Special Feature: Disqualified Lender provisions in the Spotlight
Contributors Justin Forlenza, Sid Levinson, James Millar & Paul Silverstein take on DQ provisions
Our Contributors tackle the emergence of a new tool in the sponsor toolkit – the use of DQ lists and other anti-assignment tactics to control who is at the table during times of distress. While DQ lists are not a new provision (they’ve been in some loan docs for years!), their expansion beyond traditional competitors to everyday distressed investors has caused consternation in the market, especially after well-known investors were impacted in Serta, Packers Sanitation and Byju’s.
In Serta, a large and active credit investor ignominiously had to forgive half of its loan position after being called to task by the Bankruptcy Court (an outcome that shocked us). And, then, more recently, Byju’s sued to disqualify a sophisticated distressed fund for exercising its rights to accelerate the company’s Term Loan.
We asked our Contributors to weigh in. The evolution of these provisions has wide-ranging implications for market behavior, enforcing creditor rights, liquidity and pricing. Where do we go from here??
Please read on.
Hunton Andrews Kurth
Chilling Effect of Disqualification of Distressed Investors in Syndicated Credits
Disqualified Lender or Disqualified Institution (“DQ Lender”) provisions in syndicated loan agreements have received attention recently because of concerns that they are causing, or will cause, market liquidity issues in stressed or distressed credits, and otherwise overly empower borrowers and their sponsors. For example, in Serta, Apollo, an existing lender, was subsequently added to Serta’s list of DQ Lenders (“DQ List”). Serta asserted that Apollo was then ineligible to hold its loans. (The DQ issue in Serta was settled.) More recently, similar issues arose in Packers where Strategic Value Partners, while pending assignment to acquire loans, was designated as a DQ Lender, and in Byju’s, where Redwood Capital was similarly designated as a DQ Lender post-trade. Aggressive sponsors want the option to disqualify distressed investors from owning their portfolio company’s loans.
Set forth below is a high-level summary of DQ Lender provisions generally, how they work in the market and what we can likely expect in future iterations of such provisions. While DQ Lender provisions are credit-specific and thus vary, a fundamental practical problem lies in the lack of transparency as to who is disqualified from owning a loan because DQ Lists are generally not available at time of trade notwithstanding that many credit agreements provide for the lists to be made available to lenders. Particularly where the criteria to add institutions to DQ Lists are very broad, can be amended by adding additional entities to the list, or where such list can be drafted to exclude generally any distressed investor from the credit, liquidity and price may be adversely affected in the event of stress or distress in the borrower’s business. Also touched upon below is a related issue concerning the reasonableness standard for a borrower’s consent to an assignment of a syndicated loan, another negotiated credit agreement provision that gives the borrower and its sponsor the option to keep distressed investors out of their debt as direct lenders.
DQ Lender Provisions
Syndicated loan agreements generally contain provisions that allow the borrower to designate entities that, unless the borrower otherwise agrees, are prohibited from owning the borrower’s debt by either assignment or participation. Historically, DQ Lender provisions were focused on the borrower’s competitors because lenders receive confidential and/or proprietary information on the borrower’s business and financial affairs. DQ Lender provisions with respect to competitors should be a non-issue. More recent DQ Lender provisions, however, are not limited to the borrower’s competitors. These negotiated contractual provisions allow the borrower to exclude as a direct lender or even as a participant, any entity that the borrower does not want as a lender. (Most credit agreements do not allow DQ Lenders to be participants under an existing lender; some credit agreements allow DQ Lenders to be participants with borrower’s consent or notice; and occasionally a credit agreement will provide that a DQ Lender can be a participant if the DQ List has not been made available to all lenders.)
Broadly-based or loosely-defined DQ Lender provisions (outside of a borrower’s competitors) are intended by borrowers and their sponsors to provide optionality to control who the borrower/sponsor is dealing with when the borrower’s business becomes troubled. Why would a well-heeled sponsor of a business that can be reorganized want distressed investors at its doorstep with new money to compete with the sponsor in the reorganization? On the other hand, why would original par lenders agree to limit the universe of debt buyers and thereby likely impair liquidity and pricing should the borrower’s business fall on hard times?
The LSTA Model DQ Provisions and Related Market Advisory
The LSTA’s model credit agreement provisions, most recently revised effective May 1, 2023 (the “LSTA Model Credit Agreement Provisions”), contain recommended language concerning the definition and treatment of DQ Lenders. The LSTA’s DQ Lender definition (see Annex here) suggests that as to non-competitors, the borrower must designate DQ Lenders prior to the closing of the loan and appointment of the administrative agent. As to non-competitors, the LSTA Model Credit Agreement Provisions do not appear to contemplate subsequent amendments and additions of entities to the DQ List after the loan closing and the appointment of the administrative agent. In practice, as to non-competitors, however, syndicated loan credit agreements typically allow the borrower to amend their DQ List with prospective effect (but not with respect to loans already held by lenders of record). An event of default by the borrower under a credit agreement generally does not affect the borrower’s ability to enforce DQ Lender provisions or the borrower’s ability to add entities to the DQ List.
On June 1, 2022, the LSTA issued a Market Advisory with respect to DQ Lender provisions that describes them as “Balance[ing] the competing interests of borrower and sponsors, on the one hand, and Lenders/market participants … in the secondary market and agents responsible for administering the relevant credit facilities, on the other hand.” Central to the LSTA Model Credit Agreement Provisions and its Market Advisory, the DQ List must be easily and promptly available to all Lenders, so there is transparency and certainty in the market. Unfortunately, notwithstanding the LSTA’s recommendations and guidance, at the time of trade neither the buyer, seller nor broker/dealer likely know whether the buyer is on the DQ List. Typically, such list is not, as a practical matter, accessible to the Seller and obtaining the DQ List from the agent, which is presumed to have the current DQ List, is at best a protracted process.
Most credit agreements allow lenders either to request the full DQ List from the administrative agent or, at minimum, ask the agent whether a particular prospective counterparty is a DQ Lender. Some borrowers do make the DQ List available on their online document platforms such as Intralinks, but not all agents post the list to their Lender sites and the information may not be available on the public side of the platform. Some credit agreements even give prospective lenders the opportunity to review the DQ List with or without confidentiality restrictions, but that rarely happens. Other credit agreements are silent as to the disclosure and availability of the DQ List. In fact, most lawyers who deal in the mechanics of closing loan trades have never seen a DQ List. Administrative agents often either do not have an up-to-date DQ List or do not share such information with selling lenders or broker/dealers. It’s likely that portfolio company sponsors don’t want the DQ List of lenders they have “blackballed” going public as there would probably be negative implications, even if the blackballed lender may not be interested in that particular credit, given the relatively small number of players in the distressed space.
So, how do market participants address DQ Lender issues when closing loan trades? When a syndicated loan is not in default and when an investor who is not already a lender is buying debt, borrower’s consent to the assignment of the loan is required. (Generally, investors seek assignments of loans not participations which, except in the case of revolving loans, do not require borrower consent.) But buyer consent is not obtained until closing, which can be many weeks or even months after the date the trade actually occurred. If the loan buyer is on the DQ List, the borrower can then reject the trade well after-the-fact.
When a syndicated loan is in default or when an existing lender in the credit is buying more debt, the credit agreement typically does not require borrower’s consent to an assignment of a loan. The agent, however, must sign the assignment agreement. Most assignment agreements include a representation from the buyer that such buyer is not on the DQ List. As typically only the borrower has the most current DQ List, a buyer of a loan will either seek to obtain the DQ List from the borrower or the agent as directed under the credit agreement, and, if it cannot promptly obtain the DQ List, will seek written confirmation from the agent that such buyer is not on the DQ List. If, for example, the administrative agent confirms that the buyer is not on the DQ List and is mistaken or the borrower disagrees, the credit agreements make clear that the administrative agent has no liability in connection with any matter relating to DQ Lenders. If it turns out that the secondary buyer is on the DQ List, because it was recently added or otherwise, such buyer is typically prohibited from owning the debt. Credit agreements provide mechanisms for addressing the situation ranging from buying back loans held by DQ Lenders, forcing the DQ lender to sell its loans, or by walling off a DQ Lender from any information and lender rights and remedies provided for under the credit agreement. Section 12.08 of the LSTA Model Credit Agreement sets forth examples of proposed credit agreement remedies.
It seems apparent that if the original par lenders agree to broad and flexible DQ Lender provisions, should the borrower become stressed or distressed, liquidity and price would likely be adversely affected as the universe of secondary buyers would be limited. The original lenders negotiating the DQ Lender provisions with the borrower and sponsor should demand that DQ Lists cannot be amended to include additional institutions after the credit agreement is effective without majority lender consent, and DQ Lender provisions should not be applicable upon and after the borrower’s default under the credit agreement. As those provisions are negotiated business terms at the inception of the loan, the original lenders have choices, even though such provisions seem not to be viewed as particularly significant to the original par lenders. From the borrower’s/sponsor’s perspective, (i) DQ Lenders should be either an all-encompassing general description of distressed lenders who cannot own the borrower’s loans by assignment or participation without the borrower’s consent, or a very long list of disqualified institutions, which can be amended at any time and with retroactive effect and (ii) the remedy if a DQ Lender buys the debt should include a forced sale of all loans owned by the DQ Lender, even at the lower of trade-date or then current market prices.
Reasonableness Standard for Borrower Consent to Assignments
As discussed above, an entity on the DQ List generally cannot purchase debt either by assignment or by participation and such prohibition is enforceable even after a default by the borrower under the credit agreement. Distressed investors prefer to be direct lenders (by assignment) as opposed to being participants under an existing lender for obvious reasons: A direct lender is a party to the credit agreement and can enforce its rights and remedies. Participations are credit-specific, but loan participants are not parties to the credit agreement and generally cannot vote or exercise rights or remedies other than through the record holder of the loans, which granted the participation. Loan participations have further voting limitations, particularly when the participant does not own 100% of the grantor’s (i.e., existing lender’s) position.
Prior to an event of default under a credit agreement, unless a buyer of the loan is already a lender in the credit, the borrower’s consent is required to assign the loan from the seller to the buyer. Syndicated loan credit agreements typically provide that borrower’s consent to an assignment shall “not be unreasonably withheld, conditioned or delayed.” There is virtually no clear legal precedent on what is reasonable under the circumstances, and litigation is not practical given the cost and time. Not surprisingly, distressed investors complain that borrowers are not consenting to assignments thereby resulting in investors owning sub-optimal loan participations and dealing with the nuances and limitations of beneficial ownership.
Recently, we have seen borrowers negotiate with original par lenders borrower-favorable language in the credit agreement to clarify the standard of reasonableness for not consenting to assignments Borrowers have expanded their consent rights where it is not unreasonable for borrowers to refuse to consent to assignments to a distressed investor solely because of such prospective buyer’s status or business line. The following examples from two recent credit agreements reflect such language:
[Borrower’s] consent not to be unreasonably withheld, conditioned or delayed; provided that… investment objectives and/or history of any proposed lender or its affiliates, shall be a reasonable basis for the Borrower to withhold consent…
[I]t shall not be unreasonable for the Borrower to withhold consent to any assignment with respect to any person… that invests directly or indirectly, (including through affiliates) in distressed debt, ‘special situations’ or opportunities…
It is unclear whether original par lenders negotiating credit agreements will care enough to challenge the borrower’s desire to control whether a particular distressed investor can take a loan by assignment and become a lender under the credit agreement. For revolving loans, where borrower consent to a participation is often required, it should be irrelevant. For term loans, time will tell.
Distressed investors are being excluded from syndicated loan activity in the marketplace because of aggressive DQ Lender provisions. Borrowers (and their sponsors) are limiting the transparency of DQ Lists and impairing the liquidity of their loans to the detriment of lenders. For par investors who focus on original syndications, more forethought is required during the drafting of credit agreements to limit the reach of the DQ Lender provisions. As to borrower consent to assignments to distressed investors, unless original/par lenders are troubled by restrictive limitations, assignments may have to wait until a default.
Copyright © 2023 Creditor Rights Coalition. All rights reserved.
As interest rates have risen and distressed credit opportunities have seen an uptick, disqualified lender lists (“DQ Lists”) and borrower assignment consent rights will likely take on greater importance in the broadly syndicated term loan market (the “BSL Market”). As with most credit agreement provisions, the low interest rate environment that dominated until recently had led borrowers to push for, and sometimes receive, broader rights to exclude certain lenders from the potential assignee pool for their syndicated term loans. The greater transferability restrictions can impact overall liquidity in the BSL Market, which is perhaps especially concerning in light of the continued growth of private credit as a meaningful alternative to BSL Market financings.
DQ Lists, which have been a long-time feature of loans in the BSL Market, generally prohibit assignments to certain entities on the list, as well as their reasonably (or clearly) identifiable affiliates. The DQ List can usually be updated by the borrower after the closing date; however, subsequent updates to the DQ List normally do not serve to exclude lenders that are already in the lender syndicate.
In addition, DQ Lists often include lenders that the borrower determines are “distressed debt” or similar investors. Any such investors can be added by the borrower to the DQ List after closing as well. In rare instances, however, a credit agreement will allow a borrower to retroactively add a “distressed debt” lender to the DQ List; this could then disqualify those lenders after the designation is made, on a retroactive basis. As such, in agreements that feature the maximum amount of flexibility, a borrower can potentially add a specific distressed investor to the DQ List on a retroactive basis, which would force that lender to exit the deal. This usually occurs via a borrower repayment or the forced assignment of that lender’s holdings to a new borrower-approved lender. Further complicating the issue is that some credit agreements also allow for disqualified lenders to be removed, either by repayment or assignment, at a price equal to the lowest of (1) par, (2) the amount the lender paid for the underlying loan, or (3) the current trading price. If the term loans are trading significantly down since issuance, this could force those lenders to exit their investment and book heavy losses if added to the DQ List.
Another separate, but related issue, that we have seen is the more expansive borrower consent rights to term loan assignments. Most broadly syndicated credit agreements provide borrowers with the right to withhold their consent to term loan assignments, though subject to some constraints. Most notably, borrower consent rights are usually subject to a “reasonableness” standard (i.e., the borrower cannot “unreasonably” withhold consent to assignments). However, some recent agreements also explicitly allow the borrower to consider the “investment objectives” and/or the “history” of a proposed lender in determining whether to reasonably withhold consent. Here is an example from a relatively recent sponsor-backed agreement:
“… it shall not be unreasonable for the Borrower to withhold consent for any assignment with respect to any person (including any person that manages or advises funds) that invests (directly or indirectly, including through Affiliates) in distressed debt, ‘special situations’ or ‘opportunities’…”
As such, in these instances the borrower can (arguably) decide in its discretion to withhold consent to assignments to investors that it thinks may be distressed or loan-to-own investors.
This issue has already impacted the BSL Market and will likely continue to do so. As reported by multiple sources, there were issues raised in litigations for both Serta Simmons and Byju’s regarding whether certain lenders were on the DQ List and therefore not entitled to pursue litigation based on claims arising out of their term loan holdings. As well, Bloomberg reported in October that Blackstone prevented assignments of the Packers Sanitation Services term loans to Strategic Value Partners, a well-known distressed investor, on their basis as an investor in that market. Each of these claims stemmed from disputes over the scope of assignment limitations in the existing credit agreements for each of the related borrowers.
We expect this to remain an issue going forward and we will continue to monitor documentation developments in the new issue BSL Market to alert participants to the inclusion of aggressive provisions such as these.
Copyright © 2023 Creditor Rights Coalition. All rights reserved.
Debevoise & Plimpton
While DQ provisions and lists have long been included in syndicated loan documents, the scope, reach and application of such provisions has expanded dramatically in the past few years. Historically, such provisions were designed to prevent competitors and other entities whose business interests might conflict with the borrower from becoming lenders. Recent disputes, such as those involving (among other companies) Packers Sanitation, Byju’s, and Serta Simmons, reflect the concerted use of DQ provisions to freeze out lenders who are perceived to be overly aggressive in their dealings with borrowers and their sponsors. Beyond expanding the pool of named disqualified lenders, some loan documents now allow for the names on DQ lists to be added post-closing, or even applied retroactively to existing lenders as a means to block them from exercising acceleration rights and other remedies.
It is understandable why borrowers would prefer to handpick their lenders, not simply to prevent bomb-throwers who might indiscriminately pursue remedies from acquiring their debt, but also to engage with lenders whose long-term objectives are simply to obtain a fixed coupon return for their investment as opposed to, for example, pursuing a debt-to-equity strategy. In the current market, where the demand to purchase distressed debt continues to outstrip supply, and where CLO managers are perhaps not as focused on preserving liquidity as they would be if the debt were already distressed and the CLOs were actively seeking to exit the investments, borrowers and their sponsors have been successful in obtaining favorable DQ provisions without having to pay a meaningful premium (whether in the form of higher interest rates, fees, or other consideration) in exchange for that benefit.
Unless and until original purchasers of debt and the underwriters who syndicate such debt require borrowers to pay such a premium in order to include favorable DQ provisions in their loan documents, debt investors will find themselves stuck with a far less robust secondary market (with a corresponding downward impact on trading prices) to unload their debt. This may be less of a concern to CLO managers than in the past, given the greater willingness of such institutions in recent years to maintain their holdings in the face of distress and participate in restructurings. That said, if the supply of distressed debt catches up with or exceeds demand, it would not be surprising if the pendulum swings the other way and DQ provisions are tightened in a manner that results in distressed debt investors having greater access to acquire syndicated debt, whether at the time of issuance or in the secondary market.
Copyright 2023 Creditor Rights Coalition
In my corner of the world, I have seen a recent trend where companies have greatly expanded the Disqualified Lender lists (“DQ lists”) to cover a wide swath of funds that would be likely purchasers of distressed debt. Before delving into some of the specifics, I’ll start with my big picture view: this is another example of debtors seeking to turn a relatively docile instrument into a weapon to develop leverage against a constituency. We’ve seen plenty of situations, such as third-party releases or non-pro rata exit financing opportunities, where debtors take value from one group (over their objection) and give that value to another group to get a “consensual deal.” This strikes me as more of the same.
I fully take onboard the reasoning that a company needs to have its competitors on the DQ list to prevent them from obtaining sensitive information. But what’s the reason for putting all the distressed funds on the DQ list? Evidently, it is to keep them from buying into the credit and causing “problems” in a restructuring. Let’s tease that out a bit.
If the distressed funds can’t buy the debt, then necessarily the market for the distressed debt suffers from a lack of willing purchasers and the price drops. The par holders will lose value on any trade if they can even exit the position at all. The analog to that is that funds with sophisticated strategies for maximizing the value of distressed debt won’t be able to build a position.
If the debtor has mostly par holders in its debt—and in my view, the par holders don’t spend a lot of time thinking about value-maximizing strategies for distressed debt—then the debtor will have the upper hand in any restructuring negotiations. Moreover, if those par holders are CLOs, their hands may be tied when it comes to things like putting in new money. So, the debtor can take advantage of them, give them less value, and give more to someone else. That’s really the mischief—that debtors are able to pressure the lender constituency by excluding from that group those entities that would know how to maximize the value of the debt. It’s not that the sophisticated distressed funds are causing “problems,” but rather that they are not rolling over for the benefit of others.
I’ll also note that the DQ lists nowadays often apply to participations, as well as assignments. So, the distressed funds are frozen out of any economic exposure to the credit whatsoever. The last point I’ll mention is that in some instances a company has included funds on the distressed list well after the debt is issued, a particularly ignominious move. Again, it is all driven towards levering the par holders into taking a bad deal.
To me, the one mitigating factor is that all of this hubbub about DQ lists is a matter of contract. That means that lenders should focus on it from the start and think about how they are going to get out of the credit if it goes sideways. As my father used to say, “anything man-made can be man-unmade.” So that’s the place to start—seek to ensure that the governing loan documents don’t include broad disqualifications of distressed funds (and help ensure that they can’t later be added).
Copyright 2023 Creditor Rights Coalition
Tell us what you think!
What will it take for the primary market to push back on these sponsor-friendly provisions? How will the secondary market react when we see a large secondary market trade gets DK’d? Or, are we worried about nothing. Just another example of the evolving push and take between market participants?
Tell us what you think here
The views of our Contributors should not be attributed to their respective firms or the Creditor Rights Coalition. In addition, the Coalition may take positions as part of its Advocacy efforts that do not necessarily reflect the view of Contributors and should not be attributed to any Contributor.