Further, lenders often assess the underlying bond documentation to determine whether, and to what extent, a security interest has been granted to the bond issuer. Often the underlying documentation includes an overly broad collateral description (beyond just equipment and other assets needed to complete the project). Sometimes these clauses go so far as to grant an all-assets lien. In some cases, the borrower might be required to post cash collateral to support its obligation to indemnify the surety for payments made under the bond. Rarely, however, does the surety file a UCC-1 financing statement to perfect its lien, though generally sureties reserve the right to do so. In the rare event a bond issuer files an all assets UCC-1 financing statement, the lenders may (or may not) permit such UCC-1s so long as no claim for payment under the bond has been made against the borrower that remains outstanding and unreimbursed beyond any applicable grace or cure period.
In addition to addressing lien issues with carefully crafted covenants, some lenders are guarded about lending against receivables arising from bonded contracts. These lenders may exclude bonded contracts from the loan agreement's borrowing base entirely, but understandably this may be problematic for borrowers with significant bond exposure because it may hamper their access to liquidity. For lenders who choose to limit, rather than exclude, the bonded receivables against which they will lend, a cap on the bonded receivables in the borrowing base or an overall cap on bonded projects may help address this issue. Lenders may also choose to place a cap on the overall exposure that may be subject to perfected liens.
The ultimate goal for borrowers and their lenders is to strike the right balance between allowing flexibility to permit the borrower to operate its business and grow revenues (including to generate cash flow to repay the loan) and not undermining the borrower's creditworthiness. Ultimately, it is best for both the borrower and the lender to discuss these issues at the outset of the transaction so as to agree on how to address them in the financing documentation.
Note that when analyzing these bond exposure issues, it is important for the lender and its counsel to understand that it is not in anyone's best interest for the bond to be called, as this is an extreme measure that may result in significant delays in the completion of the project and the inability of the borrower to obtain any future performance bonds. Further, the process for a borrower’s customer to make a claim under a bond includes significant procedural hurdles that must be satisfied before a surety takes any action, including making payments to the customer or securing another contractor to complete the project.
Notably, both the terms of the bond and the construction contract itself are relevant to the analysis of the customer's rights, including whether there has been a failure of performance by the borrower under the contract. A mere failure to perform is usually not enough. Rather, the underlying contracts typically require a material breach (or series of breaches) by the borrower of such magnitude that the customer would be justified in terminating the contract. This often implies continued failures by the borrower to provide adequate resources and materials or substantial defects in work (minor breaches on their own are insufficient). For lenders, part of their due diligence should be to inquire about historical performance of bonded contracts, including whether any customers have ever asserted material breaches or any bonds have ever been called. This historical information should help the lender assess the risk of lending against the associated receivables and the creditworthiness of the borrower as a whole. Counsel for lenders should also consult with their bankruptcy colleagues to discuss the treatment of performance bonds in the bankruptcy context.
In middle market acquisition financing deals, the treatment of representation and warranty claims by the buyer against the seller under the purchase agreement sometimes raises concerns for the buyer’s lender when there is seller debt. What issues are involved and when might they arise?
In middle market acquisition finance deals where a portion of the acquisition purchase price is financed with seller debt, an issue sometimes arises as it relates to offset rights, specifically around the ability of the seller to offset payments due from the buyer (that is, the lender’s borrower) under the seller note against the buyer’s indemnity claims against the seller under the purchase agreement. In this context, purchase agreements often include either an optional right of the parties to offset payments due under the seller note, or a mandatory right of setoff. Understandably, sellers favor setoff rights because in the event of an indemnity claim against the sellers, offsetting against future amounts owed to the sellers results in the sellers not being required to use current funds to satisfy the buyer’s indemnity claim.
Typically, a buyer’s loan agreement will require that the seller note be subordinated in right of payment to the buyer's bank financing. In such a case, loan agreements usually permit the borrower to make agreed-upon payments to the seller under the seller note. These agreed-upon payments are often limited to regularly scheduled interest payments, and depending on the deal, scheduled principal payments so long as certain conditions are met (for example, no default, pro forma covenant compliance, availability threshold). Further, the loan agreement may also contain a negative covenant regarding the exercise of any right of offset as it relates to the seller note. Some lenders place more value and focus on this issue than others, and those that do will also often include a restriction in the subordination agreement against the exercise of setoff rights to establish privity of contract between the lender and the seller vis-à-vis this issue.
The rationale behind the restriction of the exercise of setoff rights is twofold. First, to the extent the buyer is entitled to cash (whether or not from escrowed funds) as a result of an indemnity claim against the seller, the lender’s position is that such cash should be paid to the buyer and used for working capital, to rectify the issue that is the subject of the indemnity claim or to make any required mandatory prepayment under the buyer’s loan agreement with the lender (for example, for extraordinary receipts). The position of the buyer's lender is that funds from the buyer’s indemnity claims for breaches of representations and warranties by the seller should be paid to the borrower now, not offset against a future payment (and a future obligation of the buyer) under the seller note. Second, the exercise of setoff rights is viewed by some lenders as a subversion of the subordinated nature of the seller debt. If instead of the seller paying the borrower cash today for an indemnity claim, the seller is able to offset those indemnity obligations against future payments due to the seller under the seller note, the seller is receiving a benefit today of a "payment " that it is not otherwise entitled to receive under the terms of the subordination agreement. Notably, in an acquisition with a representation and warranty ("R&W") insurance policy, the offset right is not an issue because the buyer’s rights are against the R&W policy rather than the seller. However, in transactions where there is no R&W insurance, this issue is sometimes a point of contention between a seller and its buyer's lender, ultimately to be resolved based on their respective negotiating leverage and the specifics of the transaction.
