Recent market events have shown that not only borrowers can face financial peril. Lenders too can end up in financial difficulties resulting in serious consequences for borrowers faced with uncertain funding arrangements, cashflow issues and the stress, cost and risk of finding alternative funding. All of this ultimately impacts a borrower’s ability to do business. This article explores some of the safeguards and options available to borrowers when faced with a "defaulting lender".
It also explores whether alternative solutions might be appropriate where the “power dynamic” between the parties to the loan arrangement doesn’t fit the classic scenario of a (well funded) lender and an (impecunious) borrower.
What is a defaulting lender?
From a borrower’s perspective, a defaulting lender is any lender that is unable to meet its ongoing obligations, for example a lender that:
- Is unable to meet its funding commitments under a loan agreement, which is particularly problematic with committed undrawn facilities, revolving credit facilities or multi-utilisation loans (for example, in real estate finance development facilities),
- Is no longer properly carrying a “non-lending” role due such as facility agent or security agent (sometimes known as an “impaired agent”), or
- Has become the subject of sanctions and is no longer able to process payments with counterparties in the jurisdiction(s) which imposed the sanctions.
Existing loans: exploring a borrower’s options?
A loan is fundamentally a contractual arrangement, so any consideration of the options requires a review of the contractual terms. Most commonly, at least where there is a single lender, the documents will not directly address the possibility of a lender default.
Nevertheless, a review will also help a borrower determine the extent of its ongoing obligations and whether it has the right, and if so under what conditions, to take unilateral action such as cancelling undrawn commitments (thereby reducing commitment fees which might otherwise be payable, even though a defaulting lender cannot meet its commitment) or repaying early.
While it is open to a borrower to breach contractual terms (as the lender may well have done by failing to lend), by for example refusing to pay commitment fees or prepayment fees, careful thought would need to be given to this option, especially where a lender has security. A failure to meet obligations (particularly payment obligations) usually makes security enforceable - even if a defaulting lender is condsidered to be unlikely to enforce, it may be better to avoid antagonising a lender whose co-operation will be needed to release security, or who may need to consent to certain matters in connection with a refinancing.
If a lender has failed to fund, a borrower could treat itself as discharged from its obligations under the loan agreement on the basis that the defaulting lender’s failure to meet its funding obligations was a repudiatory breach (ie a failure by a party which goes to the heart of the contract). However, this option would result in the loan agreement terminating and immediately requiring full repayment (including amounts owed to other syndicate banks, if applicable).
Arguably, a claim for damages for breach of contract may also exist, but this will require (among other things) proof of loss such as the costs of seeking alternative funding or losses arising from delays to projects. This is rarely a favourable option however, given potentially lengthy and costly litigation, even before considering whether the defaulting lender would have the means to pay or the possible damages awarded by a court.
Similarly, a borrower could apply to court to force a defaulting lender to fund. This is only likely to be a consideration in the rare scenario where a lender chooses not to fund, notwithstanding that it has the necessary financial resources. Again, the costs involved make this unlikely to be an attractive option.
Ultimately it maybe that a borrower’s best option is to seek to repay the defaulting lender in full by obtaining new finance (equity or debt) or by using its own resources, if it has the appropriate assets. Repayment in full will free the borrower from the need to comply with the terms of the loan documents which are likely to restrict the borrower’s ability to raise additional liquidity.
As mentioned, while generally very few bilateral loan documents contain defaulting lender provisions, some market precedents, such as some of the Loan Market Association’s (LMA) form of syndicated facilities agreements, do already address the potential risk of a defaulting lender.
The LMA defines a defaulting lender as a lender which: has failed to make its participation in a loan available at the required time, has notified the facility agent or borrower that it will not make its participation in a loan available on the relevant utilisation date, has rescinded or repudiated a finance document, and / or faces an ongoing insolvency event.
If a lender becomes a defaulting lender:
- The borrower is entitled to cancel the commitment of that lender and may request another willing lender to replace the lost commitment,
- Revolving credit facilities provided by the defaulting lender are “termed out”, converting the facilities into term loans which become repayable on the facilities’ ultimate termination date (rather than at the end of the current interest period),
- The borrower will no longer be required to pay fees such as commitment fees to the defaulting lender while it continues to be a defaulting lender, and
- The defaulting lender will no longer be counted towards syndicate voting purposes if it does not respond within a specified (often relatively short) time frame to avoid delays to decision-making.
New loans: can a borrower (or other interested party) build in additional protections into the finance document?
Although it might be difficult to imagine a high street bank agreeing to defaulting lender provisions being inserted in its standard loan agreements, it should be recognised that there are many different types of loans and many different scenarios where loans are used. A commercial joint venture might be structured as two or more parties making funds available predominantly as loans, alongside smaller equity investment, and in particular providing commitments for further funding to the JV vehicle, their borrower. As mentioned, loans are contractual arrangements and under English law at least, the parties have almost complete freedom to negotiate the terms of those contracts. The LMA provisions might provide a useful starting point, particularly the concept of converting a revolving or on demand facility into a term loan, giving the borrower breathing space to arrange refinancing.
In other circumstances, for example with limited partnerships, or where the negotiating power in fact rests with the borrower, greater incentives to meet a lender’s commitment to fund can be considered. Where a loan is more for investment purposes, and where all parties are able to agree that certainly of funding is vital, it may be appropriate to agree incentives to lend which have real “teeth”. For example, perhaps a failure to fund might remove a borrower’s obligation to seek consent to new financing or equity issues, disapply a negative pledge, trigger a right to require a sale to a white knight at a discount or give a right to the other lenders to take up the defaulting lender’s unfunded position on favourable terms. Taking this further, one might envisage circumstances where a borrower (or a connected party, such as a financial sponsor) could have a unilateral right to convert a defaulting lender’s existing loans into equity on an advantageous valuation (from the perspective of the borrower or other investors).
Managing defaulting lender risk
In conclusion, prior to taking any steps, a borrower should always carefully examine the provisions of existing loan agreements. Where there are concerns around a lender’s financial health, but a default has not yet materialised, borrowers could also consider fully drawing any committed loans or revolving credit facilities as a precaution.
Any borrower that needs certainty of funding, or of refinancing, and which has the appropriate negotiating power might also consider including defaulting lender provisions in loan agreements at the negotiation stage.
It is always advisable for a borrower to diversify its funding sources, maintain contingency plans for alternative funding and remain alert to the financial health of its lenders.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, June 2023