The scope of your obligation to disgorge repayments of purchased loans may depend upon how and when you purchased them.

The Big Picture

The Eleventh Circuit’s 2012 TOUSA decision¹ has prompted secondary loan market investors to reconsider the  circumstances under which loan repayments might be subject to disgorgement. Under LSTA bank loan transfer documentation sometimes evoking the maxim that a camel is a horse  designed by a committee, disgorgement is one of the humps. No fewer than five different rules govern when repayments are subject to disgorgement. In the final analysis, the disgorgement risk a secondary loan market investor takes may, perversely, depend less upon whether loans traded on a “par” or “distressed” basis than on the form of the loan transfer (participation or outright assignment), or whether the trade closed before or after the loans were refinanced, repaid or otherwise discharged.

Rules of Disgorgement

[1] The Distressed PSA Rule: Unlimited Liability with Lender Parity

The Purchase and Sale Agreement commonly used for outright assignments of distressed loans requires buyer to “promptly return … to Seller … any portion of a Distribution received by Seller and transferred to Buyer [that is] … required to be returned or disgorged by Seller to any Entity …”, Distressed PSA §8.2(a)(iv). This open-ended buyer disgorgement obligation is tempered by seller representations that, among other things, seller has not taken action that would cause buyer to be treated less favorably than the rest of the lending group, Distressed PSA §4.1(h), giving buyer some assurance that it has “bought the credit”, not a unique loan with sui generis liabilities.

[2] The Chapter 11 Proceeds Letter Rule: Payments Made in Error

Loan transfers that have not yet closed at the time the subject loans have been refinanced, repaid or otherwise discharged generally close pursuant to forms of “proceeds letters”. The proceeds letter form used where the discharge results from confirmation of a Chapter 11 plan limits buyer disgorgement solely to situations in which “a payment or other distribution [has been] made by mistake or in error by the entity charged with making the distribution of Proceeds.” The rationale for narrowing buyer’s disgorgement obligations under these circumstances is that, if distributions are being made to the lenders, the confirmed plan’s discharge provisions likely will have already resolved any disgorgement-related claims against them.

[3] The Par Assignment Rule: No Disgorgement Obligation

Outright par loan sales close on the bare-bones assignment form, or “A&A”, annexed to the credit agreement, not a separate purchase and sale agreement. A&As generally omit any provision imposing disgorgement obligations on buyer.²

[4] The Par Participation Rule: Unlimited Liability Without Parity

Par loans sold by “participation” (instead of by outright assignment) impose unlimited disgorgement obligations upon buyers³, but without the assurance of representations or warranties rendering these obligations pari passu with those of the other lenders in the credit. A grantor of a par loan participation could, for example, seek disgorgement of loan repayments previously made to the grantor and passed along to the participant that the grantor itself was required to disgorge due to the grantor’s own acts or omissions, or that might not have been recoverable by the borrower directly from the participant if it had instead acquired the loans from grantor by assignment.⁴

[5] The Out-of-Court Restructurings Rule: Anything Goes?

An acknowledged blind spot in the treatment of disgorgement under LSTA loan transfer documentation is where a borrower completes an out-of-court restructuring before a pending trade can close. If the loans traded on a distressed basis, a special short-form proceeds letter is generally used, but the form punts the disgorgement issue, relegating to the parties’ negotiations whether a buyer disgorgement provision should be included, and how broad or narrow it should be.⁵

The situation is even more problematic when the trade has been done on par documents, as there currently is no par proceeds form, even though it is not unheard of for credits trading on a par basis to be restructured, refinanced, or otherwise paid off, before pending trades pending in the credit can close. (A well-known recent example is Harrah’s 2013 First Mezzanine Loan refinancing.) Some sellers, pointing out that a “par proceeds” situation has attributes in common with the granting of a par participation (i.e., title to the underlying loans is not transferred, but payments on the loans are passed on to the buyer/ participant), argue that the seller-friendly par participation form is the appropriate model for these situations; buyers counter that the happenstance of a payoff, refinancing or restructuring should not be responsible for saddling them with an unlimited disgorgement obligation they would entirely avoid if the trade had closed as a par assignment.

The Way We Were

When a repayment is disgorged, the status quo ante generally should be restored, such that the amount of the outstanding loans revert back to the amount that existed immediately prior to the making of the now-disgorged payment. This concept, memorialized in Section 502(h) of the Bankruptcy Code, finds its way into the LSTA transfer documentation lexicon through the concept of “Reimbursement Claims”.

Restoration of buyer’s pre-disgorgement claim is less of a certainty when disgorgement is sought not directly by borrower under Bankruptcy Code avoidance provisions, but instead contractually by seller, as there are no assurances that the “claim over” against the borrower presupposed to arise upon disgorgement will arise when the disgorged amount is repaid by buyer to seller. The par participation and the out-of-court restructuring scenarios seem particularly susceptible to this further risk.

Buyside Takeaways

• Be aware of the potentially broader disgorgement obligations par loan participations present, and consider avoiding this structure when circumstances so dictate.

• In distressed trades, consider negotiating on the trade date for a standard trade confirmation rider limiting the breadth of buyer’s disgorgement provision if there is an out-of-court restructuring of the underlying credit before the trade can close.

• In par trades, consider pushing aggressively to close on an assignment basis when a restructuring or refinancing is imminent.

Illustration by: Adam Niklewicz/Illustration Source.

1. 1  In re TOUSA, Inc., 680 F. 3rd 1298 (11th Cir. 2012)(lending syndicate ordered to disgorge multi-million dollar loan repayment received in refinancing backed by upstream guarantees held to have been issued for less than reasonably equivalent value). ↩
2. 2  The omission of a contractual disgorgement provision in the A&A does not insulate buyer from disgorgement sought directly by a Chapter 11 debtor, Bankruptcy Code §550(a)(2), or required pursuant to applicable credit agreement sharing provisions or intercreditor agreements. ↩
3. 3  The Par Participation Agreement’s buyer disgorgement provision, §8.1(d), is identical to the disgorgement provision in §8.2(a)(iv) of the Distressed PSA. ↩
4. 4  Bankruptcy Code §550(b)(1) shields a subsequent transferee of a loan repayment from having to disgorge a loan repayment avoidable in the hands of the initial recipient of repayment as, e.g., a preference or fraudulent conveyance, if the transferee received the repayment for value, in good faith and without knowledge of the availability of the transfer. ↩
5. 5  Sellers often argue against adopting the narrow “payments made in error” rule of the Chapter 11 Proceeds Letter form on the theory that, without the entry of a confirmation order, loan repayments under an out-of-court restructuring may be more easily subject to challenge. Upfront negotiation of a balanced buyer disgorgement provision in this circumstance is often impractical: buyer and seller rarely know at the time of trade that they will be compelled to close on a proceeds letter; and once seller receives the proceeds of the restructuring, it is often emboldened to insist upon a broad disgorgement provision, especially if the trade is in the money, and the value of the proceeds seller already has in hand exceed the purchase price payable by buyer. ↩