The secondary loan market uses a variety of transfer structures and settlement conventions to move the risk of owning a commercial loan from a seller to a purchaser. The widely-used distressed purchase and sale agreement (currently published in the U.S. by The Loan Syndications and Trading Association, Inc.) is derived from asset sale and assignment templates used by private law firms in the 1990’s. This article briefly describes the purpose and function of a purchase and sale agreement (a “PSA”) tailored for distressed loans.
A distressed PSA is a purchaser-friendly document designed to transfer economic ownership of the loan from seller to purchaser and re-allocate between the parties certain “distressed-asset risks,” leaving those behind with seller and providing purchaser with corresponding recourse in the event such risks surface in the future.
Modern credit agreements contemplate that lenders may at some point sell their loan positions, and to facilitate such potential sales, a simple assignment agreement (an “A&A”) is generally attached as an exhibit. The par or near-par market considers an A&A to be adequate documentation for the settlement of a par loan trade. Distressed PSA’s build upon the straightforward documentation used in the par or near-par loan market.
Under an A&A:
An A&A, while slender, is good enough for the par market because of an underlying commercial assumption: if a loan is trading at par, then the probability of repayment is high. A par purchaser believes it will recover 100% when the borrower repays the loan in full at maturity, or when purchaser resells the loan in the secondary market.
However, when a borrower is stressed or distressed, repayment of the loan at maturity is unlikely and the optimistic assumptions underlying par trading evaporate. Distressed purchasers acquire stressed and distressed loans at a discount and generally focus on three legal risks:
The distressed PSA functions as a “wrap-around agreement” between the seller of the loans and the purchaser; it supplements the A&A and integrates all terms of trade into one comprehensive document. The distressed PSA (i) provides purchaser with extensive rights under the credit agreement and all related documents, including the right to receive any and all distributions made on the loans after the settlement date (whether under the credit documents or pursuant to a restructuring or reorganization of the debt), (ii) gives purchaser a broad range of ancillary claims against seller, any prior holder of the loans and certain third parties, (iii) ensures a diligent purchaser’s assumptions about the loans are true and correct, and (iv) gives comfort to purchaser that seller’s status and its prior acts and conduct will not diminish the value of the loans, as compared to any other lender’s loans.
Under a distressed PSA:
(i) Principal amount of loans— provides purchaser with recourse if the outstanding principal amount of the loans is less than seller represents;
(ii) “No bad acts”— provides a purchaser with recourse if purchaser is treated less favorably than other lenders because of seller’s prior acts, conduct or omissions as a lender;
(iii) No notice of impairment— provides a purchaser with recourse if seller previously received written notice (which was not publicly available) that the loans could be void, unenforceable, or the subject of any other impairment; and
(iv) Accuracy of chain of title— provides a purchaser assurance that all predecessor transfer agreements are included in the important bundle of ancillary rights that purchaser receives in addition to the loans. Purchaser is a beneficiary of a seller’s rights under the predecessor transfer agreements, which can prove critical in maximizing the value of a distressed loan position.
(i) Disgorgement—any obligation to reimburse the borrower or any other entity for payments previously received seller. These “clawback” attempts often occur in a borrower’s bankruptcy proceeding and can involve large amounts of cash or other property to be returned to the borrower’s bankruptcy estate; and
(ii) Seller’s status as an “insider” or “affiliate” of the borrower resulting in purchaser being treated less favorably than other similar situated lenders. This indemnity offers purchaser another form of protection against recharacterization risk and equitable subordination concerns.
The wrap-around structure of the distressed PSA, used in the US secondary loan trading market, provides purchasers buying debt at a discount with expansive rights and claims in respect of the loans, assurances that their due diligence is correct, and market-tested protection against risks of equitable subordination/recharacterization, disgorgement and other possible impairments to the loans.