In this podcast, Joanne De Silva and Alyson Gal discuss pro rata sharing provisions in loan agreements. Although the topic may seem straightforward, there are important variations in how broadly written these provisions are, as well as what lender consents are required to amend them. These variations can make material differences in whether non pro rata exchanges and other value swinging deals can be done. In this podcast, Joanne and Alyson review the nuances in the formulations of these provisions and why they matter to lenders and investors in distressed debt.
Transcript:
Alyson Gal: Hello, and welcome to our podcast. My name is Alyson Gal, and I am a partner at Ropes & Gray in our finance practice. Joining me is Joanne De Silva, who is also a partner in our finance group. Joanne and I focus, in particular, on representing credit funds as lenders and as investors in debt financings.
In this podcast, we are focusing on one of the topics of interest to investors in debt that is, or that might become, distressed. What we're going to focus on today is what is referred to as "pro rata sharing" provisions in loan agreements.
Joanne, can you tell us: what is a pro rata sharing provision?
Joanne De Silva: Essentially, a pro rata sharing provision sets out how lenders allocate various payments by a borrower under a particular credit facility. Lenders generally expect to get a portion of scheduled amortization and prepayments—both mandatory and voluntary—that corresponds to their percentage share of the facility. So, for example, if a lender has a 20% share of a term loan facility, it would be entitled to 20% of payments by the borrower in respect of that facility. This provision is typically included in credit agreements and sometimes in security agreements.
Alyson Gal: Well, that certainly sounds straightforward. Where do the issues come up in relation to these provisions?
Joanne De Silva: You would think that this might be a boilerplate provision, but, in fact, there is a lot of variation in how this provision is written and, as a result, whether all or only some payments are covered.
At one end of the spectrum, some of these provisions state flatly that all payments made by a borrower for the benefit of the lenders under the agreement are required to be allocated on a pro rata basis. Often, all affected lenders must consent to any change to this requirement, which is a high bar. Language this tight would prevent a borrower from pursuing a Dutch auction, unless expressly permitted. This would be true whether or not an offer is made to all lenders to be repaid at less than par.
At the other end of the scale, some pro rata sharing provisions only apply to payments that are "due and payable," or to payments resulting from enforcement actions against collateral. This version would not cover things like optional prepayments, exchange offers and outright purchases of loans by the borrower.
Alyson Gal: That's a good point. Another thing to bear in mind is that sometimes—probably due to the fact that not a lot of attention is paid to these provisions in drafting—pro rata sharing provisions might apply to payments under the loan agreement, but they might not expressly apply to payments made under the collateral and guarantee agreement waterfall. Or protections against changes to pro rata sharing provisions without 100% vote might prevent changes to pro rata sharing provisions in loan agreements but not changes in the waterfall under the collateral and guarantee.
In a recent deal, in fact, whether the pro rata sharing provision applied turned on the fact that the payments to the lenders were made after default and by a guarantor subsidiary that was selling its assets and not by the borrower itself. If the borrower had been making the payment, the payment would have been required to be made pro rata to all lenders, but because the subsidiary was making the payment after the guarantee and collateral agreement was triggered, the payments could be made first to the super priority tranche and then to all other lenders.
That kind of distinction seems pretty arbitrary when you think about it.
Joanne De Silva: I agree, Alyson. That sounds both arbitrary and possibly even unintentional on the part of the lenders. As you mentioned there are two key factors here: first, what the specific language of this provision specifies; and, second, but equally important, what percentage of lenders is required to consent to an amendment to the provision.
In some loan agreements, the amendment provisions do not include pro rata sharing provisions as "sacred rights," which means that they can be amended by a straight majority vote. As a result, if the borrower agrees with a majority of the lenders on an exchange transaction, that same majority can consent to having the transaction only offered to the consenting group. Even the most tightly crafted pro rata sharing provision does not give meaningful protection to minority lenders, if at the end of the day it can be amended by a majority vote since the borrower only needs to get the majority on board.
Alyson Gal: That's right. And another perceived loophole in pro rata sharing provisions is that sometimes assignments to the borrower and its subsidiaries are not covered by the pro rata sharing provisions—that can also be a means of circumventing what lenders believe are protections if the borrower, for example, buys loans from a majority in connection with a consent transaction and the minority never gets an opportunity to participate.
The formulation of pro rata sharing provisions first became an area of focus in the 90s in the context of sponsors trying to capture trading discounts by making below par exchange offers. The fact that some credit agreements did not clearly permit payments to be made on a less than pro rata basis, even where a transaction was offered to everyone, led to changes in credit agreements in what now has become common—the inclusion of a Dutch auction mechanic, which permits non-pro rata payments or purchases of loans so long as it is done pursuant to an offer made to all lenders.
But, pro rata sharing provisions haven't really been otherwise heavily focused on by lenders negotiating loan agreements, which is probably why they have not developed into a uniform form.
Joanne De Silva: The lack of attention that has historically been paid to pro rata sharing provisions has become painfully obvious in a number of recent cases that have illustrated how important subtle differences in the language of these provisions can, in fact, be.
Alyson Gal: That's right. For example, in the NYDJ case, which got a fair amount of attention in the investor community, the provisions of the loan agreement that related to pro rata sharing had some nuances that facilitated a transaction where the majority was able to fund new super-senior loans and give the borrower the funds to effect discounted buybacks and exchanged their existing loans for a new priority tranche that came ahead of non-participating lenders' loans.
Among other things that made the NYDJ pro rata sharing provisions less than bulletproof, the pro rata sharing language itself could largely be amended by a class vote of the adversely affected class. That seems protective, but since there was only one class of lenders at the time and no requirement that the loans in that class all received the same treatment, this didn't provide any greater protection than if only a simple majority vote was required. In NYDJ, after the majority and the borrower effected this transaction, some of the minority lenders sued and the case settled.
Joanne De Silva: As you might imagine, borrowers will want to preserve maximum flexibility. Ideally, they would like to have the ability to cut a deal with the majority lenders instead of needing to get the whole lender group on board. A borrower will argue that it should not be "held hostage" by holdout lenders so long as an offer to participate, together with any related fees, is made to all lenders. A lender's perspective will depend on whether it anticipates being in the majority or minority.
Some middle of the road approaches we have seen include required consents to changes to the pro rata sharing provisions by a super majority of the lenders or by more than one group of unaffiliated lenders. This gives minority lenders some measure of protection where a single lender or a small number of lenders dominate the credit.
And, in lower middle market and club deals, another approach that we have also seen is to include provisions that require consent fees or other consideration for consenting to amendments to be offered to all lenders that are willing to consent. This allows the majority lenders to effect amendments that facilitate discounted redemption and exchange offers but protects minority lenders from being frozen out.
Alyson Gal: It is worth bearing in mind that interpretations of pro rata sharing provisions to permit transactions to be offered to less than all of the lenders are not bulletproof. The language is rarely 100% clear, and, ultimately, if these cases are litigated, judges may well be influenced by what seems fair rather than subtle nuances of language.
Joanne De Silva: That's a fair point. Nonetheless, a key takeaway on this topic is that pro rata sharing provisions and the related amendment provisions are not all the same and that they should be reviewed carefully since they can, in fact, make all the difference in whether a distressed exchange or discounted payment can be effected with a subset of the lenders to the exclusion of others. This will be increasingly important as market forces create incentives for borrowers to capture market discounts and to devise ways to pressure lenders to go along with dilutive exchanges.
Alyson Gal: That's an excellent point, and a good note to end on. Thank you, Joanne, for joining me today for this insightful discussion. And, thanks to our listeners.
For other podcasts in our series, or other topics of interest to the credit fund community, please visit our website. And of course, if we can help you navigate any of these areas, please don't hesitate to contact us.
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