LOAN TRANSFERS


LOAN TRANSFERS
Achilles Bank (“Achilles”) is proposing to purchase a $100 million participation from Priam Bank (“Priam”) by way of a funded sub-participation. The participation forms part of a $500 million syndicated loan (the “Syndicated Loan”) made available to Hector Ltd. Priam is a lender of record under the Syndicated Loan for $400 million.
Advise Achilles on the risks it faces in purchasing the participation by way of funded sub-participation and how those risks might be mitigated.
When writing the advice please consult the attached documents. When citing please follow the OSCOLA rules attached.
Aims:
Readings:
Introduction

When a bank extends a loan to a borrower, that loan then represents an asset to that bank and it will appear as such in the bank’s balance sheet until the loan is repaid or written off. The bank may wish to sell that loan in the same way that it may wish to sell other assets that it owns, such as plant or property. A loan is of course more analogous to the holding of a bond or an equity investment but is distinguishable from these in that it is normally less liquid; there will usually be a listed market in bonds and equities but a sale of a loan will have to be arranged by private treaty between the buyer and seller.

Why would a bank want to transfer a loan?  The motivation for making a loan transfer can be any combination of a large variety of factors including:





In continuation, we look at different ways in which a loan can be transferred:



Assignment may be a legal assignment created by section 136 of the Law of Property Act 1925 or an equitable assignment.

Legal assignments

In order to satisfy the statutory requirements of a legal assignment, the following must be established:




There are no rules on how the assignment must be written or how the written notice must be given.[1]  If any of the three conditions of the legal assignment is absent, however, an equitable assignment can still be completed.

The effect of completing a legal assignment is that the buyer of the debt acquires all the rights against the debtor that the seller of the debt had. If the assignment is a legal one, the buyer of the debt will completely substitute himself for the seller, he can demand repayment from the debtor and can sue the debtor for repayment without involving the seller of the debt.

Not all debts are assignable, however, and even those that are, may lead to limited rights for the assignee. For example, it is often in the interests of a party to a contract that the other party should not be able to assign his rights under the contract. It is common in a sale of land contract to find a clause preventing an assignment by the buyer at least without the seller’s consent. In this way the seller of the land can be sure he will not be forced to transfer the land to a stranger.  Likewise, in a loan contract a borrower may prefer to know his lender and wish to prohibit the original lender form transferring the loan to another bank.  If the loan contract is silent on the matter of assignments, it is assignable but if it clearly prohibits a bank from assigning its rights under the contract, this will render any purported assignment of it invalid inasmuch as the assignor will gain no rights against the debtor who will only need to pay the original lender. A lender in this situation will still be able to make a declaration that he holds the right to receive funds from the debtor on trust for another, but the debtor would repay the original lender.

Likewise, the assignment may not increase the burden of the debtor in terms of his legal obligations on the contract assigned.[2] If the loan is assignable, the assignee prima facie obtains the benefit of all aspects of the contract, but if the withholding tax grossing-up clause or other increased costs clause in the loan agreement (see, e.g., clauses 13 and 14 of the LMA loan agreement) would entitle the assignee to demand more funds from the debtor than the original lender could have claimed, the assignee will be unable to claim the additional sum.

It is also the case that the assignee can only assume such rights against the debtor as the assignor himself enjoyed. If, for example, the debtor had a counterclaim against the assignor, he can maintain the same claim against the assignee; a debt is not a negotiable instrument. The assignee in such a case may have a right of action on the assignment contract against the assignor, if the counterclaim rights were not disclosed to him.

It is also important to note that a party to a contract can only assign his rights under the contract, while his obligations under it remain his to perform. In the case of a loan contract, if the funds have been fully drawn the lender has performed all his obligations and an assignment is capable of completely transferring his side of the contract to the assignee. Where funds can still be drawn by the borrower, however, the assignor can only transfer the right to receive interest on and repayment of what has been lent. He remains liable to lend further sums which may be drawn on the contract, he cannot transfer this obligation to the assignee.[3]

When drafting an assignment agreement, it is important to deal with the question of set off, as otherwise the debt held by the assignee may be reduced by set-offs applying to it.  This is especially an issue where the assignor is the main banker to the debtor and operates a number of accounts on their behalf and is maintaining them, apart from the debt being assigned.  Such set-offs may arise as a result of the contractual relationship between the assignor and the borrower or they may arise at equity.  Alternatively, where the debt relates to a contract for the sale of goods, services, land or another debt, there remains the potential for a cross claim arising from the contractual relationship between the debtor and the other party to that contract.  This could result in a set-off reducing the size of the debt in the hands of the assignee.  The contractual approach would be to require the debtor to confirm that:


When an assignment of the loan takes place, a new contract comes into existence between assignor and assignee. This contract will also have a governing law and this also must be determined by conflict of laws rules and as it is a different contract and one of the parties is different from the loan contract, it may well be that a different governing law has been chosen or that a different country is deemed to have the closest connection to the contract. The law governing this contract of assignment deals with matters such as whether the requirements of the assignment have been met[4], what is the effect of the assignment and what rights the assignee acquires against the debtor. Of course the assignment may be properly perfected under its governing law yet the assignment can still be ineffective because under the law governing the original loan, the loan is simply not assignable.
Equitable assignments

As described above, an equitable assignment in English law is one that lacks one or more of the essential requirements of the legal assignment, i.e. that it be in writing, that written notice to the debtor be given and that it be of the whole debt owed by the debtor to the assignor. Each one of these requirements may be objectionable to a lender when he contemplates selling a loan.

For instance, it may be that a lender does not wish his borrower to know that he is selling the loan. The lender may be keen to preserve his exclusive relationship with the borrower.  Once the borrower comes to know that the loan has been sold, he may think less highly of the lender of simply decide to deal directly with the assignee next time he requires funds.

Similarly, the lender may not wish, or may not be able, to sell the whole loan. This would be for the simple reason that he can get a better overall price for the loan by selling it in tranches or that the loan is of such a size or of such a risk that no one bank would be prepared to buy it all.

More strangely at first sight, a bank may also object to the requirement that the assignment be in writing. Normally, both buying and selling banks would insist on such an important transaction being fully documented, but there can be an objection to assignments of loans being in writing and that is because in the United Kingdom, stamp duty is payable on assignments which are priced at over £30,000 and this duty is payable at a rate of 1% ad valorem[5]. Both the £30,000 lower limit and the 1% are based on the price paid for the debt, not on the face value of the loan being transferred. Clearly, most loan transfers are priced at more than £30,000 and a 1% tax represents a considerable disincentive to using the assignment method. Stamp duty is an unusual tax, however, and in this case it is possible to avoid it by ensuring that there is no written document of transfer of the debt which exists in the United Kingdom. This is because stamp duty is only payable on such a written document of transfer and a transfer of a debt which takes place without a written document of transfer is still valid but is not stampable.  Equally, if the written document of transfer is executed outside the United Kingdom, it does not require stamping in the United Kingdom. If it ever enters the country, it must then be stamped. Having said this, the authorities in fact can never compel a person to pay stamp duty[6] but an unstamped document which requires stamping cannot be used in evidence in a court action.

There is thus little incentive for the selling bank to have the assignment stamped and a buying bank might be tempted to defer stamping an assignment until such time as it needed to take legal action on the debt, if ever. However, a party who seeks to stamp a document more than thirty days after it was executed (or, if executed outside the United Kingdom, more than thirty days after it was brought into the country) may be charged penalties when it is presented for stamping, in addition to the duty itself. The penalty can include not only interest on the unpaid duty but also a sum equal to the amount of the unpaid duty.[7]

Banks can therefore employ various methods to avoid incurring the cost of the 1% duty.

You could execute the document outside the United Kingdom in a jurisdiction which does not have its own stamp duty on such documents, such as Jersey.  If it is ever necessary to sue on it in England, bring the document into the country and have it stamped within thirty days of doing so. It will be wise to have clear evidence that the document was in fact executed and kept outside the United Kingdom.


When the equitable assignment is one where no notice is given of the assignment to the debtor, significant legal issues come into play and it is fair to say that the practical distinction between different types of assignment is not between legal and equitable ones but between those where notice is given and those where it is not. Where notice is not given to the debtor, three factors may arise.

First, no new equities and counterclaims which the debtor may have against the selling bank will be able to damage the rights of the buying bank against the debtor as long as they arise after notice of the assignment was given to him. The buying bank always takes the debt he buys subject to existing equities and counterclaims but it clearly increases his risk to be exposed to further matters arising after he buys the debt.

Second, if the selling bank is dishonest and sells the same debt more than once, it will be necessary to determine the priorities of the different assignees. This is based on the order in which notice is given to the debtor, known as the rule in Dearle v Hall.[8] The risk for the buying bank of not giving notice of assignment is obvious.

Third, as the debtor does not know about the assignment of his debt, he is entitled to repay the original lender, assuming notice has still not been given by the time for repayment. A dishonest original lender could disappear with the funds or he could become bankrupt without having passed the funds onto the assignee. The funds would be held on a trust basis for the assignee, but it could happen that the funds have been dissipated and cannot be traced.


As an alternative to the assignment method, it is possible to novate the debt instead. As the name implies, this method involves the making of a new contract to replace the existing one. The original loan contract is between Lender 1 and Borrower.  When Lender 2 agrees to buy the debt, a new contract is entered into involving all three parties whereby it is agreed that the original contract will be replaced by a fresh one which provides that Lender 2 acquires all the rights against the Borrower that Lender 1 had.  Since it involves a fresh contract involving the Borrower, this novation method enables both the rights and the obligations of Lender 1 to be transferred to Lender 2 and thus the obligation to lend further sums in a facility which is not fully drawn can be fully transferred to Lender 2.

The novation method is the only one which enables a clean break to be made on a facility which is not fully drawn. It has the further advantage that, not being an assignment, no stamp duty is payable. The main disadvantage is that the borrower must not only come to know about, but must also consent to the transfer.

Namely, novation requires the consent of all the parties to the original and the new contracts.  This is inconvenient and may present an opportunity for the other parties – and, in particular, the borrower – to extract concessions for its consent. To avoid these, the LMA loan agreement obtains advance consent from all parties (see clause 24.5), although any other terms in the contract concerning procedures and restrictions must be observed, and the device must not simply be a means of trying to dispense with consent altogether.  Any new lender will take on the same terms as if they had been an original lender, including, of course, their consent to future transfers.

In addition, there are also problems where the debt is secured, as the process of novation will release any security and it will need to be retaken.  As the charges will now be taken at a later date, prioritisation will be lost if a third party has taken charges over the property in the meantime.  For this reason, it is common in the context of syndicated lending to hold security on trust to avoid problems of this sort.


You have now seen that both the assignment and the novation methods have their drawbacks in particular situations.  For this reason, the sub-participation method of transferring loans was devised; the most common type is the ‘funded sub-participation’. How exactly does it work?  First, Lender 1 makes his loan to the Borrower.  Lender 1 subsequently enters into a contract with Lender 2 that Lender 2 will lend to Lender 1 a given sum on the terms that Lender 1 does not have to repay Lender 2 if the Borrower fails to repay Lender 1 on the first contract.  By using this method, Lender 1 funds his loan to the Borrower and shifts the risk of non-payment by the Borrower to Lender 2.

The method has further advantages. First, Lender 1 may sell any number of parts of the loan to different Lender 2s.

Second, in doing so he may turn a profit as there is no requirement that the interest rate payable be the same. Thus a large bank can exploit its position of having a relationship with a borrower with a good credit rating by selling parts of such a loan to smaller banks which would not be able to lend to such a quality credit directly. Lender 1 may be receiving, say, 40 basis points over LIBOR from the Borrower but he may negotiate terms with Lender 2 that he only pays a margin of 35 basis points to Lender 2.

Third, sub-participations do not attract stamp duty. Fourth, Lender 1 can keep the transfer(s) totally silent from the Borrower and thus he can maintain his exclusive relationship with him. Finally, if the loan agreement between Lender 1 and the Borrower prohibits assignments by Lender 1, a sub-participation is nevertheless possible.

The important distinction between a participation and an assignment or a novation is that the participation is an entirely separate contractual arrangement from the underlying loan agreement and there is, accordingly, no contractual nexus between the participant and the borrower.  In basic legal terms, this means that the participant will not be able to sue the borrower in the event of default by the borrower in performing its obligations under the loan agreement.  It will have to rely on the original lender to take recovery action, although, a well-advised participant will have negotiated certain rights to influence the actions taken by the lender following a default in the participation agreement.

The main disadvantage of this method of transfer is that, from Lender 2’s point of view, there is a double credit risk. Lender 2 will not be repaid if the Borrower defaults and he will also not be repaid if Lender 1 collapses. In such a case he would merely be an unsecured creditor of Lender 1.

This principle was recently upheld in Lloyds TSB v Clarke and Chase Manhattan[9], where the court confirmed that under a sub-participation agreement, Lender 2 would receive no proprietary rights in the facility.  Hence, on the facts of the case before it, the sub-participant was found to have no claim in the underlying facility and was just an ordinary unsecured creditor in Lender 1’s insolvency.  The Privy Council held that a sub-participation agreement was not a legal term of art like a trust so the fact that an agreement was labelled by the parties as such (as in this case) did not prevent the court from reaching the conclusion that a different legal relationship existed between the parties.

Thus, the participant’s position is vulnerable because:




From Lender 1’s point of view he remains the “lender of record”, which gives the advantage stated above of maintaining his exclusive relationship with the Borrower, but it also has the disadvantage that he must bear the cost of administering the loan.

On first sight, it appears that Lender 1 disposes of all the risk of the Borrower defaulting. In real terms this, however, this is not necessarily so. Assume that Lender 1’s loan to the Borrower has gone into default. A club is formed of all the lenders in the similar position of having loans to the same borrower. In negotiations between the Borrower and the Club, it is agreed that all the loans outstanding will be rescheduled and that the loans will be rolled over so that fresh loans are made with longer maturities and these loans are used to repay the existing ones. If Lender 1 has sold his loan by using the sub-participation method, he will find that when he makes his fresh loan to the Borrower and the funds from it are used by the Borrower to repay the original loan, this process will trigger Lender 1’s obligation to repay Lender 2 on the sub-participation contract. The end result is that Lender 1 has the loan back on his books.

It is true that Lender 1 is not legally obliged to advance the additional funds but he is likely to be under considerable pressure to follow the outcome of negotiations and not break ranks with the other members of the Club. It is of course possible to draft an appropriate clause into the contract between Lender 1 and Lender 2 to declare that if the Borrower repays the loan in these circumstances then this will not trigger Lender 1’s obligation to repay Lender 2. The regulators, however, have recognised that risk may still attach to a sub-participated loan and have insisted that, if the appropriate protective clause has not been utilised, a proportion of it must remain on the books of Lender 1 for the purposes of capital adequacy calculations[10].

Not all sub-participations are funded. The transaction can be structured as a “risk sub-participation.” This involves an agreement between Lender 1 and Lender 2 that if the Borrower defaults on the loan from Lender 1, Lender 2 will pay to Lender 1 an agreed proportion of the debt. In return for this promise, Lender 1 pays Lender 2 a fee which is in effect an insurance premium for the risk being assumed by Lender 2. In this type of sub-participation, the double credit risk which is borne by Lender 2 in the funded sub-participation, now shifts to Lender 1, as he may find that the Borrower defaults and Lender 2 also fails to pay under the sub-participation agreement.

A risk participation is similar to a guarantee. The participant’s position is vulnerable because it has no contractual relationship with the borrower. However, if the participant has to reimburse the grantor, it will acquire rights against the borrower by way of subrogation, meaning it will be substituted for the grantor and may pursue the borrower
[1]Re Westerton, Public Trustee v Gray [1919] 2 Ch 104, Van Lynn Developments Ltd v Pelias Construction Ltd [1969] 1 QB 607.
[2] See Tolhurst v Associated Portland Cement Manufacturers (1900) Ltd [1903] AC 414.
[3]To do this, a novation must be employed; see below.
[4] E.g. in English law the requirements of a legal assignment under s136 of the Law of Property Act 1925.
[5]Stamp Act 1891.
[6] In the cases of sales of land or shares (prior to paperless transfer) it is not practicable to avoid stamping the transfer because the Land Registry or the company’s registrar will refuse to register the transfer if it is not stamped.
[7] Stamp Act 1891, s15.
[8](1828) 3 Russ 1.
[9][2002] 2 All ER (Comm) 992.
[10] See The Bank of England’s Notices BSD/1/1989/1 and BSD/1992/3.

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