Secondary Trading As Usual?

March.30.2020

In a very short time, the COVID-19 pandemic has spread frightening levels of uncertainty all around the world. While many schools, businesses, and houses of worship have closed, the financial markets remain open. Like other markets, the secondary market for syndicated loans has experienced stomach-churning volatility and steep declines in asset prices in recent weeks. If you aren’t thinking about how COVID-19 could affect liquidity and settlements, you should be. Fortunately, the standard trading documents published by the Loan Syndications & Trading Association (the “LSTA”) already contain important concepts and tools aimed at promoting liquidity and pushing trades toward settlement, even during times as uncertain as these. Below is a brief refresher on some of the provisions that could prove critical in the months ahead.

A Trade is a Trade

One of the LSTA’s core tenets is the idea that “a trade is a trade.”  In other words, if two parties agree to the material terms of a loan trade, then they have made a legally binding commitment to one another to settle the trade on the agreed terms. This rule applies regardless of whether the parties signed a written agreement and it applies regardless of what happens to the loan after the trade is entered. If the loan restructures into equity, the trade is still a trade, the seller must deliver the equity to the buyer and the buyer must pay the purchase price to the seller. Likewise, if the market value of the loan doubles or even falls to zero after the trade date, the parties must settle on the agreed terms because the trade is still a trade. All that said, adhering to the implied covenants of fair trading and best practices is more important now than ever before. If loan prices and borrower credit ratings continue to decline, there could be greater incentives for market participants to litigate disagreements.

Additionally, parties who don’t typically sell loans on the secondary market could find themselves settling trades on LSTA documents with which they are not fully familiar. If you want your trade to include any non-standard terms, it is best to discuss them in detail with your counterparty at trade time and ensure that those same terms are included in the trade confirmation. In addition, if your counterparty does not typically trade loans on LSTA documents, make sure that they specifically agree to settle on LSTA form documents. Additionally, regardless of who your counterparty is, push them to review and sign the trade confirmation as soon as possible.  Quick execution is especially important now because while parties may be legally bound to settle a trade buyers of loans are not immune to financial stresses caused by the current crisis so counterparty risk may be a larger concern.  It is important to note that perceived counterparty risk is typically not a reason to add additional representations and warranties to the standard documentation, but such additions should be considered on a case by case basis at the time of trade.

Buy in Sell Out Provisions

After the last financial crisis, the LSTA added the Buy-In-Sell-Out (“BISO”) provisions that were already present in the par documentation to the standard distressed trading documents. The BISO provisions are designed to allow one party to a trade to enter into a cover transaction to buy or sell loans if that party’s original counterparty will not or cannot settle. After the party invoking BISO settles its cover transaction, its original counterparty is required to pay “Buy-In Damages” which are calculated as the difference in price between the original trade and the cover trade. Although loan market participants rarely use BISO, it could emerge as a valuable tool if more trades become affected by settlement delays. At a minimum, loan market participants should refamiliarize themselves with BISO’s timing, performance, and delivery requirements so that they can preserve their settlement options.

Netting Arrangements

Settlement delays aren’t always caused by the parties to a trade. Delays sometimes arise when the borrower or another party withholds a required consent to a transfer. While most consents are subject to a reasonableness standard, the standard is not well defined and as such parties are often able to withhold consent withhold much of a reason. Settlements can also slow down when an agent bank needs to perform know your customer diligence (“KYC”) on a new lender. Because there is no standard KYC procedure across firms, KYC can be used to vet perceived counterparty risks that always plague markets during a crisis. The parties may be able to bypass these delays, which may be increased during the current crisis, by settling through a process called multilateral netting. For it to work, the buyer generally has to have a downstream sale of its own lined up to a party that isn’t subject to the same problems that are delaying the original transfer. For example, if the borrower is withholding its consent to a transfer and that consent is only required for transfers to new lenders, then the parties can break the logjam by having the seller transfer the loans directly to a downstream purchaser that is already a lender. One incidental benefit of multilateral netting is that the parties incur fewer transfer fees because fewer transfers are required to get the loans from the seller to the ultimate buyer. The LSTA has standard forms for multilateral netting that can be used in par and distressed LSTA trades. 

Participations

If you have a counterparty who cannot settle at present time, but may be able to in the future, a participation is also always an option.  Here, the parties can agree on this alternative, economic equivalent arrangement to more quickly settle the transaction whether from a temporary, or in some cases, permanent standpoint.  Like in a netting arrangement, the LSTA offers a standard agreement for these situations as well.

Considerations Going Forward

Even though the secondary loan market is built to withstand market volatility, as discussed above, parties understandably may still be cautious about entering into trades.  It is important to note another protection that can be negotiated at the outset of the trade, specifically, whether to trade on par or distressed documents. While par documents do not offer indemnities or anything other than very basic seller representations, moving to distressed documents incorporates many additional provisions.  Of these, the most significant are robust seller representations, such as a bad act representation, as well as the requirement for the Seller to provide a chain of title. Thus, while the LSTA publishes shift dates to indicate if a credit is considered distressed by the market, it is up to the parties to decide whether a trade settles on par or distressed documents.  In situations such as these, parties typically consider market conditions, industry specific concerns, as well as whether the loan is actually performing.  Where the market is extremely volatile however, parties may request settlement on distressed documents, even for performing loans, because they offer additional seller representations as well as longer settlement times.  As the days and weeks pass, we will have a clearer idea as to COVID-19’s true impact on the secondary market and its general path going forward for 2020.