Secondary Debt Trading – Part 2

Novation

The effect of novation is that the original debt between the borrower and the seller (being the lender who holds the debt prior to the completion of the transfer) is cancelled, and a new debt is created on the same terms between the borrower and the buyer of the debt. This is an option favoured by both buyers and sellers as it allows the seller to completely walk away from the requirements of the loan and gives the buyer full control going forward, having assumed both the obligations and the rights initially belonging to the seller.

This option is not always possible as it requires the borrower’s consent, since the borrower has to be a party to the novation agreement. If such consent is not forthcoming or if the parties prefer not to bring the trade to the borrower’s attention at that time, then novation may not be possible. In addition, because a new loan agreement is essentially created, any security granted in relation to the original loan will be discharged and will have to be retaken by the buyer (unless such was granted to a security agent whose identity does not change but with whom the buyer will need to establish its relationship in place of the seller).

Q: What does this mean for borrowers?

A: Borrowers may be approached by the existing lender (or, in a syndicated loan, the agent) to execute a novation agreement between the borrower, the existing lender (or the agent) and the buyer, as well as new security documents. If during the original transaction, however, the loan agreement uses the standard Loan Market Association (“LMA”) terms, then a transfer certificate (which is substantially in the form prescribed by the LMA) in agreed form will be used instead. From the date of novation, the buyer will fully replace the existing lender, and all repayments of capital and interest must be made to the buyer. Any further advances under the loan agreement will now come from the buyer rather than the previous lender.

Q: Does the identity of the new lender matter?

A: If the new lender is not a UK entity, tax implications may arise in relation to any withholding tax on interest payments. The new (non-UK) lender will need to obtain approval to receive gross interest payments, and this then needs to be “passported” to the relevant loan. The borrower will also need to obtain permission from HMRC to make gross interest payments. Further, the potential existence of so called ‘black or white lists’ setting out which lenders may or may not become a party to a loan agreement may restrict the identity of permitted new lenders.

Q: As a borrower, I do not want to sign the novation documents. Is this allowed?

A: Borrowers do not have to agree to the novation and, if this is the case, the buyer and the seller will have to find an alternative transfer method. If, however, LMA documentation was used to document the original loan, although the borrower’s consent is required, such consent must not be unreasonably withheld or delayed and will be deemed to be granted if no response is given five business days after consent is requested. It may also be very difficult for borrowers to prove that their refusal to consent is reasonable.

Q: How can I check my position before a trade takes place?

A: Carefully review the provisions of the loan agreement relating to changes to the original parties as these will govern the amount of input that borrowers may have in connection with novation.

Q: Should a buyer be concerned about having to retake fresh security?

A: When the old security is released and new security is taken, “hardening periods” start again (for more information on these, please see our previous articles on the topic here and here). This means that if the borrower becomes insolvent within a set amount of time of the new security being given (the exact amount varies depending on the type of transaction), an insolvency practitioner may set the security aside and this will then be unenforceable. Buyers should therefore ensure they are fully comfortable with the borrower’s financial situation and, if purchasing distressed debt, be especially alert to the likelihood of the borrower becoming insolvent within the hardening period.

In our next article, we will discuss the mechanics of assignment as a transfer method and the practical implications this may have for borrowers.