Ethically dysfunctional: the problem with designation in leveraged finance

Trevor Clark

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

5 thoughts on “Ethically dysfunctional: the problem with designation in leveraged finance

  1. Sounds awful. What specific action by the solicitors concerned do you recommend to stop this dodgy conduct?

    And what is a tree in the head? A quick Google of the term didn’t reveal.

  2. Thanks for your interest Mark. I am shining a light on this area of practice – it may encourage the solicitors and firms involved to reflect on their practices in this sector, a number of which I highlight in the opinion piece, and consider adjusting them. They face significant commercial pressures that disincentivise them from doing so, of course.

    I guess that’s so far a non-specific answer to your very specific question… but one specific practice they might reflect on is the one that you ask about, ‘trees in the head’. This puts pressure on the lender lawyers, and there is some evidence in my data that confidential information (unsurprisingly) leaks out as a result. I was limited to 1,500 words in this week’s opinion piece, so couldn’t get into the detail here. But if it helps, I have reproduced below the section from the previous week’s Lawyer article where I comment on this.

    Best wishes

    Trevor

    ———————————–

    ‘Trevor Clark, an ex-Linklaters finance partner and now legal academic who’s pursuing a doctorate in legal practice ethics, has two questions for his former peers: are law firms adequately managing threats to their independence? And are lawyers acting with integrity?
    Clark notes that on syndicated deals, the potential arranging banks compete for the mandate with the designated lawyer on board. Until quite recently, each bank pitching for the lead debt mandate would be advised by a separate team at the same firm, with information barriers erected between the groups. Additionally, there might also be a team carrying out standard work on behalf of the banks as a whole, such as the review of the share purchase agreement, which would be shared with all of the banks to avoid unnecessary duplication of, for example, reliance letters for due diligence report providers.
    However, notes Clark, in the last five years or so, the competing banks tend to be advised by a single team at the same firm – a practice he dubs “a virtual tree” or “trees in the head”.
    “In other words, the individual lawyers advising the banks – whose interests may conflict – erect information barriers ‘within their head’,” Clark explains. “While they may receive sensitive and confidential information from one bank in the group, which might include the proposed pricing and other core terms they intend to offer to the sponsor, they must not share it with any other bank.
    “The virtual tree is maintained until the commitment papers are agreed and ready to be signed,” he continues. “The tree is then ‘collapsed’ and the banks chosen as the arranging banks are put together, and from this point on, all information is shared between this arranging bank group.”
    At what point might this become a regulatory or ethical issue? Clark says: “There was some concern that this practice might conflict with the requirement to erect information barriers when acting for more than one client on the same matter under Rule 6.2 of the SRA’s Code of Conduct when it was updated in 2019.”
    However, the solicitors’ watchdog has so far taken no action. “The SRA, seemingly after representations made by law firms, updated its guidance on Rule 6.2 in March 2020,” says Clark, “to make clear that clients could provide informed consent that no structural safeguards were needed where, broadly, the lawyer agrees not to disclose information which is material and confidential to one client to another client.
    “It seems the guidance was updated to permit virtual trees/trees in the head, albeit the practice is not specifically referenced.”’

  3. Thanks, Trevor. From what I have read, above, the key ethical issue seems to be the market practice of party A’s solicitors nominating who will advise party B (to Z), and whether this affects the advice given to party B. There could, I suppose be greater clarity in the SRA rules about whether this practice is, per se, objectionable: whether it is unethical for party A’s solicitors to demand it, and whether it is unethical for party B’s solicitors to accept such a nomination. Perhaps, like price fixing, it should be okay if it only a recommended (retail price / solicitor).

    Without greater information, I’m not sure I see a problem with a solicitor acting for multiple banks if they don’t disclose one bank’s confidential information to another, and if the banks accept this arrangement (eg via terms in an engagement letter). From memory, the conflict rules are focused on (a) information and (b) vulnerable clients (eg acting for husband and wife). So if a sophisticated client thinks this is fine, I’m not sure reflection is needed on this aspect.

    1. Mark, on the point about “if a sophisticated client thinks this is fine…” – clearly, lending banks are not “widows and orphans” but the point which Trevor’s article makes me wonder is whether the inherent conflict in this situation may be feeding some sort of systemic risk, by pushing terms in the direction outlined by Trevor.

  4. Really interesting. ‘Treeing’ was a new term for me as well, Mark.

    Some more guidance on it that I found –

    FT 2007: https://www.ft.com/content/48c7bd48-0318-11dc-a023-000b5df10621

    Practical Law: https://uk.practicallaw.thomsonreuters.com/8-382-3883?transitionType=Default&contextData=%28sc.Default%29

    I thought it was interesting that the FCA in 2015 identified even the following non-virtual, non-lawyer example as ‘poor practice’ –

    “One firm with a small leveraged finance team would allocate employees to different financing teams in a competitive M&A situation (‘treeing’) without separating the employees, adequately limiting system access or putting in place any additional surveillance.”

    Click to access tr-15-13.pdf

    I’ve just had a look at the 2020 version of SRA rule 6.2, Trevor, and yes, it does on its face seem to allow for a very wide exception.

    However, I certainly wonder whether it’s sustainable with regard to wider principles.

    For example, at the very end of 6.2 there’s a reference to not restricting retainer in cases of imbalance, weakness etc. As drafted in the guidance, I *think* that may just relate to the ‘restriction of retainer’ topic, but I’d have though the principle is wider.

    Also, the courts have in the past been rather sceptical of even non-virtual trees (e.g. the Prince Jefri case in the late 90s, but also subsequent ones) – while things have obviously moved on since then, I wonder if such practices would survive legal challenge. That said, I’m not sure who would be sufficiently motivated to challenge it in litigation.

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