Since the financial crisis, loan-related regulatory reform has hovered on the horizon. In the past year, that horizon has gotten much closer and, indeed, several key changes are hitting now. Leveraged Lending Guidance has redefined leveraged loans — and may greatly expand banks’ leveraged loan portfolios. And there’s no long runway here: It is slated to go live May 21, 2013. Likewise, Cancellation of Debt Income (CODI), which could have the perplexing effect of making a distressed borrower pay steep taxes whenever it gets a covenant waiver, went into effect in November 2012. And while there is some runway before Chapter 11 is (possibly) rewritten, that change could temper the appeal of senior secured loans. Below, I discuss these three major regulatory regime changes.
Commission to Reform Chapter 11: Paradigm Shift?
One of the most compelling reasons to lend to a leveraged company is that such loans generally are senior and secured — and therefore generally see a high recovery in the case of default. However, this truism may become less true in the future. The reason? The possible reform of Chapter 11.
A year ago, the American Bankruptcy Institute (ABI) established the Commission to Study the Reform of Chapter 11 (Commission), with the idea of restoring “balance” in the bankruptcy process. The Commission may be entering this process with a view. Its public statement of purpose identifies two principal concerns that it believes have “affected the effectiveness of the current Bankruptcy Code”: 1) the “expansion of the use of secured credit” and 2) the “growth of distressed-debt markets.” The Commission’s statement of purpose intimates that these factors have interfered with the “goals of effectuating the effective reorganization of business debtors — with the attendant preservation and expansion of jobs — and the maximization and realization of asset values for all creditors and stakeholders.”
In order to inform its report, the Commission has held a number of public field hearings taking testimony from a broad array of witnesses. Some of this testimony and some of the writings by some Commissioners have been disconcerting. As just one example, some Commissioners have recommended a “pay-to-play” tax, which would require a secured lender to pay an across-the-board “tax” on the amount of its ultimate recovery in any bankruptcy. This tax is purported to capture the “premium” received by secured creditors under the Bankruptcy Code measured by the difference between the “going concern” value of the collateral and its theoretical “liquidation value.” Proposals such as these could have profound implications for the price and supply of secured loans.
Industry experts, rallied by the Commercial Finance Association, Midwest Finance Association and LSTA, have responded vigorously to such proposals. As an example, the LSTA has brought witnesses who testified about important topics such as credit bidding, the constitutional underpinnings of adequate protection, the motivations of investors in distressed debt, debtor-in-possession loans, loan market data, academic studies on the role of distressed investors and the perspectives of a “regular-way” institutional lender and an agent bank.
To date, there have been seven hearings with at least another seven scheduled for the remainder of 2013. The goal of the Commission is to present an overall record and report to Congress by April 2014. Inasmuch as the Commissions’ proposals could profoundly impact recovery of senior secured loans, it is an issue that deserves far more airtime than it has been receiving.
Leveraged Lending Guidance: Wolf in Sheep’s Clothing?
The final Guidance on Leveraged Lending (Guidance), which updates the 2001 Leveraged Lending Guidance, was released on March 21, 2013. The new Guidance is part of a long-term regulatory process that was informed to a great extent by the fall-out from the frothy pre-crisis loan market.
So, what does this Guidance do? In essence, it provides guidelines around what banks should consider to be leveraged loans (and how they should report on them). In effect, it may significantly increase banks’ “leveraged” and “criticized” portfolios, and thus possibly reduce lending to non-investment grade companies.
How would the Guidance do this? First, the definition of a leveraged loan may be expanded to include fallen angels (who seek modifications, extensions or refinancings), ABL loans (that have a term loan B or bond component), companies who engage in an acquisition or recapitalization transaction and whose debt/EBITDA is greater than 4X or senior debt/EBITDA is greater than 3X, loans in the trading book, and loans to financial vehicles that themselves engage in leveraged finance (such as business development companies). All told, due to these definitional changes, banks’ leveraged loan books may balloon.
Second, banks’ “criticized” books could grow as well. The agencies stated that if a company could not show the ability to amortize all its senior debt or half its total debt from free cash flow within five to seven years, the loan would likely be criticized. In addition, a leverage level after asset sales “in excess of 6X Total Debt/EBITDA raises concerns for most industries” (i.e., these loans may be flagged for further review/criticism). Thus, banks’ criticized assets may swell, again due solely to definitional changes.
Third, the Guidance requires materially more reporting, both to banks’ boards, as well as to the agencies themselves.
So, where does this stand? While the final Guidance has raised considerable questions in the industry, the general consensus is that it will not change materially. Moreover, the Guidance has a “compliance date” of May 21, 2013. With a short runway — little hope of change — most banks have shifted their focus from seeking fixes to trying to understand the nuances of the Guidance and implement the dramatic management information system changes that it will require.
CODI: The Quiet Threat
A remarkable, but quiet, problem has emerged in the loan market. In October 2012, the IRS released the final regulations on tax implications of debt exchanges. These Cancellation of Debt Income (CODI) Rules could create a daunting tax bill for issuers or lenders any time a distressed loan is amended.
There are a number of (often counterintuitive) aspects to CODI. First, for tax purposes, virtually any amendment of a loan would be treated as the retirement of the pre-modified loan in exchange for a new “modified loan.” (For instance, an amendment with an extension or a 25 bps spread change would trigger a “deemed exchange.”) Second, the rule is applied differently for loans that are “publicly traded” (or quoted) and those that are not. If a loan is publicly traded, the price of the exchanged debt is the market price at the time of the exchange. If a loan is not publicly traded (or under $100 million), the exchange price is par. Third, a borrower must recognize and pay tax on CODI equal to difference between the issue price of the old loan and the exchange price — even though there has been no debt forgiveness. Fourth, a lender may have a taxable gain equal to the difference between the price at which it purchased the loan and the exchange price — even though there has been no repayment.
As the theory is head-spinning, a practical example may be illuminating. Assume a $101 million “publicly traded” loan was originally syndicated at par, is currently trading at 80 bps, and $10 million (face value) was purchased by a lender at 70. The borrower seeks an amendment and agrees to a 50 bps increase in spread. In the IRS’s view, the borrower issued a loan at $101 million, repaid (and reissued) a loan at $80 million, and received $21 million of debt forgiveness. The borrower has to pay tax on this $21 million of debt forgiveness. Meanwhile, in the IRS’s view, the lender bought the loan for $7 million and was repaid $8 million. The lender has to pay tax on its $1 million gain.
Conversely, assume the same borrower issued a $99 million loan (which, due to its size, is assumed to not be publicly traded). A lender purchases $10 million (face value) at 70. The borrower seeks an amendment and agrees to pay a 50 bps increase in the spread. Because the loan is not publicly traded, it is assumed to be repaid and reissued at par — and thus the borrower faces no taxes. However, the lender is seen as buying the loan at $7 million and being repaid at $10 million. The lender has to pay tax on its $3 million gain.
While this may seem crazy, it’s the law. But it also has a slight possibility of changing — albeit not in lenders’ favor. The House of Representatives’ Tax Reform Bill actually addresses CODI. In the bill, if there is no actual forgiveness of debt, the revised tax code provision would treat the issue price of the modified debt as the issue price of the original debt, irrespective of its trading price. Effectively, the new provision would shield a borrower from current tax liability when it engages in a debt modification that does not result in forgiveness of debt. However, a lender would be required to recognize income at the time of an amendment measured by the difference between its purchase price and the original adjusted issue price; this would generally generate a steeper tax for the lender.
Regulation: Looking Forward
The examples above are just three of many regulations that will be coming to the loan market. While much of it may be well-intentioned, such regulation may have startling — and unpleasant — effects on the syndicated loan market. In turn, as painful as such reading may be, it behooves the informed lender to stay abreast of such changes. What you don’t know can hurt you.
Meredith Coffey is executive vice president, running the research and analysis efforts at the Loan Syndications and Trading Association (LSTA). Coffey co-heads the LSTA’s regulatory and CLO efforts, which help facilitate continued availability of credit and the efficiency of the loan market. Prior to joining the LSTA, Coffey was senior vice president and director of analysis focusing on the loan and adjacent markets for Thomson Reuters LPC.