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LOS ANGELES-In secured lending transactions, “swaps” have allowed borrowers to hedge against fluctuations in interest rates and currencies. Earlier this year, new swap rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) have come into effect, resulting in new and troubling provisions in lenders' form loan documentation.
Most swaps in secured financings occur through “over-the-counter” arrangements, not on a registered exchange. In a new effort to regulate “over-the counter” swaps, the new swap rules have instituted a “clearing” requirement for such transactions. As a result, all parties to swaps that are not executed on a registered exchange must qualify as “eligible contract participants” (ECPs). Generally, entities with total assets in excess of $10 million qualify as ECPs, so most large corporate borrowers are able to meet this minimum threshold. However, the regulators have made clear that the ECP status requirement applies not only to borrowers, but also to guarantors of swap obligations. Also, the new swap rules test ECP status each time a swap is entered into, not just at the time of loan closing.
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Because it is the lender that is penalized for violation of the new rules, lenders have modified their loan documentation in transactions that involve swaps to ensure their legality and enforceability. This means that in addition to actually verifying that borrowers and guarantors qualify as ECPs, lenders will require representations from each borrower-side entity responsible for the swap--including guarantors--regarding their ECP status, both at the time the loan is made as well as each time a swap is entered into. Lenders are also requiring new covenant to maintain ECP status, as well as provisions in guarantees and other security documents to protect against possible violations of the new swap rules. Borrowers and guarantors need to review these provisions carefully to avoid technical defaults.
To further ensure compliance and validity, lenders have added language to guarantees and other loan documents carving out any guarantees of swap obligations by a non-ECP. However, the new swap rules don't actually prevent non-ECP entities from guaranteeing swap obligations. Where credit arrangements are made with a guarantor that does not otherwise qualify as an ECP (such as a non-ECP affiliate guarantor), the current solution implemented by most lenders is the “keepwell cure” or the insertion of “keepwell” provisions in the guaranty, whereby an entity that is an ECP agrees to provide funds or other support for the obligations of the other parties to the swap that do not qualify as ECPs. ECP status is thereby essentially conferred upon such non-ECP entity.
The practical effect is that lenders continue to be able to include non-ECP entities into the financing package for credit support, while borrowers may want to negotiate to exclude such non-ECP guarantors or the use of such cross-guarantees.
In any case, borrowers and guarantors in deals with swap obligations need to carefully check the lender's proposed provisions to be sure they comply.
Anita Hsu and Tom Muller are partners of the land use and real estate practice group at Manatt, Phelps & Phillips LLP. THe views expressed in this column are the author's own.
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