Keywords: federal bank regulators, leveraged lending guidance, interagency guidance
On March 22, 2013, almost a year to the day after they issued the proposed new Interagency Guidance on Leveraged Lending, the three federal banking regulators - the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (collectively, the Agencies) - issued the final version of this Interagency Guidance. The new guidance updates and supersedes the Interagency Guidance on Leveraged Financing in place since April 2001; its effective date is May 21, 2013.1
The guidance sets the expectation of the Agencies in regard to such matters as credit and underwriting policies, institutional risk appetite, stress testing, approval processes and internal management and reporting. In the press release accompanying the final guidance, the Agencies lamented that "prudent underwriting practices have deteriorated" since the financial crisis, and expressed their continuing concern over features that limit lender recourse in the event of weakened borrower performance and the "aggressive" capital and repayment structures in some transactions.
The Agencies received 16 comment letters on the proposed guidance. These comments raised concerns about such matters as the potential effect of the guidance on smaller banks; the scope of the definition of leveraged lending; the inclusion of "fallen angels" (i.e., borrowers whose creditworthiness deteriorates over time after the closing of a credit facility), investment grade borrowers and asset-based loans; diligence and reporting requirements for deal sponsors; proposed alternatives to the de-levering expectations; covenant-lite and PIK-toggle structures; valuation methods; MIS (management information system) burdens; and fiduciary responsibility of a financial institution for loans it originates.
The Agencies made several changes in response to these comments.
With respect to smaller banks, the Agencies reduced supervisory expectations for a financial institution that primarily participates in, rather than originates, leveraged lending transactions. On the other hand, the Agencies retained the guidance statement that participants should approach leveraged lending as rigorously as originators. Revisions to the proposed guidance also addressed complaints that the MIS requirements would be unduly burdensome on smaller institutions. The final guidance allows the size and scope of each financial institution's leveraged lending activities to be a consideration in its internal monitoring and reporting functions through MIS.
The Agencies added language clarifying that the final guidance does not apply to small portfolio commercial and industrial loans, or to traditional asset-based loans (i.e., those which focus almost exclusively on asset values with borrowing base tests). However, the Agencies refused to exclude investment grade borrowers, noting that the guidance covers all borrowers, even the most creditworthy ones.
They also did not modify what some commenters perceived as a "bright line" definition of "leveraged lending." The 2001 guidance required each institution to adopt its own definition of a leveraged loan; the 2013 guidance leaves intact that approach, but establishes certain benchmarks that each bank's definition should cover. Accordingly, a loan facility to any borrower with a total debt/EBITDA ratio of in excess of 4:1 or senior debt/EBITDA in excess of 3:1 will likely be considered a leveraged loan.
In regard to underwriting standards, the guidance states that a total debt/EBITDA level in excess of 6:1 after planned asset sales would "raise concerns for most industries." The Agencies emphasize that these are examples of items to consider in underwriting standards and that they are not meant to discourage "well-structured, stand-alone asset-based credit facilities with strong lender controls." However, lenders should expect examiners to scrutinize loans with these permitted levels.
The Agencies note that required risk ratings of leveraged loans rely on a borrower's ability to de-lever within a reasonable period to a sustainable level. Commentators had raised concerns about the suggestion of a bright line test for the ability of a borrower to reduce debt, based on whether it can pay half of its total debt over a five-to-seven-year period. The Agencies attempted to characterize this more as a safe harbor example, but not an exclusive measure of adequate de-leveraging capability. However, at the same time, they stated that this EBITDA-based leverage gauge was a supervisory measure that may be an important factor to consider in defining leveraged loans.
The Agencies acceded somewhat to concerns regarding inclusion of "fallen angels" and clarified in the final guidance that a loan should be designated as leveraged only at the time of origination, modification, extension or refinance. However, because any modification of a loan to a deteriorating borrower will bring those loans within the scope of the guidance, query whether this exclusion has in fact any substance.
Sponsor diligence and evaluations will only be required when sponsors provide financial support for a transaction.
Finally, the Agencies agreed to remove any references in the final guidance to fiduciary responsibility of a financial institution to participants in loans that it syndicates.
Overall, changes from the proposed to the final Interagency Guidance were fairly limited. As a general matter, the new guidance is expected to expand the portfolio of leveraged loans at major financial institutions. This results from several factors, including a scope which is likely to capture more borrowers, as well as clear intent to cover loans held in lender portfolios which were thought by many to be outside the guidance. For example, the leveraged lending requirements now apply to loans held by financial institutions not only for their own portfolios, but also for syndication or re-sale. Participants in loans are now also included within the guidance. The guidance unambiguously states that participants in leveraged loans are to adhere to "the same standards of prudence, credit assessment and approval criteria" that would be employed if originating the loan.
The message from the federal agencies is clear: a tightening of lending standards is desirable. Whether this will cast a pall over the expanding lending market remains to be seen.
Learn more about our Leveraged Finance, Banking & Finance, and Financial Services Regulatory & Enforcement practices.
Footnotes
1. For a more in-depth discussion of the 2013 New Leveraged Lending Guidance, see "New Leveraged Lending Guidance," co-authored by Barbara M. Goodstein and published in the New York Law Journal on June 7, 2012.
Previously published on March 27, 2013
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