Sellers of syndicated bank loans in the European market are currently caught up in an unintended consequence of European Central Bank (“ECB”) monetary policy. In order to stimulate growth and encourage banks to increase their lending activity, the ECB has reduced its deposit rate to below zero. In reaction to the ECB’s new deposit rate, the Euribor rate has also fallen below zero. This sequence of events has created unforeseen consequences for participants trading loans in the European secondary market when calculating the compensation for delayed settlement based on the Euribor rate.
The delayed settlement compensation trading convention promulgated by the Loan Market Association (the “LMA”) is intended to put both the buyer and the seller in the economic position they would have been in had the trade settled within a prescribed period of time, that being 10 business days from the trade date (for par trades) and 20 business days from the trade date (for distressed trades) (each, being the “Delay Period Commencement Date”). By doing so, the LMA hoped that parties would be incentivized to settle trades in an expeditious manner. Where the loan is performing, there are usually two payment flows that accrue during the period between the Delay Period Commencement Date and the ultimate settlement date: firstly, the so-called ‘cost of funding’ which is paid by the buyer to the seller and calculated on the settlement amount due multiplied by the relevant benchmark interest rate and secondly, all accrued interest and recurring fees which are paid by the seller to the buyer and calculated on the amount of the loan traded.
With the onset of negative Euribor rates, if the delayed settlement compensation rules were to be read literally, the flow of funds for the cost of funding payment would actually be negative and so, would arguably be payable from the seller to the buyer (instead of the buyer to the seller). Cost of funding would actually act as a penalty on the seller instead of a benefit. But is this the correct reading? Is this a result that the LMA actually contemplated?
A closer examination of the LMA Standard Terms and Conditions for Par and Distressed Trade Transactions (the “LMA Standard Terms and Conditions”) appears to support the literal reading, as they specifically contemplate the potential for the cost of funding to be paid by the seller to the buyer under certain circumstances. However, the language in the LMA Standard Terms and Conditions was primarily included to cover a situation where a loan contains a large unfunded portion and, as a result, the overall settlement amount would be paid by the seller to the buyer.
Furthermore, sellers are unlikely to be persuaded by a literal interpretation of the LMA Standard Terms and Conditions on the grounds that the language in question was not drafted with negative interest rates in mind (indeed, we doubt the current interest rate environment was ever contemplated). Ascribing the terms their plain meaning arguably creates a result which is not in keeping with their intended purpose, since no funds are actually due to the buyer from the seller, assuming the flow of funds would normally be from the buyer to the seller for the underlying purchase price. For the buyer to receive compensation for its cost of funding would appear to be counterintuitive, especially since the seller may be required to compensate the buyer for any interest and fees paid to the seller during the same period. Accordingly, contrary to the intent of the delayed settlement compensation convention, a buyer would actually be disincentivized to settle a trade, since the buyer could be entitled to both (i) interest on the settlement amount it owes to the seller and (ii) any recurring fees and interest earned from the loan itself.
The LMA Secondary Documentation Committee is currently investigating this matter and we anticipate it will issue a note clarifying its position in due course. Nevertheless, for the time being opinions in the secondary market on this topic vary significantly, so participants may wish to clarify the position with their counterparties when entering into future loan trades.
Whichever side of the argument you may find yourself on, should you require any advice on this, or any other matters relating to secondary loan or claims trading, please don’t hesitate to contact Matt Hughes or Adam Colman in our London office.