Borrowers and issuers across the leveraged finance market are rapidly adjusting to the new Russia-related sanctions and navigating the risk of exposure to sanctioned creditors. Unsurprisingly, on a number of ongoing leveraged loan transactions, borrowers have been asking syndication banks to confirm that no allocation is being made to lenders that have been, or might become, sanctioned.
Other borrowers have been seeking to include absolute prohibitions on transfers to “sanctioned lenders” in their credit agreements. Under this construct, the borrower would also have the right to unilaterally remove a lender that becomes a sanctioned lender, or is “reasonably anticipated to become” a sanctioned lender, and would not be required to make any payments to that lender. These terms could quickly become market standard.
High-yield bond indentures, on the other hand, are unlikely to include such terms, because bondholders hold book-entry interests through the clearing systems, making it difficult or impossible for the issuers to know the identity of the bondholders. A payment made by the issuer will flow through a number of different entities before finally reaching the beneficial owner of the bonds.
This chain of different entities includes the paying agent, the common depositary for the clearing systems, the clearing systems themselves and the custodians that participate in the clearing systems. Because each entity in this chain would typically only know the identity of, or have a channel of communicate with, the immediately following entity, the responsibility to ensure that no funds are paid to a sanctioned bondholder largely rests with the custodians who know the identity of the beneficial owners.
Uncharted territory
For all but the most recent loan transactions that include the above-mentioned terms, borrowers (and potentially issuers) could face a tricky task in complying with the applicable sanctions laws while making sure that a payment default is not triggered if there turns out to be a sanctioned creditor and a lawful payment cannot be made pursuant to any exception.
Helpfully, under most credit agreements and high-yield bond indentures, a payment to the facility agent or the paying agent would discharge the payment obligation of borrowers and issuers, and there would be no payment default. Nevertheless, if the borrower knows of, or has reason to suspect, the involvement of a sanctioned lender, it would generally not be able to pay the facility agent and let the facility agent decide what to do with the funds.
For example, a payment to a sanctioned lender by the facility agent could constitute an indirect payment by the issuer. The facility agent might also request explicit instruction.
Some borrowers may take the view that illegality of payment excuses them from fulfilling the payment obligation with respect to the sanctioned lenders and that no payment default arises; whereas others may try to have the facility agent set up an account in favour of the sanctioned lenders which will be blocked until those parties are no longer sanctioned. Under the latter scenario, the borrower may also be required to obtain specific authorisation from the relevant sanctions enforcement authority.
In contrast, if the issuer does not know of, or has reason to suspect, the involvement of a sanctioned bondholder, as is generally expected to be the case for bonds, then the custodian might set up such a blocked account without involving the issuer; or it might try to relay the information to the issuer and try to avoid receiving any payments in respect of the amount of bonds held by a sanctioned bondholder.
Further complications may arise if a sanctioned bondholder requests that the amount of bonds it holds be removed from the clearing systems so that it can hold the bonds as a legal owner rather than a beneficial owner, in a manner that is similar to the way loans are held, giving the issuer actual knowledge of the involvement of a sanctioned bondholder. Issuers may try to include terms similar to the “sanctioned lender” construct in future bond issuances, but the book-entry system makes it difficult to fully replicate the concept for bonds.
These are potential scenarios that reflect the unprecedented scale and scope of the effect caused in the finance sector by recent US, UK and EU sanctions against Russia. There is no clear blueprint as to how these issues should be managed, and it remains to be seen how borrowers and issuers will manage them.
Joji Ozawa is special counsel (London office) in Milbank’s European leveraged finance and capital markets group.
