Standard Lender Protections in Purchase Agreements
In reviewing a draft purchase agreement, a lender should confirm that the so-called “Xerox provisions” (named for a 2009 purchase agreement between Xerox Corporation and Affiliated Computer Services, Inc.) are fully covered. The Xerox provisions cover four points where the purchase agreement should specifically refer to the purchaser’s financing sources. First, the purchase agreement should state that none of the parties to the agreement has any recourse against the lender in connection with the financing, including any failure of the lender to perform its obligations under the commitment letter. The rights of the buyer to enforce the commitment letter against the lender should come directly from the provisions of such commitment letter, not from the purchase agreement. Second, if any reverse termination fee is included in the purchase agreement, it should indicate that such fee is the sole and exclusive remedy for the seller not only against the buyer, but also against the lender. Third, the purchase agreement should indicate the venue that actions may be brought against such lender. A purchase agreement will often be governed under Delaware law and may have venue in Delaware or another location; however, such agreement should state that all actions against the lender relating to the transaction or arising out of the commitment letter may be brought against them solely in the state and federal courts in New York County and the Southern District of New York, which are historically more lender-friendly. Finally, the parties to the purchase agreement should waive any right to a trial by jury in respect of an action or proceeding brought against the lender.
Two additional provisions must be included in the purchase agreement to ensure that the Xerox provisions are, and will continue to be, beneficial to the lender. The amendments provision of the agreement must state that the terms covered above may not be amended in a manner adverse to the lender without its prior written consent. Additionally, the lender must be a third-party beneficiary to these terms so that they may enforce such terms if necessary.
In addition to the Xerox provisions, there are a few other items of note that should be reviewed by lender’s counsel in a draft purchase agreement. The lender will be interested to know whether or not the purchase agreement contains a financing condition to closing, which will impact whether SunGard provisions are included in the commitment letter. The purchase agreement will also typically state a date on which the agreement may be terminated if the acquisition has not been consummated. The lender should ensure that this termination date gives it enough time to complete its syndication and any internal processes and properly document the transaction. If the lender has negotiated for a marketing period in its commitment letter, it should ensure that the termination date of the purchase agreement accounts for this period, including any black-out days. In order to properly complete diligence and receive all financial information that the lender needs for marketing and documentation purposes, it should confirm that the purchase agreement contains a covenant whereby the seller agrees to cooperate with the lender to provide such information and participate in any necessary lender meetings. Additionally, the purchase agreement should allow for collateral assignments of the purchaser’s right. Lastly, a lender will want to review the indemnification provisions to make sure that the amounts and length of time that such amounts are available are sufficient to cover any potential third-party liabilities.
Forbearance Agreement Nuts and Bolts
When a borrower defaults on a loan agreement, a lender has the right to exercise remedies but that is rarely the first step taken. Instead, if the lender believes the borrower’s condition can improve over time, a forbearance agreement can provide the borrower with the opportunity to find solutions while further protecting the lender’s interests. The forbearance agreement preserves existing events of default while restricting the exercise of remedies otherwise available to the lender for a period of time. Prior to agreeing to a forbearance, it is advisable for the lender to conduct a collateral and lien review. It is vital that the lender reevaluate its liens, and perfection of those liens, when dealing with a borrower in distress.
Every forbearance agreement should include an acknowledgement of all existing defaults; a specific date on which the forbearance expires; acknowledgements and reaffirmations from every borrower and guarantor of the obligations owed to the lenders and the liens securing those obligations; and a release from every borrower and guarantor in favor of the lender. Depending on the circumstances of the borrower’s default, the lender should also consider a host of other tools available to it, including conditioning further extensions of credit on the lender’s sole discretion; requiring enhanced reporting (e.g., 13-week cash flow budgets updated weekly or biweekly, management calls, site visits); retention of financial advisors or a chief restructuring officer; cash equity infusions; adjustments to amortization schedules; tightening (or loosening) of existing covenants; and collateral appraisals.
Forbearance agreements terminate on a specific date, or if earlier, the occurrence of a further default. The debt and lien acknowledgements obtained in the forbearance agreement are a useful tool if the lender subsequently decides to enforce remedies; having a recent document signed by the borrowers and guarantors admitting to existing defaults, agreeing to the amount owed to the lender and the liens securing those obligations will aid the lender’s efforts to convince a court it needs immediate relief and has the right to pursue against its collateral and any guarantors.
Credit Agreement Tax Distribution Provisions
In lending transactions, it is generally customary to allow a borrower to make distributions to its members to pay taxes if that borrower is a “flow through” entity for income tax purposes. Lenders usually rationalize this tax distribution provision as essentially putting the lenders into the same position as they would be if the borrower was instead a taxable C corporation. Although this is largely true, if not crafted properly, a tax distribution provision may yield results that differ wildly. Below are specific examples of how a poorly drafted tax distribution provision may allow significant “leakage” of borrower cash. In each example, the borrower is presumed to be a partnership for income tax purposes.
Preferred Interests – assume that the borrower is a limited liability company with both preferred and common interests outstanding. Further assume that the borrower has overall net income of zero. Under applicable tax rules, it is possible that the preferred interest holders may be allocated items of gross income, while the common interest holders could be allocated items of deduction and loss. Thus, the tax distribution provision (if not drafted properly) may provide that the preferred interest holders receive a tax distribution (because they have been allocated income) even though the borrower had no overall net income. To solve for this problem, a well-drafted tax distribution provision should calculate tax distributions based on the “aggregate net income” of the borrower, as opposed to the income allocated to any particular member.
Prior Period Losses – assume that (a) the borrower has $10 million of income in year 1; (b) the borrower has a $10 million loss in year 2; (c) the borrower has $10 million of income in year 3; and (d) the borrower’s owners are subject to tax at a 40% tax rate in all years. On these facts, a poorly drafted tax distribution provision may allow the borrower to distribute $4 million in year 1 (i.e., $10 million x 40%) and $4 million in year 3 (i.e., $10 million x 40%). Thus, the borrower would distribute a total of $8 million of tax distributions even though, over such three-year period, the borrower has only $10 million of income in the aggregate. A well-drafted tax distribution provision should take into account prior period losses when determining whether and to what extent a tax distribution is permitted. In other words, in the example, the tax distribution in year 3 should be calculated by first reducing the income in year 3 by the prior period loss in year 2. After reducing the year 3 income, no tax distribution would be allowed in year 3. This result makes sense because in the aggregate, $4 million would have been distributed on aggregate income of $10 million.
Budget Act Matters – at the end of last year, Congress changed how partnerships are audited. Under prior law, any audit adjustment “flowed through” to the partners of the partnership and such partners would take such audit adjustments into account on their personal income tax returns. Under the new law, absent an election otherwise, audit adjustments are taken into account at the partnership level and the partnership pays the tax liability associated with the adjustment. Thus, a well-drafted tax distribution provision will reduce tax distributions by any amounts paid directly by the partnership to the applicable taxing authority.
Withholding Taxes – if any partners/members in a borrower are foreign, the partnership may be required to withhold taxes in respect of such foreign partner’s distributive share of income. Thus, the tax distribution provision should take this into account and reduce tax distributions by amounts withheld and paid directly to the taxing authorities.
Section 743 – if interests in the borrower are sold during the term of the loan, the buyer of the interest may be entitled to a “basis step-up” with respect to the purchase. Lenders should consider whether or not this basis step-up should be taken into account when determining the amount to distribute. On the one hand, if the borrower was a C corporation, the buyer of an interest in the borrower would not be entitled to a basis step-up. Thus, taking the basis step-up into account would put the lenders in a better position than if the borrower was a C corporation. On the other hand, if the basis adjustment is not taken into account when calculating the tax distribution, the owner of such interest will likely obtain more cash than is necessary to pay its taxes. So long as the borrower treats tax distributions as “advances” on regular distributions from the borrower, it may be logical to calculate tax distributions after taking into account these basis adjustments.
Market Trend—Limited Condition Acquisitions/Incremental Facilities
A recent trend in the leveraged loan market is the inclusion of mechanics in a credit agreement which permit a borrower to make subsequent limited condition add-on acquisitions and finance such acquisitions on a limited condition basis through an incremental facility. From a borrower’s perspective, this is an attractive feature, as it allows the borrower to compete in a competitive acquisition with other potential buyers who may be coming to a deal with traditional stand-alone “SunGard” style commitment papers or other offers not subject to a financing condition.
With these provisions in place, in the event a borrower desires to enter into an acquisition agreement, the consummation of which is not conditioned on third-party financing, it may do so and may seek incremental facility financing on a “SunGard”/“certain funds” basis. Much like in the context of a traditional new financing, this reduces the uncertainty of the financing and allows the calculation of leverage ratios, the making of representations and warranties, and the condition of no default or event of default to each be tested at the time of entry into the acquisition agreement, as opposed to the time of consummation of the acquisition. Thus, this approach allows a borrower to deliver a strong committed financing package to a potential seller.
Of course, lenders party to a credit agreement need to protect themselves. While some solace can be taken in the fact that a borrower must find financing sources which are comfortable with the acquisition, there are certain lender-friendly backstops that have become standard. First, although the absence of defaults and events of defaults are generally tested at the time of entry into the acquisition agreement, the market requires that there be no bankruptcy or payment event of default at the time of the actual consummation of the acquisition. Additionally, to protect lenders against unexpected deterioration of the credit, there should be a limitation on the duration of time between the signing and the consummation of a limited condition acquisition. One additional lender protection is to limit the number of pending limited condition acquisitions that may be outstanding at a time to one or two such transactions.
There is some uncertainty as to where the market is shaking out in terms of how to treat the pro forma effect of such an acquisition on financial metrics (for purposes of financial covenants, leverage-based governors, and other similar purposes) prior to closing. The preferred approach from a lender’s perspective is to test the metrics both as though the limited condition acquisition has closed and as though it has not closed. Given that the consummation of the acquisition is not a complete certainty, this is a logical approach.