The Loan Syndications and Trading Association, Inc. (the “LSTA”) recently published an updated suite of trading documents for all secondary market loan trades entered into on or after May 17, 2019. The changes to most of the trading documents are technical clarifications and/or intended to capture recent changes in law. One exception is the LSTA Chapter 11 Plan Proceeds Letter Agreement for Post-Effective Date Settlement of Distressed Trades (the “Proceeds Letter”), which underwent both technical as well as a more substantive change to account for a unique scenario arising from a recent bankruptcy case that is ongoing.
To better understand the reason behind the changes to the Proceeds Letter some background may be helpful.
- What does the Proceeds Letter do? The Proceeds Letter is a bilateral agreement between two parties to a secondary market loan trade where the loan has been converted in connection with a chapter 11 restructuring plan of the applicable borrower. The Proceeds Letter provides for certain representations, warranties and other provisions relating to the loan proceeds as well as mechanics for the transfer of the proceeds from the seller to the buyer.
- When is the Proceeds Letter used? The Proceeds Letter is used only if (a) the trade was confirmed using an LSTA Distressed Trade Confirmation and (b) (i) the applicable borrower is a debtor under chapter 11 of the Bankruptcy Code, (ii) the class in which the loan is placed is impaired (pursuant to section 1124 of the Bankruptcy Code), (iii) the plan of reorganization has been confirmed and (iv) the effective date of the plan has occurred. The LSTA further recommends using the form only after the record date for distributions under the plan has occurred and distributions have been made.
- Why is a form Proceeds Letter necessary? The need for a form Proceeds Letter is premised on the widely accepted principle in secondary market loan trading that a “trade is a trade”. As set forth in Section 2 of the LSTA Standard Terms and Conditions for Distressed Trade Confirmations (as well as the LSTA par trade confirmation standard terms and conditions), a buyer in a loan trade assumes the obligation to purchase the debt as it may be “reorganized, restructured, converted or otherwise modified.” Often debt is reorganized in connection with a chapter 11 plan and the Proceeds Letter is intended to document the transfer of such reorganized debt.
Perhaps the most significant revision to the updated form Proceeds Letter is the change to how disgorgement risk is allocated between buyer and seller. It is a generally accepted trading principle that any payments or other distributions made in respect of a loan or loan proceeds (as the case may be) from and after the settlement date of the transaction are for the benefit of the buyer. If agreed to at the time of trade, payments and distributions from and after the trade date may be for the benefit of the buyer as well. If the seller receives a payment or distribution due to buyer, seller is required to pass along such distribution or payment to Buyer in accordance with the terms of the Proceeds Letter. Since the seller is merely acting as a conduit by passing along such payments or distributions, it is not expected to take on the payment risk and merely passes along what it receives (if anything). Similarly, if any such payment or distribution is required to be disgorged, it should ultimately be buyer’s (and not seller’s) risk absent egregious actions by the seller or a prior seller.
Until this recent change to the form Proceeds Letter, buyer was obligated to return any payments or distributions in case of disgorgement only if such payment or distribution was “made by mistake or in error by the entity charged with making the distribution…” The premise of that language was based on the assumption that a debtor is unlikely to make any payment or distribution to creditors in connection with a plan of reorganization unless the decision to do so was final and un-appealable. Accordingly, payments and distributions should only be subject to disgorgement if such payments or distributions were made by mistake or in error. That premise was challenged in connection with the 2016 bankruptcy filing of Ultra Petroleum Corp. (“Ultra”) and its related debtors (In Re: Ultra Petroleum Corp., et al., U.S. Bankruptcy Court, S.D. Texas, Houston Div., jointly administered under Case No. 16-32202 (MI) (Jointly Administered)).
What happened in Ultra?
Ultra, together with its subsidiaries UP Energy Corporation (“Energy”) and Ultra Resources, Inc. (“Resources”), is an oil and gas exploration and production company. Resources issued unsecured notes and borrowed under a revolving credit facility in order to finance its operations and each of Ultra and Energy guaranteed those obligations. Due to steep declines in the price of oil, each of Ultra, Energy and Resources filed for voluntary bankruptcy protection. Oil prices subsequently rose during the bankruptcy proceedings, which in turn increased the value of the companies enabling them to compensate creditors in full. Pursuant to the plan of reorganization, creditors with claims on account of the notes and revolving loans were entitled to repayment of principal plus interest. The debtors asserted that since lenders were recouping their principal plus interest, they were unimpaired and not entitled to vote on the plan. The creditors argued that they were in fact impaired because the plan did not require the debtors to pay a contractual make-whole amount and additional post-petition interest at contractual default rates. The plan was confirmed without resolving the issue and the debtors set aside $400 million to compensate creditors in the future if necessary. After the plan became effective, the bankruptcy court ordered the debtors to pay the make-whole amount and additional post-petition interest at the contractual interest rates. The debtors appealed that decision in the United States Court of Appeal for the Fifth Circuit, but rather than waiting for the results of the appeal to be settled pursuant to a final order, the debtors paid creditors their proportional make-whole amount and additional post-petition interest out of the $400 million reserve. The Fifth Circuit subsequently vacated the bankruptcy court’s order and directed the bankruptcy court to consider, on remand, whether the Bankruptcy Code disallows the creditors’ claims for the make whole amount and post-petition interest. In its opinion, the Fifth Circuit expressed “doubt” that the creditors are entitled to payment of the make whole. The matter is ongoing.
How does this impact the Proceeds Letter?
A payment having been made by the debtors in respect of disputed make whole and post-petition interest amounts prior to a final un-appealable order caused disruption in the loan market. Given that the disgorgement language in the Proceeds Letter was limited to payments made by mistake or in error, lenders of record were concerned that if they passed along the payments received in respect of the make-whole and post-petition interest amount and those amounts were later disgorged (due to a reversal of the bankruptcy court’s initial findings), buyers might not be required to pay back the disgorged amount under the terms of the Proceeds Letter. As a result, many lenders of record refused to pass along the distributions they received notwithstanding the obligations to do so under the terms of the Proceeds Letter. Ultimately, a process was put into place whereby the ultimate buyer assumed the disgorgement risk thereby enabling the proceeds to be passed along. However, the circumstances in Ultra caused the LSTA to re-visit the disgorgement language in the Proceeds Letter and ultimately make the revisions discussed below.
What changes were made to address the Ultra issue?
The concerns raised by market participants as a result of the issues raised in Ultra have been addressed primarily by broadening the disgorgement provision found in Section 7(c) of the Proceeds Letter to account for any disgorgement of payments or distributions, not just those resulting from payments made by mistake or in error. That solution would have been simple enough had it not been for the distressed LSTA loan trading convention relating to the provision of predecessor transfer agreements (“Upstreams”). The basic premise with respect to Upstreams is that a buyer of a syndicated loan on distressed trading documents should not assume the risk of receiving payments that are disproportionate to the other lenders in the syndicate if such disproportionate treatment is a result of an action or omission by a prior seller in the chain of title. This is addressed in the LSTA Purchase and Sale Agreement for Distressed Trades (the “PSA”) by requiring each seller in the chain of title from the time a credit “shifts” to distressed (as determined by a market poll conducted by the LSTA) to make certain representations, warranties and indemnities that are for the benefit of the buyer and each subsequent buyer of the applicable loans. In turn, all PSAs in the chain of title are provided to, and reviewed by, each buyer in the chain of title. The Proceeds Letter (unlike the PSA) does not require seller to pass along any Upstreams from the period prior to the applicable distribution record date (Upstreams from and after the record date continue to be provided) on the assumption that once the record date has passed, and distributions have been made to the record date holder, the risk of a pre-record date holder causing disproportionate distributions should be substantially mitigated. The facts in Ultra and broadened disgorgement language in the updated Proceeds Letter, however, required a reconsideration of this practice. After considerable discussion by market participants (and particularly the LSTA Trade Practices and Forms Committee), the LSTA determined to resolve this issue by adding a provision whereby each seller is required to provide pre-record date Upstreams in the case of a disgorgement if the disgorgement (a) is disproportionate among lender of the same tranche, class or type of loan and (b) relates to pre-record date payments or distributions. In such a case, a buyer may request and seller must provide all Upstreams received by such seller whether before or after the applicable record date.
What does this mean for secondary market loan trading participants?
The expectation is that this change to the Proceeds Letter will help avoid another situation like Ultra by allocating disgorgement risk more appropriately. It is yet to be seen whether Ultra was an anomaly or beginning of a new trend, but in any event the market should be better equipped to deal with such a situation. That being said, the change with respect to providing Upstreams places an additional burden on loan market participants to maintain good recordkeeping practices as it relates to pre-record date Upstreams even after loan trades have started settling on the Proceeds Letter.