MARKET DISRUPTION CLAUSES IN BANK FACILITY AGREEMENTS
Authored by: James Farn
A typical committed term loan facility agreement will contain a number of yield protection clauses which are designed to ensure that the bank, over the term of the commitment, receives the return which it expects when entering into such an agreement. James Farn analyses the Market Disruption clause and its effects.
- The Market Disruption clause requires the borrower to compensate the lender for its actual cost of funds if a 'Market Disruption' event occurs.
- If invoked, the Market Disruption clause will impose an agreed 'substitute' rate on the borrower. This rate will be binding on all the lenders, if all the lenders agree.
- Lenders should ensure that the Market Disruption clause is included in the facility agreement. Without any contractual right to invoke Market Disruption, a bank will have no effective remedy for such compensation from the borrower.
Other than in cases where a bank may offer simple ‘on demand’ facilities (such as overdrafts and other lines of credit which are repayable on notice from the bank, a typical committed term loan facility agreement will (or at least should) contain a number of clauses which are designed to ensure that the bank, over the term of the commitment, receives the return which it expects when entering into such an agreement. These clauses are commonly known as ‘yield protection’ clauses. Two of the most important are the Market Disruption and Increased Cost clauses.
These clauses are important in the context of negotiating new or amending or re-negotiating existing facilities.
‘Matched book’ funding
Unless a bank lends at a variable or base rate, committed lending generally assumes the bank runs a ‘matched book’ – ie; the bank funds its advance to the borrower for a defined interest period by taking a deposit in the relevant interbank market which precisely matches, in terms of the amount and maturity, that bank's advance for the given interest period. Where the lending is undertaken by a UAE bank (or syndicate of UAE banks) in Dirhams, that rate would be the Emirates Interbank Offered Rate (EIBOR). The rate of interest charged to the borrower will include a margin (or profit element) which is added to the prevailing EIBOR rate.
In a single bank deal, the definition of EIBOR will effectively be the bank's cost of funds. However, in a syndicated loan, for administrative reasons, EIBOR is defined as an average figure compiled from the rate at which defined reference banks offer to supply funds to prime banks in the Interbank market as determined at the relevant fixing day or by reference to a screen rate (which quotes an 'inbuilt' average rate for a range of different currencies).
The Market Disruption clause requires the borrower to compensate the lender for its actual cost of funds if a 'Market Disruption' event occurs.
Market disruption is usually invoked if either:
- a Screen Rate is not available and only one or none of the reference banks is able to supply or determine EIBOR; or
- more likely in the current economic climate, a lending bank is unable to fund a loan or participation in a loan at EIBOR – in other words, it can only fund in excess of the prevailing Interbank Market rate (the difference between the screen rate and its actual cost of funds).
During the term of a loan facility, things may change:
- new banks may enter into a syndicate as transferees (with different credit ratings to the transferor) and, therefore, different abilities to borrow cheaply
- the original bank's ability to borrow at EIBOR may change – for example, credit rating changes or because of real or perceived problems associated with their nationality
- the market generally may change – for example, the premium which ‘second tier’ banks currently pay above ‘prime’ banks for their cost of borrowing in the UAE Interbank market may increase.
If invoked, the Market Disruption clause will impose an agreed 'substitute' rate on the borrower. This rate will be binding on all the lenders, if all the lenders agree.
Under a syndicated facility, the loan agreement will typically provide that if one or more banks (holding participations in at least, say, 1/3 of the aggregate amount outstanding under the facility) object, then they can require interest rate for all banks to be replaced by a more representative rate. A different percentage figure may be more appropriate, depending on the constitution of the syndicate.
Before imposing a substitute rate of interest, the borrower usually (or at least should) be required to enter into negotiations to agree a new substitute rate of interest. If this occurs and a new rate can't be agreed, then the loan may become repayable. However, no equivalent right is usually given to the borrower to require the banks to enter into negotiations to agree a new rate.
Can the borrower object?
The borrower will say why should he bear the risk of one or two banks in a syndicate having to pay more for their own funding than the rate as originally negotiated in the facility agreement which he is contractually obliged to pay.
This may be particularly relevant where there is a deterioration of a bank's credit rating over which the borrower has no control.
- The loan agreement should always include right for the borrower to prepay the loan (or that part of the loan) owed to the bank which has invoked Market Disruption at the end of the relevant interest period if he doesn’t like the new rate. In a situation where negotiations are likely to be successful, even the threat of prepayment should invoke the banks into negotiating a new rate. However, even where prepayment is accepted, the borrower will still have to pay the substitute rate until prepayment occurs.
- Prepayment should always be on notice and without payment of any premium or penalty.
- The loan agreement might require the affected bank to assign the loan or its participation in the loan to an affiliate of the bank concerned or to another facility office of that bank to alleviate or mitigate the effect of Market Disruption.
- A clause placing an obligation of the affected bank to mitigate against the effect of Market Disruption should always be included in the loan agreement.
Lenders are advised to ensure that the Market Disruption clause is included in the facility agreement. Without any contractual right to invoke Market Disruption, a bank will have no effective remedy for such compensation from the borrower.
Next month, James Farn will look at the practical effect of the “increased cost” clause in a committed loan agreement.