As difficult market conditions persist, financial institutions are increasingly exploring whether they can transfer portfolios of loans to third parties as a way of restructuring their balance sheets. Such a transfer can enable the transferor to pass the risk and reward in the portfolio to a third party, and free up capital and funding for other activities.
In this note, we explore some of the legal issues associated with such a transfer.
Methods of Transfer
There are a number of mechanisms for transfer of a loan. The most common ones are as follows:
- Novation - a novation transfers both the rights and the obligations of the transferor to the transferee. This terminates the relationship between the transferor and the borrower, and creates a new relationship between the transferee and the borrower, on the same terms as before.
- Assignment - an assignment transfers the rights and benefits under the loan to the transferee. Until the assignment is notified in writing to the borrower, it is effective only against the transferor (and is generally referred to as an “equitable” assignment). An equitable assignment effectively transfers the beneficial interest of the transferor in the loan to the transferee, but leaves the transferor as the legal holder of the loan. It is similar in effect to the transferor declaring a trust over the loan in favour of the transferee. Once the assignment is notified to the borrower, it becomes effective also against the borrower, subject to certain matters such as accrued rights of set-off which the borrower may have against the transferor. Upon such notification being made, the assignment is normally considered to be a “legal” assignment.
- Sub-participation - a sub-participation operates as a back-to-back arrangement between the transferor and the transferee (known as the sub-participant). The transferor passes economic risk in the loan to the sub-participant, but the transferor remains the lender of record and legal and beneficial owner of the loan. A sub-participation is usually either:
- “funded”, meaning that the sub-participant advances to the transferor an amount equal to the underlying loan (or an amount representing an agreed valuation of the outstanding loan), and the transferor passes on to the sub-participant all amounts received or recovered from the borrower; or
- less commonly, “unfunded”, whereby the sub-participant simply reimburses the transferor for losses if and to the extent that the borrower fails to pay – in effect, similar to a credit default swap.
There are a number of factors to consider in connection with a loan portfolio transfer, and these will affect in particular the choice of transfer mechanism. We summarise the most common issues below.
The portfolio may include loans governed by a law other than English law, in which case different considerations will apply. In particular, the transfer mechanisms available under Scots law are different from those under English law. The risk of different governing laws mostly arises in connection with security, as security documents are typically governed by local law. So, for example, where a loan is secured on French real estate, the security will normally be governed by French law, even if the underlying loan is governed by English law. It would be important in this case for any transfer of the security to be effective under French law.
A key question will be whether the transfer can be effected without borrower consent. As a matter of general principle, a novation always requires borrower consent. However, this consent can be obtained in advance, and is often built into the loan documentation. This will usually be the case where a “transfer certificate” arrangement is provided for.
An assignment of rights under a contract will be permitted without borrower consent, unless such consent is required under the terms of the loan agreement. Sometimes there may be an obligation to consult, even if the borrower cannot prevent a transfer. Alternatively, only certain categories of assignee may be permitted.
A sub-participation does not involve any transfer of the loan itself, and consequently it is very rare for the loan documentation to restrict sub-participation.
Disclosure of Borrower Information
Even if the transfer is permitted by the loan documentation, the transferor should also check whether the loan documentation restricts its ability to disclose information relating to the borrower to the proposed transferee. Absent a specific provision in the documentation, the transferor is likely to be subject to the banker’s duty of confidentiality. It is not clear that the exceptions to this duty are wide enough to encompass disclosure to a potential transferee of the loan, and it is important to check the terms of any specific provisions in the documentation relating to permitted disclosure by the lender.
There will also be data protection considerations, if the borrower information includes personal data.
Syndicated or Bilateral Facility?
Where loans are syndicated, they are likely to have been documented using LMA standard form. This standard form is specifically designed to facilitate transfers by way of novation and disclosure of information.
Where loans are bilateral, they are more likely to reflect the standard form of the original lender, which may or may not provide flexibility in terms of the transfer and disclosure of information.
Where loans are secured, it will be necessary to review the security documents as well as the loan documents to ensure that these do not impose additional restrictions on transfer or disclosure of information.
As novation creates a new relationship between the borrower and the transferee, in principle this requires the transferee to take new security, which has disadvantages in terms of process as well as priority, hardening periods and enforceability in certain circumstances. However, where security is held on trust for the lenders from time to time, as is normal for an LMA syndicated facility, this issue does not arise in practice.
Additional complications arise if the lender may become obliged to make further advances – either because the loan is not fully drawn, or because it is a revolving facility. In such a case, the lender will have further obligations to fulfil under the loan agreement. Absent a novation which transfers those obligations to the transferee, the transferor will remain liable to fulfil those obligations, and will need to rely on a back-to-back indemnity from the transferee to fund such advances. This will have capital implications for the transferor, as it retains some residual exposure, which can potentially be addressed through the transferee depositing cash collateral, which may also address practical issues in the transferee funding such advances if the relevant revolving facilities do fluctuate regularly.
Where a loan and related security is transferred through a legal assignment, the security will not cover further advances, and additional security will be required from the borrower. This issue does not arise where the security is held by a security trustee, or where there is merely an equitable assignment (and the transferor makes the new advance itself, using funds provided by the transferee).
A lender will typically enjoy a number of potential set-off rights against the borrower, namely contractual set-off, equitable set-off and (upon the insolvency of the borrower) mandatory set-off under the Insolvency Rules.
The impact of a transfer on set-off rights is a complex area that is beyond the scope of this note. However, it is important to analyse this impact as, in some cases, it may determine which method of transfer will be the most advantageous.
Inter-creditor Agreements and Retained Lending
Where the borrower has other debt facilities, there may be an inter-creditor agreement, regulating the relationship between the different lenders. This will typically contain both rights and obligations for the transferor. Consequently, a separate analysis will be needed as to how best to transfer the benefit and burden of the agreement.
Where the lender transfers some but not all of the facilities that it has made available to the borrower, it may become necessary to put in place new inter-creditor and/or security sharing arrangements where any such retained lending benefits from the same security as the transferred facilities, and the parties will need to address how they will jointly manage decision making and in particular the enforcement of security.
Swaps and other derivative transactions are typically documented using ISDA standard forms. The rights and obligations under such agreements are quite different from those under a loan agreement, and consequently a separate mechanism may be needed to transfer the benefit and burden of such agreements. Where the same security covers both the loan and associated hedging, care will be needed to ensure that the transfer will not prejudice the security position.
Transfer of loan administration can be difficult and time consuming for practical reasons such as systems challenges, and brings associated operational risk. It may be easier for the transferor to continue to be the lender of record and retain responsibility for loan administration. This approach typically dictates an equitable assignment (as is normal for securitisation structures) or sub-participation, coupled with a separate servicing agreement. Whether expressly set out in such servicing agreement and/or transfer agreement or otherwise agreed through loan administration protocols, in such cases the parties will need to consider how the day to day relationship and communications with the borrower will be managed.
In some cases, the lender may positively want to retain its relationship with the borrower, and consequently to avoid publicising the transfer, which would rule out, for example, novations and legal assignments.
It is apparent from the points made above that a significant due diligence exercise is needed in connection with a loan portfolio transfer, as ideally each loan would be reviewed unless there is certainty that it has been concluded using standard documentation.
The time needed to collate and review original documentation should not be underestimated.
The transferee will require a set of warranties from the transferor in relation to the loans transferred, irrespective of the due diligence. The transferor will need to make sure that these are reasonable and that, where necessary, any non-compliance has been disclosed.
The transferee may also insist on a right to put a loan back to the transferor after closing if there is a material breach of warranty.
There is a range of legal issues to consider, as well as accounting and tax issues which may arise, and it is essential to work through them carefully in good time to ensure a successful transaction.
[CMS has been involved in a large number of such transfers involving a diverse range of loan and asset portfolios and a variety of transfer structures and have acted for sellers, buyers as well as the borrowers. We would be happy to discuss any of the above issues in further detail or use our experience to help with any proposed balance sheet restructuring. Please get in touch with your usual contact or Barney Hearnden or Dipesh Santilale.]