Incremental loan provisions in non-investment grade syndicated
credit agreements uniformly contain "most favored nation"
("MFN") pricing protection provisions providing that
if the yield of an incremental term loan to be issued would be more
than a threshold number of basis points (i.e., 50 basis points)
higher than the yield of the original term loan, the interest rate
on the original term loan will be required to be increased by the
amount of such excess. For example, if the yield on the original
term loan is 5.25% (LIBOR plus 400 basis points, with a LIBOR floor
of 100 basis points, issued at 99% of par using a 4-year average
life convention) at the time of issuance of the incremental term
loan, and the incremental term loan is being priced to yield 6.25%,
the interest rate on the original term loan would be required to be
increased by 50 basis points.
Changes to the interest rate of a loan as a result of the
application of an MFN provision may result in a taxable event to
the borrower (as well as the lenders) if a "significant"
debt modification, within the meaning of applicable Treasury
regulations, occurs. A change in interest rate is a significant
debt modification if it varies the annual yield on the loan by more
than the greater of (x) 25 basis points and (y) 5% of the annual
yield on the loan. Using the MFN example above, the increase in the
interest rate of 50 basis points would be a significant debt
modification, since the yield would be increased by more than 25
basis points and more than 5% of the annual yield of 5.25%, or
26.25 basis points.
If a significant debt modification has occurred as a result of an
MFN interest rate increase, the borrower will generally recognize
cancellation of debt ("COD") income if the trading price
of the term loan, after given effect of the MFN interest rate
increase, is less than the original issue price (adjusted for
accretion, if issued with more than de minimis OID) of the term
loan. Using the MFN example above, if after the MFN rate increase
the term loan trades at 98% of par, the borrower would realize
cancellation of debt income equal to 1% of the aggregate principal
amount of the loan. Any COD income recognized by the borrower
generally would be offset over the remaining life of the term loan,
through OID deductions equal to the spread between the trading
price of the term loan at the time of the interest rate increase
and the principal amount of the loan.
The table below summarizes the COD income analysis:
If | MFN increases interest rate by more than both 25 bps and 5% of yield | and | Modified term loan trades lower than original issue price of term loan | then | Borrower will realize COD income equal to that trading difference |
Lenders may also recognize gain or loss as a result of an MFN interest rate increase. The amount of gain or loss would be the difference between the holder's adjusted basis in the term loan and the term loan's trading price.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.