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In an increasingly borrower-friendly market, 9fin has reported on technologies — including voting and concentration caps and lender DQ lists — aimed at controlling who can purchase debt, and how much of it they can own.
Whenever we hear one of these provisions clear the market, however, a chorus of sources reach out to say it’s just noise. “Good luck on enforcing it!!” one lawyer emailed.
While we potentially wait for an answer on the legal enforceability of each provision by way of a court challenge — which to the best of 9fin’s knowledge no case on the matter is even pending — or even a prevailing market view, we considered who is actually on the hook to make sure these technologies are upheld.
The likely parties on the hook are likely either the bank syndicating the loan, lenders selling or entering the debt, or sponsors consenting to the assignment of their debt. Yet, it is unclear if any party will take complete ownership of this process and claim the role of “enforcer.”
Banks say: “Not us!”
One leveraged finance banker told 9fin:
“We tend to be very focused on, as an agent on the deal and regarding the trading activity, whether we have language in place in the credit agreement defining the obligations of [the bank]. If the cap is 20%, we focus on whether [the bank] is assuming any risk or obligation to track that information or be responsible for notifying a sponsor if that threshold has been hit.”
The banker was referring to voting caps, which limit the total amount of an outstanding loan any individual lender can vote. After the loan is syndicated and sold to CLOs, trading could bump an individual lender to hold more than the cap permits them to vote.
The same logic could be applied to concentration caps. The banker added:
“Being able to track that ownership would be a very tall task for us and difficult to enforce. When we see this language, we focus on making sure those guard rails are in place so that we are not exposed to risk when trying to be flexible for our sponsor regarding the voting cap share.”
We spoke with predominately lender- and borrower-side lawyers who reiterated this sentiment. In most deals with the language, “the agent specifically disclaims their responsibility” to enforce the caps, Paul Hastings partner Jennifer Daly said.
This language is typically included under the “Successors and Assigns” section (or a similarly titled section) of a credit agreement. For example in iHeart’s term loan due 2029, in reference to assignments to lenders on a DQ list, the credit agreement states: “The Administrative Agent shall have no responsibility or liability for monitoring or enforcing the list of Disqualified Lenders or for any assignment of any Loan or Commitment or for the sale of any participation, in either case, to a Disqualified Lender. (emphasis added).”
Now that banks are explicitly not responsible, enforcement is left up to the lender and borrower/sponsor.
Self-policing lenders say… whatever they want
“Under most credit agreements, the lender, when they enter into the assignment, has to rep that they’re not holding whatever the cap is, so in those cases, I think the responsibility falls on the lender,” Daly said.
Should the lender misrepresent their position, in many cases they are disenfranchised for the amount the own above the cap, but in some cases they could become a defaulting lender or deemed in breach. This could affect their entire loan position, not just the position in excess of the cap, Daly added. This elevated risk could give lenders pause before entering agreements, which adds to the self-policing mechanism.
What sponsors don’t know can’t be enforced upon
Lender voting caps are easier for the sponsor to police itself, as any conceivable action — for example, an assignment or an amendment vote — would require the sponsor’s knowledge.
Sources agreed that enforcement comes from signing assignment agreements — documents signed by lenders and sponsors at close. This would put the final onus of enforcement on sponsors, where, by signing the document, they agree to settle the trade. Although borrowers do not always have to explicitly consent to a trade — sometimes credit agreements provide that “the Borrower shall be deemed to have consented to any assignment of Term Loans unless the Borrower shall have objected thereto within five (5) Business Days after having received written notice thereof” (language that can be seen in iHeart’s credit agreement) — this likely would not remove the onus from the borrower.
Additionally, concentration caps and lender DQ lists, however, pose further difficulties if lenders work to conceal movements.
“The reality is, DQ lists don’t stop many distressed players from purchasing loans,” Jason Mudrick, founder of Mudrick Capital Management, told 9fin this summer. He described how his firm can become the economic owner of the loan by trading on participation, adding that he can accumulate loans — and potentially build a large position — without the sponsor’s knowledge by leaving trades open.
A scenario like this, another lawyer said, would pose a real challenge to a sponsor looking to keep track of its debt.
“If not a settled trade but put or participation of synthetic exposure, the sponsor has no way of policing it,” the lawyer said. “A self-disclosing, day-by-day regime to track participation would be unworkable. Even if agents were attempting to collect that, you wouldn’t trust you have the right information on the right day.”
Relying on the kindness of people you’ll see again and who will want something from you
This results in a three-part enforcement mechanism, the lawyer added. In the first instance, the cap would be self-policed by the lenders. In the second, the sponsor would not agree to close trades that violate the cap. The third mechanism — occurring if lenders do not self-police and the sponsor does not know about the trade — is reputational harm.
The reputational harm aspect would come into play in a situation where lenders holding more than allowed under the credit agreement take an action that could potentially move the market to the detriment of other holders before corrected. For example, consider a credit agreement that only allowed any one lender to hold 20% of the loan. If a lender somehow managed to obtain 30% of the loan, and then relying on that concentration had, in theory, the 30% needed to direct an agent to call an event of default, which then caused the loan — and potentially the entire capital structure — to trade down before the sponsor had the opportunity to force this lender to dispose of any holdings above the cap, other lenders in the capital structure and additional sponsors would not look kindly on that lender in the future.
In a market where most participants plan to continue working together on future deals, it would be rare for a lender to make it to the third instance. Pushing the envelope, which could cause the debt to trade down, would be a reputational risk likely not worth the reward, the lawyer said.
If the three mechanisms fail and the lender successfully builds a position in excess of the cap, it is unclear who then would be liable for enforcement (although, not the agent). We will certainly be watching if the scenario occurs.
