject of a consensual Cease and Desist Order dated January 26, 2009 issued by the Federal Office of Thrift Supervision. In that order, OTS prohibited the bank from entering into new commitments to make commercial loans and directed the bank to develop a plan and enter into negotiations to “limit or eliminate” the bank’s loan funding exposure. The order also prohibited the bank from funding any commercial loan unless it has given prior notice to OTS and has received written “notice of non-objection” from the OTS Regional Director.35
Traditional credit agreements, which treat all lenders within a tranche as pro rata, do not address the issues that arise when a lender defaults. However, there is a now a heightened awareness of the risk and of the consequences of a Lender default. As a result, many of the credit agreements being signed today contain new provisions dealing with these issues. Some of the provisions are intended to protect the borrower, others are intended to protect the letter of credit issuer and the swing line lender, and others are designed to deal with operational issues. Among the issues addressed are the following:
- Definition of “Defaulting Lender” (DL) – Lender who fails to fund will be a “Defaulting Lender”, but how to distinguish between wrongful failure to fund and failure to fund because of a dispute over whether borrower has satisfied conditions to borrowing? Should insolvency of the DL’s parent result in classifying the Lender as a DL? Do not want the definition to be so broad that Lender could inadvertently become a DL, and on the other hand, do not want to create incentive for Lender to default on funding obligation to prompt Borrower to pay it off and release it from the credit facility.
- Consequences to the Defaulting Lender – Loses right to vote on some but not all issues; loses right to receive certain fees (what about commitment fees?); payments made by borrower that would otherwise go to the DL instead go through a “waterfall” pursuant to which the funds are used to reimburse Agent for any losses, to make the Loan that DL failed to make, and to hold as cash collateral; DL cannot assign its interest unless it cures its defaults.
- Borrower rights – has the right to replace the Defaulting Lender.
- Impact on Non-Defaulting Lender – “pro rata” share will be adjusted upward in order to reduce fronting exposure to the letter of credit issuer and the swing line lender, i.e. may have to pay more than its pro rata share (but never more than its dollar commitment) to reimburse the letter of credit issuer or the swing line lender and/or to indemnify Agent; right to remove Agent if it is a Defaulting Lender.
- Rights of LC Issuer and Swing Line Lender – right to request cash collateral for letters of credit (“LCs”) and swing line loans, both for new LCs and loans requested after a Lender becomes a DL and for existing LCs and swing line loans.
Additional obstacles arise if the defaulting lender is in bankruptcy – some of the “remedies” summarized above might not be enforceable because they may violate the bankruptcy automatic stay and the consent of the defaulting lender or consent of the bankruptcy court will be required.