The legal perspective of mitigating risk under the Loan Syndication Facility.
The legal perspective of mitigation of risk under Loan Syndication Finance and how to effectively address the same.
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At the outset Industry-specific study conducted by North Carolina Banking Institute is duly acknowledged.
Concept of a Syndicate:
The terminology ‘Syndicate’ as per the Cambridge Dictionary[1] means “a group of people or companies who join together in order to share the cost of a particular business operation for which a large amount of money is needed”. It indicates to a lending process (financial) wherein a borrower approaches a bank or financial institute for a loan amount that is comparatively heavy and also may involve international transactions and different currencies depending on the nature of the transaction. When the bank is approached by the client for availing a loan facility, the said bank fixes up the interests and other borrowing terms and conditions of the loan with the client and themselves approaches other banks for selling of this loan facility. The other banks, if agree, “Purchase” a part of the loan facility on the same or different terms and conditions depending on the terms and conditions of the agreement. In a Loan Syndication process, the client is engaged with a singular Bank only for the facility. The bank approached by the borrower to arrange credit is referred to as the Managing Bank that is responsible for negotiating conditions and arranging the loan amount and creating the offer therein. The Managing Bank need not be the “Majority lender” or “Lead bank” but only plays the role of manager or an equivalent role of an administrator in arranging the loan amount in association with other banks. Depending on the terms and conditions of the agreement between the parties any bank can play the role of Managing Bank (subject to every agreement & nature of transaction). The lead or managing bank acts as recruiting bank of other sufficient banks in the process of producing of loan, negotiating the terms & conditions, negotiating details of the agreement and preparing documentation. The bank that is titled the mandate by prospective borrower and is responsible for placing and managing the loan process, its terms and conditions and finalizing the same is known as Lead Manager, Lead Bank, Syndicate Bank. They are entitled to arrangement fees and undergo a reputation risk during this process.
The banks that participate in process of lending a portion of total loan amount facility are entitled to receive interest and participation fees are Participating Banks.
The scope of multiple lender transactions’[2] generally fall into two categories: (A) loan participations and (B) loan syndications. The first category, loan participations, involves transactions where a lead (or originating) lender sells a part of or all of a loan to one or more purchasers. Participation, thus, can be defined as a third party’s acquisition of a specified percentage of a prearranged loan. The relationship between the parties is typically formalized by a participation agreement, which is an agreement in writing stating that the purchaser receives an undivided interest in the loan[3].
Participant entities in a Syndicated Loan
1. Managing/ Lead bank.
The lead bank is mandated by the borrower to organize the funding based facility on specific agreed terms & conditions of the loan facility. The Managing bank must acquire other lending parties who are willing to participate in the lending syndicate and share or mitigate the lending risks involved. The financial terms negotiated between the arranging bank and the borrower is contained in the term sheet.
The term sheet contains the amount of the loan, repayment schedule, interest rate, duration of the loan and any other fees related to the loan. The arranging bank holds a large proportion of the loan and will be responsible for distributing cash flows among the other participating lenders[4].
2. Agent
The role of an agent in a syndicated loan serves as a linkage between the borrower and the lenders and owes a contractual obligation to both the borrower and the lenders equally. The role of the agent to the lenders is to provide them with information, data that allows them to exercise their rights under the syndicated loan agreement. Agent is a facilitator and not a decision maker. However, the agent has no fiduciary duty and is not required to advise the borrower or the lenders. The agent’s duty is mostly administrative[5].
3. Trustee
The trustee is responsible for holding the security of the assets of the borrower on behalf of the lenders. Syndicated loan structures avoid granting the security to the individual lenders separately since the practice would be costly to the syndicate. In the event of default, the trustee is responsible for enforcing the security under instructions by the lenders. Therefore, the trustee only has a fiduciary duty to the lenders in the syndicate[6].
Risk Associated & Mitigation
1. Institutional Investment[7]
The number, size, and complexity of syndicated credit transactions have grown dramatically as lenders have shifted their focus from investment growth to both maximum returns on assets and more cautious risk diversification.[8] Consequently, syndicated credit agreements are no longer strictly composed of traditional bank to bank relationships. Today, multi-lender credits increasingly are composed of nontraditional lenders such as mutual funds, trust departments, corporate treasuries, and other institutional investors.[9] This increased institutional investment in syndicated credits has brought about two risks to banks:
(A) that institutional investors will crowd out commercial banks;
And
(B) that institutional syndicate members will compete to supply the financial services required by the borrower.
i. Crowd out commercial banks
The first risk that commercial banks are exposed to when they use syndicated credits is the threat to the management of the loan syndicate due to the increased participation of institutional investors.[10] The influx of institutional investors can make syndicated credits so risky that commercial banks will not become a part of the deal. This first effect is due to the two different approaches to investments embraced by commercial banks versus institutional investors. Institutional investors take more of a “bond mind-set” (or trading mentality) rather than a more cautious “secured mind-set” in their approach to the loan.Commercial banks, characterized by the senior secured mind-set, typically are attracted to the stability of the loan market. A loan’s value is tied to interest rates. This makes them less volatile. Since banks value their loans at face value, there is not much incentive to trade them.[11]The hallmark of this mind-set is the buy-and-hold strategy, a risk adverse strategy that does not require active maintenance of the investment this is in contrast to the bond mindset, characterized by investment banks and fund managers, who are accustomed to pricing the value of their investments daily against the market opportunity to buy or sell to balance their portfolios. Market volatility is desirable, and thus institutional investors are more risk tolerant. If institutional investors become a majority of the syndicated credit agreement, this position could give them the votes necessary to control the future of a deal. Many bankers are “loath” to allow these nontraditional institutional investors to take control of a lending group: “the fear is that the investors will force bankers to remain committed to transactions with which they are uncomfortable.”[12]
For example, if institutional investors gain control of more than 50% of a syndicated loan, syndicate members should be concerned about the fate of the syndicate in case of default. Typically, if a borrower defaults, the result is acceleration by the syndicate members of all outstanding borrowings and immediate nullification of the syndicate’s commitment to lend. However, most standard credit agreements provide that the borrower is not in default until the agent declares to the borrower that the occurrence is an event of default.” An agent bank often may not declare default without first obtaining permission of a majority or all of the syndicate members, depending on the specific agreement. Thus, if disputes arise among lenders, bankers versus institutional investors, concerning the correct course of action, the result may delay or thwart a lender’s need to act quickly and decisively.
Another effect of the influx of institutional money may cause a paradigm shift in how loans are valued. Institutional investors’ trading mentality could change the market for syndicated loans drastically. As loans on the secondary market become more liquid, trades will become more frequent and prices will become more accurate. This will make it easier to judge the value of a loan as determined by the market (which institutional investors desire),”’ not its face value (which bankers are accustomed to using). Smaller banks, which do little or no secondary trading, might suffer the most. Thus this is a fair risk situation which not only has to be looked into on a prima facie level but also incorporated on a contractual basis.
ii. Increased Competition
Another more subtle structural risk faced by banks of increased involvement of institutional investors is increased competition for financial services. The syndicate members each have a direct relationship with the borrower. An agent, or any member of a syndicate, that had an exclusive relationship or even a preferred relationship with the borrower before the syndicated credit might find it difficult to maintain. [13]Syndicate members ultimately may have to compete among themselves for desirable business from the borrower. Thus, the agent may be personally introducing the competition to its customers. By including institutional investors in syndicated transactions, banks are running the risk of graduating their own clients into these other firms. As unregulated non-banks begin to offer more diverse financial services, this impact of this risk has potentially far-reaching consequences for bank’ maintenance of market share. Banks can overcome the problems created by institutional investment with the right management. First, a bank’s risk management structure should anticipate future economic problems. The syndicated credit transactions that banks underwrite should be “consistent with its long-term strategic portfolio objectives and the level of risk the bank is willing to tolerate over the long run.” Thus, when considering syndicated lending, a bank must weigh the inevitable influx of institutional investors and the concomitant challenges, increased competition and loss of control of the syndicate. Also, banks should structure “compensation systems for the lending area (which would) reward the kind of behavior that is consistent with long-term credit quality objectives.” Second, a bank’s credit culture should “reflect the standards and values of the board of directors and senior management.” Thus, lenders should be wary of purchasing loans that are based on underwriting standards set by another syndicate member that are significantly different from their own internal criteria. To assure compliance with the bank’s credit culture, the OCC recommends that a bank’s senior management and the board “should periodically assess whether employees’ understanding if the bank’s credit culture, and their resulting behavior, conform with the desired standards and values for the bank.” Additionally, independent audit and internal loan review functions could help in this assessment.
2. Easing of Credit Terms
Additionally, the great influx of new entrants in the syndicated credit loan market has increased competitive conditions which have “encouraged an easing of credit terms and conditions in both commercial and consumer lending. A prospering economy has shored up weak credit terms, allowing banks to survive the weaknesses in their loan agreements while the economy is good. One example of this is the lack of covenants in the syndicated credit agreements. Most banks make a decision to extend credit to a borrower based on the borrower’s credit rating and business prospects. Thus, throughout the term of the loan, a prudent bank will want to enact certain restrictions on the borrower’s business to maintain the continued good health (repayment ability) of the borrower.’ These restrictions are designed to ensure that a borrower maintains a sufficient operating cash flow to amortize any borrowings, a credit status that stays at a level which banks feel is commensurate with the loan commitment, and sufficient assets to remain a viable entity throughout the entire term of the loan. These goals are achieved through contractual covenants.”’ Therefore, the absence of this credit term in syndicated credit agreements leaves the very repayment ability of the borrower undermined, exposing the syndicate members to possible financial loss[14]. Syndicate members should also plan for changes in tax increases, new laws, new regulatory capital rules, or new reserve requirements that may arise after the syndicated credit agreement is entered into by including a protective credit term. Prospective thinking concerning the administrative segment in a portfolio can help syndicates establish predetermined courses of action. Thus, syndicates can avoid the unpleasantness of having to negotiate a new term in a time of crisis, and after the original deal has been completed, which drastically reduces the syndicates’ bargaining power. To insure a certain profit from the transaction, an agent should put in the loan agreement a credit term that borrowers absorb these additional costs. Active loan portfolio management can avert some to the risks presented by loose credit terms, allowing banks to remain competitive while protecting against risk. Active loan portfolio management views management in terms of the entire portfolio, as opposed to a more traditional approach of individual loan oversight, in managing overall credit risk.. A primary goal of active loan portfolio management is to control the strategic risk associated with lending.’ Poor strategic decisions about “underwriting standards, loan portfolio growth, new loan products, or geographic and demographic markets” can jeopardize a bank’s future. Active loan portfolio management can help minimize the risk of inadequate credit terms that banks undertake when participating in a syndicated loan. It is broken down into three phases: planning, acquisition, and monitoring and review. The first phase is portfolio planning. Instead of making decisions on a transaction by transaction basis, loan decisions would be made in accordance with a bank’s ideal portfolio. Using a planning effort involving the line business units, senior management, and board of directors, a bank would determine its ideal portfolio. It would establish the markets it wishes to target, volume and types of credit it is willing to offer, and prices it will charge up front. The ideal portfolio would be the “measuring stick” that all other potential transactions would be evaluated against prior to making any lending decisions and credit terms would have to comport with it. Bank’s lender and marketing personnel, armed with this information, could look for credits that meet the established criteria. More importantly, the established criteria can reign in lending and generous credit terms during a positive economic environment. The second phase in portfolio management is portfolio acquisition. In this phase, the bank will use some tools, such as facility and obligor grades, quantitative models, pricing models, and industry and geographic analysis, which assist in the underwriting process and provide data that is critical to the ongoing management of the portfolio. It identities areas that are vital to the bank’s survival, allowing bank staff to drat credit terms with this in mind. The more detailed analysis, the better information it provides upon which banks can base their decisions.[15] where a bank compares its existing portfolio with the portfolio it intends to acquire. When the actual portfolio differs from the planned portfolio, a bank should investigate the cause(s) of the variance. “‘ Any variances from the bank’s established policy, whether in the actual lending or just the credit terms of a loan agreement, that could have a material impact on the bank should be brought to the attention of the bank’s senior management and board. Further, the OCC advises that banks should have systems in place to analyze and control exceptions to their lending policies. These systems should be implemented in this final stage of the loan.
3. Internal Controls
A third risk presented by syndicated credits is that a bank does not have the infrastructure necessary to compete successfully in the syndicated loan market. New entrants are rapidly entering the syndicated loan market. Those that wish to be successful cannot underestimate the necessity of having adequate internal mechanisms to thrive in the syndicated market. Clearly, as competition increases, industry recognition and reputation will be vital for an agent’s continued survival in the syndicated loan market. Adequate internal infrastructure can help banks gain that recognition and reputation. Typically, weak internal controls are marked by two deficiencies: inadequate staffing and inadequate management information systems. Other problems such as change of political scenario or force major could be resolved by effective change in the policies.
Conclusion
Banks and the customers need to address the risks associated with syndicated credits. Incorporating due clauses in the agreements thereby acknowledging the risks involved will not only reduce a bank’s risk level, but also increase a bank’s ability to attract and retain customers.
[E]nd Notes
[1] Cambridge Dictionary, available at : https://dictionary.cambridge.org/dictionary/english/syndicate.
[2] For treatment of issues surrounding multi-lender transactions not addressed by this article, see W. Crews Lott et al., Multiple Lender Transactions: Current Issues, 112 BANKING L.J. 846 (1995) (including Uniform Commercial Code considerations, the inclusion of exculpatory clauses, and discussion of relevant case law).
[3] More banks want to enter the syndicated credit market, and are competing with established leaders for the same number of deals. For more explanation, see Too Much Money is Chasing Business, LLOYD’S LIST INT’L, Oct. 28, 1997, at 12 (analyzing competition among banks for syndicated loans in the shipping industry).
[4] See, Syndicated Loan, available at: https://corporatefinanceinstitute.com/resources/knowledge/finance/syndicated-loan/.
[5] Id
[6] Id
[7] Megan E. Jones, Bankers Beware: The Risks of Syndicated Credits, 3 N.C. Banking Inst. 169 (1999). Available at: http://scholarship.law.unc.edu/ncbi/vol3/iss1/10
[8] See OCC Advisory Letter 97–3, Credit Undenvriting Standards and Portfolio Credit Risk Management, [Vol. 6 Transfer Binder] Fed. Banking L. Rep. (CCH) 73,271, at 73,274 (Mar. 11, 1997). Banks are now focusing on managing exposure and on return rather than on credit issues. See id. This trend is caused by the reality of today’s market: there is more demand for high-yield commercial paper (short-term unsecured promissory notes of a prime corporation) than there is a supply of investmentquality transactions.
[9] See Mahua Dutta, Institutional Investors’ Rush to Bank Loans Poses a Puzzle for Banks, AM. BANKER, July 23, 1997, at 12.
[10] See OCC Advisory Letter 97–3, supra note 94, at 73,271
[11] Id
[12] Dutta, Institutional Investors’ Rush to Bank Loans Poses a Puzzle for Banks, supra note 95, at 12
[13] See Hirshfield, supra note 20, § 10.03[5][a]
[14] See id. See also Chase Amends Bruno’s, 12 BANK LOAN REP. 37, Sept. 15, 1997, available in 1997 WL 11236726 (discussing that as agent of Bruno’s Inc.’s syndicated credit agreement, Chase Manhattan agreed to an amendment and waiver of certain financial covenants which will permit Bruno’s to use up to $200 million under the revolving credit portion of its bank credit facility, despite declining sales)
[15] For example, a bank that uses a 10-point grading system and the analysis that can be derived from it is far more informative than a grading system that uses more vague categories of pass, special mention, substandard, doubtful, and loss. And, industry analysis that attempts to correlate the performance of different industry segments is much more useful than a standard industrial classification (SIC) listing.
