3.3 The Loan Market Association standard-form loan documents and English law lessons
3.3.3 The consequences of an event of default
In addition to standardising lendersʹ approaches to loans, the LMA standard-form loan documentation promotes the transferability of loans, thereby increasing liquidity in the markets.337 As Ivashina and Scharfstein put it, the significance of transferability is that it extends the credit cycle.338
3.3.2 English case law lessons regarding acceleration notices and the priority of claims While the UK body of case law in respect of disputes arising from bilateral and syndicated facility agreements and the related security agreements, and therefore disputes about secured lending, is developing, there is virtually no South African case law on syndicated lending and the related security. Two recent notable English judgments of the High Court of Justice of England and Wales dealing with acceleration notices, and the priority and subordination of claims can provide guidance to South African law on secured loans because the LMA's South African facility agreements contain acceleration rights.339 South African law has some jurisprudence on the subordination of claims.340
Acceleration notices
In English law in 2016 in African Export-Import Bank and Others v Shebah Exploration and Production Company Ltd and Others341 ('African Export'), the claimants (the lenders) sought summary judgment against the first defendant (the borrower) and the second defendant (the guarantor) for an amount of US$144.2 million plus interest, the principal debt having been borrowed pursuant to a syndicated loan facility.
When the first defendant breached the facility agreement by not repaying the loan, the claimant issued an acceleration notice on 6 September 2013, and contended that the notice took effect on 16 October 2013 (one month after the 16 September 2013 instalment was due) without the claimant having to issue any further notices. The defendants disputed the effectiveness of the acceleration notice as it was expressed to be effective at a future date, whereas the acceleration clause required the outstanding amount to be immediately due and payable. Judge Phillips granted summary judgment in favour of the claimants against the defendants and held that the acceleration clause did not entitle the claimants to pick a future date of their choice on which the loan was due and payable and that the loans must be immediately due and payable to fall within the clause. In other words, for an acceleration notice to be valid, it must set out that the loan is immediately due and payable, not that it will become due and payable at a future date if the borrower fails to repay the loan on maturity. The relevance of this judgment is discussed in section 3.3.3 (The consequences of an event of default).
337 See www.lma.eu.com; Hughes 'Transferability in Syndicated Lending' (2007) 1(1) Law and Financial Markets Review 21–
24. 338 Ivashina & Scharfstein 'Loan Syndication and Credit Cycles' (May 2010) 100 American Economic Review: Papers and Proceedings 57–61 at 57. See http://www.aeaweb.org/articles.php?doi=10.1257/aer.100.2.57.
Priority
The priority of claims over other claims is effectively the subordination of claims to other claims. Subordination of claims is a feature of syndicated, secured lending in South Africa and internationally, and is a legal construct accepted in both South African law and English law. A brief discussion of the position in English law and the position in South African law follows.
In 2013, in Bank of New York Mellon (London Branch) v Truvo NV and Others342 ('Mellon'), the claimant and defendant, two lenders, each contended that different consent levels were required under a senior facilities agreement to amend a particular provision. The clause that was being amended concerned the application of mandatory prepayments as between the senior lenders and the second lien lenders. The parties wished to amend the order in which payments would be made in certain circumstances.
Millar, the holder of the senior debt and the second lien debt, contended that the senior facilities agreement required the consent of only two-thirds of the lenders. Deutsche Bank, AG (London branch), also a holder of senior debt and second lien debt, contended that the senior facilities agreement required the consent of 100 per cent of the lenders, which included the second lien lenders. The court held that it made no commercial sense to contend that a lower percentage lender consent level was required for an important decision, and a higher percentage lender consent level was required for a less important decision. The court held that the majority lenders could amend the mandatory prepayment proceeds clause without each second lien lender's consent, which made commercial sense. This was the position especially where there was a real possibility of a distress event occurring. After considering a number of arguments, the court concluded that Millar's construction that the consent request signed by the majority lenders did not have the effect of amending or changing 'the order of priority or subordination under the ICA within the meaning of Clause 40.3(a)(v) of the SFA and there is nothing in the ICA (including Clauses 14 or 27) which would justify a contrary conclusion'343 was correct. Accordingly, the consent of all lenders was not required, and the consent of the majority lenders and Truvo to the amendment was sufficient to constitute an effective and valid amendment.
It is submitted that two important lessons can be learnt from the Mellon judgment, which ought to be applied in South African law insofar as mandatory prepayments are concerned. First, the terms 'priority' and 'subordination', although used to rank payments to creditors on the borrower's insolvency, need not be restricted to this situation. Such terms can also be used to rank payment to creditors in a mandatory prepayment scenario where the debtor is solvent. Second, the parties to the loan ought to stipulate in the loan documentation if priority and subordination will apply to the mandatory
342Bank of New York Mellon (London Branch) v Truvo N.V. and Others [2013] EWHC 136, Queen's Bench Division, Commercial Court; Kariem 'Lender Consent: Priority, Subordination and Mandatory Prepayments' Finance and Banking Alert Cliffe Dekker Hofmeyr Inc., 16 May 2016.
343Bank of New York Mellon (London Branch) v Truvo N.V. and Others [2013] EWHC 136, Queen's Bench Division, Commercial Court, para 95.
prepayment provisions, and what level of lender consent is required to alter the mandatory prepayment ranking. Ordinarily, the facility agreement contains a clause that ranks all payments received under that agreement into the payment waterfall which ought to expressly stipulate that priority and subordination will apply to mandatory prepayment proceeds.
Subordination
In South African law, subordination is an incidentale of the loan created contractually between lenders whereby the priority of one lender's claim(s) over another is agreed, and the enforceability of the subordinating lender's claims is postponed or is put in abeyance. In English law, Gough offers an instructive definition of priority (the same concept as subordination) that applies with equal force in South African law:
Priority is the process of ranking proprietary claims of different parties arising from successive charge assignments, each being valid as between assignor and assignee.344
The 'process of ranking proprietary claims of different parties' is exactly what lenders achieve by a subordination contract in South African law. Bratton suggests that subordinated debt is issued to enable borrowers to 'access or conserve borrowing room in their capital structures'. He further suggests that companies may find that their capital structure will not support further long-term, senior, unsubordinated borrowing.345 In Cape Produce Co (PE) (Pty) Ltd v Dal Maso NO and Another346 the Appellate Division held as follows:
The debt is unenforceable because while the condition subsists the creditor's cause of action itself is deficient. The creditor has no valid claim until the condition the subordination agreement spells out has been fulfilled. Until then the principal debtor has no need to invoke either a defence personal to him- or herself, or the extinction, discharge or invalidity of the debt: the principal debtor is immune from suit simply because the non-fulfilment of the condition, so long as it endures, renders the creditor's cause of action incomplete.347
It is market practice for lenders to agree in a facility agreement or a subordination agreement to subordinate their claims in favour of other lenders to enable a company to achieve an intended financial position such as solvency, or to borrow from lenders who want their claims to be first ranked, because if the company wishes to borrow, it is compelled to subordinate. In a syndicated loan, the subordination by an obligor of any of its claims in the borrower in favour of the lender's claims is typically a condition precedent or a utilisation condition to advancing the loans.348 In other words, an obligor must subordinate or back-rank its claims against the borrower in favour of the lender's claims against the borrower so that the lender's claims can be paid first. It is the obligor's
344 Gough Company Charges 2 ed (1996) 741 para 3.
345 Bratton Corporate Finance (2012) 382.
346 Cape Produce Co (PE) (Pty) Ltd v Dal Maso NO and Another [2002] JOL 9674 (A).
347 Ibid para 6.
348 The lender's term sheet and the facility agreement typically state that the subordination of the obligor's claims against the borrower is a condition precedent, and its fulfilment is typically confirmed in the enforceability legal opinion issued by the lender's legal counsel which opines on the enforceability of the finance documents.
obligation to fulfil this condition precedent by entering into a subordination agreement in favour of the lender. We state above that subordination alters the pari passu349 ranking of claims because the subordinated claim will be paid after the other claims are paid, not equally with such claims.350
Lenders may seek to alter contractually the insolvency law ranking of claims by subordination. A liquidator cannot give effect to the subordination if its object is to vary by contract the statutory ranking of claims (the so-called concursus creditorum) on the company's insolvency, as envisaged in the Insolvency Act. The concursus creditorum in respect of a company comes into being by operation of law when the application for liquidation is lodged with the registrar of the court, provided it is thereafter granted.351 It does not come into existence before then and is not a contractual term on which the loan is based. In Walker v Syfret,352 Innes J held that the concursus creditorum is when 'the hand of the law is laid upon the estate, and at once the rights of the general body of creditors have to be taken into consideration. No transaction can thereafter be entered into with regard to estate matters by a single creditor to the prejudice of the general body. The claim of each creditor must be dealt with as it existed at the issue of the order'.353 The concursus creditorum thus occurs when the liquidation of a company occurs, regardless as to whether the loan is being traded to new lenders. The liquidator is, at that point, bound by the statutory ranking and any attempt to alter it is of questionable validity. An agreement between concurrent creditors to rearrange the payment of their claims whether in respect of value or the payment sequence, so that it does not affect the concursus creditorum ranking of other creditors, may well bind a liquidator to pay such claims in the agreed order. It is submitted that subordination cannot make an insolvent company solvent merely because it back-ranks the subordinated claim(s). The fact that one lender has priority, in that its claims are paid first, does not absolve the borrower from its debt, the payment of which is merely postponed.
A distinction is drawn between contractual subordination and structural subordination. In a contractual subordination, the lender agrees to subordinate its claim.
In a structural subordination, according to Wright, the loan may be made by a lender to a shareholder as the borrower so that the loan is made to a borrower that is higher up in the group structure, without the lender taking security rights against the income- producing subsidiary of the shareholder.354 The lender subordinates its claim against the shareholder to whom it loans the money, and depends on the repayment of its loan from dividends declared by the subsidiary (after paying its creditors) to the shareholder (who is the borrower), and the shareholder receives payment of its claims only after the subsidiary's creditors have been paid. The subsidiary uses its income not to declare
349 See section 4.8 Pari passu ranking of security.
350 See section 3.2.8 Insolvency considerations.
351 Meskin Insolvency Law and its Operation in Winding-Up (1991) para 5.20.
352 Walker v Syfret 1911 AD 141.
353 Ibid 166.
354 Wright International Loan Documentation (2014) 326.
dividends immediately, but first to repay its creditors. In this way, the claim of the lender is structurally subordinate because the available cash from the income-producing subsidiary is used, first, to pay the subsidiary's creditors and, second, to declare a dividend to the shareholder which is used to repay the loan.355
3.3.3 The consequences of an event of default
In the LMA's South African facility agreements there are three principal consequences if the lender declares that the borrower has committed an event of default. First, the lender has the right to cancel any of its further funding obligations. The event of default does not automatically trigger the said cancellation.356 If the lender exercises its rights, then its declaration of an event of default contractually releases it from performing any further funding obligation. Second, if the lender exercises its rights to accelerate repayment, then advanced loans are immediately due and payable357 by the borrower on demand by the facility agent if a majority of lenders so decide.358 Wright states that in the latter instance, the lenders can declare the loan to be payable on demand without actually demanding repayment.359 The reason for this, according to Wright, is that the law in certain jurisdictions requires companies to stop trading after they are unable to pay their debts, so having this event of default avoids triggering that scenario for the company.360 Third, the facility agent may, or the majority lenders may, direct the Security SPV to exercise any of its discretions, powers, remedies or rights under the finance documents.361
In South African law, the mere existence of an acceleration clause in a contract does not necessarily trigger an obligation to pay the capital amount if the debtor fails to pay.362 Instead, it entitles the creditor to demand payment of the capital amount if the debtor fails to pay.363 Acceleration clauses in facility agreements are contractually agreed incidentalia in terms of which any borrower's default, including potential defaults, entitles the lender to accelerate the loan maturity date and/or exercise its security rights.364 Acceleration clauses are typically framed widely so that they net all borrower breaches.
It has not been decided in South African law whether a lender can accelerate the loan maturity date by reason of the borrower defaulting on an administrative obligation or an information obligation if the borrower is servicing the loan by making the agreed repayments.365 Acceleration rights are particularly important given the extensive list of defaults contained in the LMA's South African facility agreements that can give rise to
355 Ibid.
356 The LMA's Term Facilities Agreement, clause 22.22(a).
357 Ibid clause 22.22(b).
358 Ibid clause 22.22(c).
359 Wright International Loan Documentation (2014) 245.
360 Ibid.
361 The LMA's Term Facilities Agreement, clause 22.22(d).
362 Stadler v Hamilton Plase (Edms) Bpk 1977 (1) SA 211 (NC).
363 Ibid.
364 The incidentalia of a loan agreement are the terms incorporated by the parties either by way of a departure from the naturalia (terms implied by law) that would ordinarily have applied to a loan or for which the law does not make provision.
365 There is no indication in Joubert 'Loans' LAWSA (2008) that such a scenario has come before the South African courts.
exercising the right to accelerate the loan repayment.366
South African lenders should not, given the legal position in the African Export judgment, issue acceleration notices prematurely, before the debt is contractually due and payable, because such a notice has no contractual effect as the debt is not, at that time, due and payable. An acceleration notice must be issued when the debtor fails to pay a debt that is actually due and payable. The maturity date must therefore have passed without the borrower having made payment. In other words, an acceleration notice should not be issued in anticipation of, or on the assumption that, the borrower will breach its loan obligations. It is necessary to distinguish this issue from anticipatory events of default, which are typically events of default. It seems unlikely that a South African court would enforce a notice issued prematurely prior to a default occurring.