U.S. credit market remains uneasy in the world of representations and warranties

October 12, 2011

US dollar note and other currenciesBy Alex Lee

NEW YORK, Oct. 12 (Business Law Currents) – The first half of 2011 saw rebounding credit markets and an uptick in debt issuance. Due to uncertain economic conditions in the second half of 2011, however, even the most fundamental aspects of loan documentation are facing increasing scrutiny. Representations & warranties that were more routine and non-contentious transformed into significantly stricter provisions as a result of the credit crisis.

Gun shy lenders began placing more onerous terms in credit facilities and the reps and warranties were dramatically bulked up. Some borrowers are now required to announce their credit worthiness under no uncertain terms. Recent litigation concentrating on reps and warranties has heightened the already palpable sense of market unease. Lenders are escalating the investigative function of the reps & warranties to more fully flesh out the factual matrix in reliance of which they will decide to provide a credit facility.


As a part of a credit facility that is secured, the assets of the lender are substantially important with respect to any negotiated security package. Lenders are likely to also want assurance that specified assets are included for the purposes of any potential bankruptcy proceedings. Lenders will often, but not always, insist on a confirmation by the borrower via reps and warranties, to confirm the actual assets, the true status of their ownership and the quality of the assets themselves.

A recent example of an asset quality rep is S&P B+ rated Kansas City Southern de México’s $200 million revolving loan facility which has an asset quality rep for the ownership status of properties. A second interesting example is S&P BB rated HCA Inc.’s $2.5 billion revolving credit loan which not only has an asset quality rep related to ownership but also has a separate asset quality rep in relation to the ownership of intellectual property. The added IP property rep is a likely reflection of the different types of assets held by the two entities as Kansas City is a freight transportation company and HCA is a hospital company.


Another rep that is more frequently appearing is the material adverse effect clause (MAE). This provision allows the lender to refuse to finance or to complete a financing if such an event occurs. The MAE rep is made at the date of the agreement and is repeated usually on the occurrence of a significant date or with each utilization request to give assurance to the lenders that no MAE has occurred.

The simple rationale for this provision is to protect the lender from significant alterations in the borrower’s business that could adversely affect their ability to fulfill their obligations under a facility. The MAE rep specifies certain grounds for termination not only for the lender but sometimes also for the borrower. MAE provisions can come in the form of a comprehensive provision expressly included in the reps and warranties such as in Kansas City’s abovementioned facility.

MAE provisions can also provide the borrowers with the means to qualify certain reps and warranties in order to disregard immaterial breaches. For example, S&P BBB rated Darden Restaurants Inc.’s $750 million revolving credit facility qualifies their authorization/no contravention rep and warranty so that any violations or defaults that would not reasonably be expected to have a material adverse effect are ignored.

Similarly is S&P A- rated Western Union Company’s $1.65 billion revolving credit facility. Their audited and unaudited financial statements relating to the credit facility agreement had to fairly represent their financial condition. Included, is a knowledge qualifier whereby Western Union does not have any liabilities, obligations or transactions not reflected in the financial statements that to the best of Western Union’s knowledge would have a material adverse effect.


As market conditions continue to exhibit uneasiness solvency reps will also remain a major factor in today’s credit agreements. For instance, S&P BBB- rated State Auto Financial’s recent credit agreement contains a solvency rep that includes assurances that the fair value of their assets will exceed their debts and liabilities, that they will be able to pay their debts and liabilities and that they will have reasonable capital to conduct their business. This is in stark contrast to S&P A rated Caterpillar Financial Services Corporation’s recent credit agreement that has no such provision.

The lower investment grade rated companies and the speculative grade companies are the ones being forced to bend to the whims of the lenders. At the S&P B, rating the opinion of a company is said to be that it is more vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments. For companies such as State Auto, Kansas City and HCA with lower ratings there is a genuine concern on the part of the banks that they will default and thus all of their credit facilities have solvency reps.


In tandem with unstable market conditions there is also the looming threat of litigation just over every transactional horizon. Reps and warranties have recently taken the spotlight as the major focal point in DDJ Management, LLC et al. v. Rhone Group, LLC. The lenders brought a fraud case against the borrowers claiming that the borrowers had misrepresented their financial statements and induced them into providing a loan which was a breach of the reps and warranties.

The borrowers argued that the lenders failed to make reasonable inquiries and conduct proper due diligence. In the end it was decided that since the lenders extended strenuous efforts to protect their interests not only through their own diligence but by also going to the exhaustive process of obtaining written reps and warranties their reliance on the reps and warranties were justified in this instant.

Borrowers and lenders will be examining the litigation radar now that there is precedent for sophisticated parties to rely on express reps and warranties as the courts established that they do “mean something”. It is likely that meatier, lender friendly reps and warranties will remain the status quo and for lower investment grade or speculative grade borrowers they will be par for the course. As a point of comparison, Caterpillar’s credit agreement contained nine reps and warranties, whereas Kansas City’s facility had a whopping 24.

Earlier this year we saw shoots of hope for borrowers that onerous credit terms might also be starting to ease. The subsequent unrest in economic conditions has spawned a new reality that even the once seemingly simple reps and warranties are now bones of contention. Though controversial, these negotiation points appear to serve the function of bridging the gap between the harsh economic realities the borrowers face with the expectations banks have for high returns on their investments.


(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )

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