V olatility in credit markets focuses market participants on settlement risk, and post-Lehman volatility in the bank loan market has focused attention on lengthy settlement timeframes in the US secondary market for distressed bank loans. As of July 2011, only 28% of distressed bank loan trades settled within the trade date ("T") +20 business days guideline published by The Loan Syndications and Trading Association, Inc. (the “LSTA”). Average settlement time was at T+64 and the median settlement time was at T+37.1 While distressed settlement times have actually improved over the past year (largely as a result of an overall drop in distressed trading volumes), following the Lehman and Bear Stearns collapses, loan market participants and government regulators have a greater appreciation of the risks inherent in large volumes of unsettled loan trades.
In 2009, in an effort to mitigate this risk in the "par and near par" bank loan market, the LSTA revitalized and refined the previously dormant buy-in/sell-out (“BISO”) rules for loan trades governed by an LSTA form par/near par trade confirmation. The LSTA has now released (effective September 9, 2011) BISO rules for loan trades governed by the LSTA's form distressed trade confirmation.
In this memorandum, we will (i) outline the reasons behind this addition to the existing LSTA architecture, (ii) describe the new distressed BISO provisions and briefly compare them to the par BISO rules and (iii) discuss the potential impact of the BISO rules on the distressed trading market.2
THE NEED FOR BISO RULES
While counterparties commit to settle trades “as soon as practicable” and “best practice” timeframes for trading bank loans are widely published and discussed, settlement statistics show that the aspirations of market participants for prompt settlement are often not met. Buyers and sellers of bank loans have limited recourse against counterparties that fail to settle open trades in a timely manner, and this is a contributing factor to delayed settlement. Except in rare cases, trade confirmations do not set a specific date by which the transaction is required to settle nor do they indicate that “time is of the essence.” Absent overt conduct demonstrating a nonperforming counterparty’s unwillingness to proceed, market participants often find it difficult to state a meritorious claim for breach of a trade confirmation on the sole grounds that a counterparty is slow to settle the transaction, particularly when the whole secondary loan trading market is slow.
The LSTA framework includes compensation for delayed settlement, but contractual payments based on cost of funds or credit agreement margins often do not allow the party that is forced to wait for settlement to obtain the full benefit of its bargain. During a lengthy settlement period, the market price of the relevant loan may move in favor of the performing party, increasing potential losses should the non-performing counterparty become insolvent or otherwise default on the trade. Moreover, if the non-performing party is the seller and the buyer has committed to resell the loan to a thirdparty purchaser, that third-party purchaser may also be harmed by the “upstream” settlement delay.
MOVING FROM PAR TO DISTRESSED
In 2009, the LSTA released a new version of its Standard Terms and Conditions for Par/Near Par Trade Confirmations that included revised BISO provisions for par/near par loans. Although it is difficult to measure empirically whether the implementation of the par BISO provisions have helped improve settlement times in the secondary par loan market, the perception in the trading community is that they have been a helpful tool to spur recalcitrant counterparties to move promptly to settle trades.
In an effort to extend the initial success of the par BISO provisions to the distressed market, the LSTA’s recently released Standard Terms and Conditions for Distressed Trade Confirmations (the “Standard Terms and Conditions”) include a new set of BISO provisions (the “Distressed BISO Rules”) designed for distressed bank loan trading.3
The new Distressed BISO Rules permit either party to a distressed trade, under certain circumstances, to terminate a delayed trade and enter into a “cover” transaction with a third party on the open market. The parties would then cash settle the terminated trade on the basis of the price obtained for the cover transaction. The “non-performing” party would be responsible for indemnifying the “performing” party for any market losses resulting from such substitute transaction; conversely, in the event that the market price has moved in favor of the party exercising BISO remedies, the “performing” party would return any market gains to the “non-performing” party. As such, the BISO mechanism is designed to be economically neutral.
While based upon and substantially similar to the par BISO provisions, the distressed BISO Rules are designed to reflect the complexities of distressed loan trading conventions.
DISTRESSED BISO RULES
The Distressed BISO Rules are applicable to distressed loan trades with trade dates on or after September 9, 2011. Trades already outstanding on that date will continue to be governed by the prior version of the Standard Terms and Conditions, which does not contain BISO provisions.
General rule: As a general rule, if, after T+50 (the date that is 50 business days from the applicable trade date) (the “BISO Trigger Date”), the transaction has not yet settled because one of the parties (the “Non-Performing Party”) has not performed its “Settlement Delivery Obligations,” then, provided that the other party (the “Performing Party”) has performed its own Settlement Delivery Obligations, the Performing Party may deliver a written notice (the “BISO Notice”) to the Non- Performing Party advising the Non-Performing Party of its intent to terminate its obligations under the trade confirmation and effect a cover transaction. The Non- Performing Party then has a 20 business day period (the “Cure Period”) to cure such “default,” and thereby end the BISO process, by either (i) completing the performance of its Settlement Delivery Obligations or (ii) if the seller, asserting a “BISO Shield” defense, in each case as described in greater detail below.
Minimum review period: As noted above, the BISO Trigger Date is generally T+50, but is subject to a 10 business day extension if transaction document drafts or upstream documents are delivered after T+40, but before T+50, so as to give the receiving party a minimum 10 business day review period (e.g., if seller delivers drafts and upstream documents on T+49, the BISO Trigger Date would automatically be pushed back to T+59). As a result of late deliveries, the BISO Trigger Date could be pushed back as far as T+70.
Settlement Delivery Obligations: “Settlement Delivery Obligations” include the execution and delivery of the trade confirmation, the delivery of drafts of any transaction documents (in “reasonably acceptable form”) for which a party has drafting responsibility pursuant to the trade confirmation,4 and in the case of seller, delivery of any relevant “upstream” transaction documents (again, in “reasonably acceptable form”).5 Interestingly, assuming timely delivery by the drafting party, the non-drafting party is also required to execute the transaction documents in order to be a Performing Party, but the drafting party is not so required. However, if as of the BISO Trigger Date, each party has performed its respective Settlement Delivery Obligations, but the drafting party has not executed the transaction documents, the drafting party must then do so within 10 business days to avoid losing its status as a Performing Party and risking a BISO Notice being sent by the counterparty.
The cover transaction: If the Non-Performing Party fails to cure its non-performance by the end of the Cure Period, the obligations of the parties under the trade confirmation are automatically terminated (subject to possible reinstatement, as described below). The Performing Party is then obligated to use reasonable commercial efforts to enter into a cover transaction with a third-party seller or buyer, as applicable. Once the cover transaction has been settled, the Non-Performing Party must reimburse the Performing Party for any loss suffered by the Non-Performing Party -- the difference between the cover price and the price payable under the original trade confirmation.6 The Non-Performing Party may dispute the reasonableness of the cover price, with such dispute subject to binding arbitration before the LSTA. The Distressed BISO Rules are of a “no fault” nature, however; having otherwise acted in good faith or without intent is not, in itself, a valid defense to a BISO Notice.
Failure to cover: Finally, if the Performing Party fails to identify a substitute counterparty within the 10 business day period starting on the expiration of the Cure Period, the original trade confirmation and the obligations of the parties thereunder are automatically reinstated.
Applicability: The Distressed BISO Rules are applicable to assignments only. They do not apply to (i) transactions in which the parties have agreed on the trade date to settlement by participation or to transactions which, as a result of a failure to obtain necessary consents or to otherwise qualify for assignment under the applicable loan agreement, must be settled by participation, (ii) transactions settling on proceeds, (iii) transactions settling by any form of netting or (iv) transactions in which the Non-Performing Party is acting as “Riskless Principal.”7 They also may not be used if the settlement delay results from a “credit freeze” or bankruptcy proceeding (though once such impediments are lifted, the right to enforce BISO remedies is restored). Provided that they otherwise qualify, either a buyer or a seller may avail themselves of the benefit of the Distressed BISO Rules, but not (for obvious reasons) both parties in respect of the same transaction. Use of the Distressed BISO Rules is optional; a buyer or seller eligible to use the Distressed BISO Rules may continue to push its counterparty to settle or it may seek other available remedies under general contract law or otherwise.
“The BISO Shield”
Under certain circumstances, a Non-Performing Party that is a seller may assert a valid defense against a BISO Notice if it has failed to perform its Settlement Delivery Obligations solely because it has been unable to settle its upstream buy-in trade prior to the BISO Trigger Date (the “BISO Shield”). Upon receipt of the BISO Notice, the seller may, prior to the expiration of the Cure Period, deliver to the buyer/Performing Party copies of one or more fully executed and unsettled trade confirmations (with the purchase price and purchase rate redacted) proving the existence of the seller’s upstream buy-in trade(s).8 The upstream confirmation(s) must have a trade date that is not later than the date that is five business days after the trade date of the original transaction. The seller must also certify to the buyer in writing that (i) each upstream confirmation has not been delivered previously and will not be delivered subsequently as a BISO Shield with respect to another transaction, (ii) the seller has performed and will continue to perform its obligations under each upstream confirmation, and (iii) if the upstream seller has not performed or does not perform its obligations under each upstream confirmation in a timely manner, the seller will deliver a BISO Notice to such upstream seller. To the extent that the seller satisfies each of these requirements, the buyer shall not be entitled to exercise any further rights as a Performing Party against seller under the Distressed BISO Rules.
IMPLICATIONS OF DISTRESSED BISO
Time will tell how often the Distressed BISO Rules are actually used by performing parties to expedite closing of their aged distressed trades. In general, par BISO has been effective in that it has been used rather infrequently and only in the most extreme circumstances, an indication that the mere presence of the BISO regime may have had a positive impact on trade settlement.
There are, however, two notable differences between the par/near par market and the distressed market. One is that the proportion of trades that settle after the applicable “BISO Trigger Date” for each is much higher for distressed trades than for par trades. Query whether this means that the distressed BISO will be utilized that much more. Second, distressed loan trades typically require some level of document negotiation and review, along with diligence of upstream purchase documents, which factors are absent from par loan trades. This not only contributes to the abundance of delayed settlements but may make it unclear, at times, whether a party has actually performed its Settlement Delivery Obligations. As noted above, in order to be a Performing Party the drafting party must have delivered drafts (and, in the case of Seller, upstream documents) in “reasonably acceptable form.” On the other hand, for the non-drafting party to be a Performing Party, it must execute the transaction documents that have been delivered in “reasonably acceptable form.” One can easily envision a situation in which the parties disagree on whether the drafts or upstreams are, in fact, reasonably acceptable. In such a case, each side could very well consider itself to be a Performing Party and the other party to be a Non-Performing Party, resulting in a battle of competing BISO Notices.
While the Distressed BISO Rules do permit a Performing Party to terminate an outstanding aged transaction, they do not allow such party to escape its obligations with respect to an economically unfavorable trade, as the terminating party is still required to make the Non- Performing Party whole. In addition, the Performing Party still has to go through the trouble of executing and settling a trade with a new counterparty, further delaying the trade settlement process. Combined with the general ill will that may be generated by delivery of a BISO Notice to a counterparty, it is hard to imagine that the Distressed BISO Rules will be used other than under the most extreme of circumstances: for very old trades or against counterparties operating under a cloud of heightened insolvency or performance risk.
The unfettered use of the Distressed BISO Rules likely would result in short-term market chaos, as the market is currently unaccustomed to sending the requisite notices and meeting the various timing and other requirements of BISO procedures. In addition, such unchecked use could create a new category of trade disputes as counterparties argue whether the criteria for using the Distressed BISO Rules have been met and whether the prices of the cover transactions are fair. However, to the extent the Distressed BISO Rules are used prudently and sparingly, and if their mere existence represents a looming threat to non-performing counterparties, as has been the case for par trades, they should turn out to be a valuable incremental solution to the risk of backlogged problem trades.