The Lawyer has kindly allowed me to reproduce the text of my opinion piece, published on Tuesday.
Last week The Lawyer reported that lenders on the recent £3.5bn financing of The Access Group were dissatisfied with the role played by their lawyers, and with the designation model under which they were appointed. My empirical doctoral research suggests lawyer behaviour is materially shaping the evolution and transformation of transaction documents and processes in the European ‘large cap’ leveraged finance sector. Designation is key to understanding how lawyers behave and view their roles, and raises ethical questions for them to reflect upon.
There is a lot to say on this complex and nuanced topic and not enough room in this column to properly do it justice. These are consequently fairly generalised observations – not all leveraged finance lawyers exhibit the traits I describe all of the time – but they are nonetheless drawn from interviews held with senior practitioners hailing from both sides of the sponsor/lender divide.
Macro-economic forces impacting this sector over the last decade or so, principally the availability of cheap credit over a prolonged period of time, coupled with the expanding investor base for the leveraged finance product, have handed a significant bargaining power advantage to the private equity sponsors in their negotiations with their lenders. This power imbalance has had a profound effect on the ways in which leveraged finance lawyers carry out, and view, their roles.
Sponsor power means it is now commonly within the gift of sponsor lawyers to choose (i.e. designate) the lawyer at another firm that will advise the lenders. As a result, there is an implicit, and sometimes explicit, threat that the flow of instructions to a lender-side lawyer and firm may be temporarily or permanently interrupted by the sponsors’ lawyer if the former proves ‘difficult’, or does not take a ‘commercial’ stance. Lender-side lawyers delicately walk a tightrope in determining how to decode and apply these signals. They find it difficult to provide robust challenge to the sponsor lawyers, as doing so risks their being excluded from the market for lender-side work. Their continued survival in the sector is fragile. They are generally relatively downcast.
The sponsor lawyers, on the other hand, who are mostly England and Wales qualified solicitors situated in a handful of US firms, are generally cock-a-hoop. They are highly entrepreneurial, but also often coercive and aggressive, continually advocating for the relaxation of creditor protections on each deal in order to give their clients ever increasing levels of operational flexibility.
Sometimes this is flexibility their clients have not requested and may never need. Sponsor lawyers and firms are engaged in a competition to deliver best terms for their clients, but also to improve or maintain their position in the lucrative market for sponsor work. They often compete to outdo each other in pushing for new relaxations in terms and structures that they can then market to other potential sponsor clients. These relaxations are then adopted, and often expanded upon, by competitor firms for the same reason. This has resulted in a ‘race to the bottom’, and a contagion of looser deal terms across the market, which have become embedded in deal precedents drafted and then fiercely defended by sponsor lawyers.
Occasionally, sponsor lawyers push too far; on the €7.1bn financing of Thyssenkrupp’s lifts business in 2020, the sponsor lawyers were reportedly forced to offer a long list of amendments to avoid a failed syndication. Rather than acting as a brake on their entrepreneurial and coercive activity, the occasional climbdown by a sponsor law firm spurs them on, a public validation of their brand for constantly and aggressively pushing terms.
Deal documents have consequently become overwhelmingly one-sided in favour of the sponsors. It is not just ‘cov lite’, carried across from the high yield bond market through a process of loan and bond market ‘convergence’, that is the reason. Lawyer behaviour has also played an important role. Key creditor rights, including early warning signals of impending financial distress, have been lost. This has led to warnings from the Financial Stability Board, the Bank of England and others that the build-up of leveraged finance debt with weak creditor protections poses a systemic risk, not unlike the sub-prime mortgages that triggered the global financial crisis.
The documents are often unnecessarily complex, ambiguous and opaque, as a consequence of the multiplicity of permissions, deductibles, carve-outs and add-backs they contain. There is frequent uncertainty over the meaning of key contractual terms, such as in the add backs to financial covenants, the scope of the borrower’s permission to borrow further debt, or its ability to transfer assets out of the lenders’ security net, often rendering them meaningless. This ambiguity is seen to favour the sponsors, as lenders need to clearly establish that an event of default has occurred before calling one, or risk severe legal and reputational ramifications. The lenders’ unhappy predicament on the recent restructuring of Envision in the US should serve as a warning of what might be about to come should there be a widespread downturn in the European market. The transplant of terms from the US raises further questions about the effectiveness of European security and intercreditor structures.
In another reflection of sponsor power, deal processes have been redesigned to maximise competitive tension between potential lenders/arrangers and to generate cost efficiencies. In practice, this redesign restricts the lenders’ access to external legal advice (e.g. in the initial, pre-designation, phase, where the ‘commercial grid’ frequently includes legal terms too, including the imposition of the ‘deal precedent’). And it risks diluting the quality of that advice once the designated lawyers are on board (e.g. because of the extreme pressure placed on lender lawyers by ‘trees in the head’, complex, ambiguous and voluminous documents, and severe timetable compression).
There is some evidence that credit funds and other direct lenders on unitranche transactions, who ‘take and hold’ leveraged loans, distrust the designation model and its effects, and are starting to appoint their own lawyers, at least to ‘look over the shoulder’ of the designated lawyers, as the reports of The Access Group financing indicate.
In contrast, the investment banks who originate and distribute leveraged debt in large scale syndications, and the lawyers that advise them, continue with designation. They do not overly concern themselves with the dilution of creditor protections, or the embedding of loopholes in documents. The banks sell the loan in the market to other banks and institutional investors. But the risks are not necessarily fully understood by these long term lenders (they are often not legally represented), or according to the FSB, fully priced in by them. Relying on strict engagement terms, lender lawyers increasingly view their role narrowly. Rather than undertaking a comprehensive review, challenging problematic provisions carried over from previous transactions, even if the context of the previous transaction was markedly different, they confine their role to identifying ‘new’ terms which have not previously ‘cleared the market’ which might prove an obstacle to a successful syndication.
Doing away with designation would not alter the underlying power imbalance between sponsors and their lenders. But the balance in documents, and processes, has swung so far towards the sponsors to a point where a number of market participants told me that leveraged lending has become more a matter of trust in the sponsor’s business acumen, as opposed to prudent, ‘senior secured’, lending. Many question whether, but for the designation model, lender lawyers would have provided more robust challenge so that this outcome would have been avoided, or at least mitigated. The fact that the question is being asked, even if we can never be certain of the answer, is not a good ethical look for both the lender and sponsor lawyers involved.
There are formal ethical rules that come into play here. Solicitors have duties under the SRA’s standards and regulations to act in the best interests of their clients. But this is not the end of the story (although many lawyers believe that it is). Solicitors also have duties to act with independence. And with integrity, which implies a higher moral standard than mere honesty, and includes a duty not to take unfair advantage of third parties. And they have duties to uphold the rule of law and the proper administration of justice, and not to undermine public trust in the solicitors’ profession. These public interest duties are to take precedence over their duty to their client where the two duties come into conflict. If a downturn hits, and more light is shone on this sector, then it may not be long before the SRA takes a closer look at the role the lawyers played.
But these are minimum standards. Whether any rules of professional practice have been breached is not necessarily the only issue. The profession itself is clear that lawyers are required to observe high standards of conduct. The Law Society states that ‘the commitment to behaving ethically is at the heart of what it means to be a solicitor’. Many of the lawyers I spoke to, on both sides of the lender/borrower divide, were uneasy about the ethical aspects of their day to day work in this market. Many lenders reportedly share their discomfort. The picture that emerges is of a field of legal practice that is widely viewed as ethically dysfunctional.
Trevor Clark, Lecturer in Legal Profession, School of Law, University of Leeds