Secondary debt trading update: eligible transferees - what is a "financial institution"?

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Restructuring - Global Insight

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A functioning secondary debt market is an important element of the European restructuring landscape, giving sellers an option to get out of challenging capital and resource-sapping situations. Buyers of second debt are often able to buy in at a level which gives them the flexibility to sustain an impairment of the principal amount due and/or provide fresh liquidity into a distressed situation. For debtors, the introduction of a new lender can often be a fresh start in a situation which might have turned into a challenging dynamic with their former lender.

A fundamental component of the market’s operation is the basic ability of a seller to transfer loans to an eligible buyer. In the recent case of Grant & Others v WDW 3 Investments Limited and Arazim (Gibraltar) Limited, the High Court of England and Wales considered the meaning of the term “financial institution” in the context of a secondary market debt trade. The Court interpreted the term broadly, finding that a non-trading special purpose vehicle with minimal capitalization was a “financial institution” for the purposes of a transfer restriction in the underlying loan document.

What were the facts?

The dispute concerned a loan facility entered into by Olympia Securities Commercial Plc (a company specializing in commercial and residential property development) with the Irish Bank Resolution Corporation Limited.

The Olympia loans were included in a portfolio of assets which IBRC agreed to sell to LSREF III Wight Limited. By an agreement dated May 16, 2014, IBRC assigned its rights under the Olympia loans to WDW 3 Investments Limited, which acted as nominee for LSREF.

When it acquired the loans, WDW was a non-trading company without any employees. It had been incorporated in England and Wales with a share capital of £1 two weeks prior to the loan transfer.

The loan document allowed the lender (IBRC) to transfer, assign or novate its rights, benefits or obligations under the loan agreement, but only to "one or more banks or other financial institutions." On June 30, 2014, the Olympia loans became due for repayment, but payment was not made, triggering an event of default.

Olympia subsequently entered into administration and Arazim (Gibraltar) Limited, an unsecured creditor (and sole shareholder of that Olympia's parent) challenged the validity of the assignment of the loan from IBRC to WDW, arguing WDW was not a financial institution for the purposes of the transfer provisions in the loan agreement.

The Court's decision

The Court decided that both WDW and LSREF fell within the class of financial institution in the loan agreement, and the assignment to WDW was therefore valid. The Court applied the test outlined in Argo Fund Limited v Essar Steel Limited.

In Argo, it was held that a financial institution is one which has "a legally recognised form or being, which carries on its business in accordance with the laws of its place of creation and whose business concerns commercial finance," whether or not its business includes lending money on the primary or secondary lending market. The Court found it was not necessary for WDW to be "… operating on its own behalf in the field of regulated finance" to be a financial institution, as long as its "… business concerns commercial finance …".

The Court concluded that the term “financial institution”, in the absence of an express restriction, should be broadly interpreted to encompass not just a party buying and selling debt in the secondary debt market, but its agents, trustees or fiduciaries. On this basis, entities that provide managerial services on behalf of the providers or users of financial products and services could also be regarded as financial institutions.

Arazim's arguments

Arazim argued that WDW could not be considered to be a financial institution when it acquired the Olympia loans because it was non-trading.

The Court rejected this argument. Such an approach, it said, would mean that a newly formed corporate entity wholly owned by a multinational, heavily capitalized and regulated commercial bank would not be a financial institution before it entered into its first transaction, but would became one immediately thereafter.

Arazim further argued that a financial institution could not and should not include a shell company with a capitalization of only £1. However, the judge found the lack of capitalization was not relevant; it would be entirely arbitrary to restrict the meaning of “financial institution” to include only entities having a certain size of share capital.

The judge stressed it would have been simple for the parties, if they wished to limit the scope of the term “financial institution” to corporations with a minimum capitalization, to do so by express provision, but the parties had chosen not to do so.

Market observations

Issues for recalcitrant transferees: In advising on secondary trading mandates and non-performing loan transactions, we sometimes encounter transferee entities who actively eschew the label of financial institution. We can speculate as to why: a desire to direct a restructuring in the shadows (requiring trades to be settled by way of funded participation rather than full legal transfer), or to avoid any suggestion that they should be subject to the same regulatory and/or tax treatment as traditional financial institutions. Whatever the reason, the Court's decision in Grant & Others will make it difficult for most participants (where the financial institution language is relevant) to convincingly argue that they are not financial institutions. That said, it is probably very unlikely that a set of circumstances would arise in which a seller would sue a buyer simply to prove that the buyer is a financial institution in the hope of forcing it to take a full legal transfer of a loan.

Meridian - contrasting position in the US: The widely drawn position under English law is in sharp contrast to the decision of the US District Court for the Western District of Washington in Meridian Sunrise Village v NB Distressed Debt Investment Fund Ltd, which found that certain hedge funds which had acquired a distressed loan on the secondary market were not “financial institutions” in the context of the transfer provisions in the underlying loan document.

The loan agreement in question restricted the lender's ability to assign or transfer the loan to any entity other than "… any commercial bank, insurance company, financial institution or institutional lender …". The court in Meridian found that to apply a very broad definition of “financial institution” would render the surrounding terms redundant and nonsensical. The US District Court interpreted “financial institution” much more narrowly than in Grant & Others, to mean “entities that make loans.”

It should be noted that the outcome of the Meridian case appears to have been driven, in large part, by the application of the law of the State of Washington and dependence on certain extrinsic evidence. Accordingly, the impact of the decision as a precedent for future cases in the US may be limited.

Too little, too late in large cap transactions? Over the past few years, favorable conditions for large cap and upper mid-market borrowers and sponsors in the European debt market have resulted in the erosion of financial covenants and other standard rights and protections for lenders in loan transactions. Not only has there been a proliferation of so called cov-lite or cov-loose structures, but increasingly, extensive loan transferability restrictions are also being included.

Accordingly, while a broad interpretation of the term “financial institution” might be helpful to lenders in older deals (pre-global financial crisis deals in particular), it is likely to be of no practical assistance to lenders (in more recent deals) where the loan documentation contains "white lists" of eligible transferees (often excluding funds that sponsors deem too aggressive) or where bespoke restrictions on future transferees mean that industrial and financial competitors are excluded. The term ”competitor” is often very widely construed in these instances and can extend to affiliates, controlling shareholders and even debt arms of private equity competitors.

Even the occurrence of an event of default may not entirely release a lender from its restrictions on transfer. Materiality thresholds are increasingly being incorporated by borrowers to determine whether a particular event of default will override a transfer restriction on the lender. Similarly, the standard synthetic workaround, by way of sub-participation, has also been narrowed with outright restrictions and/or consent being required to pass on voting and information rights to sub-participants under a sub-participation.

Concessions on transferability at origination might seem minor; however, in circumstances where events of default (or lack of them) are triggered later (as a result of the loosening of financial covenants), and restructuring discussions are therefore more frequently prompted by liquidity issues, the ability of an originating lender to sell the loan (or its part of the loan) where its borrower is failing is becoming even more important. For lenders, the implementation of International Financial Reporting Standard (IFRS) 9 means that lenders should be concerned about maintaining transfer flexibility. On recent Non-Performing Loan trades, we have seen examples of transaction inefficiencies created by lenders that have agreed non-standard transfer restrictions. Sponsors and borrowers should also look carefully at these restrictions and balance whether the control sought is actually operating in the desired way in the stressed or distressed context. It might not always be desirable to have the same set of (par) lender institutions in the deal if it does become stressed in terms of ability to bridge to or negotiate a solution.

Should we expect negotiation of transfer restrictions to migrate into smaller cap transactions?

Historically, smaller cap transactions using bank standard documentation included minimal (if any) restrictions on the lender transferring the loan. Where restrictions had been negotiated by borrowers, they typically referred to “financial institution” as the only eligibility criteria for a proposed transferee.

Given the broad interpretation of “financial institution”' in Grant & Others and as trends in large cap and upper mid-market transactions cascade down to lower value deals, we anticipate that smaller cap borrowers may want to place restrictions on the party to whom the loan is to be repaid. This is particularly the case where there is no natural constraint, for example a licensing and/or regulatory restriction.

If restrictions are to find their way into smaller transactions, the debt sale option for lenders in these situations might be closed off entirely or could at least take a different dynamic, effectively requiring borrower cooperation to any transfer. This will be of particular concern given that smaller loans are generally far less liquid in any event.