Lenders often express concern about potential defaults under their loan agreements – but it’s usually default by the borrower that they’re concerned about, not default by the lenders. It's a sign of the times that this has now become a significant issue. With an increase in the number of bank failures and FDIC receiverships over the past year, we’ve begun to see an increase in the number of lender defaults in syndicated loan deals. If you're a lender (or a borrower) in a syndicated credit facility, you might well find yourself facing this situation.
If a lender in your bank group defaults, what can you do – and what can’t you do?
As an initial matter, it’s important to keep in mind that default by a lender does not excuse anyone else from performance. The remaining lenders still have to fund loans when requested, and the borrower still has to make payments and comply with all the covenants. However, depending on what your loan agreement says, you may be able to mitigate the effects of the default. Here are some typical provisions that many loan agreements already contain:
- Limitation on Voting Rights. Many loan agreements provide that a defaulting lender’s commitment is not counted when determining whether a required/majority lender vote has been achieved. Some loan agreements also provide that the defaulting lender simply does not have the right to vote on any issue – even issues otherwise requiring a 100% vote (perhaps with some very limited exceptions such as for increases of that lender’s commitment). This is extremely helpful, because if the lender has gone into bankruptcy or has been taken over by the FDIC, it will be very difficult, if not impossible, to get that lender to vote on even the simplest of amendments.
- Replacement of Lenders. Most syndicated credit agreements permit the borrower to remove a defaulting lender from the credit facility, under so-called “yank-a-bank” provisions. Removal of the lender would be accomplished through a forced assignment of its commitments and outstanding loans to another lender. Taking the defaulting lender out of the deal would certainly solve a lot of problems. However, the practical reality is that it can be difficult to find another lender willing to purchase the commitment at par as required – and this is particularly true when the loan is trading at a large discount in the secondary market (whether due to market conditions, as has been true recently, or due to a decline in the borrower’s performance).
- Commitment Fees. Though some agreements are silent on this point, several credit agreements include provisions permitting the borrower to stop paying a commitment fee to the defaulting lender. This seems appropriate, as borrowers otherwise find it rather unfair to have to pay a fee for a commitment that the lender has demonstrated it will not honor. A few loan agreements provide instead for the fee to be paid in the same amount as always, but for it to be shared only among the non-defaulting lenders. This provides something of a windfall for the non-defaulting lenders - which may be why this formula is less popular.
- Letters of Credit and Swingline Loans. It is relatively common to require the borrower to cash collateralize the portion of an outstanding letter of credit or swingline loan that would otherwise have been backed by the defaulting lender’s commitment. This protects the issuing bank or swingline lender from having to bear additional risk for that portion of the loan/commitment, beyond its pro rata share. Some agreements provide that letters of credit cannot be issued at all (and swingline loans cannot be made) if there are any lender defaults, but this approach is used less frequently these days, as losing access to letters of credit can make things very difficult for certain types of borrowers.
At a minimum, you’ll want to make sure your loan agreements cover these important topics. If these provisions aren't already in an existing agreement, you might consider taking the opportunity to add them the next time there is an amendment.
In our next post, we’ll offer some suggestions for how to further improve protections for the bank group and the borrower in the event of a lender default, beyond these basic provisions.