LSTA changes

[Sapphire Capital]

On April 24, 2014 the Loan Syndications and Trading Association (“LSTA”) published revised versions of its key secondary trading documents (the “Trading Documents”).

The revised Trading Documents are intended to be used for all trades entered into on or after April 24, 2014. The primary changes to the Trading Documents relate to: 1) new tax clauses to account for the implementation of the Foreign Account Tax Compliance Act ("FATCA"), 2) the ability of a participant to elevate a participation if the grantor or its parent becomes the subject of a proceeding under the Bankruptcy Code or similar debtor relief laws and 3) explicit statements providing that the intent of the LSTA participation agreement is to be a true sale.

A) FATCA:

FATCA requires certain foreign financial institutions (“FFIs”) to report to the Internal Revenue Service (the “IRS”) or, in the case of foreign financial institutions resident in a country that has entered into an intergovernmental agreement with the United States (an “IGA”), the tax authorities in such country, information with respect to financial accounts maintained by the institution held by certain U.S. persons and by certain non-U.S. entities that are wholly or partially owned by U.S. persons. For these purposes, an FFI generally includes an investment entity such as a hedge fund, private equity fund or CLO, and a financial account includes a debt or equity interest in such an investment entity. The purpose of FATCA is to prevent U.S. persons from hiding assets in offshore accounts. FATCA generally imposes a 30% withholding tax on U.S.-source income (including interest payments) and gross proceeds from the disposition of property that can give rise to U.S.-source interest or dividends (including principal repayments and proceeds relating to a sale of loans) made to FFIs that do not report U.S. account holders to the IRS or tax authorities in their country of residence if there is an IGA with that country. Of particular importance to the loan market, anyone who is defined as a "withholding agent" under FATCA (including anyone making a payment in the secondary market) is required to withhold on such payments to non-compliant FFIs.

Under FATCA, withholding on principal repayments and gross proceeds begins on January 1, 2017, and withholding on interest payments begins on July 1, 2014. Although loans outstanding on July 1, 2014 are “grandfathered” and not subject to FATCA, the LSTA has amended the Trading Documents for all trades going forward (including “grandfathered” loans) since such protection can be lost if the loan is subsequently materially modified. The broad definition of FATCA in the Trading Documents includes any IGAs.

1) Under Most Circumstances FATCA is a Payee Risk with No Gross Up Obligation:

In general, the Trading Documents view the withholding risk related to FATCA as a risk of the party receiving the payment (the "Payee") because compliance with FATCA is within the Payee’s control. This is in line with standard industry practice and therefore requires the Payee to provide documentation evidencing compliance with FATCA (as well as exemption from any other tax withholding) in order to receive a payment free of withholding.

The Trading Documents, including the trade confirmation (both par and distressed), have been revised to provide, other than in the situations set forth below, that if the Payee is not in compliance with FATCA, the party responsible for remitting funds under any LSTA governed transaction (the “Payor”) does not have to "gross up" the Payee for any withholding due to FATCA. The Trading Documents provide that in order to receive a payment free of withholding, the Payee must provide reasonably requested documents to demonstrate FATCA compliance as well as exemption from any other tax withholding obligation.

2) Gross up Provision for Non Compliant Payors:

While generally the risk of FATCA withholding is a Payee risk, the Trading Documents provide circumstances under secondary loan transactions where certain Payors are required to gross up certain Payees on the theory that in these specific situations compliance with FATCA is in the Payor’s control. In these circumstances, if the Payee is fully compliant with FATCA and would not have been withheld upon but for the fact that the Payor is not in compliance with FATCA, the Payor is required to gross up the Payee for any losses due to such withholding. The following two scenarios dealt with in the Trading Documents describe the application of this “gross up”:

Secondary Trade Closing by Assignment: In a secondary trade closing by assignment this “gross up” will generally be a factor when at closing the seller (Payor) is required to transfer to the buyer (Payee) certain payments that accrued prior to the closing date. Again, on the theory that any FATCA withholding on such payments was due to the seller’s noncompliance with the FATCA requirements.
Participation Agreement: In the case of a participation agreement, if the grantor under the participation agreement (Payor) is not in compliance with FATCA, such grantor may have to gross up for FATCA withholding (if the participant is FATCA compliant) on the theory that the FATCA withholding was due to the grantor’s noncompliance with the FATCA requirements.

The rationale for this limited gross-up protection is that the LSTA takes the position that when entering into a loan trade, buyer is not assuming any FATCA withholding risk that is in the control of seller.

3) FATCA Related Terms in all Trading Documents:

While in many situations these new FATCA provisions may not be applicable (where buyers and seller are both U.S. entities) these modifications nevertheless are included in all of the Trading Documents to help streamline secondary market trading by avoiding these discussions at the time of trade and during the documentation negotiation process.

B) Participation Elevation in the Event of a Grantor Default:

The LSTA participation agreements (both par and distressed) have been modified to provide that if the grantor of a participation becomes subject to a proceeding under the Bankruptcy Code or similar debtor relief laws, the participant may request an elevation and grantor will be deemed to have consented to such elevation. The type of proceedings that will trigger this elevation clause is defined very broadly to include a proceeding under the bankruptcy code, and all other liquidation, conservatorship, bankruptcy, assignment for the benefit of creditors, moratorium, rearrangement, receivership, insolvency, reorganization, or similar debtor relief laws of the United States or other applicable jurisdiction. This definition matches what is found in the current version of the LSTA model credit agreement. These being the first revisions to the LSTA participation agreements (both par and distressed) since 2008, are being instituted primarily to address concerns that came to the attention of the loan trading market after the collapse of Lehman Brothers. The LSTA has announced that they intend to release a form of elevation document later this quarter.

C) True Sale Terms in Participation Agreement:

Although LSTA participation agreements are already generally considered to be true sales, and were treated as such in the Lehman Brothers bankruptcy proceedings, Section 2.1(d) of the modified LSTA participation agreement now explicitly states that “it is the express intent of the Parties that sale of the Participation by Seller to buyer hereunder be and be treated for all purposed as a true sale by Seller of the Participation”.

D) Inclusion of Tax Provisions in LSTA Trade Confirmations:

The Trading Documents for the first time include tax withholding provisions in all LSTA trade confirmations. The trade confirmations now obligate a Payee to provide reasonable evidence of exemption from tax withholding obligations, in addition to FATCA, before a Payor is required to make any payment. Until now similar tax provisions were only found in the Participation Agreement (par and distressed) as well as the Purchase and Sale Agreement for distressed trades. With this change, par trades (which close via assignment and constitute the vast majority of secondary market loan trades) will include these provisions that were previously only included in distressed or participation contexts.