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von Holger Langer, LL.M.

Syndicated Loan Agreements III – Structure and Contents

A. Conditions precedent

Conditions which must be satisfied by the borrower before the obligation of the lending banks to disburse funds is triggered
  • conditions precedent to all loans (drawdowns)
    • various documents relating to
      • constitution of the borrower
      • powers, status and capacity to enter into the agreement
      • internal authorisations and exchange control permissions
      • legal opinions (on questions of foreign law)
    • seek to ensure
      • that the loan agreement is a valid and enforceable legal agreement
      • that the borrower has the power and all necessary authorisations to enter into the agreement
  • conditions precedent to each loan separately
    • representations and warranties are true on updated basis
    • no event of default has occurred
    • no material adverse change has occurred
      • seek to ensure that all legal and financial matters are still in order prior to each drawdown
  • can either party after entering into the loan agreement but prior to the satisfaction of the conditions precedent walk away and withdraw from the agreement?
    • depending on the construction of the clauses under Common law
      • contingent conditions (true conditions precedent)
        • probably no valid agreement until condition is fulfilled
        • no binding contract between the parties, no obligations between them
      • promissory conditions
        • common practice in syndicated loans
        • both parties bound by an existing contractual obligation to lend and to borrow from the moment of the signing of the loan agreement
        • performance of obligations only suspended until condition has been satisfied
        • withdrawal on the side of the lenders not legally possible
          • until the time for satisfaction of the conditions has elapsed      or
          • the borrower has had a reasonable time to satisfy such conditions
      • remedies for failure by the banks to lend
        • no specific performance (South African Territories v Wallington)
        • damages for reasonable foreseeable losses
          • e.g. extra interest and costs incurred by the borrower arranging another loan (Prehn v Royal Bank of Liverpool)
          • lender not responsible for extra costs based on a decline in the borrower’s credit in the meantime (Bahamas (Inagua) Sisal Plantation v Griffin)
        • damages for specially contemplated losses
          • e.g. inevitable default by the borrower on a contract financed by the loan, loss of profit on such contract
          • only if the bank had knowledge that the loan is to be used for such contract and of the consequences of default (Manchester & Oldham Bank v Cook; Wallis Chlorine Syndicate Ltd v American Alkali Co Ltd)
      • remedies for failure by the borrower to fulfil the conditions
        • no specific performance (borrower is not forced to take the money!!!)
        • damages for breach of contract (reasonable foreseeable losses plus specifically contemplated losses: Rogers v Challis)

B. Representations and Warranties

substratum of facts on the basis of which the syndicate makes the loan facility available to the borrower

  • must be distinguished from the covenants which constitute the requirements which the borrower has to comply with in the future until the final maturity of the loan

First group

  • rep’s and warranties that are virtually identical to the conditions precedent (legal rep’s and warranties)
    • that the borrower has the legal status and capacity to enter into the agreement
    • that all obligations of the borrower are valid, legal and binding
    • that all internal and external authorisations have been obtained
    • that the performance of the obligations will not violate any laws in the home state

Second group

  • rep’s and warranties that relate to the financial and business position of the borrower
    • accuracy of all financial reports and accounts submitted by the borrower
    • no litigation or similar proceedings pending which would have a material adverse effect on the borrower’s financial or business condition
    • borrower not in default under any other loan agreement
    • borrower has title to all assets appearing on the balance sheet
  • in revolving facilities or loans which are disbursed in a series of tranches rep’s and warranties have to be repeated (like conditions precedent) prior to each drawdown

Remedies

  • remedies if rep’s and warranties are untrue or inaccurate
    • right to terminate the agreement and demand immediate repayment (acceleration)
      • right is contained in the loan agreement itself by making a breach of rep’s and warranties an event of default
    • if inaccuracy leads to the agreement being null and void (e.g. lack of capacity), damages for fraudulent or negligent misrepresentation under Common law

C. Financial arrangements

Mechanics and procedures for the transfer of funds, the payment of interest and other administrative aspects

  • currency of the loan
  • period of the loan
  • amount of the loan
  • drawdown of funds
  • repayment of the loan
  • prepayment of the loan

D. Covenants

Terms that have as their primary objective the protection of the investment, since syndicated international loans are usually for a long period of time and are not secured by security over assets of the borrower

I. Financial covenants

  • Debt to equity ratio
    • debt of the borrowing entity should not at any time exceed a certain multiple of its equity represented by its share capital and accumulated profits and reserves
    • esigned to prevent over-borrowing of the borrower
  • Minimum net worth
    • value of tangible assets less all outstanding liabilities should be maintained above a specified threshold level
    • designed to prevent liquidation of revenue-generating assets
  • Current ratio
    • maintenance of a certain ratio between borrower’s current assets and current liabilities
    • designed to ensure that there are sufficient liquid assets to enable borrower to make its payments of interest and principal
  • Minimum working capital
    • minimum level of liquid assets in excess of current liabilities which fall due within the next 12 months
    • designed to preserve corporate liquidity
  • Debt service ratio
    • annual interest payments and loan repayments do not exceed a particular ratio in relation to the borrower’s profits prior to payment of tax and interest

II. Financial information covenants

  • to enable the syndicate to obtain financial information about the borrower other than that publicly available

III. Asset disposal covenant

  • prohibits disposal of all or a substantial part of the assets
  • seeks to preserve the asset quantity and asset quality
    • prohibits large scale disposals of revenue-generating assets
    • prevents asset stripping, particularly on takeovers, with the effect that the real productive assets are converted into a claim on a possibly worthless company
    • prevents a creeping change of business
    • limits evasion of negative pledge
  •  “substantial
    • threshold would be cumulative disposals of 10 to 15% (Commercial Union Assurance Co Ltd v Tickler Ltd)
  • Exclusions
    • majority consent of the syndicate banks
    • disposals in the ordinary course of business, e.g. sale of goods
    • disposals of assets which are immediately replaced by equivalent assets

IV. Merger control covenants

  • prohibit the borrower from merging with another corporate entity (covers takeover and amalgamation)
  • seeks to preserve the legal identity of the borrower
    • is not necessary for the case where the borrower transfers all assets to the merger partner since this case would be caught by the asset disposal covenant (supra)
    • covers, however, the case where the borrower takes a transfer of all assets and liabilities (!!!) of the merger partner, since in such a case the borrower would not be in breach of an anti disposal clause

V. Pari passu covenants

  • borrower warrants that its obligation under the syndicated loan agreement will rank equally with the rights of the borrower’s other unsecured creditors
  • primary objective is to ensure that the borrower has not conferred priority to any other unsecured creditor at the time the syndicated loan agreement is agreed
  • However, doubtful whether this clause is effective to prevent other unsecured creditors obtaining a prior or preferred position over the claims of the syndicate in the event of insolvency, which might be conferred upon the other creditors by the law governing the insolvency ’ doubtful whether a contractual clause will be held to override the law of the jurisdiction governing the insolvency
  • Loan agreement would render such an event an event of default, conferring a right to accelerate upon the syndicate
    • however, in practice extremely unlikely to find out a breach of pari passu covenant before the occurrence of bankruptcy or insolvency of the borrower

VI. Negative pledge

1. Purpose

  • most fundamentally important covenant
  • essential commercial and financial purpose
    • to ensure that the borrower does not give security over its assets to subsequent lenders and, thus, to prevent preferential allocations of assets
    • most syndicated loans in the international market are unsecured, so that in the event of liquidation or bankruptcy of the borrower the syndicated banks would be at a serious disadvantage since secured assets would not be available to unsecured creditors Ù whenever an asset of the borrower is pledged in favour of one creditor, this may prejudice the position of the borrower’s unsecured lenders
    • to prevent the borrower from obtaining financing by giving security over assets at a time where its financial performance has deteriorated to a level where it is unable to obtain funds on an unsecured basis

2. Security covered

  • prohibition should also cover existing security
    • however, sanction is only event of default
  • should include all forms of security
    • mortgage = transfer of a legal interest in land or other property (independent of possession) for the purpose of securing the repayment of a debt
    • lien = a personal right to possess the property of another or to retain possession of such property as security for the performance of an obligation (arising by operation of law)
    • charge = right of a creditor to receive payment out of some specific fund or out of the proceeds of the realisation of a specific property
    • pledge = transfer of possession (but not ownership) of a chattel as security for repayment of a debt or performance of an obligation
    • all other security interests

3. Exceptions and qualifications

a. Possible exceptions where the scope of the negative pledge is too wide

  • Security with the consent of a majority of the syndicate banks
  • Security if the bank is equally and ratably secured on the same or equivalent assets
  • Liens
    • under s 39 Sale of Goods Act 1979 an unpaid seller of goods has a lien on the goods arising by implication of law
    • unless a specific exemption is provided to the negative pledge clause the non-payment of a $30 bill for a minor repair e.g. for a company car would constantly put a borrower in default and would possibly result in a breach of the negative pledge covenant and might amount to the acceleration and repayment of a multi-million dollar loan
    • should, however, be discharged within a grace period, e.g. 30 days
  • letters of credit
    • security over goods, bills of ladings, proceeds etc. in the ordinary course of trading (in the context of a letter of credit the bank would usually take a pledge or charge over the shipping documents until the bank is paid by the buyer)
  • existing security
    • Security on after-acquired assets to secure finance to acquire the asset (allows the borrower to purchase new assets and mortgage them for the price)
    • Security on assets of after-acquired subsidiaries (purchase of a company which may already be subject to encumbrances or security interests over its assets)
    • However, need to place a “cap” or “ceiling” on borrowings so that there is a maximum limit on borrowings which may be secured by existing security

b. Qualifications where the scope of the negative pledge is too narrow

  • Subsidiaries
    • clause should be extended to security by subsidiaries (e.g. a holding company borrower arranges for its subsidiaries to charge their assets as security for an unsecured loan of the holding company)
    • effect is that the group cannot raise finance when its financial or credit status would not allow for further unsecured finance
    • prevents “downstreaming” of assets to subsidiaries (in Re Associated Gas & Eletric Co it was held that downstreaming of nearly all the parent’s assets to a subsidiary, which charged them to secure finance in favour of other lenders, was held to be a breach of the parent’s negative pledge
  • Second-ranking security in secured loans
    • clause should also prohibit second-ranking security in secured loans
    • essential in floating charges since a junior creditor might obtain priority of a fixed charge
    • second mortgage might restrict the management in cases of default or restructuring, since junior creditors have veto rights which they could use to harass the senior creditors into paying them out
  • Title Finance
    • many transactions which have the commercial effect of giving security over assets, but which cannot be classified as “security interests” under English law
    • Sale and repurchase (“repo”)
      • borrower will sell asset and transfer ownership to a bank for a sum equivalent to the total financing required
      • borrower will simultaneously agree to repurchase the asset from the bank after a given period at a premium which would reflect the interest charge for such period
    • Sale and leaseback
      • like repo, but instead of repurchasing the asset it is immediately leased back with an option to buy it back at the end of the period for a nominal consideration; the leasing rate would be equivalent to interest during such period
    • Even though bank has obtained title to the assets and thus obtained security (in a commercial sense), such transactions would not constitute the creation of a charge or mortgage or other security interest (McEntire v Crossley Bros Ltd)
    • Title retention (conditional sale)
      • problematic and impracticable to restrict since they are routine in sales of goods contracts
    • Set-off arrangements
      • impracticable because it would prevent the borrower from being indebted to a creditor who owed money to the borrower

4. Applicable law

  • Meaning of  “security interest”
    • concerns the true meaning and interpretation of words in a contract
    • generally determined by the governing law
      • Art. 10 (1) (a) Rome Convention
      • Proper law of the contract under English conflicts rules
        • closest and most real connection (Bonython v Commonwealth of Australia)
  • Legal nature and effect of transaction in respect to the assets
    • fixed assets
      • lex situs – location of the assets
      • if according to the lex situs of the assets, those assets are subject to a security interest, a security interest has been created within the meaning of the words of the contract (it is not necessary for a security interest to arise on the same facts in the governing law)
      • consequently, breach of the negative pledge
      • conversely, if the lex situs does not treat the transaction as creation of security interests, there should be no breach of the negative pledge even if under the governing law such transaction would be regarded as creating a security interest
    • assets other than fixed assets
      • ambulatory assets (ships, aircrafts etc.)
        • law of the flag
      • intangible movables (bonds, receivables, bank deposits, contract rights etc.)
        • if a security interest is enforceable under the lex situs of such assets, the governing law should recognise this, which leads consequently to a breach of the negative pledge, even though under the governing law such transaction would not give right to a security interest

5. Enforcement of the negative pledge

  • Practical difficulty with enforcement of a negative pledge
    • breach of a negative pledge would in practice trigger a cross-default clause in all other loan agreements to which the borrower is party
    • consequently, a bank could accelerate such a loan under the cross-default clause
    • declaration of default by one syndicate would inevitably lead to a similar declaration by all other lenders, which would result in the insolvency of the borrower
    • in the event of insolvency it is extremely likely that the secured creditors would have priority over the unsecured creditors, so that the syndicate which called default on the breach of the negative pledge is more likely than not to precipitate the very event which the negative pledge was designed to prevent, namely a secured creditor obtaining a preferred position in a bankruptcy
  • Three alternative mechanisms to overcome this difficulty
    • Equal security clause
      • requires that if the borrower grants security to other lenders, he is required to grant security which is equal in value
      • could be enforced under English law by specific performance
    • Same security clause
      • requires that if the borrower grants security to other lenders, he will procure that the same asset will equally secure the syndicate’s loan pari passu
      • could be enforced under English law by specific performance
      • however, it may be impossible to erode a security interest which has been created and create another security interest which ranks equally in the event of bankruptcy
    • Automatic security clause
      • seeks to create a security interest simply by virtue of the operation of a contractual clause, which would normally provide that in the event that the borrower creates a security interest over an asset, that same asset will “immediately and automatically” secure the borrowings under the particular loan agreement
      • extremely doubtful whether a court would regard a contractual provision in an agreement as being capable of creating a security interest in respect of an asset ranking equally with a security interest perfected by reference to all formalities required by the law
      • the problem is that the asset is future and has not been presently identified, which is sufficient in England for the creation of a security interest, but might lead to problems in other jurisdictions
      • it has been suggested that some sort of equitable interest may arise under English law, but it is extremely unlikely that a court of the lex situs would give effect to such an equitable interest
      • it has been also suggested that if a subsequent lender took security with full knowledge of the existence this might in some circumstances give rise to injunctive relief against such lender
        • principle laid down in De Mattos v Gibson
        • it was held that where a person acquires an asset from another with knowledge of the existence of a previous contract in respect of that asset a court could interfere to ensure that the acquirer of the property shall not use the property in a manner inconsistent with the contractual stipulations of which he is aware
        • however, it is unlikely that an English court could use this principle to interfere with the rights of a lender who has taken security over an asset with knowledge that the borrower is acting in breach of an existing negative pledge covenant when he gave that security (Swiss Bank Corp v Lloyds Bank Ltd)
      • However, such third party creditor taking the security might be liable in damages for the tort of inducing a breach of a subsisting contract (see Swiss Bank Corp)
        • mere knowledge of the subsistence of the contract is by itself insufficient; there has to be some inducement or persuasion on the part of the defendant (Emerald Construction Co v Lowthian)

E. Events of default

  • calling default will give the banks a right to accelerate the loan, i.e. a right to require immediate repayment of all outstanding loans from the borrower and discharge of all further loans under the agreement
    • one of the main reasons for the choice of English law as governing law in international syndicated loans is the ability of English law to provide syndicate banks with such an unqualified right to accelerate on occurrence of an event of default without subsequent interference by a court
  • calling default upon an event of default is therefore last resort
  • Events of default clause supports the network of rights and liabilities under a syndicated loan agreement
    • all covenants, rep’s and warranties should be locked into the default mechanism
    • however, commercial value is little, since by the time such an event occurs the ability to recover the loan is poor
    • however, the sanction of acceleration gives the banks a bargaining lever in restructuring negotiations
    • clause should in any event be unqualified (i.e. without addition of “material” or “substantial”
  • Three types of default
    • non-payment
    • non-compliance with covenants or representations and warranties
    • cross-defaults (early warning or anticipatory)
  • Four effects of default
    • right to accelerate (termination of agreement and immediate repayment of all outstanding funds)
    • cancellation of obligation to lend further loans
    • suspension of further loans under the conditions precedent clause
    • may constitute a default under a cross-default clause in another loan agreement
  • Examples
    • Non-payment
    • Breach of covenants, e.g. negative pledge)
    • Breach of warranty
    • Creditor processes (e.g. attachment against borrower’s assets)
    • Liquidation and insolvency proceedings
    • Actual insolvency
    • Material adverse change
    • Change of control (“poison pill”)
  • Cross-default
    • leading anticipatory event of default
    • if the borrower has defaulted on another loan, it may only be a matter of time before the borrower defaults on this loan
    • links all borrowings made by one borrower on the international syndicated loans markets together with the result that if the borrower is in breach of any covenant in any international syndicated loan agreement, each and every one of the borrower’s syndicated loans is capable of being accelerated
    • default
      • even if on the occurrence of a breach of covenant under one particular loan agreement the lenders do not take action by way of acceleration, such a breach would nevertheless give other lenders in other loan agreements the right to accelerate
      • otherwise “cross acceleration” clause
    • gives the banks the ability to be included in debt restructuring negotiations since the sanction of acceleration could lead to the insolvency of the borrowe