New England Biz Law Update
In Joseph Conrad’s Heart of Darkness, a young man named Marlow travels up river to find the greatest of all station chiefs, the legendary Kurtz, the man responsible for the vast success of the trading company that employs them both.
Yet Marlow discovers Kurtz is a crippled shell of his former self. Kurtz, dying before Marlow’s eyes, realizes in achieving his unbounded success, he has destroyed himself. His final words, uttered as he contemplates what he has wrought, resonate with us today: “The horror. The horror.”
As we survey the state of the leveraged finance markets in spring 2008, we are reminded of Marlow’s trip and his discovery – of how a successful and functioning system was, if not killed, at least seriously crippled, by the very means by which it achieved such success.
Spring 2007 was a heady time for the leveraged finance market (i.e., the market for bank and high-yield debt used for financing leveraged buyouts). From plain-vanilla transactions to highly complex acquisitions with numerous capital tranches, deals got done.
Mega buyouts of $100 billion dollars were bandied about in the financial press. And yet, in spring 2008, we find ourselves contemplating the wreckage of this system and witnessing the detritus of broken deals as we travel further into the year.
Apt metaphor
A journey upriver is an apt metaphor to examine the exemplar for all that has recently gone wrong in the leveraged finance market: The Clear Channel leveraged acquisition. We travel from the sunny days of spring 2007, when the commitment papers were signed, to the very heart of darkness, when sponsors sue their banks to force them to fund the transaction.
In breathless language, the sponsors in their complaint against the banks, detail a journey in which we are told a commitment letter is not a commitment, precedent is not worth the paper it is written on, and parties only pretend to negotiate in good faith, but in reality attempt to poison the transaction.
Of course, the sponsors’ complaint only tells us one side of the story. But what a side it is. And, if we give allowance for the tendentious nature of the sponsors’ telling, we can glean from the story an accurate view of the movement of the market over the past year.
In May 2007, the banks offered to the sponsors “aggressive” terms to provide fully underwritten, long-term financing to the sponsors for the Clear Channel transaction.
The banks expected to earn “huge” fees in return. These terms included a “covenant-lite” structure (i.e., no financial maintenance covenants) for the senior secured bank debt, and permissive terms for restricted payments, as well as refinancing terms of additional debt.
As conditions in the credit markets worsened in mid-2007, and even though the banks’ commitment was not subject to any market conditionality, the sponsors claim the banks “plotted” to shift losses to the sponsors by asking with “hat in hand” to change key economic terms in the deal.
When the sponsors initially refused to renegotiate the transaction, the banks then threatened (the sponsors claim) to disrupt the financing for an altogether separate transaction with a different company in an effort to force concessions in the Clear Channel financing.
When that didn’t work, the banks, according to the sponsors, resorted to “pretext and misdirection” when the time came finally to document the financing agreements. Indeed, the sponsors claim, the banks only “pretended” to negotiate the final documentation in good faith, but in reality, and knowing the sponsors would never agree, inserted into the final documents “poison” provisions that were squarely contrary to the commitment letter, normal sponsor precedent, and communications to the sponsors and others.
From the sponsors’ point of view, such terms showed the banks were seeking not merely to renegotiate their commitments. Rather, the banks trying to avoid their commitments altogether by making it impossible for the sponsors to accept such terms, causing the financing arrangements, and the Clear Channel transaction, to fall apart.
In March 2008, almost a year to the date of the signing of the commitment letter, the sponsors filed lawsuits in New York and Texas to force the banks to fund the Clear Channel transaction.
Unprecedented litigation
The very concept of litigation between sponsors and their banks is almost unprecedented. That both parties were willing to take this matter to the courts evidences the serious consequences each side believes it is facing.
The sponsors appear to believe Clear Channel is a unique asset, and that the financing, as originally proposed by the banks, is no longer available to them in the market. For these reasons, the sponsors are seeking specific performance of the commitment letter, so that they may close the acquisition of Clear Channel with the benefits of the financing they believed was committed to them.
On account of the degraded nature of the type (and pricing) of debt that would be required to be funded, the consequences to the banks are immediately and painfully quantifiable. Most sources estimate the banks would incur losses of approximately $2.65 billion upon funding.
How the litigation may proceed and what its eventual outcome will be are beyond the scope of this article. However, like Marlow, in our review of the Clear Channel transaction, we have gone upriver to find that what was once vibrant and successful is now a place of desiccation and recrimination.
The Clear Channel transaction, from commitment letter to lawsuit, is a cautionary tale of too easy terms and too much liquidity, fueled by an insatiable appetite for fee income on the part of the banks. By negotiating terms that bound them to a static market, the banks blinded themselves to the very fluidity of the market.
And so, like Kurtz, what created their success – the ability to continually engineer financial terms to suit the needs of the sponsors – ultimately crippled them. The inability to sell loans with such terms in the current market has led to substantial write-downs and charge-offs for banks, causing many of them to go hat in hand to investors to shore up their capital base.
The leveraged finance markets will return, and the banks will survive and again prosper, just as Marlow returned down river and came back to London. And much like the flotsam and jetsam on a river eventually runs to the ocean, the unsold debt built up on the banks’ books will eventually be cleared.
But the question is: Will the banks have learned anything from the pain and destruction wrought by vagaries of the market? Or will they, like Kurtz, recall only the horror?
William Egler is counsel with international law firm Nixon Peabody LLP in the firm’s global finance practice group. Mr. Egler has a broad range of experience representing major international financial institutions structuring, negotiating and documenting credit facilities. He can be reached at [email protected].
