Should Hedge Funds Include Automatic Termination as a Term of Bank Debt Trades on the New Loan Market Association Forms?
Hedge Fund Law Report
On January 25, 2010, the Loan Market Association (LMA) – the European trade association for the syndicated loan market – launched a combined set of standard terms and conditions for par and distressed trading documentation (Combined Terms and Conditions). One of the key additions to the form loan documentation is a termination upon insolvency provision. Specifically, the new provision creates a default rule whereby the non-insolvent party to a bank debt trade may terminate the trade upon notice to the insolvent party. The parties may also revise the default rule to provide for automatic termination upon the insolvency of either party. In addition, the provision provides a mechanism for calculating damages upon a termination occasioned by insolvency of one of the parties. The inclusion of the termination upon insolvency provision is widely perceived as a direct response to the experience of loan market participants in the Lehman Brothers bankruptcy. In that case, absent a termination right on the part of Lehman’s non-insolvent bank debt trade counterparties (many of whom were hedge funds), Lehman generally had the right to (and in many cases did) keep open trades for which it was in the money, and cancel trades for which it was out of the money. In short, the rules as they existed at the end of 2008 and through 2009 permitted Lehman entities to “cherry pick” favorable trades. Part of the policy behind the new provision is to prevent parties trading in bank debt from using bankruptcy (or, in the U.K., administration) to obtain a trading advantage. For hedge funds, one of the key questions raised by the new provision is whether to include automatic termination provisions in bank debt trade documentation. This article explores that question, and in doing so discusses: the details of the new LMA Combined Terms and Conditions; the specifics of the termination on insolvency provision (including the default rule requiring notice of termination and permitted alterations to the default rule); the mechanism for calculating early termination payments; the disadvantages of providing for automatic termination, highlighting the different relevant bankruptcy rules in the U.K. and the U.S.; the advantages of providing for automatic termination, also highlighting the variations in analysis between the U.K. and the U.S.; the extent to which automatic termination can harmonize bank debt and derivatives documentation, at least in the U.K.; the effect of automatic termination on bank debt trade pricing; and relevant differences between LMA and LSTA documentation.