The leveraged loan market has been significantly impacted by COVID-19 with waves of defaults, bankruptcies and ratings downgrades. In March of 2020, the average bid level for leveraged loans fell below 80 for the first time since July 2009.1 Although market prices began to recover in April, the average loan price still remained at 85, a considerable decline from 96 at the start of 2020.2 Rating agencies have indicated that the defaults may rise in 2020 to near 2009 levels.3 In these uncertain times, we want to remind market participants of some issues to be mindful of when trading loans in the secondary market, particularly in distressed situations.
This is the first installment of a multi-part series of client alerts designed to ensure that participants in the secondary loan market safely and efficiently navigate the road ahead.
The Loan Syndications and Trading Association, Inc. (the “LSTA”) publishes standard documentation to trade leveraged loans as either par/near par or as distressed. At the time of trade, the parties to the trade determine whether a particular leveraged loan should be traded as par/near par or as distressed based upon an analysis of the credit facility and the financial condition of the borrower. In turbulent times, when the risks of defaults and bankruptcies are high, market participants should be aware of the shift date when deciding whether or not to trade on par near/par or distressed documentation. The LSTA has established Shift Date Rules, which sets forth the LSTA’s process for determining if market convention for trading a loan has “shifted” from trading on par/near par documents to distressed documents. The LSTA publishes these “Shift Dates” upon the request of its members, after reviewing trade data and/or additional public information. Once the Shift Date determination has been published by the LSTA, it is binding on parties trading on LSTA documentation.
Once a Shift Date indicates a loan has shifted to trading distressed, parties will typically trade that loan on LSTA distressed documents. However, if parties have already agreed to trade a loan on LSTA par/near par documents prior to a Shift Date determination, that loan will still settle on LSTA par/near par documents, regardless of when the shift occurs.
Market participants should be mindful of the risks of settling distressed trades on par/near par documentation after the Shift Date and establish protocols to monitor loans which may shift to distressed to ensure that they are entering into trades on the proper documentation. In particular, in circumstances when a loan shifts to distressed after the trade date where parties have already agreed to par/near par documentation, the parties, and in particular the buyer, should understand the implications of settling trades on par/near par documents after the Shift Date.
When a loan trades and settles on LSTA distressed documentation, the buyer receives the benefit of the robust protections built into the LSTA’s distressed documents. In particular, the seller makes a number of representations and warranties thereunder, including with respect to the chain of title and a “no bad acts” representation in which the seller states that it has not engaged in any act or conduct (or omissions thereof) that will result in the less favorable treatment of the buyer than other lenders. The seller also provides an indemnity to the buyer for its breach of any representation and warranty. In a bankruptcy scenario the seller’s representations and warranties and indemnity are especially relevant because the bankruptcy court has the power to equitably subordinate a transferee of a claim based on the conduct of a transferor.4
When a buyer sells a loan downstream after the Shift Date, the buyer will provide those same representations and warranties and indemnity, as a seller in such subsequent trade. If the loan was settled on par/near par documentation after the Shift Date, the seller will be expected to provide the buyer with customary “step-up” provisions, which include representations and warranties on behalf of prior sellers to cover the representations and warranties which would have otherwise been made by such prior sellers for the period from Shift Date through the settlement date had it settled on distressed documentation. Since loans that settle on par/near par documents do not include representations and warranties as to the chain of title, a buyer has no way of knowing the identities of the prior sellers in the chain of title. If a buyer subsequently sells the loan downstream and is required to provide step-up representations to its buyer, then such party may be providing those step-up provisions on behalf of multiple prior sellers. The more prior sellers with respect to which a seller must provide step-up provisions, the more risk such seller bears. A longer period from the Shift Date to the settlement date will bring with it more risk, both in the length of time the step-up provisions cover, but also the potential for a greater number of prior sellers being covered.
Therefore, market participants should be mindful of the factors that impact a Shift Date determination. If a loan buyer believes that a loan is at risk of shifting to trading under distressed documentation, and particularly if a default or bankruptcy is imminent or such buyer is aware that other market participants are trading a particular loan using distressed documentation, it should consider trading the loan on distressed documentation.
If you would like additional information about this or any other matter, or wish to discuss distressed debt and claims trading further, please feel free to contact your Seward & Kissel relationship attorney.