Governing Interest Practice

A - Choice of Law

In practice, in the case of a lender having its offices, in for example, London or the United States, the governing law of the agreement will probably be English law or the law of the State concerned in the United States. Although in theory there is no objection to choosing any law as the governing law, lenders in practice prefer to choose the system of law with which they are familiar or in which they have sufficient confidence. Borrowers may sometimes find themselves in a situation of no-choice; in a market dominated by demands for loans, lenders may be in a position to impose their choice even in respect of the governing law. This would imply that in the case of loans from syndications, the principle of the freedom of the choice of law of contracting parties may not be maintained. Choice of a neutral law, such as the general principles of law, may be regarded as an alternative to the traditional practice, and would maintain the freedom of parties as to the choice of law. English Law and New York Law tend to be considered to be such neutral laws and English law is often the law of choice in most international commercial contracts. England is also considered to be the international centre of arbitration and for these reasons if a dispute arose it would be much easier to resolve.

If the Mexican government are about to put moratorium on the loan than it will of course be preferable that it is not governed by Mexican law as it will prove more difficult to bring moratorium if it is governed by the law of Mexico .

B- Security Interests .

This raises a couple of issue. The first thing to note is that the lead manager has certain duties to the other members of the syndicate. On one hand, it implies the duty to avoid a conflict between the personal interest of the Agent and the interest of the syndicate. This is especially crucial where the Agent subsequently develops some other form of relationship with the sponsor, such as being its financial advisor or becoming a lender in another context. The Agent is also required by law to fulfil his duties to the syndicate with skill, care and diligence to the standards of a reasonable man and would be liable to his principal in Agency. He also has a duty to disclose information such as the CMG requesting that only wish BFT to have the power of calling default and not the whole syndicate. The lead manager would also have to disclose information such as the fact that the transactions proposed by CMG are likely to be security interest irrespective of the governing law.

It is imperative for a well-designed syndication agreement be extensively worded to cater adequately for the needs of all the lenders to the syndication agreement. The importance of exculpatory clauses in this regard, cannot be over-emphasized. Similarly, the relationship between the co-lenders within the Agreement should be governed by equity, adequately balancing the interests of majority lenders with the minority. Situations of default, syndicate democracy and loan transfers constitute the trial period for the determination of the sufficiency of the syndication agreement. A well-drafted Agreement would ensure minimum friction, even in these situations.

Security is important to the loan agreement as it is probably the most familiar example of the surrender of a property right by a borrower to his lender. Its purpose and effect is to make available to the lender in the insolvency of the borrower a particular property or fund to the exclusion of the other creditors. It is accordingly a major exception to the pari passu rule. Therefore if many security interests are created, this means in the event of a default and or insolvency by the borrower the money is going to be difficult to recover. It may be important at this stage for the lead manager to arrange some security for the loan as the security relationship is essentially a trust relationship and will be subject to the general principles of equity and these may vary as between the participants themselves, depending on their respective status of knowledge and notice of matters affecting the security and to some extent the loan itself. Alternatively it may be that a restrictive covenant is placed on the agreement .i.e. a negative pledge restricting creation of security, restrictions on incurring financial indebtedness and entering into sale and leaseback transactions, prohibitions on asset disposals, restrictions on making loans and giving guarantees, prohibitions on mergers, acquisitions, or investments in business or shares, restrictions on changes in business, restrictions on payment to equity and redemption of equity and issuance of new shares, requirements to maintain appropriate insurance and prohibitions on amendments to key documents.

C - Set off in Default

The senior loan will generally require prepayment in the event of a public offering, a flotation or a listing or significant business sale (whether or not a change of control occurs). These provisions and their cost implications must be reviewed in light of the venture capital investors exit strategy. The arrangers may argue that the early prepayment fee is market standard and is a commercial requirement of both the original and potential syndicate banks.

Events of default are primarily designed to permit the agent (usually on instruction of the majority banks) to accelerate outstanding debt and/or to enforce security prior to scheduled maturities. With regard to loans, they also allow the agent to place loans on demand, cancel commitments, suspend further drawdowns and require cash cover for letters of credit or other contingent liabilities of the syndicate banks. The arranger will usually not have too much difficulty accepting "market standard" exceptions and materiality qualifications and, in addition, in relation to the breach of covenant and misrepresentation events of default, appropriate cure periods for the borrowers to remedy such default before an event of default occurs. These terms proposed by BFT obviously do not follow the market standard and if they were to apply these they would fall out of the market standard and furthermore they may have difficult in enforcing them. The market standard does not provide for the set off in part against all of loans outstanding and this will therefore take this out of the market standard.

D-Material Prejudice to the Syndicate - Default Clause

Lenders regard financial ratios as a key component of the syndicated finance package enabling them to monitor the financial performance of the borrowing group. The ratio levels are set by reference to the projected financial performance of the borrowing group at the time the loans are advanced and will enable the syndicate lenders to test whether the creditworthiness of the borrowing group has deteriorated from the creditworthiness projected at the time of initial advance.They serve not only to protect the syndicate lenders in the event of a downturn in financial performance, as a failure to maintain financial ratios would give rise to an event of default, but often also to determine the interest rate on the loans. They are also used as part of tests which must be satisfied before a distribution can be made to the venture capital investor. They are likely to comprise, among other things, a combination of profitability to debt and/or interest and cash flow tests.

The purpose of this clause is to include those situations in which a default in payment may be declared, and the borrower may be obliged to make repayment of the loan earlier than the stipulated date. Events of default fall into two basic categories: (a) actual non-payment by the borrower; and (b) other events. The purpose of including 'other events' has been very clearly explained by Youard when he stated that it is:

'to enable the lenders to take action before non-payment has actually occurred but when it is likely or possible. In other words, the other events give the lenders a time advantage so that, instead of having to wait until non-payment has occurred, they can take action in advance. To wait for non-payment may deprive the lenders of many alternative courses of action, some of which could benefit the borrower.'

Whereas non-payment clearly indicates that the borrower will not or cannot pay, 'other events' of default provide lenders with an early warning system. Although from a strict legal point of view, enforcement action by lenders is possible, in practice however it is extremely unlikely to produce any positive results from them; herein lies the importance of discussion for more information and renegotiation, and it is perhaps worth considering whether negotiation clauses should be compulsorily included in loan ageements. The suggestion by some experts that a 'materiality test' provision should be included in loan agreements is not devoid of problems. What would be the criteria of this test (threshold figures) and whose decision on this test would be final? In view of the time lag involved in carrying out the materiality test or objective test, the lender(s) will certainly incur more losses.

On the other hand, it has to be appreciated that default in repayment may be occasioned by certain circumstances which are beyond the control of the borrower, eg insurrection, civil war etc. In fact, banks, lenders or even the agent, who are apparently the most appropriate institutions to determine default by an application of the materiality test or objectivity test, in practice, would prefer not to be involved in this exercise, because of possible consequent unpopularity in the borrowers' world. In this connection the lenders must also consider 'cross default' provisions in a loan agreement, that is, what other loans are likely to be in existence for the borrower during the life of the loan being negotiated. Acceleration of repayment may not necessarily be achieved by bringing too much to bear upon the borrower.

Additionally, the borrower will not wish to be unduly restrained in its access to loans from other agencies, non-governmental, international or otherwise. Instead, it might be appropriate in many cases to somehow link the International Monetary Fund into the loan agreement, as is often done by the Paris Club. Indeed, in view of the importance of retaining membership of the IMF, all member countries would try to avoid default, and the lenders might have their repayments without having to strain their relationship with borrowers. It has to be emphasised that delay in repayment, benefits the borrower, whereas it deprives the lender of many alternative means of action for recovering the debt.

Another alternative would be for them to include a MAC clause. In English law, a MAC clause will often act as the precursor of an actual event of default, and allows banks to lead the negotiations with their borrower from the front. It is also reflected in the privileged position of banks in a number of recent debt restructurings in Europe.This clause, largely because of its function of protecting the interests of lenders, has become an indispensable contractual tool for any document evidencing the undertaking of a bank, from a mandate letter or financing offer, to an underwriting letter, or any credit agreement.

Bibliography

Journal Articles

Skene G, (2005) Syndicated Loans: Arranger and Participant Bank Fiduciary Theory, Journal of International Banking Law and Regulation

Sullivan J (1992) The Roles of Managers and Agents in Syndicated Loans, in Journal of Banking and Finance Law and Practice (1992).

Books

Gabriel, P, (1986) Legal Aspects of Syndicated Loans, London, England: Butterworth,

Kalderen & Siddiqi (ed) (1984) Sovereign Borrowers: Guidelines on Legal Negotiations with Commercial Lenders

Smith R & Walter I, (2000) Global Banking, London

Watson D & Head A, (2004) Corporate Finance: Principles and Practice, Prentice Hall Financial Times

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