September 5, 2024 - The following article first appeared in the Summer 2024 issue of Loans Magazine.
In May 2022, the LSTA published revised Model Credit Agreement Provisions (“MCAPs”) which included modifications to the provisions relating to the treatment of entities prohibited from owning a borrower’s loans (the “LSTA DQ Structure”)1. We continue to hear from our members that the LSTA DQ Structure is still not being adhered to by certain credit agreement parties. As our members know, at the LSTA we do not wield the equivalent of a regulatory stick though for times like this it would be satisfying if we could do more then try to encourage and cajole our members into doing the right thing and adhering to the LSTA DQ structure.
Because we continue to receive reports from members who are frustrated by this lack of adherence to the LSTA DQ Structure, we would like to take the opportunity in this article to explain again the elements of that structure, the areas where we hear of parties departing from it, and then explain why liquid loans are so important for an efficient and healthy Loan Market. The message of this article is simple — to educate as many loan market participants as possible about the importance of adhering to the LSTA DQ Structure should a borrower choose to include a DQ list in its credit agreement.
LSTA DQ STRUCTURE
The LSTA DQ Structure was originally formulated in 2014 (the “2014 structure”) to balance the competing interests of borrowers and sponsors, on the one hand, and lenders/market participants that may be seeking to acquire a borrower’s loans in the secondary market and agents responsible for administering the relevant credit facilities, on the other hand. The 2022 updates, which are reflected in the MCAPs, ensure that the LSTA DQ Structure more closely reflects market practice.
At the request of our members, we published a Market Advisory in June 2022 which outlined the different elements of the updated LSTA DQ Structure, the applicability of the DQ Structure to assignments and participations and of the borrower’s list of entities that are prohibited from owning its loans by assignments and participations, and the restrictions on sharing information with disqualified institutions. This article is again attempting to highlight and educate our members about the importance of those key elements of the LSTA DQ Structure.
WHAT IS A DISQUALIFIED INSTITUTION?
The LSTA DQ Structure was developed to accommodate the need of borrowers and/or sponsors to exclude certain entities from a lending syndicate either because
(i) that entity is, or is affiliated with, a competitor and would gain access to sensitive or confidential information of the borrower if they became a lender, or (ii) the borrower otherwise wishes to reject the entity for legitimate business reasons. The LSTA DQ Structure provides that lenders are prohibited from making assignments or participations to a “Disqualified Institution”. The term “Disqualified Institution” is defined in the MCAPs as follows:
“Disqualified Institution” means (a) any Person designated by the Borrower as a “Disqualified Institution” by written notice delivered to the Arranger on or prior to [date of the Commitment Letter], (b) any other Person that is a Competitor of the Borrower or any of its Subsidiaries, which Person has been designated by the Borrower as a “Disqualified Institution” by written notice delivered to the Administrative Agent from time to time and (c) as to any entity referenced in either of clauses (a) and (b) above (the “Primary Disqualified Institution”), any of such Primary Disqualified Institution’s Affiliates designated by the Borrower by written notice delivered to the Administrative Agent from time to time or otherwise reasonably identifiable as an Affiliate of a Primary Disqualified Institution solely on the basis of the similarity of such Affiliate’s name to the name of any entity set forth on the DQ List, but excluding any Bona Fide Debt Fund.”
The DQ List is comprised of all those entities identified by the borrower, on or before the date of the commitment letter (the 2014 structure referenced the date of the credit agreement), as not being permitted to own its loans. The borrower may update the list, from time to time, with the names of its competitors (this term is not defined in the MCAPs, but the MCAPs highlight that the term should be defined with specificity in reference to the particular borrower and its business). The definition in the MCAPs has also been expanded and now the borrower may also include, by sending written notice to the agent from time to time, affiliates of a Primary Disqualified Institution (as defined above) and entities otherwise reasonably identifiable as an affiliate of a Primary Disqualified Institution solely on the basis of the similarity of such affiliate’s name to the name of any entity set forth on the DQ List, but excluding any Bona Fide Debt Fund (as defined). A Primary Disqualified Institution is, generally, an entity already included on the DQ List.
It is worth noting that LMA style credit agreements tend to provide for a list of approved entities (this is colloquially referred to as a “whitelist”). This achieves a similar result, but instead the list includes the universe of entities that are permitted to own a portion of the borrower’s loans rather than create a list of those that cannot own those loans. When the two approaches began to emerge about a decade ago, the US loan market considered and rejected the idea of adopting an approved list of entities in favor of the DQ List because the US loan market has many institutional investors and is ever evolving, and market participants considered it to be too difficult to draw up a list of all possible approved funds.
POSTING AND SHARING THE DQ LIST
In the LSTA’s DQ Structure, the agent is expressly authorized by the borrower to post the DQ List to that portion of the platform that is designated for public side Lenders of Record (the “Lender”). This is probably one of the most important topics of the LSTA DQ Structure. Posting the DQ List to a deal site that the Lenders can freely and regularly access properly notifies Lenders of the identities of the Disqualified Institutions. The LSTA DQ Structure provides that the agent is not obligated to monitor or enquire as to whether a Lender, participant. prospective lender, or prospective participant is a Disqualified Institution, and further, that the agent bears no liability arising out of any assignment or participation made in contravention of the provisions of the LSTA DQ Structure (given that agents serve as loan administrators only and, therefore, seek to limit their discretionary responsibilities, this approach is understandable). Because of this, it is important that credit agreements provide that the DQ List and any updates to it for competitors or affiliates are disseminated or otherwise accessible not only to the agent but to all Lenders such that a Lender would know when selling its position in a loan, if a potential assignee is on a DQ List. The LSTA form of assignment agreement provides that every assignee is required to represent that it meets all the requirements to be an assignee under the successors and assigns provision of the credit agreement (subject to such consents, if any, as may be required). By confirming that it meets all those requirements, the assignee is also confirming that it is not a Disqualified Institution. The assignee could not give this representation if (1) the Lender does not notify such assignee that it is not on the DQ List or (2) although not required to do so, the agent does not confirm that such assignee is not on the DQ List. The list must be published and available to all Lenders, including those on the private side as well as those on the public side, for them to confirm that the assignee is or is not on the DQ list.
APPLICATION OF DQ LIST – TRADING WITH AND YANKING A DISQUALIFIED INSTITUTION
One of the critical reasons the LSTA first tackled the drafting of the DQ Structure in 2014 was that members reported seeing language in credit agreements that sought to nullify trades entered by lenders with disqualified institutions. The LSTA’s approach in the LSTA DQ Structure is not to try to invalidate or nullify trades made in contravention of the disqualified institution provisions but to provide the borrower with an array of remedies to protect its interests if a Disqualified Institution becomes a lender, including purchasing the loan, canceling the commitment, and/or forcing an assignment. Thus, the borrower can (i) let the assignment or participation stand (while prohibiting such Disqualified Institution from receiving information provided to lenders, attending lender meetings, engaging in fundamental lender actions and taking part in creditor decisions in connection with insolvency scenarios), (ii) for trades involving a revolving commitment, terminate the revolving commitment of such Disqualified Institution and prepay or purchase the obligations of the borrower owing to such entity in connection with that revolving commitment, (iii) for trades involving a term loan, prepay or purchase the term loans held by such Disqualified Institution, or (iv) require the Disqualified Institution to assign its rights and interests to an eligible assignee, effectively allowing the borrower to “yank” the Disqualified Institution by buying back the loan or forcing an assignment. The price paid to the Disqualified Institution will be the lesser of the principal amount of the loan and the amount that the Disqualified Institution paid for the loan. The option to pay at market price which was included in the 2014 structure has been deleted from the updated MCAPs.
Provisions which establish that trades are rendered null and void by subsequent unilateral action of the borrower contravene the balance established in the LSTA DQ Structure and create uncertainty in the market. If a secondary market participant is on a borrower’s DQ List for a deal, a Lender may not settle a trade by assignment or by participation with that participant (subject to a three-day period which is discussed below). This is a workable restriction which does not impede the liquidity of the market because the LSTA DQ Structure assumes the DQ List will be posted on the platform and, therefore, may be accessed by Lenders. It would not be suitable for the DQ List to apply to participations (and assignments) if Lenders could not regularly and easily review it because, since 2002, loan trades become legally binding contracts when they are orally entered into by the traders. Thus, when the seller and buyer agree the material terms of the trade, the loan trade becomes a legally binding contract between them. The signing of the LSTA Par/Near Par Trade Confirmation (the “Par Confirm”) or LSTA Distressed Trade Confirmation (the “Distressed Confirm”) evidences that loan trade but need not ever be signed for the loan trade still to be a legally binding contract. If the parties are unable to settle the trade as an assignment or as a participation, they are still required under Section 1 of the LSTA Par Confirm or Distressed Confirm to settle that trade “on the basis of a mutually agreeable alternative structure or other arrangement that affords Buyer and Seller the economic equivalent of the agreed-upon trade”.
The updated portion of a DQ List also has no retroactive effect, and the MCAPs state that any updating of the list shall take three business days to take effect. The LSTA suggests three business days but highlights that parties should consider the appropriate time period for effectiveness of notice regarding modifications to the DQ List. The period is designed to allow time for the Lenders to learn about the new additions and brief their teams accordingly. Thus, if a Lender has already entered into a trade with a party which is subsequently added to the list, the parties may still settle their trade; however, the borrower has the right to “yank” that entity by buying back the loan (see discussion above).
PROHIBITION ON SHARING OF INFORMATION
Under the protections set forth in the MCAPs’ provisions related to successors and assigns, the LSTA DQ Structure provides that all Disqualified Institutions are prohibited from receiving confidential borrower information, engaging in fundamental lender actions, and taking part in creditor decisions in connection with insolvency scenarios. Thus, credit documentation in and of itself should not invalidate any assignment or participation to a Disqualified Institution because the borrower and its information is always protected and may not be shared with the Disqualified Institution even if it is in the syndicate. The remedies available to the Borrower were discussed above.
STRUCTURAL ELEMENTS NOT FOLLOWED
The LSTA’s DQ Structure works when each element of the paradigm is present. If the DQ List is to apply not only to assignments but also to participations, then it must be posted so Lenders may easily review it and know with whom they can settle their loan trades. If the agent has no responsibility for monitoring the list, then Lenders must be able freely and regularly to access it and share it with prospective assignees. If the list is capable of being updated periodically for competitors and affiliates, then there must be a notice period before the updated DQ List takes effect.
REPORTS OF DIVERSION FROM THE LSTA DQ STRUCTURE
Flagrant disregard of the LSTA DQ Structure is bad for the loan market; therefore, it is unacceptable when DQ Lists are not posted on the deal sites and available to Lenders. This behavior unfortunately has become the norm rather than the exception. Lenders or their prospective assignees typically contact the agent to verify if the assignee is on the DQ list. We regularly hear that the agent is not always readily available to respond. Consequently, the assignee is unable to execute the Assignment Agreement until it can affirmatively verify, within the document, that it is not on the DQ List. This can cause the assignee to forfeit delayed compensation unless the counterparty waives the forfeiture. Worse yet is when the assignee is on the DQ list and therefore thinks that it can walk away from the trade. As stated earlier, if the parties are unable to settle the trade as an assignment or as a participation, they are still required under Section 1 of the LSTA Par Confirm and LSTA Distressed Confirm to settle that trade “on the basis of a mutually agreeable alternative structure or other arrangement that affords Buyer and Seller the economic equivalent of the agreed-upon trade”. Therefore, the trade itself is not null and void by virtue of the fact that an assignee is found to be on the DQ List.
One other topic that inhibits liquidity that is worth mentioning is the increase in borrowers denying consent to broker dealers. Dealer desks are in the business of making markets, not investing in loans. It is unfortunate that they are viewed from a “lender lens” as this is not the business to which they aspire. If anything, it would improve liquidity and settlement times if dealers were exempt from obtaining borrower consent.
But back to DQ Lists, we know that borrowers, even investment grade borrowers, are opting to include disqualified institution structures in their credit agreements. None of this bodes well for the mature, liquid loan market. DQ Lists naturally impede the liquidity of a borrower’s loan. Illiquid loans can, in turn, impede the loan market itself by reducing market efficiency, and they can increase borrowing costs because lenders will seek higher interest rates to be compensated for the additional risk of owning an illiquid asset. In addition, by limiting access to the loans they can limit or even reduce the number of interested and eligible institutional investors in the loan market. The LSTA is committed to improving the liquidity of the market and thereby creating a healthier, more mature market.
CONCLUSION
Loan market participants are urged to remember that the elements of the LSTA’s DQ Structure are carefully intertwined; changing one aspect without regard for the whole can impact its effectiveness. The LSTA views such deviations from the LSTA DQ Structure as contrary to the intention of and guidance set out in the MCAPs and notes that such deviations may undermine the overall loan market liquidity which can, in turn, increase borrowing costs. The LSTA, therefore, encourages borrowers, sponsors, agents, and lenders entering into credit agreements to carefully review the disqualified institution provisions set forth in the MCAPs and to adhere to the LSTA DQ Structure.
- The LSTA has subsequently updated and published revised MCAPs which may be found on the LSTA website. ↩︎
