FEC Corporate & Financial Services Alert On March 22, 2013, the Board of Governors of the Federal Reserve Board (the Board), the Federal Deposit Insurance Corporation (the FDIC) and the Office of the Comptroller of the Currency (the OCC) (collectively, the Regulators) published the Interagency Guidance on Leveraged Financing (the 2013 Guidance). On November 7, 2014, the Regulators ...
FEC Corporate & Financial Services Alert
On March 22, 2013, the Board of Governors of the Federal Reserve Board (the Board), the Federal Deposit Insurance Corporation (the FDIC) and the Office of the Comptroller of the Currency (the OCC) (collectively, the Regulators) published the Interagency Guidance on Leveraged Financing (the 2013 Guidance). On November 7, 2014, the Regulators released answers to Frequently Asked Questions (the FAQs) relating to the 2013 Guidance. Also, the agencies simultaneously released the Shared National Credit Program 2014 Review (2014 Review), which includes a supplement relating exclusively to leveraged loans (the SNC Supplement).
As low-interest rates and highly liquid loan market conditions prevailing in recent years have contributed to a competitive environment among originators of leveraged loans (i.e., loans with covenant lite terms, flexible capital structures and historically higher leverage), regulators have become increasingly focused on leveraged lending compliance. The 2013 Guidance is intended to help institutions strengthen risk management frameworks to ensure that leveraged lending activities do not heighten risk in the banking system through the origination and distribution of poorly underwritten and lowquality loans. The responses contained in the FAQs foster industry and examiner understanding and promote consistent application and implementation of the 2013 Guidance. In releasing the additional guidance, the Regulators reiterated that federal banking regulations require institutions to employ safe and sound practices when engaging in commercial lending activities, including leveraged lending. The Regulators further announced that they will increase the frequency of leveraged lending reviews to ensure the level of risk is identified and managed.
I. Applicability
The guidance discussed herein applies to all Board-supervised, FDIC-supervised or OCC supervised financial institutions, including insured depository institutions, financial holding companies, bank holding companies and their non-bank subsidiaries; however, only a limited number of community institutions have exposure to leveraged credits.
II. Background 2013 Guidance
The 2013 Guidance is not a rulemaking action, but rather a set of standards that institutions should use to assess their risk management frameworks for leveraged lending. In the 2013 Guidance, the Regulators stated that a lack of robust risk management processes and controls at a financial institution with significant leveraged lending activities could contribute to supervisory findings that the financial institution is engaged in unsafe-and-unsound banking practices. The 2013 Guidance required institutions to maintain a definition of leveraged lending that is sufficiently detailed to ensure consistent application across all business lines. The Regulators identified four common characteristics of a leveraged loan:
- it is used for buyouts, acquisitions or capital distributions;
- it may involve a borrower whose Total Debt-to-EBITDA ratio or Senior Debt-to-EBITDA Ratio exceeds 4:1 or 3:1, respectively, or other defined levels as appropriate to the industry or sector;
- the borrower is recognized in the market as highly leveraged, characterized by its debt-tonet-worth ratio; and
- the borrowers post-financing leverage exceeds industry norms or historical levels based on debt ratios or industry standards.
The FAQs explain that these characteristics are simply a starting point for a banking institution to develop a definition of leveraged lending that takes into account the institutions own risk management framework and risk appetite. The FAQs further emphasize that a banking institutions definition should, at a minimum, include borrower characteristics that are recognized in the debt markets as leveraged for each industry in which the banking institution makes loans.
The 2013 Guidance stated that poor underwriting could be unsafe and unsound regardless of whether a loan is fully distributed or held on the books of the originating institution. Going beyond the pipeline risk of a large unsyndicated commitment, the Regulators cautioned institutions in the 2013 Guidance to be wary even of fully distributed loans that are poorly underwritten, because they may find their way into a wide variety of investment instruments and exacerbate systemic risks within the general economy. The SNC Supplement also emphasized this point by providing that the origination of leveraged transactions, whether for investment or distribution, should have a sound business premise, an appropriate capital structure, and reasonable cash flows that support the borrowers ability to repay and to de-lever to a sustainable level over a reasonable period.
III. 2014 SNC Review and SNC Supplement
During 2014, the interagency Shared National Credits Program (theSNC) conducted the 2014 Review, which examined a portfolio of leveraged loans and identified areas of weaknesses and risks in the leveraged lending arena. The 2014 Review examined the credit quality of syndicated loans held by U.S. banking organizations, foreign banking organizations and non-banks based on an examination of $975 billion in credit commitments (which comprised 29% of the SNC loan portfolio), using data collected between December 31, 2013 and March 31, 2014. Of this total, the 2014 leveraged SNC loan portfolio consisted of $767 billion in commitments across 24 industry segments, of which the SNC examined 782 leveraged loan obligors consisting of $623 billion of commitments, representing 81% of the 2014 leveraged SNC loan portfolio by dollar commitment.
The SNC Supplement states that the 2014 Review found serious deficiencies in underwriting standards and risk management of leveraged loans. Thirty-one percent (31%) of the leveragedloans originated since the 2013 review (of approximately $623 billion in commitments reviewed) are cited as weak, because of high leverage, an absence of financial maintenance covenants, nominal equity and minimal de-leveraging capacity, among other factors cited. The Regulators criticized covenant deterioration in particular, including the use of net debt in leverage covenants and features that permit debt to be increased above opening leverage, as well as provisions that permit dilution of senior secured positions. The 2014 Review also identified risk management flaws, including inadequate support for enterprise valuations, general weakness in credit analysis and overreliance on sponsors projections.
Given the Regulators concern associated with leveraged lending, they announced in the SNC Supplement that they expect that all firms with leveraged loan exposure will:
- establish underwriting standards to prevent the origination of new non-pass credit;
- establish policies to enhance the credit position of non-pass borrowers seeking to refinance current credit structures;
- set prudent limits for leveraged transactions to highly cyclical industries that would struggle to meet obligations during a down cycle; and
- set prudent limits for leveraged transactions that do not result in increased cash flow for the borrower, such as dividend recapitalizations.
IV. FAQs
Simultaneous with the release of the SNC Supplement, the Regulators released answers to FAQs on related guidance intended to advance industry and examiner understanding and promote consistent application in policy formulation, implementation, and regulatory supervisory assessments. Several of the FAQs probe the applicability of the 2013 Guidance in certain situations or to certain types of financings.
This Alert is provided to Clients and friends of the Firm. If you have questions regarding any of the items discussed, please contact one of the following attorneys: Paul B. Benham III(501) 370-1517, Robert T. Smith(501) 370-1559, John F. Griffee IV(501) 370-1426.
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