Interpreting Ambiguities In Loan Documents - Part II

Tuesday, June 1, 2004 - 01:00

Part I of this article appears in the May 2004 issue of The Metropolitan Corporate Counsel.In Part I of this article we examined some of the basic rules of contract interpretation and their application to a hypothetical situation involving the priority of postpetition interest.1 We will now examine the rules more closely by testing their application to additional hypothetical situations.

Drawdown Requests When Default Looms

Hypothetical 2: Do we really have to honor drawdown requests from a borrower that we know in three weeks will flunk all of the financial covenants in the credit agreement? Isn't that, in itself, a "default"?

Suppose the financial reports given to you by the borrower indicate that the borrower will breach the financial covenants in the credit agreement at the end of the current fiscal quarter.2 The credit agreement prohibits the borrower from borrowing if there is a "default or event of default" and defines the term "default" to mean "any event which upon the giving of notice or lapse of time or both would constitute an event of default." The section of the credit agreement listing the events of default provides grace periods permitting the borrower to avoid an event of default by curing certain violations of the credit agreement within limited periods of time (for example, failure to pay interest when due, failure to comply with certain affirmative covenants, and failure to pay final judgments do not ripen into events of default until the lapse of a specified number of days), but there is no grace period given for violations of financial covenants. Accordingly, the violation of a financial covenant results in an immediate event of default. You fear that the borrower is going to draw down funds under the facility and file a bankruptcy petition shortly afterwards. You don't want to look foolish to your credit committee and believe the loan documents "clearly" permit you to decline to lend because there is a "default." You'd like to warn your borrower that it shouldn't bother to submit any further borrowing requests. To be sure, you email your views to your lawyer and await the one-line confirmation of your view.

Unfortunately, your lawyer will probably tell you that a default does not exist. How can this possibly be? Let's apply some of the rules of construction. Looking only at the four corners of the document, you see that the term default is defined, and the plain meaning of the key phrase in that definition ("the lapse of time") seems to support exactly the view that there is already a default. The phrase "lapse of time" doesn't appear anywhere else in the credit agreement, so there are no other uses of the phrase in the agreement to worry about. Your lawyer will likely tell you that the phrase is nonetheless ambiguous because the "time" referred to in the definition might refer to either (1) time in general or (2) the specific grace periods mentioned in the section of the credit agreement that lists the events of default. Also, the entire definition of the term "default" might be viewed as a trade term and "everyone knows" that the lapse-of-time phrase refers to the lapse of the specified grace periods in the list of the events of default and not to the lapse of time in the ordinary sense. For example, a leading treatise on commercial loan agreements explains the difference between a "default" and "event of default" as follows:

"If grace or cure periods are granted, then a distinction is usually drawn in the loan agreement between defaults and events of default. A default exists if any of the items listed in the events of default section occurs, even if the applicable notice has not been given or the grace period has not expired. The item does not become an event of default until all required notices have been given and/or the applicable grace period has expired.... The distinction between a default and an event of default is recognized in the following definitions: "Default" means any of the events specified in Section ..., whether or not any requirement for the giving of notice or the lapse of time or both has been satisfied. "Event of Default" means any of the events specified in Section ..., provided that any requirement for the giving of notice, the lapse of time, or both has been satisfied."3

This isn't such an outlandish interpretation after all. Could the borrower and lender really have intended to create "anticipatory" measurements of default? Would they have meant to require the borrower to look at every single provision of the credit agreement to determine whether at some point between the time in question and maturity it is only a "matter of time" before there is an event of default? After all, isn't there another provision that prohibits borrowing if there is a "material adverse change"? If so, that would, in itself, produce a faster trigger in most cases. Having said all of this, while the authors believe that most bank lawyers would advise lenders that there is no "default" in the above hypothetical, a court may disagree.

Defining "Substantially All"

Hypothetical 3: What exactly is a sale of "all or substantially all" the assets of the borrower anyway?

Often, in addition to other provisions dealing with the purchase and sale of assets, a credit agreement will contain a covenant restricting the ability of a borrower and its subsidiaries to sell "all or substantially all" of its assets to a third party. High-yield bond indentures frequently contain the following provision:

"The Issuer shall not, in a single transaction or series of related transactions, consolidate or merge with or into any Person, or sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of the Issuer's assets (determined on a consolidated basis for the Issuer and its Subsidiaries) unless [certain requirements are met]."

A similar concept is sometimes included in the "change of control" provisions of credit agreements.

Suppose the borrower wants to sell assets that comprise, as of the most recent fiscal year, 55 percent of its consolidated assets (based on book value), 75 percent of consolidated assets (based on fair market value), 85 percent of the consolidated net income, and 45 percent of consolidated revenues. Is the proposed sale a sale of "substantially all" of its assets which would trigger the restrictions of the covenant? Most lawyers (including the authors) will admit that they really don't know the answer to this question and mumble something to the effect that "it's a question of the facts and circumstances," "we'll know it when we see it," or "there isn't a lot of case law to provide definitive guidance on this one."

A banker may want the threshold to trigger the prohibition in the asset-sale covenant to be very low and thus triggered in the foregoing hypothetical. Unfortunately, credit agreements, except as noted below, rarely provide a specific definition of the phrase "all or substantially all." Dictionary definitions provide weak guidance. The term "substantial" is defined by various dictionaries using such concepts as "considerable in quantity," "significantly great," or "in the main." All we gather from this is that there must be a bunch of assets sold. In other words, the plain meaning doesn't really help to place percentages into the words.

Let's consider the four corners of the document, however. Credit agreements frequently use this phrase in two other provisions. A court might look at the other usages to determine its meaning in the asset-sale covenant, but bankers may be surprised when they examine the other usages closely. First, credit agreements usually limit the investments borrowers may make but permit the borrowers to invest in "cash equivalents." This term, in turn, is often defined to include money market funds "substantially all" of whose assets are invested in some other type of cash equivalent. In this usage, most bankers probably expect the "substantially all" threshold to be extremely high (in the 90 percent to 95 percent range). This, of course, is inconsistent with their view in the asset-sale hypothetical, where they expect the threshold is much lower. Accordingly, most bank lawyers would argue that the investment provision has a different purpose from the asset-sale covenant and the term "substantially all" in the investment provision, even if identical to the term used in the asset-sale covenant, should be interpreted differently. Second, the credit agreement provision relating to amendments of the loan documents often provides that consent of all lenders is required to approve an amendment authorizing the release of "substantially all" of the collateral. The banker might switch views on the threshold, believing the threshold in this case is much lower than the 90 percent to 95 percent range.

The term "substantially all" is used in the corporation laws of many states. These statutes provide typically that shareholder approval is required in the event a corporation sells all or "substantially all" of its assets. There are numerous judicial decisions interpreting this phrase in such statutes, but none of them are directly applicable to the interpretation of the phrase in a credit agreement or indenture. Nonetheless, at least one court has held that the interpretation of the phrase in the corporation laws is relevant to the interpretation of the phrase in an indenture.4 There are relatively few cases interpreting this phrase as used in credit agreements and indentures, so definitive guidance on this point is extremely difficult to provide.5

If you're confused, you clearly understand the content of this article. Contract interpretation is often difficult. Lawyers don't necessarily give the right answer, but rather simply the answer that appears to have ample justification based on the foregoing (and other) rules. The key to remember is that virtually any answer provided by a bank lawyer is bound to be second-guessed by a court.1 Since publication of Part I, the United States Court of Appeals for the First Circuit has ruled that the Rule of Explicitness "has no application in the context of bankruptcy" where the state law governing the relevant subordination agreement "has not adopted the rule as one of general applicability" (a "bankruptcy-only rule" is not sufficient). See HSBC Bank USA v. Branch (In re Bank of New England Corp.), 1st Cir., No 03-1321, 4/13/04). Even if a subordination agreement explicitly provides that subordinated debt is junior to the payment of postpetition interest on senior debt, this decision draws into question whether a court would enforce such provision. This decision does not render the case cited in Part I (In re Southeast Bank Corp.) bad law or otherwise overrule it, rather it creates a split between the First and Eleventh Circuits regarding the Rule of Explicitness.
2 For purposes of this example, assume that there is an absolute certainty that the borrower will flunk the financial covenant at the end of the fiscal quarter and that there are no other provisions of the credit agreement that might be available to block further borrowings (e.g., a condition that no material adverse change in the financial condition of the borrower has occurred since a specified date).
3 Sandra Schnitzer Stern, Structuring and Drafting Commercial Agreements, 8.01[2] at 8-3 (A.S. Pratt & Sons, 2002). Note that the definitions of "default" and "event of default" are slightly different than those used in the hypothetical in that the treatise's defined terms refer to "requirements" for the lapse of time. It is easier to justify the absence of a "default" in the hypothetical where the agreement includes such language.
4 U.S. Bank National Association v. Angeion Corporation, 615 N.W. 2d 425 at 431 (Ct.App. Minn. 2000), review denied October 26, 2000.
5 See, B.S. F. Co. v. Philadelphia Nat'l Bank, 204 A.2d 746 (Del.Supr.Ct. 1964) (the case involved the phrase used in an indenture governed by Pennsylvania law, and the court held that the sale of 75 percent of the issuer's assets triggered the covenant in large part because the assets represented a high percentage of the total assets of the issuer as well as its only income-producing assets) and Sharon Steel Corp. v. Chase Manhattan Bank, N.A., 691 F.2d 1039 (2nd Cir. 1982) (the case involved a sale of assets representing 38 percent of the operating revenues of the issuer, 13 percent of its profits, and 51 percent of its book value, and the court held that the sale did not trigger the applicable covenant).

William E. Hiller is a Partner in the Corporate and Financial Services Department in the New York office of Willkie Farr & Gallagher LLP. Geoffrey R. Peck is an Associate in that same department. This article was originally publsihed in the March 4, 2004 edition of Commercial Lending Review (Vol. 19, No. 2, pp.21-25). Reprinted with permission from Aspen Publishers.

Please email the authors at or with questions about this article.