The need for thoughtful drafting of lender assignment clauses in bank loans has been underlined by a recent US judgment.
Although the decision does not reflect New Zealand law, the US Federal Court’s reasoning has relevance to both lenders and borrowers in negotiating loan facilities in this country.
Once viewed as mere “boilerplate” provisions, assignment clauses allowing bank loans to be traded have assumed greater importance in the age of stricter capital and liquidity rules. Banks need to ensure that they can market their debt as freely as commercially possible to maintain balance sheet liquidity, especially in scenarios involving distressed credit or - to use the industry euphemism - “special situations”.
A typical assignment clause
Most loan facilities give the lender, to varying degrees and subject to commercial negotiation, the right freely to assign the loan and associated securities to “another bank or financial institution”. The borrower’s consent is typically required, however, for assignment to any other entity. Investors other than banks are active in the secondary debt markets, and the presence of these investors can be very important to a bank looking for an exit strategy.
So the question becomes: What sorts of entities fall within the meaning of “financial institution”?
The Meridian case
After technically defaulting on the covenants over loans of US$75 million, Meridian Sunrise Village (Meridian) faced a choice – either consent to the assignment of at least part of its debt to a hedge fund specialising in distressed debt (NB), or incur additional default interest.
Citing past negative experiences with distressed debt funds, Meridian refused to consent to the assignment. One of the banks, however, went ahead and assigned its debt position to NB.
Meridian filed for bankruptcy and entered into a reorganisation plan allowing its creditors to vote on various matters relating to the insolvency. It then argued successfully before the Court that NB had no right to vote as a creditor because the assignment from the bank to NB had breached Meridian’s loan agreement which required Meridian’s consent to assignment except to a “commercial bank, insurance company, financial institution or institutional lender".
NB argued that it was a “financial institution” for the purposes of the clause. The Court rejected this on the basis that:
- the original lenders had initially sought Meridian’s consent to the assignment, showing that those lenders themselves did not regard NB as a ‘financial institution’
- if NB’s argument were accepted, the assignment clause would have no limitations whatsoever and would permit the loan to be assigned to any person with only a “remote connection to the management of money” (such as a pawnbroker or shell corporation), and
- the context indicated that “financial institution” must be a “bank-type” institution.
Assignment clauses are one of the rare instances in a loan facility document where lender action requires borrower consent. Lenders should consider carefully the drafting of these clauses, bearing in mind that assignment to an “alternative” financial entity could become an important option, especially where the borrower’s credit has deteriorated. To achieve certainty, the relevant clause should be drafted to expressly include (or exclude) hedge funds or other entities regularly engaged in purchasing or investing in loans, securities or other financial assets.
We do not expect a New Zealand court would necessarily be convinced by the Meridian decision. The Court in Meridianappeared to be swayed by Meridian’s argument that it did not intend to be subjected to hedge funds, which the Judge himself described frequently in the judgment as “predatory investors”. In addition, the Judge’s interpretation that, contextually, the assignee must be a money lender does not sit well with the inclusion of insurance companies in the approved list.
We would expect a New Zealand court to focus instead on the plain meaning of the words “financial institution”, and follow other overseas authority (which adopts a more lender and liquidity-friendly approach to assignment).
The meaning of any clause in a loan agreement is really a matter decided by the ordinary rules of contract interpretation. However there are also wider policy reasons – discussed below - which favour a more flexible approach to deciding what constitutes a “financial institution”, at least in situations where the parties do not expressly exclude hedge funds and other investment vehicles.
Why this matters at a macro level
One element of the recent BASEL III bank regulatory capital rules (adopted by New Zealand from 1 January 2013) is the introduction of liquidity ratios. Ensuring that banks hold sufficient liquid assets to meet their current liabilities is seen as critical to promoting the RBNZ’s mandate of maintaining a sound and efficient financial system. The RBNZ’s current liquidity policy requires that "liquid" assets should be eligible for realisation by sale even in stressed circumstances.
In the wake of the GFC, the trend towards deleveraging has led internationally to a shift in loan assets from the balance sheets of banks to those of hedge funds, mutual funds and pension funds.1
A smaller but systemically important subset of these institutional investors is distressed debt or "special situations" funds (such as NB) which specialise in taking bad assets off bank balance sheets and realising value by investing in riskier debt.
While the New Zealand landscape is dominated by the major trading banks, it is necessary to recognise the important role of these "alternative" players in the secondary debt markets and their contribution to the overall liquidity of the financial system.