On July 10, 2012, the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission released final rules and guidance (the "Final Rules") further defining the terms "swap" and "security based swap" for purposes of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").1 There was great concern in the loan market that standard LSTA and LMA style loan participation agreements would be regulated under Dodd-Frank as swaps. The Final Rules make it clear that these participation agreements are not swaps and are thus not subject to regulation under Dodd-Frank.
Swaps are Subject to Regulation Under Dodd-Frank
Under Title VII of Dodd-Frank, swaps are subject to regulation. Swaps are defined broadly as:
[A]ny agreement, contract or transaction . . . that provides . . . for the exchange . . . of 1 or more payments based on the value . . . of 1 or more interest or other rates, . . . [or] instruments of indebtedness, . . . and that transfers . . . the financial risk associated with a future change in any such value . . . without also conveying a current or future direct or indirect ownership interest in an asset . . .2
This definition could be interpreted to include LSTA and LMA style loan participation agreements. LSTA and LMA style loan participation agreements, unlike assignments which effect the transfer of legal and beneficial ownership of a loan and substitute the assignee for the assignor as a "lender of record," only transfer the economic benefits and risks of a bank loan from a seller to a buyer. The seller retains legal ownership of the loan.3
The Final Rules
The Final Rules provide that loan participations that reflect the transfer of a current or future direct or indirect ownership interest in an underlying loan are excluded from regulation and set forth four characteristics that should be present in any such transfer:
- The seller of the loan participation is a lender under, or participant or sub-participant in, the loan that is the subject of the loan participation being granted;
- The loan participation being granted does not exceed the principal amount of the seller's interest in the underlying loan;
- The entire purchase price of the loan participation is paid in full when the loan participation is granted and is not financed; and
- The loan participation provides the buyer with all of the economic benefit and risk of the whole or part of the loan that is the subject of the loan participation being granted.4
LSTA Style Loan Participation Agreements
A customary LSTA style loan participation agreement would meet all four of these criteria. Specifically, LSTA style loan participation agreements typically grant some form of voting rights to the buyer giving them the right to direct the seller's (legal owner of the loan) actions and decisions under the credit agreement. LSTA style loan participation agreements also require the seller to use commercially reasonable efforts to effect an assignment in the loan in the future (an "Elevation"). These provisions are indicia of granting a current beneficial interest and a future ownership interest in the loan.
LMA Style Loan Participation Agreements
LMA style loan participation agreements, unlike LSTA style loan participation agreements, provide that no beneficial interest in the underlying loan is transferred to the buyer. LMA style loan participation agreements are contracts under which the seller makes payments to the buyer in an amount equal to the payments received by the seller under the loan. However, LMA style loan participations satisfy the criteria set forth in the Final Rules since: (i) the seller represents that it owns the loan, (ii) the seller covenants that it will not sell, transfer or otherwise encumber the loan other than in favor of the buyer, (iii) the seller agrees to use commercially reasonable efforts to effect an Elevation, and (iv) the buyer pays the full purchase price on the transaction closing date. The interplay among the representations outlined in (i) and the covenants described in (ii) and (iii) results in a current indirect and future direct ownership interest in the loan in favor of the buyer.5
The election to settle a loan market transaction by a loan participation agreement is driven by many factors6 and may not be determined at the time of trade. A loan participation is an important and efficient method of transfer that is customarily and frequently used in the loan market. Regulation of loan participation agreements under Dodd-Frank would be costly and burdensome to market participants and would cause a severe disruption in the loan market, decreased liquidity and would constrain bank lending activities. The Final Rules make clear that customary LSTA and LMA style loan participation agreements are excluded from regulation under Dodd-Frank. Market participants should take care that negotiated transactions satisfy the criteria for exclusion set forth in the Final Rules.
1.Pub. L. 111-203 (July 21. 2010).
2.Section 721(a)(47) of Dodd-Frank.
3.See generally Letter from R. Bram Smith, Executive Director, LSTA, Jan. 25, 2011.
4.Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, Release No. 33-9338; 34-67453; File No. S7-16-11, available at http://www.cfc.gov/ucm/groups/public/@newsroom/documents/file/federalregister071012c.pdf, at p. 166
5.See generally Letter from Clare Dawson, Managing Director, Loan Market Association, July 22, 2011.
6.Loan participation agreements allow lead banks to quickly and efficiently fund a borrower while allowing a syndicate of lenders to simultaneously share risk in the loan. An original lender can maintain a direct business relationship with the borrower while actively managing and downsizing its own risk exposure. Stringent transfer restrictions and lender eligibility requirements in credit agreements may preclude a transfer by assignment.
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