Restricted liquidity conditions in the secondary market (www.practicallaw.com/8-107-7216) for leveraged (www.practicallaw.com/7-107-6316) loans have meant that good quality loans are now being traded below par value (typically between 15% and 35% below par).
This has presented an opportunity for borrowers. Usually, the only way for a borrower to retire its debt is to repay or prepay it at par, pro rata between its lenders in order of seniority. However, when debt is being traded at a discount, if the borrower purchases its own debt, it can effectively retire the debt more cheaply.
Alternatively, if a related party (an affiliate, parent or investor such as a private equity sponsor) purchases the borrower's debt, it can use its powers as a lender strategically (for example, to protect the borrower in a restructuring situation through use of its voting rights).
Loan agreements do not typically contemplate the situation where a borrower (or related party) buys back its own debt. This means that, while there is no express prohibition on their doing so, there are also no express provisions dealing with what happens if they do.
To date there have been only a handful of publicly acknowledged debt buy-backs. The first borrower buy-back took place in February 2008, when TDC, a Danish telecoms company owned by a private equity consortium, bought EUR200 million of its senior debt at a discount of 90-95 cents in the euro. It is likely that numerous similar transactions have taken place under the radar (see box, Examples of recent debt buy-backs).
The TDC buy-back was particularly unsettling for the members of TDC's banking syndicate that were not bought out. TDC did not seek permission from other syndicate members, or offer to buy the debt on a pro-rata basis. Some lenders felt that this approach ran counter to the spirit of syndicated lending, in which lenders share credit risk and are repaid in an agreed order of seniority and priority.
However, quite apart from questions of principle or sentiment, there are also technical challenges in effecting a borrower buy-back. As noted above, the current standard loan agreements do not expressly contemplate the situation where a borrower buys back its own debt (although the LMA is working on guidance for borrowers and lenders to negotiate such terms going forward (see Legal update, LMA statement on debt buy-backs (www.practicallaw.com/2-382-1212))).
In practice, this means there is uncertainty as to how such a transaction can be carried out in accordance with the terms of the loan agreement (for examples of alternative structures that achieve the same economic outcome, see box, Alternative structures).
If the borrower obtains the consent of the other syndicate lenders, it can purchase its debt without these concerns.
Under a standard loan agreement such as the LMA Senior Multicurrency Term and Revolving Facility Agreement (the LMA standard), the key provisions likely to concern a borrower seeking to buy back its own debt are:
Restrictions on transfer, which may mean that the lender is not permitted to transfer the loan to the borrower.
Restrictions on prepayment, which limit prepayment of the loan except on certain terms, including sharing between the lenders.
Restrictions on the use of free cash and on incurring further indebtedness, which may limit the borrower's ability to fund the buy-back.
Whether the borrower seeks to acquire its debt by assignment or novation, the transaction will constitute a transfer under the terms of the loan agreement (see Practice note, Understanding the syndicated loan market: Transfer mechanisms (www.practicallaw.com/5-204-3000)).
The borrower will need to overcome any restrictions on transfers. These restrictions are usually intended to operate in the borrower's favour, to ensure that transfers do not have a negative effect on the borrower's tax or commercial position.
In clause 29 of the LMA standard, for example, a lender can only transfer 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".
Views differ as to whether borrowers that do not obviously qualify as banks or financial institutions can bring themselves within these categories of permitted transferee.
While it is impossible to generalise, some guidance as to whether the borrower would qualify as a permitted assignee/transferee is provided by the Court of Appeal in Argo Fund Limited v Essar Steel Limited  EWCA CIV 241.
In that case, the court held that in order to overcome the restriction on loan transfer, the entity must only be a legally recognised form or being, carrying on its business according to the laws of the place it was created, whose business concerns commercial finance, regardless of whether this includes lending money on the primary or secondary debt market (see Legal update, Bank or other financial institution (www.practicallaw.com/4-202-1471)).
"The restrictions on transfer in the loan agreement would normally prohibit the borrower from purchasing its debt, except in limited circumstances, notwithstanding the fact that it now covers new market participants," says Trevor Wood, a partner at Berwin Leighton Paisner.
However, there are exceptions. According to Malcolm Sweeting and James Johnson, both partners at Clifford Chance, a borrower that acts as a treasury conduit for its group might fall within clause 29, for example if it regularly borrows externally and then lends on to other group members.
The key question here is whether the wording of clause 29 requires an external rather than an internal administrative function. TDC self-certified that it was a treasury conduit for its group for the purpose of its buy-back in February.
Others are more robust on the question of whether transfers to the borrower are permitted. According to Stephen Gillespie, a partner at Kirkland & Ellis, if an express corporate purpose of the borrower is, or can be construed as, "making, purchasing or investing in loans, securities or other financial assets", then the borrower is a permitted transferee, regardless of whether these are things that it does in the ordinary course of its business.
What the borrower actually does is only relevant if it is not an express or implied corporate purpose of the borrower, in which case it is a question of fact whether the borrower "regularly engages in" or was "established for the purpose of" making, purchasing or investing in loans, securities or other financial assets.
In practice, lenders may prefer to put the position beyond doubt, for example, by amending the existing wording to prohibit transfer of all or part of the loan to the borrower or an affiliate of the borrower (including any affiliate who is a lending entity and may otherwise be a permitted transferee), although these changes would be likely to be resisted by the borrower community.
If the buy-back results in the debt being extinguished (see below, Effect of buy-back), there is a risk that the transaction, if challenged, could be recharacterised by the court as a prepayment (rather than a transfer) of the loan.
"Most loan agreements prevent prepayment of debt by a borrower except on strict terms, which do not include any discount to par. A debt buy-back by the borrower that is recharacterised as a prepayment is therefore likely to infringe prepayment provisions," says Johnson.
It is difficult to predict what factors would influence a court to recharacterise the buy-back as a prepayment. "The court would obviously look at the facts of the case," continues Johnson. "For example, the greater the discount, the more likely it is that the transaction would not be construed as a prepayment. However, the law is not clear and a case on the matter could go all the way to the House of Lords."
In Gillespie's view, the courts would be reluctant to recharacterise arrangements voluntarily entered into between sophisticated market parties. "We take the view, consistent with recent precedent on contractual interpretation, that the loan documentation means what it says and that the courts will be very reluctant to impose the 'substance over form' interpretation required to recharacterise the transaction as a prepayment, simply because some provisions of the contract lead to an unforeseen result."
If a transfer were to be recharacterised as a prepayment, the terms of the loan agreement that govern prepayments would apply. These usually include a provision requiring amounts received from a borrower to be shared equally between the lenders.
For example, clause 33 of the LMA standard provides that, if a lender receives an amount from the borrower other than through the normal payment procedures and then applies this amount to a payment due under the loan agreement, the lender must pay most of the receipt to the agent so that it can be shared with other lenders. "If the sharing provisions apply, this would defeat the purpose of the lender selling the debt," says Johnson.
If the transaction is not a prepayment, it is unlikely that the sharing provisions would apply, as the payment received by the lender in consideration of the sale is not being applied against sums due under the loan agreement, but rather to the amount due under the transfer agreement.
To buy back its debt, the borrower will either need to use free cash or incur further debt. While terms will vary greatly, loan agreements usually restrict how the borrower can use its free cash, so any buy-back of debt from free cash must comply with the restrictions.
The borrower will also need to comply with restrictions on incurring further financial indebtedness, in the unlikely event that it wants to finance the debt buy-back from new borrowings. In practice, if the debt is trading at a discount, the borrower is likely to have to borrow on less favourable terms.
The borrower will typically have covenanted not to incur any further financial indebtedness and also have given a negative pledge not to provide security for any further debt (subject to agreed exceptions).
The legal effect of a debt buy-back by the borrower is unclear.
One widely held view is that the debt is extinguished. This derives from the principle that a party cannot contract with itself, given the final remedy for breach of contract is to sue the other party, and no party can sue itself. A loan is a chose in action, that is, the right to make a claim against the other party to the contract.
In a debt buy-back, although the borrower does not contract with itself, it acquires an existing claim against itself. It is therefore arguable that the claims of the borrower in its capacity as "lender" are merged with the obligations of the borrower in its capacity as "borrower", and the debt is effectively extinguished.
"There are certain exceptions to this general rule, such as in the Bills of Exchange Act, so it might be possible to persuade the courts that they should create another exception for the loan market, but it would probably take the House of Lords to do it," says Sweeting.
According to Gillespie, it is also at least arguable that a debt purchased by the borrower of that debt is not extinguished until it actually becomes due for payment. In the same way that a bond issuer can buy, sell, invest or trade in its own bonds and a joint stock company can buy, sell, invest or trade in its own shares, it could be argued that by analogy, there is no reason why a borrower cannot buy, sell, invest or trade in its own debt.
"The key point in all three cases is that the bondholder/company/borrower cannot sue itself - you cannot action your own obligations. Therefore, in the case of a debt, the argument goes that the bought back debt becomes a nullity at the point at which (but not before) it becomes due and payable, as a borrower could not sue itself for non-payment, but there is no reason in principle why a borrower could not, prior to maturity, own a debt owed by it," says Gillespie.
Whether or when the debt is actually extinguished is irrelevant to the borrower from a commercial perspective. The net cost to the borrower of servicing the debt bought back will be nil, as the borrower will not need to pay interest to itself.
Assuming that it is not extinguished, the debt is likely to be characterised as "subordinated debt" for intercreditor purposes. Depending on the drafting of the loan agreement, it may then fall out of the "financial indebtedness" definition and no longer count for the purpose of the leverage covenant.
One way to avoid the conceptual difficulties surrounding a buy-back by the borrower itself is for a related party to buy back the debt.
There would then be no question of the debt being extinguished automatically.
The same considerations regarding restrictions on transfers in the loan agreement apply to a buy-back by a related party. Depending on the drafting of the loan agreement, an affiliate may also be caught by restrictions on the use of free cash or incurring financial indebtedness in the borrower's loan documents (this is unlikely to affect related parties above the borrower in its group or investing in the borrower).
In addition, related parties will need to consider the buy-back on its own terms. For example, the directors of corporate affiliates will need to consider whether effecting the buy-back is in accordance with their duty to promote the success of their company, or their duty to avoid conflicts of interest (if they are directors of both the borrower and the affiliate). Private equity sponsors will need to consider whether the buy back is permitted under the terms of their fund documentation.
There is also the question of financing the buy-back: "Although a private equity sponsor purchasing the debt circumvents any issues of prepayment, the weakness of this route is that it would not allow the borrower or its group to use available cash to effect the purchase and thereby retire the debt," says Gillespie.
Following a buy-back by a related party, in principle, the borrower could keep the debt alive by continuing to pay interest and repay capital. This may not have any direct economic benefits for the borrower itself (having purchased at a discount, the related party will make a profit if the debt is fully repaid), but it may have considerable strategic value in relation to voting rights acquired in respect of the debt.
Typically, lenders require a two-thirds majority to make most of the decisions under a loan agreement, including whether to accelerate a loan after an event of default. A unanimous vote is often required for decisions altering the pricing, security or seniority of the loans. How voting power is exercised is important. For example, in a restructuring the sponsor could frustrate the attempts of other syndicate lenders to amend or waive certain provisions of the loan.
Alternatively, a related party could forgive (release) the debt. As for the borrower, release of the debt will need to be in accordance with the terms of the loan agreement and the same considerations apply. In addition, the release would need to fall within an exception to the requirement that intra-group transactions must be undertaken at arm's length.
According to Wood, law firms have taken opposing positions as to whether borrower debt buy-back is possible, and given the uncertainties of undertaking such a buy-back, borrowers need to look at their options carefully. He concludes: "The alternative methods of 'acquisition', being principally funded sub-participation and collateralised total return swaps, should be considered by any entity intending to purchase its own debt, although again, the terms of the loan agreement, any applicable regulatory restrictions and tax issues should all be fully considered before undertaking the trade."
Alarna Carlsson-Sweeny, PLC.
The considerable uncertainty surrounding the legality of the borrower directly purchasing its debt can be avoided by using a different structure to achieve essentially the same economic result. For example:
Funded sub-participation (www.practicallaw.com/1-107-7333). In this case, the lender instead of transferring the debt, "sub-participates" it to the borrower. New rights and obligations are created, rather than transferring existing rights and obligations, and the sub-participant (the borrower in this case) does not become party to the loan agreement. (For further information, see Practice note, Understanding the syndicated loan market: Transfer mechanisms (www.practicallaw.com/5-204-3000))
Total return swap. (www.practicallaw.com/1-217-7954) In this case the borrower and the lender enter into a bilateral contract under which the borrower receives the total return on the asset in exchange for paying the lender a periodic cash flow. This method effectively passes the risk in respect of the underlying loan (thereby giving the borrower the economic exposure to the asset) without a transfer of the loan taking place. (For further information, see Practice note, ISDA documentation: overview (www.practicallaw.com/5-201-6737).)
Trust. In this case a financial institution purchases the debt from the lender and declares a trust over the debt claims for the benefit of the borrower.
In February 2008, TDC, the Danish telecoms company owned by a private equity consortium, bought EUR200 million of its loans at a discount of 90-95 cents in the euro. The buy-back was particularly unsettling for TDC's banking syndicate, as TDC did not seek permission nor offer to purchase debt from the lender's on a pro-rata basis.
In March 2008, PAI Partners bought back second-lien debt associated with the EUR1.96 billion acquisition of the roofing division of Lafarge.
In March 2008, Citadel Broadcasting, the US radio operator, approached its creditors about buying back $200 million of its debt for about 80 cents in the dollar.
In May 2008, Bridgepoint bought back £10 million of the debt it used to leverage the buyout of the clothing retailer Fat Face. The debt was purchased from several creditors at an average discount of 60-65%.