The European Lawyer

USA

12 Mar 2010

International Acquisition Finance - United States

Editors: Cravath, Swaine & Moore LLP - Timothy Massad and Philip Boeckman

I. INTRODUCTION
Any transaction whereby funds are used to effectuate an acquisition involves “acquisition finance.” In the United States, there are several types of acquisition finance structures: those that involve a financial sponsor (i.e., a private equity sponsor), those that have existing management acquiring the company or business, and those involving a strategic buyer (i.e., a company in a similar line of business as the target). The targets may be public companies with securities listed on a stock exchange or a private company.

In private equity transactions, the buyer is usually a special purpose vehicle which receives its funds from two main sources: equity contributions from one or more private equity sponsors or other investors (usually less than one-half the total purchase price) and debt financing borrowed from banks and other financial institutions or investors. The “debt financing” part of the structure is the acquisition finance portion of the structure. While there is often debt financing in management buy-outs and strategic acquisitions, the structures and terms of debt financing have been developed to the largest extent in the context of private equity transactions.

This chapter will provide a brief overview of acquisition finance in the United States, particularly in the context of private equity transactions. The content will focus on typical two-step acquisition finance structures. We also discuss changes in market practice arising from the credit crunch that began in the summer of 2007.

2. OVERVIEW OF U.S. ACQUISITION FINANCE
Acquisition finance structures in private equity transactions typically involve the establishment by the investors of one or more special purpose vehicles (SPV) to effectuate the acquisition. Typically, one entity is established as a holding company (Holdco), which receives the equity contributions from the sponsors or other investors. Holdco often then establishes a subsidiary which is the acquisition vehicle. This subsidiary receives the equity contributions from Holdco and incurs bank or other senior debt as well as, in some cases, subordinated debt. The subsidiary then purchases at least a majority of the outstanding shares of the target company and merges with and into the target company, resulting in the target company (i) becoming a wholly-owned subsidiary of the acquiror and (ii) assuming, by operation of law, liability for the debt.

The typical capital structure has the operating company (Opco) as the principal borrower. Opco’s debt obligations are guaranteed on an “upstream” basis by its domestic operating subsidiaries and “downstream” by Holdco. Holdco generally owns all the Opco shares and is restricted from engaging in activities and incurring additional debt. At the subsidiary level, the “sister company” guarantees are guarantees by one subsidiary of the obligations of another subsidiary. However, sister company upstream guarantees may be subject to fraudulent conveyance concerns (discussed below).

3. TYPES OF ACQUISITION FINANCE
The principal types of acquisition finance available in the United States include bank loans and debt securities. Generally, banks and their syndicates make bank loans to the borrower. Syndicate members and subsequent purchasers of the bank debt may include lenders that are not “banks,” and the loans may have characteristics of other debt instruments, such as high-yield bonds (discussed below).

3.1 Bank loans
The main types of bank loans in the United States include (i) revolving credit (allowing borrowers to draw down, repay and reborrow), (ii) term loans, which typically are either (a) amortizing term loans with progressive repayment schedules that run for six years or less and (b) term loans made by non-bank institutional investors with bullet maturities of seven years or more, (iii) asset based loans (ABLs), where typically ABL lenders advance against a “borrowing base” comprised of the most liquid collateral (i.e., outstanding exposure never permitted to exceed the “borrowing base”), (iv) letters of credit and (v) bridge loans (providing short-term financing to provide a “bridge” to an asset sale, bond offering, etc.).

3.2 Debt securities
The main types of debt securities in the United States include (i) regular high-yield bonds, which may be senior or subordinated, (ii) PIK bonds (allowing the issuer to choose to pay interest by issuing additional bonds rather than paying in cash; PIK bonds may be issued by companies owned by private equity funds to pay dividends or to repurchase stock) and (iii) convertible bonds.

3.3 Bank loans versus debt securities
Loans and bonds both constitute debt instruments (i.e., they represent an obligation on the part of the borrower or issuer to repay, with interest, at specified times). Market conditions, timing, cost and types of covenants are a few considerations that drive the decision as to whether to use bank loans, bonds, or a combination and the relative amounts thereof. Often, deals will include both a bank loan facility and a bond offering. Despite converging markets, there are a number of key differences between loans and debt securities (see Diagram 3 below).

Bank and bond debt may differ in terms of seniority, security, economic terms, types of covenants, identity of lenders and other terms. Typically, any acquisition finance transaction will have senior debt which is comprised of bank debt or other loan facilities. If there is also bond debt, it may be additional senior debt or subordinated debt. Typically, the senior debt is secured; the subordinated debt is generally not secured. Transactions also may be consummated on the basis of a senior bank facility and a subordinated bridge loan that is refinanced shortly after the closing by an offering of subordinated bonds. The differences in the terms of senior and subordinated debt and some of the typical variations, as well as security arrangements, are discussed further below.

Bank debt typically bears interest at floating rates; bond debt is typically at fixed rates. Bank debt is generally prepayable at the option of the borrower, without premium or penalty, whereas bonds are usually not callable for a period of time (such as five years for a bond with a ten-year maturity), and then require prepayment premiums for the first several years after that.

Bank and bond debt also differ in terms of covenants. Typically, credit agreements have both “incurrence” and “maintenance” covenants. Incurrence covenants impose limitations on certain actions that a borrower may wish to take, such as incurring additional debt, paying dividends, making investments, or selling assets. These may be outright prohibitions or restrictions that allow the action if the borrower meets certain financial tests or ratios. Maintenance covenants require the borrower to meet certain financial tests or ratios every quarter, such as tests pertaining to leverage, net worth, total debt, or interest coverage. These generally require the borrower to improve its financial performance over time, at least in the early years. Bonds typically have only incurrence covenants, and those covenants are sometimes more relaxed than those in the bank debt.

The nature of the investors or lenders accounts for certain differences. Bonds are sold in public or quasi-public offerings, typically in $1,000 increments, often trading on securities exchanges or through the PORTAL system. The issuer cannot control who owns its bonds, whereas the borrower generally has a greater ability to determine the lenders under a credit facility.

The difference in the nature and number of investors is one reason why covenants differ between bank loans and bonds. That is, bonds may not have maintenance covenants, and may have more exceptions to incurrence covenants, because it is assumed the borrower must live with the covenant package until maturity, and it is generally more difficult to obtain a waiver of bond covenants because there may be larger number of holders. In addition, if a borrower cannot get a lender’s consent, it can always refinance and prepay the loans, at par with no premium (assuming market conditions permit a refinancing). However, it may not be possible or economical to prepay the bonds, or even defease them. Bond waivers and amendments are obtained through “public” consent solicitations, while bank loans are modified privately though the lead agent or arranger. Note that most bond covenants, other than the key economic (or “money”) provisions, can be amended or waived with the approval of the majority of the holders, while bank covenants sometimes require super-majority approval (i.e., 662/3 per cent).

Over the last several years, there has been an increasing convergence between the bank and bond markets. In particular, prior to the credit crunch that began in mid-2007, institutional term loans took on more characteristics of high-yield bonds. Some examples include (i) elimination of financial maintenance covenants (so-called “covenant-lite” deals), (ii) elimination of borrower consent rights to assignment, (iii) assigning CUSIP numbers to loans, (iv) continued growth of an active secondary trading market for loans and (v) ”call protection” for loans or making loans with “original issue discount.”

The following chart outlines some of the typical differences between bank debt and high-yield bond debt.

Senior Bank Debt

• Bank loan
• Credit Agreement
• Administrative Agent
• Senior and generally secured
• 5-8 year tenor, with amortization
• Prepayable at borrower's option at par or, sometimes, at a 1% to 2% premium under limited circumstances
• Floating rate of interest

4. U.S. FINANCING STRUCTURES
The senior component of an acquisition financing package will consist of a bank loan facility (and sometimes debt securities) that will be senior in right of repayment to other debt of the borrower. The term “senior in right of payment” means the obligation is not contractually subordinated to other debt. Bank loan facilities are also typically “structurally senior” that is, they are not structurally subordinated by virtue of there being debt at a subsidiary, which would create a prior claim on the assets of that subsidiary.

Generally, the bank loan will be secured by the assets of the borrower, although occasionally the bank loan is unsecured. A secured loan provides the lenders with a priority claim to specific assets ahead of unsecured creditors. Typically, if a financing package includes a bank loan and senior debt securities, the bank loan will be secured and the debt securities will be unsecured. In this case, the bank loan will rank pari passu with the debt securities in terms of repayment, but will have a senior claim on the assets until the bank loan is paid in full. In many cases, however, the debt securities will be subordinated, not senior. If the debt securities are subordinated, they are usually unsecured.
In some cases, there will be a senior secured bank facility and senior bonds which are secured by the same collateral. In some cases, the bonds (or other debt) will have junior liens (i.e., “second-lien” financings).

A typical acquisition finance capital structure may include any of the following components in ascending order of payment risk:
   - Libor + Spread
   - Base Rate + Spread
   - The Spread represents the Bank’s “profit”

• Sold to private investors using non-SEC style “bank book”
• Assignments generally require borrower/agent consent
• Revolving credit facility (together with term loans)
• “Maintenance” and “financial” covenants
• Amendments (generally) easily obtainable for modest fees.

 High-Yield Bonds

• Security
• Indenture
• Trustee
• Often subordinated and generally unsecured, though increasingly see "second-lien" bonds
• 7-10 year tenor; no amortization
• Generally not callable for 5 years; then repayment premiums
• Generally fixed interest rate for durations
• Sold in public or quasi-public offering using near-SEC compliant offering memorandum or prospectus
• Freely tradable; issuer may not know who owns its bonds
• Only one funding
• Incurrence only tests
• Amendment requires public consent solicitation

4. U.S. FINANCING STRUCTURES
The senior component of an acquisition financing package will consist of a bank loan facility (and sometimes debt securities) that will be senior in right of repayment to other debt of the borrower. The term “senior in right of payment” means the obligation is not contractually subordinated to other debt. Bank loan facilities are also typically “structurally senior” that is, they are not structurally subordinated by virtue of there being debt at a subsidiary, which would create a prior claim on the assets of that subsidiary.

Generally, the bank loan will be secured by the assets of the borrower, although occasionally the bank loan is unsecured. A secured loan provides the lenders with a priority claim to specific assets ahead of unsecured creditors. Typically, if a financing package includes a bank loan and senior debt securities, the bank loan will be secured and the debt securities will be unsecured. In this case, the bank loan will rank pari passu with the debt securities in terms of repayment, but will have a senior claim on the assets until the bank loan is paid in full. In many cases, however, the debt securities will be subordinated, not senior. If the debt securities are subordinated, they are usually unsecured.
In some cases, there will be a senior secured bank facility and senior bonds which are secured by the same collateral. In some cases, the bonds (or other debt) will have junior liens (i.e., “second-lien” financings).

A typical acquisition finance capital structure may include any of the following components in ascending order of payment risk:

• Senior secured debt
• Senior secured "second-lien" debt
• Senior unsecured debt (and/or general liabilities)
• Senior subordinated debt
• Holdco senior debt
• Preferred shares
• Common shares

4.1 Senior secured debt
Senior secured debt will usually consist of the creditors having claims on specific assets pledged as collateral. This gives the secured creditors priority over other unsecured creditors. The secured debt may be otherwise pari passu in right of payment with other senior debt and liabilities. Senior secured debt is typically incurred at the Opco level in order to ensure a first claim on the assets. The collateral for secured bank loan facilities includes (i) accounts receivables, (ii) inventory, (iii) property, (iv) intangibles, including contract rights, (v) intellectual property and (vi) the shares of other borrowers and subsidiaries.

4.2 Senior secured “second-lien” debt
Second-lien debt will usually consist of the creditors having claims on borrower’s assets that are second in priority to the claims securing other creditors’ loans, such as the senior bank facility. Second-lien debt is also typically incurred at the Opco level in order to ensure it is second in priority to the claims of other non-senior secured creditors. Second-lien debt typically tends to be targeted to, and held by, hedge funds and other institutional investors. Such debt will generally have less restrictive covenant packages, in which maintenance covenant levels are set wide of the senior secured debt, resulting in second-lien debt being priced at a premium to the senior secured debt.

Although senior secured debt and second-lien debt can be part of a single security agreement, it is recommended to have separate agreements because in a U.S. bankruptcy, if the collateral does not cover both the senior secured and second-lien creditors, the bankruptcy judge may choose to deem both creditors as a “unified class” and divide the collateral on a pro rata based priority.

4.3 Senior unsecured debt
Senior unsecured debt may include bank and bond indebtedness that are pari passu with each other, and with other obligations and liabilities such as (i) debt for borrowed money, (ii) derivatives (swaps and other hedging arrangements), (iii) guarantees of debts or liabilities, (iv) taxes, (v) contracts, leases and employee claims and (vi) other litigation claims.

4.4 Senior subordinated debt
Senior subordinated debt by its terms is contractually subordinated to other debt. Terms of such subordination include (i) payment of principal amounts of subordinated debt only after payment-in-full of priority debt, (ii) agreement to pay over any collections received in violation of the subordination agreement or in bankruptcy and (iii) payment blockages and other standstills to give the senior debtholders a specified period of time before the subordinate debtholders may exercise any remedies.

4.5 Mezzanine financing and equity
4.5.1 Mezzanine financing
Mezzanine financings consist of either deeply subordinated debt or preferred equity (discussed below). If debt is used, then mezzanine financing is typically subordinated to any other debt in the capital structure. If the debt is at the Holdco level, it is structurally subordinated to the debt at the Opco level. (See discussion of structural subordination below.) If the debt is contractually subordinate, then subordination terms for mezzanine financing are consistent with or more onerous than the terms for traditional subordinated debt and may include remedies blockage (e.g., the holders of the mezzanine debt cannot take action upon an event of default) in addition to payment blockage. In addition, mezzanine financing often includes warrants for common shares as an equity kicker (typically found in LBOs, equity kickers provide potential additional returns to mezzanine financiers if the transaction is successful or demonstrate to rating agencies that convertible securities will in fact become equity securities rather than remain in the form of preferred shares or a debt obligation).

4.5.2 Preferred shares
Holders of preferred shares have a claim based on a liquidation preference that is paid only after all debt claims and other general liabilities, but prior to distributions to common equity holders. Dividends are often PIK (pay-in-kind), which pays holders in additional shares in lieu of cash. In leveraged transactions, preferred shareholders typically receive cash dividends once specified leverage thresholds are met (an increasingly common form of sponsor equity, at least prior to the credit crunch).

4.5.3 Common shares
Common shares, like preferred shares, are equity claims on the residual value of a company after all debt claims and preferred equity claims are satisfied. Together with preferred shares, common shares typically represent anywhere from 20 to 45 percent of the capital structure in an acquisition financing, depending on market conditions.

5. SECURITIES OFFERINGS
The issuance of debt securities (as opposed to bank loans) needs to be carefully structured to comply with federal and state securities laws and regulations in the United States. As a general rule, the U.S. Securities Act of 1933 (the Securities Act) requires that an offering of securities in the United States must be registered with the Securities and Exchange Commission (SEC) unless an exemption applies. A widely used exemption for high-yield debt securities involves the combination of Section 4(2) of the Securities Act and Rule 144A under the Securities Act, which placements are referred to as “Rule 144A offerings.” Section 4(2) provides an exemption for “transactions by an issuer not involving any public offering,” and Rule 144A provides a further exemption for private resales of securities to certain types of institutional buyers (i.e., “qualified institutional buyers” or “QIBs”) so long as certain conditions are met.

In a typical Rule 144A offering, the issuer will initially sell securities to one or more investment banks under the Section 4(2) exemption. The investment banks, referred to as “initial purchasers,” will then resell those securities to QIBs under Rule 144A. QIBs generally include insurance funds, pension funds, mutual funds, hedge funds and other similar institutions whose investment portfolios meet certain size requirements.

It is also common in Rule 144A offerings for a portion of the issued securities to be placed to non-U.S. persons located outside the United States by relying on a separate exemption provided by Regulation S under the Securities Act. Securities placed in Rule 144A/Regulation S offerings are “restricted” or “unregistered” securities and may not be resold in the United States or to U.S. persons unless the resale is registered with the SEC (via a so-called A/B exchange offer) or another exemption is available. Investors in high-yield debt securities placed under Rule 144A/Regulation S will therefore be limited to reselling those debt securities either to other QIBs under Rule 144A or in resales to non-U.S. persons located outside the United States under Regulation S, until the resale is registered with the SEC or unless another exemption is available.

Rule 144A/Regulation S offerings are often used instead of registering an offering with the SEC because they can be executed more quickly and easily. This is because the SEC review process can take time. In addition, the SEC rules require significant financial and other information about the target and pro forma financial information showing the effects of the acquisition which can take time to prepare. However, the custom in the Rule 144A/Regulation S market is to provide the same level of disclosure as in a registered offering if at all possible.

6. OTHER CONSIDERATIONS
While there are often many other structuring issues to consider, particularly depending on the industry at issue, the following issues arise frequently:

6.1 Structural subordination
Structural subordination issues arise when loans are made at the Holdco level. Generally, the majority of the assets and revenues of the business are at the level of the subsidiaries of the Opco. The only claim against those assets and revenues is through the Opco equity ownership of the subsidiaries. Creditors who lend to, or otherwise obtain a debt claim against, those subsidiaries will have a structurally senior claim against those assets and revenues. To avoid such structural subordination, the standard construct is to have the subsidiaries give upstream guarantees, so as to create claims against the subsidiaries. In cases where it is not possible to obtain guarantees or simply as further protection, the covenant may restrict borrowing at the subsidiary level. However, tax liens, employee claims and trade creditors, to name a few, are not consensual and all of these would be structurally senior to a parent company loan.

6.2 Foreign subsidiaries
In many jurisdictions, upstream guarantees are illegal, void or voidable regardless of the solvency of the subsidiary guarantor. In addition, under subpart F of the U.S. Internal Revenue Code, if a subsidiary is a “controlled foreign corporation” (CFC) of a U.S. borrower, the Internal Revenue Service (IRS) can deem the foreign subsidiary to have made a transfer of its assets to the borrower in the amount of the guaranteed debt, subjecting the borrower to U.S. income tax on amounts it never actually received. According to the IRS, a pledge of more than two-thirds of the voting stock of a foreign subsidiary may raise deemed dividend issues. Note that the two-thirds threshold was established because many state and federal corporation laws in the United States provide that a corporation can liquidate itself only upon the approval of two-thirds of its outstanding shares. Accordingly, foreign subsidiaries typically do not guarantee the debt of a U.S. borrower, and pledges of foreign subsidiary shares are usually limited to two-thirds of such shares.

6.3 Fraudulent conveyance
A bank that lends money to finance the acquisition of a business needs to be assured that (i) in the event of a bankruptcy, its lien on the assets will secure the loan and (ii) any note given by the acquired company will indeed be enforceable. If a pledge of assets is deemed to be a fraudulent conveyance under the U.S. Bankruptcy Code or comparable U.S. state law, then the pledge will be set aside and voided, and even the note can be rendered worthless.

Generally, fraudulent conveyance issues arise when there are upstream guarantees of a parent borrowing or cross-stream guarantees of a subsidiary borrowing. Under Section 548 of the U.S. Bankruptcy Code, the two types of fraudulent conveyance issues that typically arise are (i) “actual fraud,” which occurs when there is actual intent to hinder, delay or defraud the creditor and (ii) “constructive fraud,” which occurs when both (a) the borrower does not receive “reasonably equivalent value” in exchange for its pledge and (b) one of the following conditions exists: (1) the borrower is “insolvent” at the time of such transfer or became “insolvent” as a result of the transfer, (2) the borrower is left with “unreasonably small capital” as a result of the transfer or (3) the borrower “incurred or intended to incur” debt beyond its ability to repay. Usually, guarantees and pledges by a parent to support borrowing by its subsidiary (i.e., downstream guarantee) do not present fraudulent conveyance issues.

6.4 One-stop shopping and anti-tying
Due to changing market conditions, there is now more flexibility to allocate acquisition financing between bank debt, bonds and other types of financing. However, this increases the risk of inadvertently running afoul of the anti-tying restrictions of Section 106 of the U.S. Bank Holding Company Act Amendments of 1970 (Anti-tying Act). Under the Anti-tying Act, a bank cannot condition the availability or price of the extension of credit or any other product or service on a requirement that the customer obtain another product or service from the bank or an affiliate of the bank (e.g., in the context of acquisition financing, engaging a bank’s broker-dealer affiliate to act as an underwriter for the bond financing). However, there are exceptions to this rule, and anti-tying does not apply in cases whereby the bank’s customer (i.e., the borrower) is a non-U.S. person or where the arrangements are not imposed by the banks (as opposed to being requested by the borrower).

6.5 Regulated targets
In certain regulated industries, federal or state statutes and regulations govern change of control transactions. These federal and state regulatory statutes typically provide that the acquisition of a certain percentage of a company’s securities is deemed to constitute a change of control and that regulatory approval is required before the transaction may close. Federal regulatory statutes which require approval of change of control include (i) the Federal Communication Act; (ii) the Federal Aviation Act; (iii) the Interstate Commerce Commission Termination Act; (iv) the Atomic Energy Act; and (v) the Federal Power Act. On the state level, among other regulatory schemes, insurance holding company laws police the acquisition of insurance companies, and statutes and regulations require certain actions when a company with a liquor or arms license is acquired.

6.6 Listed targets
There are two basic ways to effectuate acquisitions of public companies in the United States: (i) a proxy solicitation to effectuate a merger and (ii) a tender offer. Timing, competitive considerations and other factors will dictate which option is chosen.

In the first case, the target will prepare a proxy statement soliciting the approval of the merger from its shareholders. The proxy statement must be filed with the SEC, which may or may not review the proxy statement before it is mailed to shareholders. The proxy statement will set the date for a shareholder’s meeting which, under Delaware law and most other U.S. state laws, must be at least 20 days after notice. If the requisite percentage of shareholders approve the merger (a majority requirement in Delaware and most other states), the merger can be consummated on the day of the meeting by filing a certificate of merger with the relevant state authority. Assuming the SEC reviews and comments on the proxy statement, the statutory merger process could take three to four months to be completed.
In a tender offer, the bidder takes its offer directly to the shareholders by offering to purchase the shares. This also requires a filing with the SEC. Under SEC regulations, the tender offer must stay outstanding for at least 20 business days. If all conditions are satisfied or waived by the bidder, the tender offer closes and the bidder must pay for the purchased shares “promptly,” which is usually interpreted to mean within three business days. The “minimum condition” is the minimum number of shares that must be tendered before the offer can close. In a friendly deal under Delaware law, the minimum condition is usually a majority, which gives the bidder control of the target. If the bidder receives at least 90 percent of the shares tendered, the bidder itself can cause a merger to occur without the affirmative vote of any other shareholder (so-called “short-form” or “squeeze-out” merger). However, under Delaware law, if the bidder receives more than 50 percent but less than 90 percent, for the merger to occur, the bidder will have to go through the proxy statement process to close the back-end merger.

6.7 Margin stock
Caution should be exercised with respect to margin stock issues in tender offers. Regulations promulgated by the Board of Governors of the U.S. Federal Reserve System under the U.S. Securities Exchange Act of 1934, limit the ability of banks to extend “purpose credits” that are secured directly or indirectly by margin stock. A purpose credit is a loan made for the purpose of purchasing or carrying margin stock. “Margin stock” is generally defined as any equity security registered or having unlisted trading privileges on a national securities exchange. ADRs traded on a national securities exchange are also margin stock.

7. DOCUMENTS AND TERMS FOR BANK LOANS
The documents in a bank loan facility will include the commitment papers (composed of the commitment letter, term sheets, fee letter and engagement letter, if applicable) and the loan documents (including the credit agreement, any guarantees and security documents).

7.1 Commitment letter
In the United States, unlike the UK and other European countries, there is no legal requirement that the borrower have its funding in place prior to making an offer to purchase shares (the so-called “certain funds” requirement). However, market practice is typically to have a commitment letter (or, at the least, a highly confident letter) from a lender prior to launching a transaction.

The intent of the commitment papers is to set out basic terms and conditions (i.e., amount, maturity, interest rates, fees, covenants, defaults, security and conditions to lending) on which the lenders are willing to lend money. The commitment letter, together with related term sheets and fee letter, sets forth (i) the terms and conditions of the commitments to lend, (ii) the lenders’ rights and (iii) the borrower’s obligations, including in respect of syndication. In essence, the commitment letter is both a legal and marketing document, while mitigating concerns of the acquiror’s ability to complete the acquisition by confirming the banks commitment to lend (subject to the conditions precedent in the letter).

For the borrower, the most important line in the commitment letter is “We are pleased to inform you of our commitment to provide [the entire amount of the Facility][up to X% of the aggregate principal amount of the Facility].” The most important line from the bank’s perspective is “Our commitment is subject to . . .”. In the year or so preceding the credit crunch of mid-2007, the list of “subject to’s” became shorter, but the pendulum has since started swinging back (see discussion below).

7.2 Conditions precedent in commitment letters
Banks usually condition their commitments on the satisfaction of conditions precedent that include due diligence, absence of market conditions that make it difficult to syndicate the loans (i.e., market out), absence of other similar debt instruments issued by the borrower during a specified period (i.e., clear market) and no business material adverse change (business MAC). A variety of other conditions also may be included. The diligence condition is usually satisfied and removed prior to the signing of the commitment papers. Prior to the recent credit crunch, borrowers were often able to eliminate the “market out” condition, and to eliminate or scale back the scope of the “no business MAC” condition.
In the United States, a similar concept to the UK and European “certainty of funds” theory (i.e., commitments in public acquisitions are essentially conditionless) exists in what has come to be known as the “SunGard Approach,” named after the acquisition of SunGard Data Systems, a Pennsylvania-based global software company (SunGard), by a consortium of private equity firms in 2005. Unlike the historical practice in other LBOs in the United States, SunGard’s merger agreement did not give the buyer a “financing out.” As a result, the sponsor group was greatly incentivised to align the banks’ conditions under the financing commitments with the buyer’s conditions under the merger agreement. To accomplish this, among other things, (i) the banks were required to conform their business MAC verbatim to the business MAC in the merger agreement, (ii) the only representations and warranties in the financing documents that could serve as conditions precedent to the funding were limited to certain material representations and warranties in the merger agreement and certain fundamental “Specified Representations” and (iii) the failure to deliver certain guarantees and collateral prior to the closing date could not serve as a funding block. The SunGard Approach was subsequently followed in other large U.S. LBOs (for both public and private companies), with financial sponsors closing the gap between their own limited conditionality in acquisition agreements and the somewhat broader conditionality traditionally given to banks in commitment letters.

7.3 Fee letter
The fee letter sets forth the various fees to be paid to the banks. Other than the fees, the most important section of the fee letter is the “market flex” provisions. Market flex gives the arrangers or agents the right to modify the terms agreed to with the borrower in order to syndicate the facility. Generally, there are two types of market flex provisions: (i) “open flex,” which permits the arrangers to tighten the commitment terms by changing price, structure or other necessary terms without the consent of the borrower and (ii) “closed flex,” which limits the terms that can be modified to certain specified items and may require the consent of the borrower. Closed flex became market standard, at least prior to the credit crunch.

7.4 Credit agreement
The credit agreement is the definitive agreement between the borrower and the lenders, and it supersedes the commitment letter (except for certain fee and indemnity obligations that survive). The general components of the credit agreement include:

• Conditions precedent, specifying what the borrower must deliver to the creditors (or administrative agent), what actions must be taken and what other circumstances must exist in order for credit to be available on the closing date;
• Representations and warranties, which will be repeated (or “brought down”) at closing/funding;
• Covenants (both affirmative and negative) which are designed to preserve the business and financial health of the company and prevent the outflow of cash or a decline in the credit-worthiness of the borrower;
• Optional and mandatory prepayments and repayments of loans without a call premium or penalty, but which may be subject to a breakage fee (in addition, the borrower may be subject to mandatory prepayments that arise from proceeds of equity issuance, debt issuance, insurance, asset sales or excess cash flow);
• Events of default, which arise when, among other things, the borrower violates one of the covenants or the representations and warranties are found to be incorrect and the provided cure period, if any, has expired (which then permits acceleration of the loans);
• Tax and cost provisions, where the lenders typically want to ensure they receive payments of interest from the borrower free and clear of all withholding taxes and want to be made whole for certain other costs;
• Amendments and voting, which typically needs the consent of a majority in interest of the lenders (sometimes 662/3 in older transactions); and
• Applicable law, which in the United States the applicable law for contract interpretation is state law (in addition to the Uniform Commercial Code (UCC) which governs most security, guarantee or collateral documents in the applicable state law; New York law is typically used for the larger credit facilities).

7.5 Intercreditor arrangements
In a U.S. acquisition financing with both first and second lien debt, an intercreditor agreement is utilized to establish the relative priorities between the first and second lien secured parties’ claims to a borrower’s assets, as well as certain limitations relating to the exercise by the second lien holders of their secured creditor rights. (With senior debt and traditional subordinated high-yield bonds, a separate intercreditor agreement is not used; the subordination provisions are directly included in the high-yield bond indenture and the senior debtholders are express third-party beneficiaries of such provisions.)

The critical issue for the intercreditor agreement is generally how “silent” the second lien will be (cf., second lien bonds are typically truly “silent,” and second lien bank debt is typically “quiet”). Note that the second lien is not contractually subordinated in the traditional sense (i.e., payment subordination), but instead its lien is subordinated (i.e., its claim to the collateral (or proceeds thereof) is shared with the first lien debt). The second lien creditors only agree to turn over to the first lien secured creditors’ collateral (or proceeds thereof) that they receive prior to the discharge of the first lien obligations. By contrast, traditional “payment” or “debt” subordination involves payment blockage rights and requires the subordinated creditor to turn over to the senior creditor any payment received in bankruptcy from any source until the senior creditor has been paid in full.

Under the intercreditor agreement, the release of the second lien is handled differently depending upon whether the release occurs in connection with a straight sale or a sale in connection with a foreclosure or other enforcement action. In the context of a straight sale, both the first lien and second lien are released, but only if the sale of the collateral is permitted under both the first and second lien documents. In the context of a foreclosure or other enforcement action, the second lien is automatically released if the first lien is released. In addition, in the context of a bankruptcy with the attendant automatic stay, second-lien creditors are prohibited from seeking to lift the stay as it pertains to the second liens at any time prior to the discharge of the first lien obligations. However, such first lien exclusivity usually lasts only for 120 to 180 days from the triggering date (so-called “standstill period”). After the expiration of the standstill period, the second lien creditors may exercise rights or remedies relating to collateral, except to the extent the first lien creditors have commenced and are diligently pursuing the exercise of any rights or remedies with respect to any collateral. Nevertheless, any proceeds recovered by the second lien creditors would be subject to the turnover provisions of the intercreditor agreement, which require all proceeds of collateral to be turned over to the first lien creditors until the first lien obligations have been repaid in full.

7.6 Legal opinions
Generally, lenders in a loan facility will require, as a condition precedent to closing, that formal written legal opinions, dated the closing date, be delivered affirming the legality, validity, binding effect and enforceability of the bank loan documents. The opinions will typically come from the borrower’s counsel and the local counsel where guarantors may be located or collateral may be pledged. The opinion is typically addressed to the banks, applicable agents and, where applicable, the lenders as of the closing date (yet permitting other lenders that come in by syndication to rely on the opinion). The opinion should confirm that (i) corporate formalities with respect to the borrower group have been followed; (ii) each of the loan documents is a valid and binding obligation of the borrower or guarantor party thereto; (iii) each of the loan documents is enforceable against the borrower and guarantors (and in the case of foreign local counsel, the opinion should confirm that each of the loan documents is enforceable under the applicable local law); (iv) the acquisition has been consummated in accordance with the acquisition agreement and applicable law; and (v) the financing transaction does not violate or conflict with a requirement of law or local law or require the consent of any governmental authority or third party. In addition, typically the opinions (including the local counsel opinions) cover the validity of the security interests granted and the perfection of such security interests. It is important to note that except for opinions relating to share pledges and the like, opinions with respect to priority of security interests are not given (not even by local counsel). The language of typical closing opinions is the product of many years of developing custom and the internal policies of individual law firms, generally leaving little room for much negotiation.

8. SECURITY INTERESTS AND ENFORCEMENT
8.1 Types of collateral
Various types of collateral that can be granted for a loan in the United States include real property, personal property and intellectual property. Real property can be given as collateral by mortgage, deed of trust, leasehold mortgage or leasehold deeds of trust, or assignments of leases depending on differing state laws. Personal property, such as inventory, accounts receivables, equipment, contract rights and investment property (including capital stock and securities accounts), can be provided as collateral by granting of a security interest under Article 9 of the Uniform Commercial Code (UCC). Other types of personal property now within the scope of the UCC include deposit accounts, health care insurance receivables, commercial tort claims and letter of credit rights. In addition, intellectual property, such as copyrights, trademarks and patents, can similarly be pledged as collateral.

8.2 Security interests, enforcement and related issues
In the United States, the UCC, as enacted in each state, governs the “creation” or “attachment,” “perfection” and “priority” of liens, and the enforcement of remedies with respect to personal property, including securities and bank accounts. “Attachment” of a security interest is the process by which the lender obtains a security interest in an asset of the borrower that is legally enforceable against the borrower. “Perfection” is the process by which the lender ensures that its security interest will be effective (i) against the bankruptcy trustee in bankruptcy and (ii) against certain other creditors and other parties outside of bankruptcy. “Priority” is the ranking of those perfected rights in the collateral as against other third parties (including other creditors) with perfected rights in the collateral.
Perfection is most often achieved by filing a financial statement in the appropriate jurisdiction. For certain types of collateral, such as stock, instruments, and chattel paper, perfection can also be achieved by possession or “control” which will result in a higher priority than perfection by filing a financial statement. This will usually involve the physical delivery by the grantor of such collateral. In a bank loan facility, possessory collateral is held by an agent or trustee, commonly called a ‘collateral agent’, which may or may not be a lender.

In the case of deposit accounts (i.e., cash accounts), filing a financing statement does not perfect a security interest (whereas securities accounts are “investment property” under the UCC and can be perfected by filing as well as by control). Perfection over such deposit accounts requires “control” by the secured party over the account. A security interest in a deposit account of a depositary bank other than a secured party is perfected by entry into a control agreement among the agent bank (on behalf of the secured parties), the borrower and the depository bank, in which the depository bank agrees that it will take instructions from the agent bank as to the disposition of funds in the account, usually upon proper notice from such agent bank (most typically issued as a result of a default or event of default).

It is important to note that different laws, depending on the collateral in question, govern the perfection of such collateral. In general, (i) possessory security interest/pledged certificated securities are governed by the law of the collateral’s location; (ii) deposit and securities accounts are governed by the law of the bank’s or intermediary’s jurisdiction; (iii) uncertificated securities are governed by the law of the issuer’s jurisdiction; (iv) foreign debtors are governed by the laws of their chief executive office (the District of Columbia is deemed the location of a foreign debtor whose chief executive office is in a location whose law does not provide a system for filing for non-possessory security interest); and (v) real property and fixtures are governed by the laws of where the real property and fixtures are located.
Certain property has requirements falling outside the UCC under state and federal law. The following (apart from real property) are the most significant in the context of syndicated lending: (i) federally pre-empted property, which includes (a) intellectual property (as discussed below), (b) aircraft and certain aircraft-related assets, (c) railroads and related assets, and (d) certain vessels (all of which have federal filing registries); and (ii) insurance policies.

Security interests in intellectual property (such as copyrights, trademarks and patents), aircraft and railcars are subject to separate regulations and federal filing requirements (e.g., copyrights in the U.S. Copyright Office, patents and trademarks in the U.S. Patent and Trademark Office, certain aircraft with the Federal Aviation Administration and railroad cars with the Interstate Commerce Commission).
The lien of property subject to certificates of title (e.g., cars and trucks with state motor vehicle departments) is recorded on the actual certificates of title. Foreign collateral is subject to foreign law and in the case where such collateral is material (taking into account deemed dividend issues), lenders will engage local counsels for such jurisdictions.

If a security interest over an asset is perfected, then a security interest in the proceeds of that asset automatically remains perfected for 20 days after the borrower receives those proceeds. After that, the security interest in the proceeds becomes unperfected unless (i) a financing statement was filed to perfect the security interest in the original asset and proceeds are (a) assets over which a security interest can be perfected by filing a financing statement in the office where the original financing statement was filed and (b) the security was not acquired with “cash proceeds,” (ii) the proceeds are identifiable cash proceeds, or (iii) the security interest in the proceeds is perfected as an original secured asset before the expiration of the 20-day period.

9. BANKRUPTCY CONSIDERATIONS
In most large bank loans, the purpose of collateral is not to foreclose following default, but to solidify the lenders’ position in bankruptcy. Bankruptcy cases in the United States are governed by the U.S. federal bankruptcy code (Bankruptcy Code). Under the U.S. federal system, the Bankruptcy Code supersedes any conflicting state laws. Bankruptcy cases are handled by a specialized branch of the U.S. federal court system (i.e., the bankruptcy court). Under the Bankruptcy Code, the instant a bankruptcy case commences, the “automatic stay” precludes creditors from taking virtually any enforcement action against the bankrupt debtor. Creditors cannot, without the bankruptcy court’s permission, (i) sue on their debts outside the bankruptcy court nor can they sell collateral, (ii) take any additional collateral or perfect or take enforcement action on any security interest in collateral, or (iii) exercise set off rights, except to collect on most financial derivative and repurchase contracts, securities contracts, and commodity contracts. Further, counterparties to contracts cannot terminate contracts or commitments to the debtor based solely on the occurrence of a bankruptcy, with certain exceptions, including a contract to make a loan or provide other financial accommodations to a borrower who is in bankruptcy and most financial derivative and repurchase contracts, securities contracts, and commodity contracts.

There are two common types of bankruptcy proceedings applicable to company insolvencies: “Chapter 11” and “Chapter 7” cases.

9.1 Chapter 11 cases
A Chapter 11 case involves the “reorganization” of the debtor under the supervision of the bankruptcy court. A Chapter 11 case may be initiated by the debtor for any good faith reason or by its creditors (three or more creditors, who in the aggregate hold only more than $13,475 in undisputed, unsecured claims) on the grounds that debtor is not generally paying undisputed debts as they become due. Under a Chapter 11 case, the debtor continues to operate as a “debtor-in-possession” for the benefit of the creditors and retains control of its assets. Ordinary course of business transactions are unaffected. In a Chapter 11 case, the debtor proposes a plan for approval by its creditors and shareholders and by the bankruptcy court. If the debtor’s plan is not approved by the bankruptcy court within a certain period, creditors may propose alternative plans for approval. As a general rule, creditors are not entitled to post-petition interest, except to the extent that they are oversecured (another reason to take as much collateral as possible).

9.2 Chapter 7 cases
A Chapter 7 case involves the liquidation of the debtor’s assets under the supervision of a trustee appointed by an agency within the U.S. Department of Justice. In a Chapter 7 case, the proceeds from the liquidation are distributed to creditors in accordance with the priorities established by the Bankruptcy Code (including, if applicable, by contractual arrangement between creditors, i.e., intercreditor arrangements). Like a Chapter 11 case, a Chapter 7 case can be initiated voluntarily by the debtor or involuntarily by its creditors.

9.3 Voidable preferences
During a bankruptcy, certain transfers can be set aside if they are found to prefer one creditor over another (so-called “voidable preferences”). If a debtor transfers any of its assets (including paying cash or granting a lien) to or for the benefit of a creditor (i) while the debtor is insolvent, (ii) within 90 days before the commencement of a bankruptcy proceeding, (iii) on account of an antecedent debt, and as a result, (iv) the transferee receives more than it would have received in a straight liquidation of the debtor, then the trustee in bankruptcy (or the debtor in possession in a Chapter 11 case) can avoid and recover the transfer. All the conditions have to be met for a transfer to be avoided as a preference.
Important factors to note are that (i) the 90-day period is extended to one year if the transferee is an “Insider”. “Insider” includes any director, officer or person “in control” of the debtor (“control” is not defined and is a factual question). Any person controlling 20 percent of the voting securities of the debtor is deemed to be an Insider, but pledge of voting securities will not result in Insider status unless the pledgee exercises voting power; however, lenders are generally not considered Insiders; (ii) the potential for voidable preferences obviously makes “springing liens” less attractive; and (iii) for purposes of the Bankruptcy Code, a security interest is deemed “transferred” when it is perfected and will not be deemed to be on account of an antecedent debt if it is perfected within 30 days after closing.

10. IMPACT OF THE "CREDIT CRUNCH"
In the year or so before the credit crunch of mid-2007, strong demand by the purchasers of syndicated bank loans and similar credits meant that borrowers and sponsors were able to extract increasingly aggressive terms from their banks. This resulted in (i) financial maintenance covenants being removed (creating the so-called “covenant lite” transactions), (ii) greater operating flexibility (such as for acquisitions, incremental debt, investments and dividends for borrowers), with bank covenants looking more like bond covenants, (iii) narrower interest rate margins, even as market interest rates increased and credits became more leveraged (so banks took more risk and earned less profit), and (iv) lower underwriting and arrangement fees, with sponsors being required to contribute less equity to their transactions, resulting in greater leverage, greater risk and greater amounts of debt to raise.

In the context of acquisition finance, borrowers, sponsors and targets insisted on minimal conditionality through the elimination of (i) “financing conditions” in acquisition agreements and (ii) “market MACs” in commitment letters, and the imposition of the SunGard approach (discussed above). In addition, arrangers committed to provide certain structural “innovations,” such as “PIK Toggle” features, “covenant-lite” and “super priority revolvers” that became increasingly difficult to syndicate. By mid-2007, the subprime mortgage crises, record oil prices and poor earnings reports changed overall conditions dramatically, and leveraged loans structured before July 2007 became unattractive. The result was that demand for institutional term loans came to a halt in the summer of 2007. Financing for new acquisitions became much more difficult to obtain, and the pendulum swung back in favour of the banks with respect to the terms and conditions of acquisition financing, when available.

Timothy Massad is a partner in the New York office of Cravath, Swaine & Moore LLP and Philip Boeckman is a partner in the London office of Cravath, Swaine & Moore LLP. The authors would like to thank Tamer Bahgat, an associate at Cravath, Swaine & Moore LLP, for his assistance in the preparation of this article.