The market in trading distressed corporate debt, a necessity born of the last recession, looks here to stay. But attempts to instil standard market practice have so far failed to establish a consensus. This may not matter now. But the point at which it will the next economic downturn ushering in a wave of corporate defaults will be too late. For those in charge of debt-trading desks, this is the time to make sure that existing documentation and procedures provide adequate protection, especially in a market where the speed of dealing and the thin margin on any particular trade may make it impracticable to obtain legal advice every time.
All loan traders should keep a wary eye on Bank of England pronouncements. The Bank is concerned that a secondary market in corporate debt should not undermine the so-called London Approach. The London Approach is a set of principles, overseen by the Bank, which encourage lenders to a company in difficulty to work together to continue to support it. The secondary market moves some corporate debt to banks that have no direct relationship with the borrower. The more international the market, the less beholden some participants may feel to the Bank. The greater the ability to trade distressed debt, the less inclined some creditors may be to see a work-out through, not least since the legal mechanisms for trading debt can be less than perfect.
These include assignment (legal or equitable), novation and sub-participation (funded or unfunded). The most effective of these, novation and legal assignment, involve the borrower. In novation, the borrower is a party to the trade because the existing loan is replaced by a new one and the existing lender falls away completely. This is rare. In legal assignment, the borrower has to be notified of the trade. It also requires the whole of the debt to be assigned, not a part. The Bank of England requires the borrower to provide formal acknowledgement of the assignment for it to be effective for risk-asset ratio purposes. But notifying the borrower may be impracticable. It may undermine the existing lender’s relationship or there may be a prohibition in the loan agreement against assignment (assignment in breach of an express prohibition is effective as between the buyer and seller of the debt, but it still leaves the seller in the middle between the buyer and the borrower).
Anything less than a legal assignment or novation gives the buyer of the debt a double-credit exposure to the seller of the debt as well as to the borrower. This is where the legal position becomes complicated.
In the case of a funded sub-participation, where the buyer deposits with the seller the amount of the seller’s exposure to the borrower, the seller may find himself in the position of trustee of the buyer’s right against the borrower. Instead of dropping out of the chain, he has to take action on the buyer’s behalf, for instance to protect the latter’s interests if the borrower is wound up. In an unfunded sub-participation, where the buyer guarantees to the seller repayment of his principal exposure, the buyer may find that under the pro rata sharing provisions of the syndicated loan agreement, his guarantee extends to all the other lenders as well. In a nightmare scenario, the borrower’s parent may be able to assert rights of contribution where its own guarantee is called by the lending syndicate. The reason that syndicated loans complicate debt trading is because the obligations under them are not necessarily just one-way, from the borrower to the banks. The banks have obligations in return, as well as to the agent bank and each other. Each may regard its participation as a single loan from it to the borrower, but the borrower has certain legal safeguards which enable it to treat the loan as one. This is why, for instance, to be effective a legal assignment has to be of the whole of a bank’s exposure and not just part; otherwise the borrower could find its obligations increasing as its debt was being split up and on-sold.
Aside from the complexity of the legal mechanism of transfer, there is the issue of confidential information. The London Approach advocates the use and dissemination of the most up-to-date information relating to a borrower in difficulties. But where that information is disseminated to buyers of the debt, existing lenders must ensure they are not in breach of the banker/customer duty of confidentiality. The law on the banker/customer relationship was set out in Tournier v National Provincial in 1924 which established the banker’s duty to keep confidential all information obtained by the bank out of the banking relationship with the customer. However, not all providers of credit these days are banks. Nor is it clear that advancing funds under a syndicated facility is necessarily carrying on banking business in the traditional sense. However, there is always the risk that an aggrieved borrower may try to take the point. In any case, Tournier is just one example of a commercial relationship giving rise to a duty of confidentiality. Where the buyer of the debt is, for example, the finance subsidiary of a competitor of the borrower’s, the seller may find himself caught where the buyer is using the purchase of the debt simply to obtain commercially sensitive information about the state of a competitor’s finances. Even where the loan agreement contains provisions allowing for the disclosure of information on the sale of a participation in a loan, it may be construed narrowly to apply only to information relevant to the financial covenant in the agreement.
There is a further consideration in relation to information about the borrower, especially where it is undergoing financial reconstruction: the new insider dealing rules brought into effect by the Criminal Justice Act 1993, which replaces the Companies Securities (Insider Dealing) Act 1985. The buyer and seller may be prevented from dealing in debt securities if they possess inside information in relation to those securities or the issuer of those securities (the trade must take place on a regulated market or through a professional intermediary for this to bite).
They may also be prevented from passing information between each other where it is likely to have a significant effect on the price or value of the securities. The essence of this second offence is the prohibited disclosure of inside information. No actual dealing need take place.
Any loan traders concerned by these legal complexities should refer to the Financial Law Panel’s discussion document on the secondary debt market, published earlier this year. The panel is concerned that insufficient weight is being given to these issues. You have been warned.
