Goldberg Kohn Finance and Bankruptcy: 2023 Mid-Year Update
Asset Based Lending Trends
Our 2022 year end update provided high-level information on covenant trends in the leveraged lending market. While the last several years have been marked by a high volume of middle market cash flow lending deals, predictably, so far in 2023 deal flow has tilted somewhat more towards ABL lending. In looking at GK deal activity, a little over 20% of deals in 2022 were ABL transactions, whereas in 2023 so far that number is closer to 40%. Though the ABL market is more immune to aggressive covenant trends - and that holds true from 2022 to the first half of 2023 - a comparison of some key ABL metrics that GK has seen may be informative:
Springing Covenants: In 2022, a little over half of deals (about 55%) had springing covenants. In the first half of 2023, this fell to 40%. In the vast majority of transactions across both years, the covenant package included just a minimum fixed charge coverage ratio requirement, though a small minority also included a liquidity covenant.
Existence of MAE Default: In 2022, about a quarter of deals had a generic default tied solely to the occurrence of a Material Adverse Change/Effect. This is mostly consistent so far in 2023, with close to 20% of deals with an MAE default – though this provision is often driven by the specifics of a particular transaction, including the creditworthiness of the borrower.
Reserve Criteria: In 2022, nearly all deals allowed for discretionary (as opposed to fixed) borrowing reserve criteria, subject to customary conditions on determination of reserves. Most did not require prior notice for implementing reserves (only 30% had an affirmative prior notice requirement). This also remained consistent in 2023, again with nearly all deals allowing for discretionary reserves, and about 40% requiring prior notice.
Borrowing Base Delivery: The majority of deals in both 2022 and so far in 2023 required a monthly borrowing base only absent a triggering event – in 2022, only 25% of deals required a more frequent (weekly) borrowing base, and in the first half of 2023 that number was close to 20%.
LIBOR Transition [1]
Six years after the UK Financial Conduct Authority announced that LIBOR would be phased out, and after 37 years as the standard rate for US dollar loans, the last panel submissions for LIBOR were made on June 30. Though most commercial loans have now made the switch to an alternate rate (the vast majority to Term SOFR), either via a negotiated amendment or by virtue of "LIBOR replacement" provisions, there are still a small percentage LIBOR-based loans that have not been amended.[2] As it pertains to those loans, a few important reminders:
Synthetic LIBOR: Synthetic LIBOR will be published for 1, 3 and 6 month tenors (overnight and 12- month LIBOR have been fully discontinued) through September 30, 2024, and is calculated using the relevant CME Term SOFR Reference Rate plus the ARCC recommended credit spread adjustments. The FCA has made clear that synthetic LIBOR will not be representative of what the LIBOR panel might have determined if the rate had continued to be published via panel submissions – therefore, the publication of synthetic LIBOR does not affect loans that have a non-representativeness trigger for the unavailability of LIBOR.
LIBOR Act: The Adjustable Interest Rate (LIBOR) Act and the related Federal Reserve regulations also provide a way forward for "tough" legacy LIBOR loans that do not already adequately address the transition to an alternate rate. The LIBOR Act regulations cover LIBOR loans that neither specify a set fallback rate nor designate a "determining person" who is authorized to set the rate – however since even older commercial loan documentation generally at least has a customary "base rate" or "prime rate" alternative to LIBOR, the LIBOR Act will not apply to most commercial loans.
LIBOR Tenors: Borrowers who reset LIBOR tenors before the cessation date (or within a few days after cessation when taking into account the two-day lookback to determine the LIBOR screen rate) can carry those rates past cessation to the next reset date – and in fact this is how the transition will work for many loans that are relying on fallback language for the transition. Depending on the date the LIBOR periods commenced and the LIBOR tenor selected, these loans may continue to bear interest based on LIBOR for up to 6 (or in some cases 12) months after the June 30 cessation. Bloomberg Law noted that leveraged loan data in June shows a significant uptick in borrowers that selected a 6-month LIBOR tenor, indicating that some borrowers still prefer to keep their loans at LIBOR for as long as possible[3].
Notable Bankruptcy and Secured Lending Cases
Proxy Exercises: In April, the Delaware bankruptcy court handed down an important decision confirming the validity of a secured creditor's proxy exercise.[4] After a loan default, lender Twin Brook ("TB") exercised its contractual proxy right to, among other things, amend corporate documents and replace the board of directors of a company and its subsidiaries. Six days later, the holding company pledgor ("Holdco") filed chapter 11 and requested that the court find TB in violation of the automatic stay (on account of its continuing voting rights) and to direct TB to cease any further exercise of such rights and to rescind its prepetition actions because, among other alleged grounds, TB failed to provide sufficient advance notice of its remedies exercise and that TB's proxy was not valid. The court held that TB's prepetition actions were properly taken and found that the "substantially concurrently with notice" language in the pledge documents did not require a two-step notice (despite the presence of certain "notice of intent" language in the pledge agreement). As a result, Holdco was no longer permitted to vote the pledged stock as of the date it received TB's remedies notice and no postpetition stay violation occurred. The court also held that the duration of the proxy extended past the three-year default period under Delaware law because the loan documents stated that the proxy shall continue until the debt is paid in full. While the case was ultimately an important win for lenders, it also underscored the importance of carefully drafting pledge agreements and ensuring that ancillary documentation related to the pledge is also properly drafted and delivered at closing and that any proxy exercise is done very carefully and strategically.
Dancing Around the Texas Two-Step: 2023 has seen several high-profile cases addressing issues surrounding the validity of the "Texas two-step" bankruptcy strategy – in which an otherwise solvent company facing significant tort liabilities transfers its liabilities to a newly formed affiliate through a divisive merger and files the affiliate for chapter 11 bankruptcy protection. Most recently, in a 2-1 decision on June 20, the Fourth Circuit ruled that a North Carolina bankruptcy court had jurisdiction to stay asbestos-related litigation against Georgia Pacific LLC while its affiliate Bestwall LLC is in bankruptcy; however, the dissenting opinion pointed to criticisms of the divisive merger strategy that have also been raised in other cases.[5] For example, 3M's bankruptcy of affiliate Aearo Technologies, which was created to hold tort claims related to allegedly defective combat earplugs, was dismissed by an Indiana bankruptcy court on June 9 because the lawsuits did not create an impending insolvency risk to the company.[6] The Aero case has already been cleared for direct appeal to the Seventh Circuit. Similarly, in January the Third Circuit ruled that the bankruptcy of J&J subsidiary LTL Management (created to hold talc-related liabilities) was improperly filed because the company was not in apparent and immediate financial distress, in large part because its liabilities were backstopped by J&J, which was an otherwise healthy operating company.[7] More courts may rule on the divisive merger bankruptcy strategy, and a potential circuit court split may bring the strategy before the US Supreme Court.
Emerging Issues
Generative AI: Discussions around the use of generative AI have exploded in the last several months, in part due to high-profile situations in which law firms have faced sanctions as a result of reliance on inaccurate information from large language models to generate legal documents. The use of generative AI tools presents both opportunities and risks, and potential users should not use them without discussing in advance with both technology and legal advisors. While the evaluation of any AI tool will be dependent on the particular use case, below is some general guidance that industry commentators have noted on what to consider in evaluating these tools:
Clarity of inputs: The results from a generative AI tool depend on the accuracy and clarity of the information that is being input, so inputs should be succinct, clear, and not open to multiple interpretations.
Confidentiality: If any information that will be input into an AI tool constitutes confidential information, especially personally identifiable information, this greatly increases the risk of using the tool. It is important to understand how data that is input into the tool is stored and protected, and also whether the terms of use allow data to be stored and re-used or involve any human review of or access to confidential data. If any inputs involve third party data, keep in mind that there may be restrictions from those third parties on use of their data.
Manual Review for Accuracy and Bias: Consider implementing a plan to review the outputs of any AI tool, both in order to ensure that the results are accurate and that the results are not reflecting a problematic bias.
Record-Keeping: It is important for individuals using AI tools to keep records of such use, including to note (1) any prompts, requests, instructions, or other inputs provided to the tool, (2) any information uploaded to the tool, and (3) the output generated by the tool.
Terms and Conditions: When evaluating a license to any AI tool, it is important to carefully review all the terms and conditions the provider imposes. This may especially include (1) any terms granting the provider rights to the inputs (including whether they can retain or use the inputs to further train the model), (2) any terms limiting use of the outputs, and (3) terms of liability and indemnification if the model produces inaccurate output or otherwise subjects the provider or the user to third party liability, including any copyright infringement.
This newsletter is provided by Goldberg Kohn's Commercial Finance and Bankruptcy & Creditors' Rights practices. The attorneys in these practices collaborate to represent a diverse group of banks, commercial finance companies, providers of mezzanine loans and other institutional lenders engaged principally in middle market lending operations. Goldberg Kohn is known for the depth of its practice, providing practical legal guidance, efficient staffing, and ability to facilitate smooth closings.
If you have any questions about this newsletter, please contact our Knowledge Management Attorney, Laura Jakubowski, or the Goldberg Kohn attorney with whom you normally consult. The information contained herein is provided for general information purposes only, and for review and use only by the direct recipient of this newsletter. The information contained in this newsletter is not intended to be and should not be relied upon as legal advice.
Laura Jakubowski
312.201.3858
Laura.Jakubowski@goldbergkohn.com
[1] A modified version of this article was published in Westlaw Today on July 18, 2023.
[2] Loan Syndications and Trading Association: LIBOR Countdown! (June 26, 2023); LIBOR: Rest in Peace(ish) (June 29, 2023).
[3] Bloomberg Law: US Dollar Libor Is Dead! What It Was, What Comes Next: QuickTake (June 30, 2023).
[4] In re CII Parent, Inc., No. 22-11345 (Bankr. D. Del. Apr. 12, 2023)
[5] In re Bestwall LLC, No. 22-1127 (4th Cir. June 20, 2023)
[6] In re Aero Techs. LLC, No. 22-02890 (Bankr. S.D. Ind. June 9, 2023)
[7] In re LTL Mgmt, LLC, No. 22-2003 (3d Cir Jan. 30, 2023)
