Understanding Cash Control Events In Subscription Finance

Executive Summary

Cash control provisions are critical features of any subscription credit facility, safeguarding lenders' primary repayment sources while also potentially impacting the Fund's cash management operations. Lenders and borrowers should therefore understand the implications of Cash Control Events and carefully negotiate the scope of these provisions in subscription credit facility documentation. This Legal Update explains the role of Cash Control Events, the common scenarios in which they occur, and the consequences of a Cash Control Event.

Background

The underwritten source for repayment for subscription credit facilities is the capital contributions made from time to time by the Fund's investors. Subscription credit facility documentation requires that such contributions be funded into a collateral account over which the administrative agent has a perfected first-priority lien. While Funds have flexibility to manage cash within the collateral account during the ordinary course of business, parties to subscription credit facilities frequently negotiate specific circumstances – commonly referred to as "Cash Control Events" – upon which such flexibility is limited.

A Cash Control Event generally occurs in three scenarios:

1. an event of default has occurred and is continuing;
2. a potential default (i.e., a breach still subject to a grace period) has occurred and is continuing; or
3. a mandatory prepayment has been triggered (i.e., a borrowing base deficiency).

Upon a Cash Control Event, the Fund's ability to withdraw cash is suspended and the administrative agent is entitled to exercise its control over the collateral account.

What You Need to Know

The Difference Between an Event of Default and a Cash Control Event

Cash Control Events provide the administrative agent with the ability to take exclusive control over capital contributions in the collateral account, ensuring such funds are available for repayment of facility obligations if necessary. While events of default have broader consequences, Cash Control Events have narrowly tailored consequences that balance the Fund's operational flexibility with the lenders' need to control the primary repayment source for the outstanding obligations during a Cash Control Event. Cash Control Events serve as a "pause" mechanism, allowing the parties to address issues without necessarily escalating actions that could disrupt further operations.

Cash Control Events in Negotiations

During negotiations, Funds may seek to limit the scope and consequences of Cash Control Events in two main ways:

1. Limiting what constitutes a Cash Control Event: While Cash Control Events nearly universally include the occurrence and continuance of an event of default and a mandatory prepayment, there can be extensive negotiation around what potential defaults constitute Cash Control Events. Funds often seek to narrow the definition of what constitutes a Cash Control Event to exclude potential defaults that are more mechanical in nature. A common compromise is to only include potential defaults relating to certain matters such as nonpayment, bankruptcy, judgment and failure of certain affiliated investors to fund capital calls as Cash Control Events.
2. Limiting the consequences of a Cash Control Event: Funds may also seek to limit the actions the administrative agent and the lenders can take during a Cash Control Event, such as maintaining the ability to pay management fees, tax distributions, and other distributions. While these exceptions may be appropriate in certain circumstances, they should be weighed carefully against the administrative agent's and the lenders' needs to protect their interests. Insufficient safeguards may lead to less flexibility in resolving the underlying issues that triggered the Cash Control Event, ultimately harming the Fund's position. Any exceptions to the consequences of a Cash Control Event should also be assessed in conjunction with any negotiated limitations on the scope of what constitutes a Cash Control Event, and should take into account any applicable baskets (either based on specific dollar amounts or percentage calculations).

Cash Control Event Consequences

If a Cash Control Event occurs, the Fund's access to the collateral account is restricted and the administrative agent has the right to take exclusive control over the collateral account and the capital contributions that flow into the collateral account. Careful consideration should be given by both parties to the terms of the account control agreements governing such collateral accounts and the ability to terminate exclusive control thereunder, which varies by depository bank. Cash Control Events can trigger additional limitations in the subscription credit facility documentation, affecting borrowing, extensions, increases, distributions or servicing other debts until resolved. These measures aim to protect the interests of the administrative agent and the lenders while allowing room for the Fund to maintain operational flexibility and giving the parties a chance to resolve issues and/or have constructive conversations around next steps for restoring compliance with the loan documentation.

Takeaways

Cash Control Events are an important component of subscription credit facilities, enabling the administrative agent to take control over the collateral account and implement protective measures while facilitating discussions about next steps. Both lenders and borrowers should understand the implications of these events and approach the negotiation of cash control provisions with care.