Incremental loan provisions in non-investment grade syndicated credit agreements uniformly contain “most favored nation” (“MFN”) pricing protection provisions providing that if the yield of an incremental term loan to be issued would be more than a threshold number of basis points (i.e., 50 basis points) higher than the yield of the original term loan, the interest rate on the original term loan will be required to be increased by the amount of such excess. For example, if the yield on the original term loan is 5.25% (LIBOR plus 400 basis points, with a LIBOR floor of 100 basis points, issued at 99% of par using a 4-year average life convention) at the time of issuance of the incremental term loan, and the incremental term loan is being priced to yield 6.25%, the interest rate on the original term loan would be required to be increased by 50 basis points.
Changes to the interest rate of a loan as a result of the application of an MFN provision may result in a taxable event to the borrower (as well as the lenders) if a “significant” debt modification, within the meaning of applicable Treasury regulations, occurs. A change in interest rate is a significant debt modification if it varies the annual yield on the loan by more than the greater of (x) 25 basis points and (y) 5% of the annual yield on the loan. Using the MFN example above, the increase in the interest rate of 50 basis points would be a significant debt modification, since the yield would be increased by more than 25 basis points and more than 5% of the annual yield of 5.25%, or 26.25 basis points.
If a significant debt modification has occurred as a result of an MFN interest rate increase, the borrower will generally recognize cancellation of debt (“COD”) income if the trading price of the term loan, after given effect of the MFN interest rate increase, is less than the original issue price (adjusted for accretion, if issued with more than de minimis OID) of the term loan. Using the MFN example above, if after the MFN rate increase the term loan trades at 98% of par, the borrower would realize cancellation of debt income equal to 1% of the aggregate principal amount of the loan. Any COD income recognized by the borrower generally would be offset over the remaining life of the term loan, through OID deductions equal to the spread between the trading price of the term loan at the time of the interest rate increase and the principal amount of the loan.
The table below summarizes the COD income analysis:
|If||MFN increases interest rate by more than both 25 bps and 5% of yield||and||Modified term loan trades lower than original issue price of term loan||then||Borrower will realize COD income equal to that trading difference|
Lenders may also recognize gain or loss as a result of an MFN interest rate increase. The amount of gain or loss would be the difference between the holder’s adjusted basis in the term loan and the term loan’s trading price.