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Q&A with David W. Morse, Banking & Finance Chair at Otterbourg P.C.
Serendipity is the word that comes to mind. While I knew that I preferred to do transactional work, I certainly never thought specifically about being a finance lawyer, much less a secured lending lawyer. I was fortunate that at the time I started at the firm there was a real need in the finance practice as the firm’s business in that area was growing. Once here, part of my decision to stay in the field was to some extent a function of the firm’s approach to training. New attorneys go right into a practice area and stay with it rather than doing rotations. As a result, you learn faster, so that you get to a point where you have substantive knowledge more quickly and can offer real assistance to clients in a much more significant way much earlier in your career. Having the expertise and being able to be helpful was a very positive aspect of being at the firm. I was also very fortunate to have people here at the firm that were great mentors and while certainly demanding, very supportive. Next thing you know—the years have gone by and you are a finance lawyer.
The biggest challenge for attorneys representing lenders comes from the current market forces that lenders confront. Looking back over the years, there has been a distinct evolution of the dynamic between lenders and borrowers. Financing has become as much a service as a product. Companies and sponsors looking for financing have very high expectations about the flexibility that they will be given from their lenders. The ongoing challenge is advising lenders and helping them understand the risks they are taking in trying to accommodate the demands of their customers. A lender needs to balance the level of risk it is prepared to take as an institution and for its shareholders with the borrower’s needs and demands. Overall, to the extent that you are dealing with borrowers looking at their realistic needs you can usually solve the equation. More often than not, the answer lies in establishing the conditions and limits around terms of the arrangements in a way so that it works from the perspective of both parties.
The market development that impacts my practice is the shift of supply and demand. In the market, a significant amount of dollars need to be deployed by financial institutions in order to achieve their earnings goals. At the same time, the number of borrowers is reduced because of the large pools of cash held by corporates and private equity firms. There is a lot of liquidity in the market. So while the number of financing opportunities has declined, the supply of funds for borrowing has increased, not only because of the volume of the deposits held by banks, but from alternative lenders of all shapes and sizes. This poses multiple challenges. It has a ripple effect. Mergers and acquisitions activity is impacted because the sellers are demanding higher prices. Private equity firms are finding that it does not make economic sense for them to pursue certain acquisitions. Private equity groups (PEGS) are competing with strategic buyers. All of this affects M&A activity, which has an impact on lenders and the opportunities for them. Overall, the market is just very competitive. And then there are the regulators.
Even though it seems like old news, since the Leveraged Lending Guidance goes back to March, 2013, it did not really hit financial institutions until the fall of 2014 and in particular in November 2014 with the issuance of the Supplemental Leveraged Loan Guidance from the three regulators. That fall, there was also the issuance by the regulators of a “Matter Requiring Immediate Attention” (MRIA) to one major institution in the LBO arena that I think captured the industry’s attention.
Now institutions have to look at the transactions in a different way to address the concerns raised by the regulators and each institution is trying to figure out the best way to do that. In the meantime, as I mentioned, the pool of opportunities for deals is diminished. Lenders are between a rock and a hard place—trying to be more flexible so as to win deals, while at the same time addressing the concerns of the regulators. Ultimately the financial institutions face the dilemma of balancing the need to grow and meet their earnings goals versus the regulators’ perception of their risks.
In the meantime, the regulatory environment has created new opportunities for unregulated lenders.
Given that each year the regulators go into institutions and examine their portfolios in the annual Shared National Credit (SNC) reviews, it seems likely based on such examinations that there will be some further developments in how the institutions are applying the Guidance, although unlikely that there will be anything as comprehensive as what the regulators did in November 2014. Even though there may be further refinement of the Guidance, which is not technically a regulation, I would not expect the feedback from the regulators pursuant to the SNC to take the form of regulations per se. But there will be dialogue and challenges. At a philosophical level it is interesting how the regulators have chosen to do this and the expectations created because it is “Guidance”—not a regulation and not a law. The regulators were very clear that each institution has to develop its own rules and interpret the Guidance in its own way. For lenders that is very challenging. It seems like the regulators are trying to be accommodating and provide flexibility, which you would think would be positive from the banks’ perspective. On the other hand, it puts the institutions in a bind wondering if they are being too conservative or too relaxed in the interpretation of the Guidance. It will take at least one or two more SNC review cycles to get all of this nailed down to where it is more manageable.
There are at least two significant developments. First, there is the decline in the more highly leveraged transactions.
Second, however, are the other aspects of the Leveraged Lending Guidance that sometimes get lost in all the noise. One of these is the Guidance’s references to the ability of a borrower to repay its debt within 5 to 7 years, 50% of total debt and 100% of secured debt. The PetSmart deal is a very interesting example of balancing those other elements. It was above 6x leverage. But there were other factors that made the institutions believe it was still within the Guidance.
Another, from a legal perspective, is the elements of “weak structures” that the Guidance identifies. These are issues that we consistently confront in the negotiation of the loan documents— whether it is talking about EBITDA (earnings before interest, taxes, depreciation, and amortization) add backs, the use of expansive baskets, or the reduced use of financial maintenance covenants versus incurrence covenants, or equity cures. All of these in some combination are specifically identified in the Guidance as elements of weak structures. These elements should lead to a trend for financial institutions to push back more when they get the requests from borrowers for the types of accommodations that the regulators have said are not desirable.
We do a fair amount of transactions with international elements, which is always interesting. It’s something I’ve been doing since the mid-1990s. These deals require a very intensive understanding of the laws of the different jurisdictions that are involved in such transactions. I worked on a recent transaction that was challenging because it was an exit financing involving 10 countries. Managing that whole process, with the overlay of the bankruptcy issues, and a tight time frame, made for some real stress. Fortunately, we have a great team of experienced lawyers here at the firm who are more than capable of handling such circumstances. It was also very helpful that we have familiarity with the country-specific issues from our years of experience in doing international deals. Part of the process is to be able to describe the foreign law issues in a way that make senses to a U.S. lender. Having the knowledge base to be able to do this in multi-jurisdictional deals is one of the things that I like to think we bring as part of the “value-add” to our U.S. clients.
In another case, we were involved in a recent bankruptcy that had some challenges because our clients, the pre- petition secured lenders, did not end up doing the DIP (debtor-in-possession) financing. An affiliate of the equity sponsors came in to do the financing to protect their position and was able to do so on a third lien basis because of the value of the collateral that supported it. The equity sponsors were trying to protect their position so it made sense for them to provide the DIP financing on a very aggressive basis, and with manageable risk given the collateral values. That deal had some interesting twists and turns because the pre-petition lenders usually provide the post-petition financing as a defensive move.
While specializing in finance generally offers great opportunities, asset-based lending offers the opportunity to gain a particular breadth of knowledge that is extremely valuable for any attorney to have. It is a great training ground and ultimately leads to skills that can be valuable in any aspect of a finance practice. Someone with these skills and knowledge is always going to be needed. One of the things about asset- based lending is that it has all of the elements of lending plus you have all of the elements of the collateral and then the operational issues on top. You have to understand the Bankruptcy Code, the Uniform Commercial Code, letters of credit, some intellectual property law, the Perishable Agricultural Commodities Act and similar federal laws, the Federal Tax Lien Act, together with any number of industry-specific issues depending on the borrower’s business, including the different issues for a retailer versus a manufacturer, or how consignment arrangements work both from a legal perspective and a practical perspective, the rights of a surety providing a bond, etc. You may need to know about the Assignment of Claims Act or maritime law. You also have to understand what’s market in the ABL industry including for a smaller bilateral credit facility for a company that is not performing well or for a large syndicated facility for a company with significant cash flow. Not to mention intercreditor issues whether in the context of a first lien/second lien transaction or a split collateral structure or for a unitranche facility.
Last summer I was working on a $2.3 billion credit facility at the same time that I was working on a $10 million credit facility. Sometimes you have companies that are almost investment grade and sometimes you have companies that are about to file Chapter 11. That’s the diversity of what you are dealing with in asset-based lending. With that spectrum of transactions you acquire a lot of knowledge. For a new attorney it is a great opportunity.
As to advice to a junior attorney: bring a full dose of enthusiasm and curiosity and constantly look to expand your knowledge and hone your skills, both technically and in how you communicate. Communicating clearly and precisely will be critical to your success.
There are two types of transactions that are particularly enjoyable. First, there are the international transactions, where structuring to deal with the laws of the different jurisdictions can require some creativity. In those countries where guarantees may be of limited value, you have to figure out who and where your borrowers are, while dealing with issues like retention of title and financial assistance. Or, for example, you may have regulatory issues in a jurisdiction like Singapore, but if there is a UK company, the lender may be willing to lend to the UK company in reliance on the guarantee from the Singapore company with “on-lending” by the UK to Singapore.
Acquisition financings that involve multiple layers of debt are another type of transaction that I enjoy working on. One clear trend that I did not mention earlier might be summarized as “convergence.” It is not uncommon to have an ABL facility, alongside a term loan B; or an ABL and a term loan and a high yield; or perhaps, instead, a first lien and second lien term loan, etc. As a result of these types of debt being side by side for the same company there is pressure to import concepts from one debt product to another, which has its risks and challenges. But these are fun because you need to be familiar with each of the products and both the market practice for each and how they work separately and together. And intercreditor issues are key. Dealing with these issues is fun because when working in asset-based lending you get involved in workouts and bankruptcies that give you a real life understanding asked me why I wanted to be a lawyer and sneered at me when I gave him my answer. Now here it is several decades later, notwithstanding his reaction, and reality, so that hopefully ultimately with a better understanding of the law and the practice, they can get more satisfaction from what they do—just as I have. As of many of the provisions in the although it may sound trite, my answer is agreements and their significance. It is satisfying to be able to bring those experiences into the negotiations and the drafting of the documents.
Personally what I find very satisfying involves two aspects of a career in law.
Years ago, when I was looking for a job out of law school, I was in an interview at a firm with a very senior lawyer, a name partner in this particular firm, a litigator with a very tough attitude. He still the same—helping the clients. There is nothing more satisfying than when a client comes to you with a situation or an issue and you are actually helping solve the problem. That is very satisfying.
The second aspect of what I do that I find satisfying comes from working with more junior attorneys and being able to talk to them about the issues, to challenge them and help them to begin to really think about what they are doing and why; helping them to see the connections between what we do or say and the substantive areas of law; and then figuring out how these abstract concepts actually play out in reality, so that hopefully ultimately with a better understanding of the law and the practice, they can get more satisfaction from what they do—just as I have.
David W. Morse is a member of the law firm of Otterbourg P.C. in New York City and is chair of the firm’s banking and finance practice. He specializes in the representation of banks, hedge funds, commercial finance companies, and other institutional lenders in structuring and documenting loan transactions, including working capital facilities, financings for leveraged acquisitions, term loans, and second lien loans, as well as loan workouts and restructurings. In the course of his career, Mr. Morse has worked on numerous financing transactions confronting a wide range of legal issues raised by Federal, State, and International law