Yield Protection in Loan Agreements – Current Issues
07 February 2011
A lender entering into a loan agreement expects that it will receive a certain return that is usually calculated by reference to an agreed margin over its cost of funds. This pricing model rests on certain assumptions regarding the broader tax and regulatory treatment of both the loan and the lender. If the treatment of either changes so as to make the loan more expensive for the lender or otherwise reduce its rate of return, the lender expects to have the right under the loan agreement to pass on those costs to the borrower and so protect this expected return. Various provisions of a loan agreement relate to such yield protection, with the key provisions being the taxes clause and the increased costs clause. It should be noted at the outset that while a lender will wish to have the right to recover certain costs under its loan documentation, it does not follow that lenders will always exercise that right in practice.
The financial crisis has resulted in various proposals to change the rules surrounding the treatment of loans by lenders, many of which are still in the process of discussion and implementation. There is still a considerable degree of uncertainty as to the final form of many of those changes and their impact on loans. Consequently, loan agreements drafted today must anticipate a number of different regulatory outcomes and provide appropriate protection. This note discusses a number of issues that are being considered by the loan market on current deals.
Concerns about the implementation of the proposed changes to the Basel Framework (the latest round of such changes usually being described as Basel III) are not new. Throughout 2010 lenders and borrowers discussed how loan agreements should treat the changes contemplated by Basel III. The rules text of the Basel III framework was published on 16 December 2010, though it is not required to be implemented at a national level until at least 2013. The background and detail of these changes have been discussed in more detail elsewhere, but the loan market appears to be forming a broad consensus as to how the issue should be addressed, at least for the moment.
Although a number of borrowers have sought to carve Basel III costs out of the protection offered by the increased costs clause (and, in certain deals, have succeeded in doing so), lenders have usually managed to resist the change. The most common position on current deals is that the increased costs clause does not exclude the right of lenders to recover Basel III costs. The justification given by lenders is that the scope and effect of the Basel III changes remain sufficiently uncertain and potentially wide-ranging that they need to retain the increased costs protection until it is possible to quantify and price in the impact of Basel III. This position is likely to change as further details of the scope and effect of Basel III become clear, just as the carve-out for Basel II costs became increasingly widely accepted in the market.
In certain transactions we have seen the lenders go further and make specific reference to the fact that Basel III costs are to fall within the ambit of the increased costs clause. Arguably such additional language is not necessary on the basis that the relevant national laws and regulations are not yet in effect and the increased costs clause would pick them up automatically at that point. It does however have the benefit of avoiding any future discussion about exactly when Basel III was introduced into law, as there might be a debate as to whether the relevant date would be the date on which the framework was published or the date on which any national laws or regulations are enacted.
The existing Basel II carve-out has itself attracted greater scrutiny in light of Basel III, as a concern has been identified that the usual language used for the carve-out is likely to inadvertently extend so as to also exclude Basel III costs. This is because Basel III has been implemented by way of an amendment to the existing Basel II regime. The LMA recently issued a note flagging this as a concern. Where Basel II costs are excluded from the increased costs clause of any loan agreement then the prudent approach for a lender is to make specific reference to the fact that this does not extend to Basel III costs. Given that Basel II represents existing law in the majority of jurisdictions we would suggest that the exception is no longer required in many increased costs clauses and can be removed where present, which in turn addresses the concern about the language inadvertently carving-out Basel III costs.
UK Bank Levy
The June 2010 budget in the UK saw the introduction of a bank levy to be applied to the banking industry with effect from 1 January 2011. As at the date of this note the enacting legislation is still in draft form, though expected to be included in the Finance Bill 2011. It is likely that a lender could claim these costs from a borrower under the increased costs clause in most loan agreements. Since last June some borrowers have sought to exclude such costs from the scope of the increased costs clause in deals involving UK lenders. In many cases banks have resisted this change since, as with Basel III costs, there was a concern about understanding exactly what the impact of the bank levy would be.
However, unlike Basel III costs it is perhaps harder for a bank to argue that the increased costs clause should extend to a bank levy, which could be characterised as a tax on the institution, albeit one linked to its eligible liabilities. Historically borrowers would not expect such taxes to be recoverable under the increased costs clause. Following the publication of the draft legislation the details of the levy have become clearer, so our expectation is that affected banks will be more willing to consider its exclusion. Once the levy becomes law then of course it will no longer be recoverable under most increased costs clauses in any event. A drafting point to note is that borrowers may frame the requested exclusion in very wide terms, referring not just to the specific UK bank levy but also to future levies of any nature in any jurisdiction. Such wording should be considered carefully as our expectation is that lenders will be willing only to exclude specific levies which can be quantified. Other jurisdictions, including France and Germany, have also introduced bank levies and affected lenders will need to consider if the costs of such levies can now be measured and priced into deals or whether they need to retain the right to claim these costs from their borrowers.
The Dodd-Frank Wall Street Reform and Commercial Protection Act (Dodd-Frank) is a federal statute introduced in the United States in the wake of the financial crisis. It became law on 21 July 2010. It is wide reaching in its impact and has been described as the most sweeping change to financial regulation in the United States since the Great Depression.
One of the effects of Dodd-Frank will be to trigger certain additional regulatory costs that will be borne by those banks who are subject to its provisions. Just as in Europe, the usual approach in the US is for the borrower to bear the risk of a regulatory change following the signing of loan documentation but for the lenders to take the day-one risk. However, notwithstanding that Dodd-Frank has been signed into law, its scope and detail will not fully become clear until the implementing regulations have been established. At present, those regulations are all still at various stages of preparation and discussion.
Given this lack of clarity and the huge potential impact on a bank's business, many US lenders are looking to protect their position and to retain the right to pass on these potential costs to their borrowers via the increased costs clause, at least until such time as the detail of the implementation of Dodd-Frank can be properly assessed. Even though existing legislation would not ordinarily be regarded as a change in law, in the case of Dodd-Frank an exception has been made and many US loan agreements now expressly contemplate Dodd-Frank as a "Change of Law". Indeed, the current draft of the LSTA Model Credit Agreement Provisions, which is likely to be finalised this quarter, reflects this position.
This has to date been an issue primarily for US banks in their domestic market. However, if it becomes an established exception in the US loan market then US lenders may look to achieve a similar level of protection under the increased costs clauses of loan agreements in other markets, though non-US borrowers may be less receptive to agreeing to such wording and non-US lenders may not feel as strongly on the point.
US tax legislation – FATCA
On 18 March 2010 the Hiring Incentives to Restore Employment Act became law in the United States, incorporating many of the provisions of the Foreign Account Tax Compliance Act of 2009 (FATCA). This represents an extensive change to the US withholding tax and information reporting requirements. In particular, it seeks to penetrate bank secrecy rules to address tax evasion. The details of FATCA are outside the scope of this note, but it is likely to have an impact on loan documentation where non-US entities receive US-source interest and certain other payments.
FATCA will potentially impose a 30 per cent. withholding tax on certain US source payments made to "foreign financial institutions", unless such institutions can demonstrate compliance with the new reporting requirements. In addition to payments of interest, other payments potentially subject to withholding might include the proceeds of sale or participation in a loan to a US borrower (even where the lenders in question are non-US financial institutions). The risk, of course, is that such a tax might be imposed in a situation where neither the borrower nor the lender is expecting it, resulting in either a material gross-up obligation on the borrower or the risk of a payment shortfall on the part of the lender. As the legislation has already been signed into law, lenders may need to consider whether they are still able to confirm that they have day-one "Qualifying Lender" status under the gross-up clause of a loan agreement.
Unlike the other points considered in this note, this one does not relate to bank regulation. However, it relates to the same issue of ensuring that a loan provides the expected yield. Even if a loan transaction originally involves only US entities, FATCA affects how easily that loan might be sold down to non-US lenders who may not benefit from the relevant FATCA exceptions. We anticipate that lenders will therefore need to consider this issue on any transaction with US borrowers or transactions where US entities may subsequently accede as borrowers. Given the broad implications of FATCA, we anticipate that many non-US financial institutions are likely to seek to become FATCA compliant by entering into the appropriate information sharing agreements with the US authorities, though this is likely to be a less attractive option for many funds who are active in the leveraged finance market. Borrowers with US operations may also need to consider the risks of having non-FATCA compliant lenders in their lending syndicates.
Allen & Overy have direct experience of all of the issues considered by this note and the different solutions that can be found. If you would like to discuss any of these issues please feel free to approach your usual A&O contact.