Over the past few months, David Karp, partner at Schulte Roth & Zabel has enlightened readers with a fascinating series on the technicalities inherent in trading and closing trades in the world of distressed debt. For the last piece of the series, David takes on the complexities of bank debt trading, which has become an increasingly prevalent instrument for distressed debt funds to engage in. It's an incredible read. Enjoy!
Bank Debt Trading on the Modern Day Back of the Napkin
While it may be surprising to market outsiders, every day bank debt traders in the Unites States, Europe and around the world enter into multimillion dollar binding trades — over the phone, on Bloomberg instant messages and via email — for which many complex collateral, tax, counterparty risk and other material terms and conditions are left off of the modern day “back of napkin.” While the Loan Syndication and Trading Association (“LSTA”) and the Loan Market Association (“LMA”) have set the baseline standards for bank debt trades in the United States and Europe respectively, trades often include material issues that need to be addressed after the traders say “done,” but before entry into a formal written confirmation and eventual settlement. While recent case law in the United States and Europe has confirmed that these informal communications are binding, it also shows traders the importance of at least including some reference to material issues (in addition to price, amount and facility) on the “napkin” at time of trade.
For instance, the U.S. Court of Appeals for the Fifth Circuit held on Oct. 2, 2012 that an oral trade of certain bank debt from Bank of America (“BofA”) to Highland Capital Management (“Highland”) was binding despite follow-up emails stating that the claim was “subject to appropriate consents and documentation.” Highland Capital Mgmt., L.P. v. Bank of America, N.A., 698 F.3d 202 (5th Cir. 2012). That decision brings U.S. case law in line with a 2007 English High Court decision, which held that oral trades are binding even if certain terms of the trade, such as the settlement date or the form of transfer, remain undecided. See Bear Stearns Bank plc v Forum Global Equity Ltd.  EWCH 1576. While the bank debt market’s mantra continues to be “a trade is a trade” and the LSTA’s standard documentation makes clear the binding nature of oral trades, what is interesting (and perhaps scary) about these cases is that they were resolved only through years of protracted litigation, involving a significant commitment of time and expense by the parties. Even if all of your counterparties have a full appreciation of the market standard that an oral trade is binding, judges are not in the market and, if the economic incentives are tempting enough, a counterparty could try to take advantage of courts’ general lack of market awareness.
In 2009, Highland and BofA began negotiations on a potential sale of certain bank debt of Regency Hospital from BofA to Highland. (Footnote #1) On Dec. 3, 2009, a representative from Highland called BofA to finalize the trade and its terms. Id. The parties agreed over the phone that Highland would purchase, and BofA would sell, $15.5 million of the debt at 93.5 percent of par and that the agreement incorporated the Standard Terms and Conditions published by the LSTA. Id. The BofA representative did not reserve any non-LSTA or non-industry terms during the Dec. 3, 2009 call. Id. After the call, the Highland representative sent an email to the BofA representative confirming that the debt-trade agreement was complete. Id. The BofA representative responded with a confirmation of the agreement, noting that it was “subject to appropriate consents and documentation.” Id.
After the Dec. 3, 2009 call, BofA refused to settle the trade unless Highland agreed to additional terms, including an indemnification, payment of legal fees and waiver of legal claims. Id. at 205. Highland viewed these additional terms as departing from the standard LSTA terms and the Dec. 3, 2009 oral agreement. Id. The Regency Hospital loan ended up paying out 100 percent of par and Highland subsequently sued BofA for breach of contract. Id.
Relying on BofA’s “subject to” language, the trial court held that the parties did not intend to be bound by the trade without additional “consents and documentation” and, therefore, granted BofA’s motion to dismiss. Highland Capital Mgmt., L.P. v. Bank of America, N.A., 2011 WL 5428779, at *5 (N.D. Tex. 2011). Highland appealed that decision to the Fifth Circuit arguing that the lower court failed to accept Highland’s pleaded facts as true, as required on a motion to dismiss (as explained in note 1) and improperly considered factual issues related to the parties’ intent and industry standards. Highland, 698 F.3d at 205.
Fifth Circuit’s Analysis
The Fifth Circuit began by observing that oral contracts are valid under New York law. Id. at 206. In fact, New York law specifies that bank debt oral trades are binding under a statute providing that the statute of frauds does not apply to the assignment, sale, trade, participation or exchange of indebtedness or claims relating thereto under certain qualified financial contracts, which include bank debt. See N.Y. Gen. Oblig. Law § 5-701(b)(2)(i) and (ii). However, if the parties do not intend to be bound until the oral contract is reduced to writing and signed, then the oral contract is not binding until that time. Highland, 698 F.3d at 206. Whether or not the parties intend to be bound is a factual issue to be determined by the court or a jury based on evidence. See id. The trial court nevertheless found BofA’s intent not to be bound in its “subject to appropriate consents and documentation” email. Id.
Highland’s complaint, however, alleged that the parties had agreed to all of the material terms on the Dec. 3, 2009 call because the LSTA standard terms specify that parties agree to be legally bound by any subsequent calls or emails that reach agreement on material terms. Id. at 207. Under Section 21 of the LSTA Standard Terms and Conditions for Par/Near Par Trade Confirmations, once you execute an LSTA trade confirmation, you are bound by the LSTA standard terms in all future debt trades with that same counterparty unless you specifically say otherwise at the time of trade. Section 21 LSTA Standard Terms and Conditions for Par/Near Par Trade Confirmations provides as follows:
By execution of a Confirmation incorporating by reference the Standard Terms and Conditions, each Buyer and Seller agrees to be legally bound to any other transaction between them … with respect to the assignment, purchase, sale and/or participation of commercial and/or bank par/near par loans, or any interest therein, upon reaching agreement to the terms thereof (whether by telephone, exchange of electronic messages or otherwise, directly or through their respective agents, and whether the subject of a confirmation), subject to all the other terms and conditions set forth in any confirmation relating to such transaction, or otherwise agreed.This also applies to distressed trades pursuant to Section 22 of the LSTA Standard Terms and Conditions for Distressed Trade Confirmations. The same section also commits the parties to New York law, and to not raise a defense for lack of a writing based on the statute of frauds.
Highland’s complaint also correctly asserted that the “consents” referred to in BofA’s “subject to” email referred to borrower consent, which is often required to effect the assignment of bank debt transfers. Id. Highland explained that, even if borrower consent were not available, the LSTA standard term would still require the parties to close the transaction by participation or otherwise. (The LMA standard terms include a similar provision. The potential pitfalls related to borrower consent in Europe are discussed in a prior post, Prospecting for European Distressed Loans.) Id. Highland’s complaint also alleged that the “documentation” in BofA’s “subject to” email referred to the execution of a standard LSTA trade confirmation, noting that the execution of the trade confirmation is not a condition precedent to formation of a binding trade. Id. at 207-08.
In its consideration of whether or not the parties intended to be bound by the oral agreement, the Fifth Circuit used the four-factor test generally used by courts in breach-of-oral-contract cases. Id. at 206. The test considers: “(1) whether there has been an express reservation of the right not to be bound in the absence of a writing; (2) whether there has been partial performance of the contract; (3) whether all of the terms of the alleged contract have been agreed upon; and (4) whether the agreement at issue is the type of contract usually committed to writing.” Id. at 209. First, taking Highland’s allegations as true, the Fifth Circuit saw no indication that BofA had expressly reserved the right not to be bound without a written agreement. Id. Second, Highland alleged that the parties had agreed on all material terms. Id. Finally, the LSTA standard terms indicate that debt trades can be conducted orally and only later committed to writing in a trade confirmation. Id. Taken all together, the Fifth Circuit concluded that the emails following the Dec. 3, 2009 phone call did not unambiguously indicate that the parties did not intend to be bound and, therefore, the issue of the parties’ intent was unfit for a motion to dismiss at that early stage. See id. Given that the emails did not clearly negate an intention to be bound, without further evidence, the Fifth Circuit held that the district court erred in granting BofA’s motion to dismiss. Id. at 210.
Accord with English Case Law
The Fifth Circuit’s decision in Highland brings U.S. case law in line with English case law on the subject. In a 2007 opinion, the High Court held that parties to a notes trade were bound after they agreed on price over the phone, despite other outstanding terms of the trade, such as the settlement date. See Bear Stearns Bank plc v Forum Global Equity Ltd.  EWCH 1576. In the Bear Stearns case, the High Court considered the binding effect of a phone call agreeing to the price of Parmalat SpA notes and accompanying claims in the Parmalat insolvency under the Marzano Law Decree. Much like the analysis performed by U.S. courts, the High Court considered the parties’ intent to be bound and held that the buyer did show such an intent when it orally provided a “firm bid” on the price. The court held that there was a binding oral agreement, even though there was no agreement on a settlement date or the form of transfer, because there was no legal reason why the parties could not later reduce the agreement to a writing in which the buyer obtained the economic benefit of the notes and claims in exchange for the agreed price. Unlike in the Highland case, however, the High Court did not conclude that the standard terms of the LMA, the English equivalent of the LSTA, applied because the parties did not specifically refer to LMA standard terms at the time of the call and there was no clear and convincing evidence that at the time of the trade (July 2005) it was an established practice to use LMA terms for transactions in this type of asset, given the unusual nature of the particular claims that accompanied the notes. Nevertheless, there is now clear case law in both the U.S. and England that upholds the binding nature of oral debt trades.
The trial court decision in Highland was completely at odds with market understanding and it took a successful appeal to the Fifth Circuit to bring the decision in line with market expectations. The time from trade to appellate decision (solely on the motion to dismiss) was almost three years. This is not the first time (and will not be the last) that parties have had to “take one for the team” and litigate an issue — one that perhaps the market had taken for granted — up to the circuit court level in order to get case law up to speed. For example, as discussed in Part I of this series, we saw Longacre fight the good fight in the Second Circuit to confirm that “objected to” means “objected to,” with respect to claim assignment put right triggers where a claim seller attempted to add a “substantive” objection requirement to the plain language of the claims trade contract.
The trial court in the Northern District of Texas missed the mark in Highland. There are plenty of other district and state courts that are not bound by the Fifth Circuit’s Highland decision that could do the same. In fact, we need only look to the New York Appellate Division, First Department’s decision in Credit Suisse First Boston v. Utrecht-America Finance Co., 80 A.D.3d 485 (N.Y. App. Div., 1st Dep’t 2011), which suggested that a trade confirmation that included language that the trade was “subject to negotiation, execution and delivery of reasonably acceptable contracts and instruments of transfer,” which is in all standard LSTA trade confirmations, imposed on the parties only an obligation to negotiate the definitive documents in good faith, not a binding obligation to close the transaction. See id. at 19-20. While that case settled after the Appellate Division remanded it to the trial court for determination of certain factual issues, the mere suggestion (by a New York court, no less) that a standard LSTA trade confirmation was not a binding agreement to close the transaction has certainly caused some jitters for traders and their counsel.
The take-away is to front load as many of your desired terms (amount, price, tranche, form of transfer, participation or assignment only, interest convention, etc.) into the initial trade conversation as possible so that there are no surprises in the written trade confirmation process.
Footnote #1: Procedurally, on an appeal of a motion to dismiss, the appellate court only considers the facts as presented in the appellant’s briefs and assumes those facts to be true, without taking the evidence or testimony that would be presented in a trial setting. Therefore, the facts presented in this piece, as taken from the Fifth Circuit’s opinion, are Highland’s version of the facts, and the Fifth Circuit made clear that it was not taking a position on the veracity of those facts but only considering the parties’ purely legal arguments. Id. at 204.
David J. Karp is a partner in the New York and London offices of Schulte Roth & Zabel, where his practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. David is an avid speaker and writer on distressed investing related issues, recently co-authoring “European Insolvency Claims Trading: Is Iceland the Paradigm?” for Butterworths Journal of International Banking and Financial Law and “Trade Risk in European Secondary Loans” for The Hedge Fund Law Report. David is an active member of the LMA, APLMA, INSOL Europe and the LSTA where he is a member of the Trade Practices and Forms Committee. Alexia Petrou and Neil Begley, associates at SRZ, assisted in the preparation of this entry.