The secondary market in bank loans, in which hedge funds are key players, has experienced significant growth in recent years. According to the web site (www.lsta.org) of the Loan Syndications and Trading Association, Inc. (“LSTA”), a trade group that plays a significant role in facilitating trading in this market, the volume of secondary loan trading grew over 1200% between 1990 and 1999. One study by Edward I. Altman and Shubin Jha of New York University Business School, shows that the defaulted and distressed, public and private debt markets in the United States were worth $942 billion in face value and $512 billion in market value at the end of 2002. Following highly publicized bankruptcy filings by Enron, Kmart, and WorldCom, the volume of distressed debt is considerable, such that in 2002 “for the first time, there was more trading in distressed bank debt (loans trading at or below 90 cents on the dollar) than in non-distressed loans.” Id. This article explains how a specific type of distressed debt, i.e., bank debt, is typically traded.
In a given bank debt trade, the seller might be an original bank lender seeking to rid itself of its piece of a troubled loan (a transaction called an original assignment), or the parties might be trading a piece of bank debt previously assigned by the original lender (a transaction referred to as a secondary assignment). How do the parties find each other? As might be expected, there are brokers in the distressed debt market that bring together buyers and sellers. One type of broker will remain involved in the settlement process to ensure that the trade settles; regardless, the buyer typically will take the assignment in its own name, be listed on the sale documents as the buyer, and be legally obligated to perform as specified in the sale documents. Certain banks and financial institutions will also act as brokers, but (primarily as a service to the sellers), they will do so by acquiring the debt piece from the seller and then selling it to the buyer, which, again, will be legally bound by the sale documents it enters into with the broker that is selling the debt piece.
A bank debt trade usually begins with an oral agreement between traders on the price and amount of debt that is to be assigned. The next step is to enter into a written trade confirmation, a standardized version of which, like many other transaction documents in the distressed debt market, has been published by the LSTA. The trade confirmation specifies the key terms of the transaction: the trade date, the nominal (i.e., face) amount of the assignment, the purchase rate (usually expressed in percentage terms), the form of purchase (assignment or participation), the settlement date, the form of the purchase and sale agreement, the treatment of accrued but unpaid interest, and which party is responsible for paying the assignment fee, among other terms and conditions. It is important to realize that the standard trade confirmation form for distressed trades not only covers the terms of trade just mentioned, but also incorporates the LSTA’s standard terms and conditions, which, if not attached to the confirmation, are available for review on the LSTA’s web site. These terms and conditions should be read and understood by both buyer and seller, because (unless the parties agree otherwise), they will govern the treatment of many key issues, including how the net price of the trade is to be calculated, ways to treat interest payments and fees, and what compensation (if any) is to be paid for delayed settlement.
Once buyer and seller have agreed on the trade confirmation, the next task is to draft the purchase and sale agreement (the “PSA”); typically, the trade confirmation sets forth whether buyer or seller is responsible for drafting the PSA. (Note that a PSA is typically not used when the debt piece is trading at or near par; unfortunately, there is no standard definition of “near par,” so parties may disagree as to the need for a PSA in the case of a piece of bank debt trading in the high 80’s or even low 90’s – prices, as stated above, are expressed in percentage terms). The LSTA has published a standard form PSA, of which there are four versions, encompassing the four types of trades. (The four variants relate to whether (i) the assignment is original or secondary and (ii) the borrower is in bankruptcy.) On occasion parties ask to insert their own language into the PSA, which may or may not be warranted under the circumstances, but can have the effect of delaying settlement of the trade (as of March 2003, the LSTA is apparently on the verge of approving a revised version of the PSA that will provide parties with fewer opportunities to deviate from the standard provisions).
Two other documents in addition to the PSA are necessary to settle a bank debt trade: an assignment and acceptance agreement (the “A and A,” which is executed by the assignor, the assignee, and the agent for the bank group that originally made the loan), and a purchase price letter (the “PPL”). Most credit agreements provide a form of A and A as an exhibit, and agents usually have low tolerance for any deviations from that form. The A and A typically states that the seller is assigning to the buyer the given piece of bank debt per the terms and conditions of the credit agreement, and that the agent approves such assignment. In one sense, the A and A is the most important document in the entire transaction, because until the agent for the bank group approves the assignment and executes the A and A, the transaction cannot be consummated (at least not as an assignment, as discussed further below).
The PPL sets forth the net purchase price of the transaction and explains how the price is calculated. Under the LSTA Standard Terms and Conditions several adjustments can be made to the purchase price. For example, if the assignment includes debt issued under a revolving credit facility, the amount being assigned may include an unfunded portion. If so, the buyer will receive a credit for the unfunded portion equal to the unfunded amount multiplied by 1 minus the purchase rate. As an illustration, if the seller is selling a $5 million revolving credit commitment at 65 cents on the dollar, with an unfunded portion of $1 million, the buyer will be charged 65% of the $4 million funded amount, but the buyer will receive a $350,000 credit for the unfunded amount (i.e., $1 million multiplied by 1 minus 0.65). The buyer receives a credit because at some point in the future, if and when the borrower is able to borrow the unfunded amount under the revolving facility, the buyer will be required to lend funds to the borrower at 100 cents on the dollar. Providing the buyer with a credit on the unfunded portion at the time of the assignment is advance compensation for this possibility, so that the buyer’s real cost in lending on the unfunded portion will actually be 65 cents on the dollar (i.e., 100 cents minus the 35 cent credit).
In addition to providing a credit for unfunded commitments, the PPL may need to reflect other adjustments to the purchase price to account for permanent commitment reductions and permanent repayments of fees, as well as adjustments to the purchase price when there is a delay in settling a trade. In short, the PPL in a distressed debt trade can have many components, and it is advisable to have such letters (together with the other operative trade documents) reviewed by an experienced attorney.
Ideally, after the parties have agreed on the PSA, A and A, and PPL, they would then submit the proposed trade to the agent for approval. Obtaining such approval is usually straightforward, and most agents for bank groups are familiar with the workings of the secondary loan market. However, on occasion there can be delays at this stage, especially if the proposed assignee is not already “in the credit,” i.e., not currently a holder of any other pieces of the bank debt being assigned. In such cases, the agent may ask for evidence of the proposed assignee’s creditworthiness. Given the potential for delay, it is usually advisable to submit the A and A – even in draft form – to the agent as early as possible and inform the agent of the pending trade.
In theory, closing bank debt trades is a smooth, rational process. Of course, the reality can be different and at times difficult. Certain recurring issues tend to be problematic. The first concerns “upstreams,” i.e., the sources from which the current seller acquired the debt piece. The buyer will want to ensure that each of the upstream sellers (if there are more than one) conveyed good title, and that the agent duly approved each assignment. Another problem area can be the credit agreement itself, which in certain instances will require that assignments be in minimum amounts of $5 million or $10 million. Obviously, if the parties contemplate assigning less than the minimum required amount of debt, such minimums can pose a problem. However, buyer and seller can overcome this difficulty by effectuating an oversale and buyback, whereby a buyer seeking to assign a net amount of $2 million, but faced with a $5 million minimum under the credit agreement, would assign $7 million of debt and then buy back $5 million.
Another nettlesome issue is the treatment of accrued but unpaid interest. Typically, though not always, when the borrower is in bankruptcy, unpaid interest is handled on a “trades flat” basis. This term means that any interest payments or fees that are accrued but unpaid as of the trade date (i.e., the date buyer and seller agree to enter into the transaction) will go to the buyer when (and if) they are paid. If the borrower is not in bankruptcy, a debt trade may be settled “without accrued interest.” This treatment means that interest payments or fees that are accrued but unpaid up to (but not including) the settlement date (i.e., the date upon which seller receives the purchase price) are for the account of seller. Settling a trade can become even trickier because of compensation for delayed settlement, which usually takes effect on the date that is 20 business days after the trade date (hence the importance of specifying in the trade confirmation when the trade date is). If the parties have not settled the trade by “t plus 20,” as this date is commonly known, then buyer becomes liable for paying a penalty calculated as the 1-month LIBOR interest rate (as of the t plus 18 date) multiplied by the net purchase price. In this situation, seller also is penalized and must pay buyer any interest and fees that are paid by the borrower and allocable to the “delay period,” i.e., the period from and including the t plus 20 date to, but excluding, the settlement date.
Two final issues are worth discussing: participations and netting. On occasion, for a variety of reasons, it becomes impossible (or extremely difficult) to settle an assignment of bank debt. In such situations, it is frequently possible to take the alternative approach of entering into a participation, whereby the seller retains title to the debt piece, but sells the underlying economic interest to the buyer. It is also possible to enter into a temporary participation that the parties can later “elevate” to a full-fledged assignment. (It is advisable to review the credit agreement for any restrictions on entering into participations.) Finally, netting can be a useful device when parties have created a chain of assignments that may involve many buyers and sellers. On occasion, it is possible to expedite the settlement process by having the intermediate parties “step out of the middle,” which has the net effect of allowing the initial assignor to settle with the ultimate assignee.
As should be apparent from this brief overview, settling a bank debt trade can be an intricate exercise. As such, it is advisable to retain experienced counsel who can guide buyers or sellers through the process and is familiar with the relatively small world of practitioners specializing in this work
|By Marc Bennett. Mr. Bennett is an associate in the Global Restructuring Group in the New York office of Allen & Overy. He advises hedge funds and banks on buying and selling bank debt. He has also represented debtors, secured and unsecured creditors and boards of directors in numerous bankruptcy cases and insolvency proceedings throughout the United States.