Borrowers purchasing their own debt - Key issues

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Introduction

The opportunity has arisen for borrowers to take advantage of the falling market price of debt held by lenders, including those operating in the leveraged loan markets, by purchasing their own debt. They may do this either directly by disclosed assignment or novation (or undisclosed assignment), or gain an economic exposure to the debt indirectly by way of sub-participation, total return swap, a trust arrangement or other more structured methods. Besides the obvious financial benefit which would accrue if any debt is purchased at a discount to par, other benefits (such as voting rights) may also be acquired which may be strategically important for the Borrower. There has been much debate in the market in recent weeks regarding whether this activity is permissible.

This paper identifies the principal issues which arise in these circumstances. Whether a buy-back breaches the terms of a loan agreement depends on the wording of the agreement and the method by which the buy-back is undertaken. The analysis below is based on the standard LMA leveraged finance Senior Multicurrency Term and Revolving Facility Agreement (and defined terms used in this paper refer to that document).

Broadly, the circumstances in which a debt buy-back takes place and the issues which arise in each may be summarised as follows:

a) where the Borrower itself undertakes the purchase - the Borrower must consider (i) whether it is a permitted transferee under the loan agreement, (ii) is there a merger of rights and obligations, (iii) should receipts under the loan agreement be shared, (iv) what are the methods of funding the transaction and (v) other restrictions (such as covenants and events of default) imposed by the loan agreement.

b) where another member of the Borrower's Group undertakes the purchase - many of the issues set out in (a) above arise here too (other than issues of merger and sharing of receipts) particularly given that covenants (and events of default) are generally made on a group-wide basis.

c) where a third party undertakes the purchase - as the third party may be a financial institution or other entity outside of the Borrower's group most of the issues noted in (a) and (b) above may be avoided, although the direct benefit of the purchase may not immediately be obtained by the Borrower; for example, the debt will remain outstanding and will therefore have to be serviced in the normal way.

In each case, the UK tax implications are complex and must be fully considered prior to any buy-back.

Purchase by way of a novation

Transfer restrictions

One immediate issue which any Borrower wishing to purchase its own debt must deal with are the restrictions on transfer contained in Clause 29 of the Facility Agreement.

Clause 29.1 provides that a Lender may assign any of its rights or transfer any of its rights and obligations under any Finance Document to “another bank or financial institution or to a trust, fund or other entity which is regularly engaged in or established for the purpose of making, purchasing or investing in loans, securities or other financial assets”.

Unless the Borrower or other member of the group wishing to purchase the debt is therefore an entity which is either a financial institution or is regularly engaged in investing in loans, then it will be barred from undertaking the trade.

In The Argo Fund Limited v Essar Steel Limited [2006] EWCA CIV 241 it was held that for the purpose of restrictions on loan transfer, the entity need only be a legally recognised form or being, carrying on its business in accordance with the laws of its place of creation, whose business concerns commercial finance. Except in limited circumstances, this provision will prohibit the Borrower (or other members of the Group) from purchasing the debt. It should be noted that the definition of permitted transferee was extended by the LMA some time ago so as to include new market participants, although it would seem unlikely that in normal circumstances a Borrower will be able to able to comply.

If the Borrower (or another member of the Borrower's group) is unable to purchase the debt itself by virtue of this provision other methods of transferring the economic benefit (namely sub-participation, trust and total return swaps) should be considered. As an alternative it may be possible to use an existing (or to create a new) “debt buy-back” entity in the group if it is established “for the purpose of making, purchasing or investing in loans, securities or other financial assets”.  Care would be required in establishing this entity as if a new company is created the creation must be for either a Permitted Acquisition or a Permitted Transaction. The former definition, for instance, provides for the incorporation of a company provided it is incorporated in a given jurisdiction with limited liability, its shares are owned by an Obligor and security over the shares of such company are provided to the Security Trustee within 30 days of the date of incorporation. Otherwise the Borrower would breach Clause 27.8 of the Facility Agreement which prohibits the incorporation of a company by an Obligor.

If such a company is incorporated or an existing entity is used, it should also be borne in mind that:

i) it may fall within the “Material Company” definition and as such must become a Guarantor under Clause 30.4 of the Facility Agreement; and

ii) being the New Lender, it should be a Qualifying Lender for the purposes of the tax gross-up.  If not, the gross-up and tax indemnity will not apply to it.  Indeed, the LMA Transfer Certificate generally requires the New Lender to confirm that it is a company resident in the UK for UK tax purposes. Similarly, know your customer checks will need to be made. Therefore, the provisions of each loan which is the subject of a proposed buy-back should be reviewed with care.

Merger of claims

To the extent that the Borrower is able to undertake the purchase using the transfer provisions in Clause 29 of the Facility Agreement, immediately upon the acquisition taking place, the debt acquired will, by operation of law, merge with obligations owed by the Borrower and will be extinguished. This leads to the issue of whether, in law, this will lead the extinguishment to be re-characterised as a prepayment under the Facility and therefore subject to the sharing provisions contained in the Facility Agreement. Further, to the extent that the assignment or transfer does constitute a prepayment, the provisions contained in Clause 11 of the Facility Agreement must be observed.

To the extent that a different legal entity (for example, an affiliate of the Borrower) purchases the debt, the doctrine of merger will not apply and the debt will live on (and be subject to the terms of the Facility Agreement in the normal way albeit with interest and other moneys payable being paid to the new Lender, i.e. the affiliate of the Borrower).

Sharing

If the doctrine of merger does apply, an issue which arises is whether the sharing provisions also then apply to the transaction. Clause 33 of the Facility Agreement provides that if a Finance Party “receives or recovers any amount from an Obligor” other than through the normal payment mechanics under the Agreement and “applies that amount to a payment due under the Finance Documents” then it is obliged to notify the Agent, and within three Business Days of demand by the Agent, pay to the Agent an amount equal to such receipt or recovery less any amount which the Agent determines may be retained by it as its share of the payment. The Finance Party which has been forced to share is then able to subrogate itself to the rights of the other Finance Parties which have shared in the redistribution.

In the (unlikely) event that any debt is directly acquired by the Borrower, which is then merged and thereby cancelled, it would clearly be open to the other syndicate Lenders to argue that the Borrower (in its capacity as a Lender) had received or recovered an amount other than by way of the normal payment mechanics under the Facility Agreement and therefore the Borrower (being a Finance Party for this purpose) should pay a proportional amount of the retired debt to the other Finance Parties. Whether this is a correct interpretation of the Facility Agreement is however open to question. For instance:

i) has the Borrower “received or recovered an amount from an Obligor” by merely purchasing the debt thereby allowing the doctrine of merger to apply so as to cancel the debt by operation of law?

ii) has the Borrower “applied” the amount to a “payment due under the Finance Documents”? Firstly, unless an Event of Default has occurred pursuant to which the Agent has accelerated the Facility no amount under the Facility will be due at that time save (i) for revolving loans at the end of their Interest Period, interest and fees which have become due, or (ii) where the merger of the debt claim is re-characterised at law as a prepayment of all or part of the Facility (see above). Secondly, it is arguable whether elimination of debt by means of merger constitutes “applying” that amount as required under the Facility Agreement.

Where the sharing provisions do apply, the economic purpose of acquiring the debt by the Borrower will be defeated. It is of course open to the other Lenders to argue that crafting a way around the sharing provisions is not, in any event, in accordance with the spirit of the document although it is questionable where such argument actually leads. In view of this however, any Borrower intending to undertake a debt buy-back, should also consider the reputational risks associated with the transaction, as indeed should any bank proposing to intermediate the purchase on its behalf.

Merger/Sharing - Tax

The UK tax implications of a merger will also have to be analysed in some detail.  Generally in such a situation the tax should follow the accounting treatment and, provided care is taken in documentation and execution, one would not expect an adverse tax impact on the Lender or the Borrower. 

In the more likely event that an economic exposure to any debt is acquired by an indirect route, the sharing argument is likely to have little force. If a merger does not take place, and the debt is acquired by a party connected (a wide definition) with the Borrower, it should be borne in mind that careful structuring will be required to ensure that neither party's tax position is prejudiced.

Funding the deal

Any acquisition of debt must be funded either from free cash or by incurring further indebtedness. In the case of free cash, it is often the case that the loan agreement will restrict its use so the Borrower or other member of the Group undertaking the purchase must bear any restrictions in mind. To the extent that further debt is used, the Borrower (and other members of the Group) must comply with the Financial Indebtedness covenant in Clause 27.23 of the Facility Agreement. This restricts the incurrence of Financial Indebtedness by members of the Group, save for Permitted Financial Indebtedness or Financial Indebtedness for a Permitted Transaction. The provision of further Financial Indebtedness will be generally prohibited save for the de minimis basket within the Permitted Financial Indebtedness exception which is likely to be of little assistance. Similarly to the extent that security is required for any additional indebtedness , the negative pledge in Clause 27.15 of the Facility Agreement will prohibit the Borrower and members of the  Group from providing security for any further indebtedness, once again save for any de minimis basket agreed within the definition of Permitted Security.

Note that if a member of the Borrower's group which falls outside the scope of the “Group” (as defined in the Facility Agreement) borrows the money to on-lend to the Borrower so that it can effect the purchase, that loan or security should not be caught by the restrictions on indebtedness noted above.  Some relatively straightforward structuring should enable this requirement to be circumvented.  However:

i) any loan provided to the Borrower by such entity is likely to be caught by the terms of an intercreditor agreement which will subordinate such intra-group claims to the Senior and any Mezzanine debt;

ii) the question of corporate benefit of the affiliate lender must be addressed in order for the loan to be made; and

iii) the Borrower and other members of the Group will not be permitted to provide guarantees in respect of such debt in view of the restrictions in Clause 27.19 of the Facility Agreement.

Financial covenants in the Facility Agreement (see Clause 26) must also be considered if the Borrower (or another member of the Group) intends to borrow moneys (from whatever source) in order to fund the acquisition of existing debt. To the extent that moneys are borrowed from banks or financial institutions this will have an adverse affect on the ability of the Borrower to comply with Cashflow and Interest Cover ratios in that Finance Charges will increase as a result of the new borrowing. Similarly the Leverage ratios will also be pushed higher with the new indebtedness which is incurred. Even if finance is provided by another member of the group falling outside of the Group definition, the Leverage ratios remain affected by the new borrowing (although the Cashflow and Interest Cover ratios will not unless the group entity providing the finance is itself a bank or financial institution).

The UK tax aspects of a loan from a connected company to buy back the debt would have to be considered on the precise facts.  It is likely that a transfer pricing analysis would need to be undertaken.

Other issues

One final issue to be aware of is whether Clause 28.6 of the Facility Agreement will apply in circumstances where the Borrower (or any member of the Group) makes an initial approach to any Lender to purchase the debt. This Clause provides that an Event of Default will arise  where any member of the Group commences negotiations with one or more of its creditors with a view to rescheduling any of its indebtedness.  Although we consider that such an action is unlikely to succeed in a debt buy-back transaction (given the specific language of Clause 28.6 of the Facility Agreement), this provision is open to interpretation and it is arguable that negotiating the purchase of debt with a view to such debt being retired may fall foul of it. Care should be taken however, particularly if the clause refers not only to formal processes for a cooperation with creditors but also informal “steps” being taken with a view to any form of rescheduling. This provision will not bite on the acquisition of debt if made by an entity outside the “Group”, or by a third party.

Other methods of getting the benefit: intermediation, sub-participation (funded), total return swap (collateralised) or trust

The issues outlined above may be significantly reduced or avoided if neither the Borrower nor other members of the Group purchase the debt themselves.

If, for example, a financial institution (or other third party) purchases the debt and sub-participates the risk (presumably on a funded basis) to the Borrower, the transfer should not be prohibited and no merger of the debt should occur (meaning that the issue of sharing will not arise).  A similar outcome may be achieved by a fully collateralised total return swap.  Another alternative would be for a financial institution to purchase the debt and declare a trust over the debt claims for the benefit of the Borrower.

Finally, as noted above, it may be possible to use an existing (or create a new) “debt buy-back” entity in the group which may avoid any immediate restrictions on transfer contained in the Facility Agreement (be being established specifically “for the purpose of making, purchasing or investing in loans, securities or other financial assets”) although other limitations in the Facility Agreement (not least the restrictions contained in the Facility Agreement which generally prohibit the incorporation of companies by any Obligor) may apply which restrict the application of this alternative route.

Whichever route is chosen, there are certain structures in the market which should produce the required economic, legal and tax results. Again it should be noted that unless free cash is used for the acquisition (i.e. to fund the participation, collateralise the swap or put the trustee in funds), indebtedness will need to be incurred which may breach the indebtedness covenants and financial covenants as noted above. The terms of any intercreditor agreement and other Finance Documents must also be considered on a case by case basis.

Conclusion

The acquisition of debt by debtor companies has become attractive given the reduction in market price and the consequential economic gain which is available. Other benefits of acquiring debt, such as voting rights, may also be of strategic importance and have incentivised Borrowers to examine their positions. There is also interest being shown on the lender side, with new financing opportunities and intermediary positions arising from debt buy-backs.

Law firms have taken opposing positions as to whether debt buy-back is possible. Some (who generally act for lenders) have argued that the provisions of the Facility Agreement prohibit such activity, whilst others consider that it is possible, provided it is undertaken properly. Given the difficulties which arise under the Facility Agreement and the legal uncertainties of undertaking a buy-back if the Borrower itself or other members of the Group acquire the debt, from a practical perspective it is unlikely that this will be the most appropriate route to follow. The alternative methods of “acquisition”, being principally funded sub-participation and collateralised total return swaps should therefore be considered by any entity intending to purchase debt, although again, the terms of the Facility Agreement and other Finance Documents, any applicable regulatory restrictions and tax issues should all be carefully considered before undertaking the trade. 

With careful structuring and full consideration of the issues which arise, it should be possible to proceed.

For further information, please contact Trevor Wood at trevor.wood@blplaw.com; Mark Daley at mark.daley@blplaw.com; or Michael McKenna at michael.mckenna@blplaw.com.