Introduction to the US Secondary Loan Trading Market
The secondary trading of syndicated bank loans in the United States is approximately a $600 billion market,1 with the vast majority of these loans trading on documents published by the Loan Syndications Trading Association (LSTA).2 LSTA loan trades are transacted with either "par/near par" or "distressed" treatment. Of the $597 billion loans that traded on LSTA documentation over the course of 2015, approximately 94 percent traded as par/near par with only six percent traded distressed. The LSTA publishes separate sets of documents and related settlement protocols to facilitate each of par and distressed trading. The LSTA also assists the secondary trading market in helping determine the calendar date on which a loan has flipped from trading par/near par to trading distressed.3
The LSTA's Par/Near Par and Distressed Trading Documents
The primary LSTA document used for trading a loan as par/near par is the Par/Near Par Trade Confirmation. This document, which is effective as of the trade date, contains the terms of the transaction including the pricing, the form of settlement, whether or not seller will provide credit documents to buyer and the applicability of a collateral annex and/or collateral accounts in the event the trade settles via participation. The trade confirmation also incorporates standard terms, including "big boy" language and ERISA representations. Of significant note, under an LSTA par/near par trade, the seller is not obligated to represent or warrant that the loan is a secured obligation of the borrower or even to represent that the seller hasn't done anything that will impair the loan.
Par/near par loan trades are settled using an assignment agreement in the form attached to the relevant credit agreement, which is signed by buyer, seller, administrative agent as well as any other required consents, such as the borrower (Assignment Agreement).4 Prior to settlement, buyer and seller also exchange a funding memo delineating the consideration that will be paid on the effective date of the loan transfer.
For a distressed trade, the core LSTA documents include the Distressed Trade Confirmation as well as the Purchase and Sale Agreement for Distressed Trades (PSA). The PSA incorporates many additional provisions that are typically not included in a par/near par loan trade, the most significant being a number of additional seller representations, warranties and covenants, as discussed below. In addition to the distressed trade confirmation and PSA, an LSTA distressed loan trade also utilizes an Assignment Agreement as well as a pricing letter that is executed by buyer and seller (in place of the funding memo, used for par loan trades). Once a distressed loan trade is made effective, the PSA supersedes the trade confirmation as the governing document among the parties with respect to the trade.
Determining When a Loan Should Trade Par/Near Par or Distressed
The LSTA does not dictate whether a loan should trade on par/near par or distressed documentation. Rather, the decision is a deal-specific term agreed to by the parties prior to a trade. The LSTA, upon the request of a member, conducts a "shift date review" whereby they undertake a process to determine if there is consensus within the loan market to consider the credit facility as distressed. This involves the analysis and review of trade data provided by broker dealers and may also involve a review of public information. If the LSTA concludes that a shift has occurred but cannot determine the shift date, the LSTA will hold a meeting of a three-person committee of the LSTA's Board of Directors to determine the applicable shift date (note that such meeting of LSTA Directors has thus far never been necessary).5 Once a credit is published by the LSTA as being distressed, the determination of whether distressed or par documentation should be used on a particular trade is typically no longer made on a trade-by-trade basis.
Until fairly recently, practically every credit facility trading at a price below eighty cents on the dollar traded on distressed documentation. Over the last year or so, we have seen an increasing number of facilities trading on par/near par documentation at prices far below eighty percent. An analysis of recent shift date polls indicate that many credits do not switch to trading distressed until a few days before the related borrower files for bankruptcy.
It is unclear why credits are continuing to trade on par/near par documents even when trading at relatively low prices. This trend may merely reflect that these credits have a low probability of default regardless of their trading price, or it may represent a more fundamental shift in the allocation of risk in the secondary loan trading market.
Protections Provided in the LSTA Purchase and Sale Agreement (PSA)
There are two key categories of protection afforded to buyers when utilizing the LSTA's distressed trading documents: (1) additional representations and warranties and (2) the ability to track prior payments and distributions.
Representations and Warranties: The PSA contains representations and warranties of seller beyond those included in the LSTA model form of Assignment Agreement. The core function of these representations is to protect the buyer from certain impairments to the transferred loan. It is important to recognize that the LSTA distressed representations do not protect the buyer against the risk of the entire credit facility being impaired; it only provides protection in the event seller's action or inaction causes the specific loans acquired by buyer to suffer disparate treatment from the other loans under the same facility. The Enron case is probably the most famous example where a bankruptcy court differentiated amongst the holders within a loan facility in order to withhold distributions from individual holders where the court found that such holder's upstream seller committed bad acts during the period when it held the loan.6
Ability to Track Prior Payments and Distributions: Under both par/near par and distressed LSTA loan trades, a seller is only obligated to transfer payments to buyer if seller has actually received such payments.7 Typically, a buyer has no recourse against seller in the event that seller does not receive a payment or distribution. The Annex to the PSA contains a section where seller is required to list each of the predecessor transfer agreements under which seller acquired the transferred loan (or portion thereof) and the relevant chain of title for all predecessor distressed trades. The listing of predecessor transfer agreements provides a buyer under the PSA with the identity of each prior holder of the loan, from the date that the credit started trading distressed through the date of buyer's purchase. This enables the buyer to track missing payments and, since under the PSA seller transfers its rights under predecessor transfer agreements to buyer, to demand such payment directly from the prior holder (or holders) of the loan. This ability to track and collect missing payments is an often overlooked advantage of trading on distressed documents as it is far more common for buyers to suffer a loss due to a missing payment rather than due to an impairment of the loan due to a breach of a representation.
Disparate Treatment of Interest under Distressed and Par/Near Par Documents
Another key difference between par and distressed trading is that under par/near par documents settlement is supposed to take place within seven business days of the trade date (T+7), while under distressed documents settlement is supposed to take place within twenty business days of the trade date (T+20). Currently, for both par/near par and distressed trades, after their respective target settlement date, buyer is entitled to the interest coupon (minus the delayed compensation which is LIBOR or the spread) on a no-fault basis.
The par/near par trading documents are being revised to provide that a buyer's right to receive interest during a delayed settlement period will no longer be no-fault. Rather, buyer will only be entitled to the interest coupon accruing during the delayed settlement period if buyer certifies that they are ready to close on every day starting from T+7.8
Comparing Settlement Time between Par/Near Par and Distressed Trades
The average settlement time for both par/near par and distressed trades has consistently been longer than the target times of T+7 and T+20. This delay in settlement limits the payment liquidity of the loan market which is a matter of concern to regulators as well as to funds that may need the proceeds for investor redemptions.9 During the first quarter of 2016, the median settlement time for par/near par trades was T+13 and the median settlement time for distressed trades was T+37.
There are many factors that attribute to delayed settlement and the difference between the par/near par and distressed settlement times. While only distressed trades require legal review of the PSA and upstream documents, this review is typically not extensive and should be easily completed well before T+20. One factor in distressed trades settling slower than par/near par trades is that parties often do not focus on distressed trades until a number of days after the trade is executed due to the fact that the target settlement date and the date that buyer becomes entitled to interest is not until T+20.
Additionally, the common practice of brokers attempting to match their buys and sales to close on the same day may also delay settlement. For distressed trades in particular, where the loan inventory is less fungible since the upstream documents are sent to the downstream purchaser, the matching of trades is a key cause of delay.
|Provision / Concept:||Par / Near Par:||Distressed:|
Purchase and Sale Agreement
|Date that buyer becomes entitled to interest payments||T+7||T+20|
|Protection that loan will not be impaired due to Seller's bad acts||No||Yes|
|Buyer receives Seller's interest in predecessor transfer agreements||No||Yes|
|Buyer right to direct recourse against predecessor transferors||No||Yes|
|Ability to utilize upstream chain to track payments||No||Yes|
|No-fault delayed compensation||Yes (anticipate change on July 17, 2016)||Yes|
|Median settlement time during first quarter of 2016||T+13||T+37|
When determining the appropriate document regime to utilize for a loan trade, it is important for market participants to consider the full scope of differences between par/near par and distressed documents, including the sometimes overlooked ability to track payments, which is contained in LSTA distressed documents but not in the par/near par documents.
1. See Lsta.org – January 2016 Semi-Annual Review: http://www.lsta.org/data-and-analysis/lsta-research.
2. The Loan Market Association is the equivalent trading association for the UK and Europe. See http://www.lma.eu.com.
3. Both the current par/near par documents and distressed documents were published on April 24, 2014.
4. The LSTA has published a form of Assignment Agreement which it recommends using when drafting the form to be attached to credit agreements.
5. See LSTA.org—Shift Date Rules: http://www.lsta.org/legal-and-documentation/secondary-trading.
6. See: Springfield Associates, L.L.C. v. Enron Corp., Case No. 06 Civ. 7828 (SAS).
7. Under LSTA distressed documentation, seller is also responsible for delivering any distributions to buyer that buyer would have received but for the fact that the trade date for seller's purchase of the loans was subsequent to the trade date of the sale to buyer.
8. The LSTA is planning to make this change effective for par/near par trades entered into on and after July 17, 2016.
9. Note that the loan market consistently provides trading liquidity with respect to sellers' to find to find prospective purchasers of their loans; the liquidity concern relates to the timing of settlement (even during the recent economic down-turn this remained true).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.