The Practical Lender — May 2003 ThePracticalLender Finance & Transactions Group
Highlighting the practical effects of law on the finance business. May 2003
THE USE OF CAPITAL CALL AGREEMENTS: BRIDGING THE GAP IN TODAYS CREDIT ENVIRONMENT
Tight credit markets and the large number of recent effect of voiding the underlying guaranty. While a financial restructurings have led to an increased use of properly drafted guaranty agreement should avoid capital call agreements. In new transactions, the lenders such issues, the availability of common law defenses and the owners (or private equity funds sponsoring a is often seen by a guarantor as a bargaining chip in leveraged buyout) may disagree on the initial amount of negotiations with the lender. equity needed to fund and operate a borrower. In Further, under the common law, if a guarantor restructurings, existing lenders may only be willing to performs under a guaranty and pays the lender, the make credit accommodations to a troubled borrower if guarantor steps into the shoes of the lender that borrowers owners agree to make future investments (technically becomes subrogated to the rights of the in the borrower. Capital call agreements are a mechanism lender) with respect to all of the rights and remedies for bridging these and other disagreements and conflicting of the lender. The subrogation issue can be perceptions. particularly troubling if the guaranty runs toward the These agreements, also often called support or senior creditor and the transaction involves a layer keep-well agreements, are basically contracts whereby of subordinated debt. In such a case, by honoring its one party, typically the owner, agrees to invest in the guaranty of the senior debt, the guarantor (the owner) borrower or a related entity, upon the triggering of certain could leapfrog the subordinated lender on the balance conditions. These agreements have several advantages sheet. over other types of credit enhancements such as Rights of subrogation and common law defenses guaranties and letters of credit. Unlike a guaranty, a capital are not applicable to the obligor under a capital call call agreement avoids the common law defenses available agreement, which is governed by the law of contracts. to a surety or guarantor and the issue of subrogation. The obligor under a capital call agreement essentially Under the common law, a guarantor (or surety) is a has the rights and defenses specified in the capital favored party and, as a result, is given a number of legal call agreementno more, no less. protections. For example, if a lender were to release any Nevertheless, private equity fund groups, and portion of a borrowers collateral (including releases given most other owners, prefer liquidity support or capital in connection with the sale of such collateral) without the call agreements over guaranties because they would consent of the guarantor, such release could have the rather inject equity into portfolio company borrowers
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www.vedderprice.com The Practical Lender — May 2003
(and get a better equity position) than pay on a investment. Otherwise, the borrower, guaranty. controlled by the investor, may simply fail to Of course, from the lenders standpoint, capital enforce its contractual rights. When possible, call agreements are not as valuable as a letter of lenders should have the right to make the credit. They are, however, distinctly more preferable capital call directly, for the benefit of the from the standpoint of the investor or owner. Letters borrower, or to require the capital call to be of credit are rarely issued by financial institutions made automatically upon certain triggering unless supported by hard collateral, often cash. From events (such as the failure to meet a final an investors standpoint, if it must use cash or other covenant or meet a net availability test). hard assets to support a letter of credit pledged to secure the borrowers debt, then it may as well The lender and its counsel must ensure that directly invest the funds in the borrower, similar to the obligor under a capital call agreement has an investors reluctance to provide a guaranty. the actual power and authority to enter into the agreement. The owner (investor) in many Legal Issues in Drafting Capital Call deals is a fund controlled by an equity sponsor. Agreements/Practical Tips In such a case, this can be accomplished by making sure that (a) the fund has the Section 365(c)(2) of the Bankruptcy Code irrevocable contractual right to call capital from prohibits a debtor (borrower) from assuming the funds limited partners, (b) there is an or assigning any contract which requires a adequate unrestricted capital reserve in the party to make a loan to, or an investment in, fund, and (c) the general partners right to call the debtor (borrower). This would seem to capital from the limited partners is assignable say that capital call agreements are useless to the senior lenders, if possible. In every case, when the borrower files for reorganization the lender and its counsel should review a funds under Chapter 11, the time when such organizational documents to ensure that no agreement is most needed. The problem is prohibition on the fund delivering a capital call overcome by making the lender a third-party agreement is in effect. Prudent lenders should beneficiary to the capital call agreement and also obtain an opinion from the funds counsel by making the investor (owner) waive any that the execution of the capital call agreement, benefit of Section 365 of the Bankruptcy Code. and performance by the fund of its duties under As a further protection, a well-drafted capital the capital call agreement, have been duly call agreement should give the lender the right authorized by the appropriate fund authorities to demand that the amounts due under the and do not contravene any such organizational capital call agreement be paid directly to the document. Lenders may meet objections from lender to reduce the borrowers obligations. sponsor groups that fund organizational This last provision, however, may cause a court documents are private and subject to to characterize the capital call agreement as a confidentiality restrictions. In such event, guaranty. lenders at a minimum should insist on receiving appropriate opinions of counsel. Also, lenders A lender must ensure that the capital call and their counsel should conduct due diligence agreement permits the lender to demand that to ensure that the fund or investor does not the owner (investor) make the required have a history of failing to honor capital call agreements or guaranties.
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Credit Issues agreement and on an ongoing basis. Further, the capital call agreement may contain financial Like a guaranty, a capital call agreement, no matter covenants which would give the lender the right to how well-drafted and no matter how enforceable, is trigger the capital call if the funds financial condition still only of use if the underlying obligor (investor) is deteriorates. Once a lender is able to get a business credit worthy. Lenders must do their own business understanding on a capital call agreement, the lender due diligence to ensure that is the case. Often, the and its counsel need to focus on both the due diligence first step in conducting this due diligence is ascertaining and legal drafting to ensure the capital will be available who exactly the underlying obligor is and what are to the borrower when called. To the extent that its assets. Equity sponsors often manage a whole investors are seeking escape clauses from series of separate funds, each of which is a distinct performing capital call obligations, lenders must be legal entity. A lender must be certain that the party entering into the capital call agreement is the party it willing to stand behind the often controversial decision anticipates, and that such entity has adequate to insist on well-drafted legal documents. The uncommitted and available funds to meet any of its consequence of a poorly drafted capital call obligations. A lender should also obtain financial agreement could be the failure to realize upon the statements from the obligor, both on the date of the benefits of the capital call.
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The Practical Lender is published by the law firm of Vedder, Price, Kaufman If you have any questions regarding material in this issue of The Practical & Kammholz. It is intended to keep our clients and interested parties Lender or suggestions for a specific topic you would like addressed in generally informed on developments in the commercial finance industry. a future issue, please contact the executive editor and group Chair, It is not a substitute for professional advice. Michael A. Nemeroff. © 2003 Vedder, Price, Kaufman & Kammholz. Reproduction of this bulletin is permitted only with credit to Vedder, Price, Kaufman & Author: Allen J. Gable Kammholz. For an electronic copy of this newsletter, please contact us Executive Editors: John T. McEnroe and Michael A. Nemeroff at [email protected].
V EDDER, PRICE, KAUFMAN & KAMMHOLZ
About Vedder Price Steven J. Gray Timothy W. O’Donnell Vedder, Price, Kaufman & Kammholz is a national, full-service law firm Lane R. Moyer with approximately 200 attorneys in Chicago, New York and New Jersey. Jeffrey C. Davis Geoffrey R. Kass The Finance and Transactions Group William J. Bettman Paul R. Hoffman The Finance and Transactions Group of Vedder Price actively represents John T. Blatchford publicly held and private corporations, financiers, leveraged buy-out Dana S. Armagno firms, private equity funds, venture capitalists, lenders, and related Matthew T. O’Connor parties in a broad range of matters, including mergers and acquisitions; Mark J. Kosminskas equity and debt financing; mezzanine financing; venture capital; private Eric S. Prezant equity investments; and related transactions. Joseph H. Kye David C. Blum Principal Members of the Finance and Transactions Group: David P. Kaminski Nathan D. Koch Chicago: Adam S. Lewis Michael A. Nemeroff (Chairman) Jennifer Durham King Robert J. Stucker Megan E. Meyers Thomas P. Desmond James W. Morrissey John T. McEnroe Meeghan O’Donnell Daniel O’Rourke Leslie Allen Jonathan H. Bogaard Robert W. Dixon Michael G. Beemer Jacob C. Pond John R. Obiala Allen J. Gable Jennifer R. Evans Robert J. Moran New York and New Jersey: Dalius F. Vasys Ronald Scheinberg Guy E. Snyder Donald A. Wassall Daniel T. Sherlock Denise L. Blau Douglas J. Lipke Steven R. Berger Douglas M. Hambleton Stewart Reifler Dean N. Gerber Van Z. Krikorian Richard L. Williams III Sara Stewart Champion Thomas E. Schnur Kathleen R. White
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