Safety in numbers

Debt trading documentation has been updated to address counterparty default. Even the humble insolvency sub-participation agreement and the insolvency risks it involves have been the focus of ­attention. Two particular developments in an English context illustrate how established concepts need to be reconsidered.

Bad examples

The Lehman Brothers administration and the recent Global Trader case have shown that the concepts of client money and client assets may not provide investors with the protections they envisaged and that prime brokerage and similar documentation may have provisions with unexpected consequences.

The theory of client monies and client assets is that, if the financial institution ­holding these monies and assets becomes insolvent, the client retains a proprietary interest in them. The client should therefore be able to recover them and be (relatively) unaffected by the insolvency. These concepts are enshrined in the rules of the FSA to give investors protection against insolvencies of regulated institutions that receive their monies and assets.

However, documentation entered into by the investor can reduce this protection materially. Client categorisation or ‘opt outs’ may exclude the benefit of client asset treatment. Rights of rehypothecation (the right of the financial institution to use the investor’s assets) are contained in many agreements with financial institutions such as prime brokers. The investor will ­generally cease to have a proprietary interest in a rehypothecated asset. Improperly completed or perfected arrangements may also prejudice protection. The default (whether deliberate or innocent) of the financial ­institution may destroy the client’s protected interest in its assets, as happened in the Global Trader case, where the financial institution (apparently honestly) failed to categorise its clients appropriately, keep good records or identify properly which of the assets in its possession were client assets. Clients are well advised, then, to examine closely the ­documentation they sign and the manner in which their assets are being held.

Riding for a fall

Senior debt and mezzanine debt structures, on customary documentation terms, have been a standard financing arrangement for leverage acquisition deals in England for a number of years. Restructurings and the series of cases in the English courts involving schemes of arrangement, most recently illustrated by the IMO Car Wash Group case this year, have demonstrated that ­traditional intercreditor documentation between the senior and mezzanine creditors may not provide the level of protection that the mezzanine creditors anticipate.

Probably the most significant issue these cases raise in the context of senior-mezzanine relationships concerns the release mechanics included in all intercreditor agreements. ­Senior-mezzanine deals have traditionally been structured so that the debt is incurred by the same borrower and is supported by guarantees and shared security from all material members of the borrower group. The intercreditor arrangements will place the mezzanine lenders as ranked second after the senior lenders. In addition, the ­intercreditor arrangements will normally provide that, upon enforcement, the ­security trustee (on the instructions of the senior lenders) can release all guarantees and ­security granted by the members of the ­borrower group on a share sale.

The language does not customarily address a credit bid (as the release mechanics for a high-yield bond intercreditor arrangement would). A credit bid is a bid by the senior lenders where, instead of cash, they use their outstanding senior debt as a credit against the price for the asset being sold. Credit bids can come in many forms and the senior lenders would argue that, if there is a senior lender credit bid, as part of the process, all the guarantees and security given for the benefit of the mezzanine lenders can be released upon the transfer of the assets of the relevant borrower (ie the shares of subsidiaries) to the purchaser.

The precise wording of the release mechanics are critical to this analysis, but if sufficiently broad (and many of the provisions are very broad), the mezzanine lenders can be stripped of their guarantees and security on a prepackaged credit bid by the senior lenders. If the value clearly breaks in the senior debt, the mezzanine lenders may have little scope to frustrate or object to the credit bid in the absence of alternative potential buyers.

The relative ease with which the senior lenders can strip the mezzanine lenders of their guarantees and security in an English deal should cause a reconsideration of the standard release mechanics and of the ­protection that the second ranking status of the mezzanine lenders actually provides in the context of a restructuring.

Clifford Atkins is head of Shearman & Sterling’s European finance group