The Importance of Settling on Distressed Documents as Default Rates Increase

Background

As highlighted in our previous alert, “Bank Debt Investments: The Importance of Distressed Protections as Risks of Default Rates Increase,” the vast majority of U.S. bank loans that trade in the secondary market settle on either par or distressed forms published by the Loan Syndications and Trading Association (LSTA). The distressed forms offer significantly more protection for buyers of bank debt, including representations, warranties and indemnities specifically designed to guard against certain credible risks inherent in a restructuring or a bankruptcy proceeding. In light of the recent credit impact of COVID-19 and the related market turmoil, credits that have been trading on par documents now may be sufficiently stressed that investors should consider the advantages of settling trades with the protections provided by the distressed forms. This alert sets forth key differences between the LSTA Distressed and Par Secondary Trading Documentation.

Par Versus Distressed Trading Documents 

The Trade Confirmation and Assignment Agreement

The preliminary document used for trading loans is the LSTA Trade Confirmation (Trade Confirm). Although the form Trade Confirms for par and distressed trades are similar, there are fundamental substantive differences in the standard terms and conditions that apply to these two types of trades. For instance under a par trade, the Seller is not obligated to represent or warrant that the Seller has not taken any action that would impair the loan. The transfer of loans under the par regime is settled using the form Assignment Agreement (AA) provided under the relevant Credit Agreement. The primary purpose of the AA is to transfer title of the debt in the name of the Buyer. Prior to settling a par transaction, the Buyer and Seller exchange a funding memo setting forth the consideration to be paid on the effective date.

The Distressed Purchase and Sale Agreement

One of the key differences between par and distressed trades is that the parties to a distressed trade enter into both an AA and a Purchase and Sale Agreement (PSA). Whereas an AA merely provides for the transfer of legal title, a PSA evidences the transfer of a broader bundle of rights and protections, which include: (1) a limitation on obligations assumed by the Buyer; (2) additional representations, warranties and indemnities provided by the Seller (including protection from disgorgement and equitable subordination); and (3) the Buyer’s ability to track the chain of title to claims and causes of action of prior sellers.

(1) Assumed Obligations: Under the terms of the AA, the Buyer assumes all obligations to be performed with respect to the debt from and after the Settlement Date, irrespective of when such obligations arose. Under the PSA, the Seller specifically retains all obligations arising or occurring (i) prior to the Settlement Date and (ii) from Seller’s bad faith, willful misconduct or breach. It is important to note that, in a distressed transaction, the Buyer assumes only those obligations not retained by the Seller.

(2) Representations, Warranties and Indemnities: Typically, a “distressed” borrower is one that is in bankruptcy, considered by the market to be in financial distress, or likely to default or file for bankruptcy protection. To offset the increased risks to the holder of a distressed claim, the PSA provides significant protection (in the form of representations and warranties). If a Seller breaches its representations and warranties, the PSA requires the Seller to indemnify (or make whole) the Buyer for any losses, costs or damages stemming from the breach. The most significant representation provided by a Seller is the “no bad acts” representation in which the Seller represents that it has not taken (or omitted to take) any action that would result in the buyer being treated differently than other lenders. This representation is a cornerstone in distressed loan trading, as it effectively gives the Buyer the benefit of its bargain — that it will be treated the same as other lenders generally with respect to the amount and timing of distributions.

(3) Chain of Title: What if a Buyer is treated differently than lenders generally because of a “bad act” of a party that owned the debt prior to the Seller owning it? To be protected, a Buyer must be assured that each party that previously owned the debt made the same representations and warranties as the Seller did. This is a key difference between par and distressed trading. In a par transaction, the Buyer knows only its direct Seller. However, in a distressed transaction, a Buyer will examine the entire chain of title, back to the original holder of the debt (or the earliest Seller of the debt on a distressed basis). These predecessor transfer agreements are known as the “upstream documents” and are listed in the annex to the PSA. The provision of the upstream documents by the Seller enables the Buyer to track missing payments and, since under the PSA document the Seller transfers its rights under predecessor transfer agreements to the Buyer, to demand such payment directly from the prior holder (or holders) of the loan.

Pricing and Interest Treatment

In a par transaction, settlement is intended to take place within seven business days of the trade date (T+7), whereas in a distressed transaction, settlement is meant to take place within 20 business days of the trade date (T+20). This is known as the “Commencement Date” and, for both par and distressed trades, the Buyer receives the benefit of the interest on the underlying loan from the Commencement Date until the actual Settlement Date. It is important to note that the LSTA Standard Terms and Conditions include further adjustments to provide for Delayed Compensation in the event trades settle after the expected Settlement Date.

Summary Chart

Below is a brief summary chart highlighting the key differences between the distressed and par trading documents summarized in this alert.

Conclusion

It is important to note that market practice requires that determination of the type of trading documentation be negotiated by the parties “at the time of trade.” Thus, when entering into a new trade, it is critical that loan market participants consider the full scope of differences between par and distressed documentation and whether the allocation of risk for a particular credit warrants distressed forms.