Reprinted from JIBFL, Vol. 28 – No. 6, 2013

KEY POINTS To comply with the Guidance, Financial Institutions may have to allocate additional Feature compliance resources and broaden the scope of their existing compliance monitoring resources. Potential bright-line criteria in the Guidance may cause discrepancies between Financial Institutions and the Agencies in their assessments of risk levels in leveraged loan portfolios. Th e Guidance will likely have considerable infl uence on the operation of the leveraged loan market due to the regulatory power wielded by the Agencies; however, it is unclear how Agencies will enforce the Guidance and what forms of disciplinary action they may take. Financial Institutions were required to begin to comply with the Guidance on 21 May 2013.

Authors Douglas Landy, Andrew Sagor and Spencer Pepper US bank regulatory agencies issue fi nal guidance on leveraged lending practices: high-level considerations for fi nancial institutions

In this article, the authors raise several high-level issues that US fi nancial institutions crises underscore the need for Financial and certain US offi ces of foreign banking organisations may have to consider in Institutions to employ sound underwriting, determining how best to comply with the fi nal Guidance recently issued by US bank ensure strong risk management, adequately regulatory agencies. monitor borrowers, and engage in stress- testing in order to be able to withstand adverse events in the future. Th e Agencies BACKGROUND 2001 (the “2001 Guidance”) and finalises assert that Financial Institutions that fail to In an eff ort to reduce systemic risk the Agencies’ proposed guidance from adhere to these practices may not only “suff er ■in the US fi nancial system and to March 2012 (the “Proposed Guidance”) acute threats to their fi nancial condition and address the potential for deteriorating which had been subject to significant viability” but may also “generate risks for the underwriting practices by US fi nancial comment by the US banking industry. fi n a n c i a l s y s t e m .” institutions and certain US offi ces of The Agencies addressed some of the In contrast to a rulemaking action, foreign banking organisations (collectively, commenters’ concerns with the Proposed the Agencies leave implementation and “Financial Institutions”), the US federal Guidance while also arguably maintaining application of the Guidance up to each bank regulatory agencies have issued fi nal bright-line criteria that could result in individual Financial Institution. Th e joint guidance (the “Guidance”; see 78 Financial Institutions needing to adopt applicability of the Guidance, however, is Fed. Reg 17776 (Mar. 22, 2013)) for the high-level reforms within their leveraged also subject to the discretion of Agency Financial Institutions that they supervise lending practices. examiners who will take into account and which engage in leveraged lending Similar to many other regulations and institution-appropriate criteria. Financial activities. In this article we raise several guidances issued by the Agencies in recent Institutions were required to begin to high-level issues that Financial Institutions years, the Guidance should be viewed as part comply with the Guidance on 21 May 2013. may have to consider in determining how of the Agencies’ broader eff ort to identify In reaction to this compliance date, the best to comply with the Guidance. and to reduce systemic risk while keeping Loan Syndications and Trading Association The Guidance was issued on pace with changes in market practices. In (LSTA) and the American Banking 21 March 2013 by the Board of Governors the aftermath of the 2001 Guidance, the Association (ABA) have sent the Agencies of the Federal Reserve System (Federal Agencies observed periods of “tremendous a joint letter in which they have requested Reserve), the Office of the Comptroller growth in the volume of leveraged credit and a one-year extension of the 21 May 2013 of the Currency (OCC) and the Federal in the participation of unregulated investors,” deadline for Financial Institutions to be Deposit Insurance Corporation (FDIC, inadequate lender protections in debt in compliance. Financial Institutions that Federal Reserve and OCC, collectively, agreements, and aggressive capital structures, originate or sponsor leveraged fi nance the Agencies). The Guidance replaces the all of which could have negative ramifi cations transactions may have several signifi cant leveraged lending guidance that was last for the fi nancial system as a whole. high-level considerations to weigh in jointly issued by the Agencies in April According to the Agencies, the fi nancial implementing the Guidance.

Butterworths Journal of International Banking and Financial Law June 2013 333 Reprinted from JIBFL, Vol. 28 – No. 6, 2013

Feature Biog box Douglas Landy is a partner in the New York offi ce of Milbank, Tweed, Hadley & McCloy LLP. He is an acknowledged expert in US fi nancial services regulation and has been at the forefront of the fi nancial services practice during the recent credit crisis. Email: [email protected] Website: http://www.milbank.com/attorneys/douglas-landy.html

DEFINITION OF “LEVERAGED type of robust in-house monitoring and Agencies did not accept previous comments LENDING” AND THE POTENTIAL analytic functions set up for their trading from various fi rms (including from BROAD SCOPE OF THE GUIDANCE portfolios as they do for their origination Milbank, Tweed, Hadley McCloy LLP) that Th e Guidance applies to leveraged teams. Th erefore, there may be potential the Agencies abandon or clarify a proposed loans, which begs the question of how for increased compliance costs as Financial test that total debt-to-EBITDA levels in the Agencies defi ne “leveraged lending”. Institutions may ultimately decide to excess of 6x would “raise concerns for most Th e Agencies simultaneously require allocate additional resources toward their industries.” While the Agencies frame their Financial Institutions to adopt a defi nition trading portfolios in order to comply with Guidance in this area as a useful metric for “leveraged lending” across their the Guidance. for consideration, the Guidance suggests business practices that is appropriate to Th ere is further potential for Financial that such loans may be fl agged for criticism each individual institution while also Institutions to incur compliance costs by Agency examiners and by credit rating setting forth several potential bright- even in areas where the Agencies sought to agencies. It remains to be seen how the line criteria common to leveraged loans. address issues raised in comments to the Agencies’ references in the Guidance to this Such potential bright-line criteria include Proposed Guidance. For instance, both specifi c matter will impact the availability of transactions where a borrower’s total debt- the LSTA and several individual banks credit for more highly leveraged companies. to-EBITDA ratio is in excess of 4.0x or commented on the Proposed Guidance senior debt-to-EBITDA ratio is in excess that so-called “fallen angels” – credits that VALUATION STANDARDS of 3x, respectively. Financial Institutions deteriorate post-inception and become Recognising the role that enterprise value may raise objections to such bright-line highly leveraged – should not be included plays in the underwriting and assessment rules because such rules may, in some in the fi nal Guidance. Th e Agencies of leveraged loans, the Agencies state in circumstances, be contrary to prevailing accepted this argument to a point: “fallen their Guidance that enterprise valuations transactional practices. For instance, the angels” are not included within the scope should be performed by qualifi ed persons aforementioned leverage test does not of the Guidance unless the credit at issue independent of the origination function within Financial Institutions. ...a potential consequence ... could be that Financial Institutions Th e Guidance specifi cally states that underestimate the risk in their leveraged loan portfolios in capitalised cash fl ow and discounted cash fl ow analyses are the most reliable methods comparison to how the Agencies would assess such risk. for calculating enterprise value. Moreover, if a Financial Institution relies upon appear to address the concept of net debt is modifi ed, extended or refi nanced. enterprise value or illiquid collateral in its that is used in numerous contemporary Given the high volume of loans that are credit decisions, internal policies ought to credit facilities whereby a borrower’s expected to be modifi ed, extended or provide loan-to-value ratios, discount rates unencumbered cash is netted against its refi nanced in anticipation of what remains and collateral margins. indebtedness in order to calculate the of the “refi nancing cliff ,” it appears at least Although the Agencies explicitly borrower’s leverage. Th erefore, a potential possible that many refi nanced credits could state that a Financial Institution should consequence of this aspect of the Guidance be constituted as being part of a bank’s perform its own valuation analysis, it will could be that Financial Institutions leveraged lending portfolio and be subject also be interesting to observe whether underestimate the risk in their leveraged to Agency examiner criticism. Financial the Guidance in this area will result in loan portfolios in comparison to how the Institutions could potentially be compelled Financial Institutions separating their Agencies would assess such risk. to shift monitoring and compliance valuation teams from the teams heavily Th e Agencies appear to include coverage resources to cover such loans, leaving involved in originating leveraged loans. It of leveraged loans held in trading portfolios their leveraged lending monitoring teams is also possible that Financial Institutions by stating that Financial Institutions stretched thin. may seek to outsource these functions to “should consider positions held in available- specialised valuation fi rms, potentially for-sale or traded portfolios or through UNDERWRITING STANDARDS increasing the costs of originating leveraged structured investment vehicles owned or Th e Agencies emphasise in the Guidance loans for both Financial Institutions and sponsored by the originating institution or that Financial Institutions should have for borrowers. its subsidiaries or affi liates.” Th e potential clear, written and measurable underwriting broad applicability of the Guidance in this standards. While the generic language of PIPELINE MANAGEMENT area could raise high-level concerns within the Guidance in this area may not appear to Th e Guidance emphasises that a Financial some Financial Institutions to the extent confl ict with the existing best practices of Institution should have strong risk such institutions do not have the same US banks in the leveraged loan market, the management controls over leveraged loan

334 June 2013 Butterworths Journal of International Banking and Financial Law Reprinted from JIBFL, Vol. 28 – No. 6, 2013

Biog box Feature Andrew Sagor is an associate in the New York offi ce of Milbank Tweed, Hadley & McCloy LLP. His practice focuses on representing and counseling banks, other fi nancial institutions and borrowers in various domestic and cross-border fi nancing transactions. Email: [email protected] Website: http://www.milbank.com/attorneys/andrew-sagor.html

transactions in its pipeline, including loans sponsors and corporate borrowers alike), structure loans for distribution, which also to be held and distributed, in order to the Agencies’ broad application of such enables Financial Institutions to better avoid incurring material losses in a market specifi c tests or standards could have manage balance sheet risk. An additional environment where selling down such loans unintended consequences and lead to possibility is that various “amend-and- is diffi cult. Th e Guidance underscores increased volatility in leveraged fi nancing extend mechanics,” whereby certain existing that such controls ought to be able to markets. lenders agree to amend a credit agreement diff erentiate leveraged loan transactions In this regard, we note the Agencies’ in order to extend the maturity date of by tenor, investor class, structure and key highlighting of a test presented as generally some or all of their leveraged loans, could borrower characteristics. applicable to leveraged credits as perhaps be swept up within the Amortisation Test Notably, borrowers do not appear to be particularly noteworthy: that Agency and be subject to greater scrutiny by Agency considered investment-grade by virtue of examiners consider adequate repayment examiners because the loan maturity has the ratings assigned to them by credit rating capacity to be evidenced by a borrower’s been pushed past the fi ve-to-seven year time agencies. Rather, the metrics contained “ability to fully amortise senior secured period embedded in the Guidance. in the Guidance, such as the amortisation debt or the ability to repay at least 50% of In addition, incremental facilities or and leverage tests discussed elsewhere in total debt over a fi ve-to-seven year period” “accordions” that allow borrowers to choose this article, appear to control. Th erefore, (the Amortisation Test) and that, in the to increase lenders’ commitments or to it is possible that investment-grade ratings absence of such evidence, a credit will add an additional tranche of indebtedness issued to borrowers by credit rating receive an adverse, substandard rating from up to a certain amount and/or subject to agencies are overridden by such tests in Agency examiners. pro forma leverage ratios, could also run the Guidance, which would be consistent Th e general applicability of the afoul of the Amortisation Test because with the requirement in the Dodd-Frank Amortisation Test poses a number the incremental facility has increased the Act that the Agencies develop alternative of issues. Th is test may not be well- quantum of debt on the borrower’s balance standards of creditworthiness that do not rely on external credit ratings. Given this It is also possible that the Amortisation Test will make possibility, it will be worthwhile to monitor it more diffi cult to structure specifi c loans or other how Agency examiners assess investment- grade borrowers as well as the impact on instruments for the tailored demands of lenders. Financial Institutions’ assessments of such borrowers, in their mutual interpretation suited to earlier stage companies or sheet such that the credit no longer satisfi es and implementation of the Guidance. companies in industries with higher the requirements of the Amortisation Test. relative levels of capital investment, such RISK RATING LEVERAGED LOANS as telecommunications, healthcare and DEAL SPONSORS Th e Guidance describes the Agencies’ certain technology and manufacturing Th e Guidance addresses the support of expectations for sound risk management companies. Such companies are likely to fi nancial sponsors (typically private equity of leveraged fi nancing activities, including, be unable to generate cash-fl ow projections fi rms) that hold equity interests in companies among other things, the development and demonstrating their ability to comply with borrowing in the leveraged loan market. maintenance of transactional structures the Amortisation Test even though their Th e Agencies make clear that Financial that refl ect a borrower’s ability to repay ability to service and ultimately repay their Institutions should evaluate the qualifi cations and “de-lever to a sustainable level within debt is not compromised. of sponsors and, where sponsors are relied a reasonable period of time,” whether It is also possible that the Amortisation upon as a secondary source of repayment, underwritten to hold or distribute, and Test will make it more diffi cult to structure implement processes to consistently monitor well-defi ned underwriting standards that specifi c loans or other instruments for the a sponsor’s fi nancial condition. Factors identify “acceptable” leverage levels and tailored demands of lenders. Institutional for consideration include the sponsor’s amortisation expectations. However, lenders and investors have signifi cant historical performance in supporting Financial Institutions may be concerned demand for loans that possess particular its investments, the sponsor’s economic with the Agencies’ attention to examples characteristics, such as security and tenor, incentive to fi nancially support the credit of specifi c tests or standards that may and care less about other characteristics, (such as equity contributions), the sponsor’s not be as simply or broadly applicable such as maintenance covenant protections dividend and capital contribution practices to leveraged credits as suggested in the and amortisation. Th e leveraged loan and the likelihood of the sponsor supporting Guidance. And because the Guidance will market is suffi ciently stratifi ed in its a particular borrower compared to other be given great attention by leveraged loan demands that the Amortisation Test could companies in the sponsor’s portfolio. Th e market participants (Financial Institutions, aff ect negatively the ability of arrangers to Agencies clarifi ed in the Guidance that they

Butterworths Journal of International Banking and Financial Law June 2013 335 Reprinted from JIBFL, Vol. 28 – No. 6, 2013

Feature Biog box Spencer Pepper is an associate in the New York offi ce of Milbank, Tweed, Hadley & McCloy LLP. He represents banks and other fi nancial institutions in a variety of domestic and international fi nancing transactions. Email: [email protected] Website: http://www.milbank.com/attorneys/spencer-pepper.html

agreed with a previously submitted comment equity fund, its investment manager or Financial Institutions. that “the ability of Financial Institutions to management company. Should additional Of particular interest to market obtain fi nancial reports on sponsors may be inquiries need to be made of a sponsor’s participants, Financial Institutions and limited in the absence of a formal guaranty.” investment manager or management borrowers, is whether any formal enforcement Th erefore, the Guidance appears responsive company, it may create administrative action could be taken against loan parties to the concerns of Financial Institutions in and relationship hurdles for Financial under certain circumstances or whether this context. Nevertheless, since leveraged Institutions, particularly when an investment the Guidance will, instead, be used only fi nance transactions diff er in the level of manager or management company is informally by the Agencies to guide its support expected of a sponsor with respect to unwilling or unable to disclose fi nancial examiners. For example, the Agencies do not a borrower (for example, whether there is a information about itself. state whether examinations will emphasise particular statements in the Guidance more Of particular interest to market participants, Financial than others. Th e Guidance will likely have considerable Institutions and borrowers, is whether any formal infl uence on the operation of the leveraged enforcement action could be taken against loan loan market due to the regulatory power wielded by the Agencies and its examiners. parties under certain circumstances ... While the Guidance does state that adverse, substandard or nonaccrual ratings may guarantee, comfort letter, or verbal assurance), COMPLIANCE, APPLICATION AND be applied to leveraged loans that fail the it remains to be seen how Agency examiners ENFORCEMENT Amortisation Test, to the extent disciplinary will assess the approach taken by Financial Th e Guidance outlines for Financial or adverse regulatory consequences fl ow to Institutions to evaluate sponsors as well as any Institutions high-level principles relating to Financial Institutions and borrowers from secondary support by sponsors (including any safe and sound leveraged lending activities entering into leveraged loan transactions documentary support received by Financial that are important for institutions to develop that are not aligned with some or all of the Institutions from such sponsors). and to maintain. Th e Agencies do not, Guidance, those adverse consequences may Th e Guidance does not specify whether, however, off er clarity regarding the manner not be clearly known at this point to all to the extent such sponsor evaluations are in which the Guidance will be expected current and future market participants.  undertaken, Financial Institutions will be to be practically applied to, and aff ect the expected to evaluate an individual private availability of, credit provided to borrowers by Th e author’s views are his own.

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336 June 2013 Butterworths Journal of International Banking and Financial Law