Finding cash in the attic
12 November 2021
Background
'Consent fees' are relatively commonplace in the world of European corporate bonds. A corporate Issuer may choose to offer a fee to Noteholders in a consent solicitation process for a number of reasons: – perhaps there is an expectation of 'voter apathy' or a concern that the result may not be clear-cut or, alternatively, time is of the essence and the Issuer might look to reward Noteholders for reverting with consent by a specified deadline.
It is less common to see consent fees offered on securitisation transactions. Unlike an unsecured corporate bond, cash-flows on a securitisation are much more strictly regulated both pre and post-enforcement by the transaction documents. In particular, on CLO transactions, there would be very few avenues to find excess cash to enable the Issuer to offer Noteholders a consent fee, without potentially prejudicing other investors.
In this article we consider where a CLO Issuer (or a CLO Manager) may look to offer cash incentives to a Class of Noteholders by way of a consent fee and what a Trustee should be wary of in such a scenario.
When might a CLO Issuer/Manager look to incentivise Noteholders to vote?
There are a number of reasons why a CLO Issuer/Manager may feel it necessary to incentivise Noteholders to vote but, in most cases, it will likely relate to a documentary restriction that prevents amendments to portfolio profile tests or collateral quality tests unless certain Noteholders grant consent.
By way of an example:
- The CLO Issuer/Manager may wish to amend the Weighted Average Life Test. Perhaps if it is currently failing then it may not be possible for the CLO Manager to reinvest in deal assets.
- The CLO Issuer/Manager may, depending on the relevant provisions of the deal documents, be restricted from amending the Weighted Average Life Test without Controlling Class consent.
- The Controlling Class may be hesitant or unresponsive in discussions around granting this consent.
- The CLO Issuer/Manager could look to break this stalemate by offering a consent fee to the Controlling Class if they agree to an amendment to the Weighted Average Life Test.
Where is the money coming from?
A CLO transaction will have strict rules on how monies can be used with an expectation that the bulk of cash receipts will be flushed from the deal accounts on a Payment Date, starting with amounts due on the Senior Notes before any available funds are paid to the Subordinated Noteholders at the end of the payment run.
The provisions relating to payments are core provisions and amendments to these terms routinely require higher voting thresholds so may not be easily changed. On the face of it, this may prevent CLO Issuers/Managers from being able to offer the Controlling Class a consent fee or any form of additional payment if doing so would result in a deviation from the strict Priorities of Payment.
One route that may, however, allow the CLO Issuer/Manager to offer a consent fee is if the CLO Issuer/Manager can find monies further down the waterfall. In our experience, the most commonly considered method of achieving this is for the CLO Issuer/Manager to work with the Subordinated Noteholders to consider diverting amounts due and payable to the Subordinated Noteholders on an upcoming Payment Date. These diverted amounts would then be used as a consent fee to incentivise the Controlling Class to pass any necessary resolutions, so as to allow the relevant amendment to proceed.
There are, however, potential issues with this approach and a prudent Trustee should be conscious of the risks involved.
In a market that is notorious for tight deadlines, the pressure is often on a Trustee to make a speedy (but informed) decision and having experienced legal counsel on board is critical to any Trustee's ability to do so.
Three key questions
It is important to consider the following issues:
- What is required under the contractual framework, i.e. who needs to consent to the amendments or the diversion of funds?
- Is there any risk in the Subordinated Noteholders 'diverting' amounts due to them?
- Is there any risk in the CLO Issuer offering diverted amounts to the Controlling Class?
1. The Contractual Framework
It is necessary to consider the deal terms carefully. The terms on any given CLO may be materially different from any other CLO, even with the same CLO Manager in place.
In principle, however, most CLO transactions will state that:
- Any consent, amendment or waiver that would impact the Priorities of Payment or the amounts due to a Class or Classes of Noteholders will require an Extraordinary Resolution from all relevant Classes of Note; and
- To the extent that a Resolution only impacts one or more Class of Notes (each an "Affected Class") then it is only necessary for each Affected Class to approve the relevant Resolution.
As a result, and subject to the specific terms of any given deal, it may be possible for deal parties to consider the Subordinated Noteholders as the only 'Affected Class' in respect of a Resolution seeking to divert funds away from the Subordinated Noteholders. The practical effect would be that only the Subordinated Noteholders, and not any other Class of Notes, are required to pass a Resolution.
As mentioned above, given the core nature of the Resolution at play here (relating to a right to payment under the Priorities of Payment) it is likely that the documents will require an Extraordinary Resolution to be passed by the Subordinated Noteholders as opposed to an Ordinary Resolution.
It is critical to understand the contractual framework and which Classes of Noteholders are required to pass any Resolution as well as the necessary consent threshold. CLOs are not a 'one size fits all' transaction type and there may be complex veto or higher voting rights applicable depending on any proposed amendment or consent.
2. Diversion by the Subordinated Noteholders
Determining that the Subordinated Noteholders are the only Affected Class is not the end of the story. In our view, any diversion of cash by Subordinated Noteholders creates a number of potential red flags that a prudent Trustee may wish to consider in more detail.
In particular:
- Why would an investor give up cash that is about to be paid to them?
- Does the composition of the Class of Subordinated Noteholders raise any further concerns?
- How is the resolution being passed? At a meeting, by electronic consents or by a written resolution?
Readers may query what the role of any Trustee is in 'investigating' these issues – the Trustee is neither a commercial investor nor a pro-active investigator and the Trustee is generally entitled to assume that the deal parties are complying with their respective obligations. Why should the Trustee ask these questions?
Though these principles are undoubtedly true, leading legal counsel to any Trustee would generally be expected to flag any reputational risk or potential challenges that may arise out of any course of action that involves the Trustee. We note in particular that, in the example discussed in this article, it would be the Trustee that determines which Class is an 'Affected Class' and the Trustee may also be involved in implementing any Resolutions passed by any such Affected Class.
With that in mind, what should the Trustee really be worried about here? Why does the Trustee care what the Subordinated Noteholders choose to do with money due to them?
The power of a majority to bind a minority
We note that there is extensive authority in the English courts that a majority cannot bind a minority if there is fraud or if the majority are not acting in good faith. As per British America Nickel Corporation, the power to bind a minority:
"…must be exercised subject to a general principle, which is applicable to all authorities conferred on majorities of classes enabling them to bind minorities; namely, that the power given must be exercised for the purpose of benefitting the class as a whole, and not merely individual members only."
Looking again at the red flags mentioned above and the example referred to in this article:
- It is likely that we have an Extraordinary Resolution passed by a majority (of two thirds or more) of the Subordinated Noteholders agreeing to simply forsake funds that would otherwise be due to them on a Payment Date.
- It is also likely that, in order to comply with EU/UK Retention Requirements, the CLO Manager holds some or potentially a significant amount of the Subordinated Notes so may be driving both the proposal and the voting on the proposal.
- Finally, it may be the case that the intention is to pass the Resolution outside the Clearing Systems by way of a Written Resolution meaning that the minority/non-consenting Subordinated Noteholders may have no knowledge of the diversion of funds until a number of days after the Resolution is passed (potentially only finding out on or after the Payment Date itself).
If we combine each of these concerns, it is certainly possible to see how a minority holder of the Subordinated Notes could query whether any such Extraordinary Resolution passed by the majority Subordinated Noteholders (particularly if passed privately outside the Clearing Systems as a result of Notes held by the CLO Manager) has been appropriately disclosed and is truly being passed "for the purpose of benefitting the class as a whole and not merely individual members only".
On the other hand, this may simply be unfortunate optics and there could be very good reasons why the Subordinated Noteholders are prepared to divert funds in any structure – perhaps they genuinely believe that effecting the relevant amendments will ultimately generate more income for the Subordinated Noteholders as a Class and that it is therefore entirely reasonable to forsake amounts so as to incentivise the Controlling Class accordingly.
What we consider important here is to ask these questions and to fully understand the reasoning behind the proposal, as well as to consider whether the method by which the Resolution is being proposed represents equitable dissemination of information to all relevant investors.
Being able to demonstrate that parties have considered these risks will mitigate any reputational or other damage that could arise as a result of a Resolution being challenged in the English Courts.
No party to a transaction wants to run the risk of reputational damage or legal challenge. Where there are a number of potential red flags with a proposed Resolution it is prudent to ensure that the right questions are being asked, that it is possible to demonstrate the rationale for the passing of the Resolution and that assumptions are being challenged and worked through to provide comfort that parties and investors are acting in good faith and for the benefit of the relevant Class as a whole. With experienced legal counsel on board, a Trustee can enhance its reputation and demonstrate its commercial understanding by promoting a transparent and common sense approach so as to minimise risk for all.
3. Offering a consent fee to the Controlling Class
Having considered the contractual framework and the various risks in respect of Subordinated Noteholders waiving their right to payment (and potentially binding a minority of the Subordinated Noteholders to this course of action without their consent), the CLO Issuer/Manager will be left with funds that enable it to offer a consent fee to the Controlling Class of Noteholders. The final hurdle will therefore be obtaining the consent of the Controlling Class to the relevant amendments and paying the consent fee to this Class.
Consent fees under English law
The English courts have, on a number of occasions, made clear that offering an incentive to voters is not, in itself, something that invalidates a resolution provided that the incentive is:
- properly disclosed;
- available to all voters equally; and
- not being used as a means to intimidate a minority.
Similar to the discussion above, we expect that any prudent Trustee would want to be informed by its legal counsel if a proposed consent fee (or the method in which it is to be paid) runs a risk of the Resolution (or the steps taken to effect such Resolution) being struck down by the English courts, given the potential for reputational or other harm.
It is notable that, on European CLOs, it is very common for Resolutions to be passed privately outside of the Clearing Systems, by way of Written Resolution. This may be because large institutional investors continue to hold very significant portions of a Class of Notes and remain in contact with the CLO Manager during the life of the deal. Generally, this ability to pass a Written Resolution outside the Clearing Systems can be extremely useful and, if the CLO Manager is aware of a small pool of investors, it is an attractive method of obtaining a result in a cost-effective and speedy manner. Further, the process for obtaining consent by way of a Written Resolution will almost certainly be detailed in the underlying Transaction Documents so will be expressly permitted.
Notwithstanding this, it is difficult in the light of English case law to see how it is possible to balance the convenience of a private Written Resolution process outside the Clearing Systems with the requirement that any consent fee is available to all voters equally (unless the entire Class of Notes is held by a single investor in which case a Written Resolution could be appropriate). It is our view that, if a consent fee is being offered, it must be fairly and transparently offered to all holders of the relevant Class and not simply to certain individual Noteholders who may have engaged in discussions behind the scenes with a CLO Manager. This may necessitate the consent process being run by way of electronic consents through the Clearing Systems or, alternatively, a Noteholder meeting.
To the extent a Resolution attaching a consent fee is proposed by way of electronic consents through the Clearing Systems, it may also be appropriate to consider the timeframe given to investors to consider the Resolution. If it is only possible for a Noteholder to obtain the consent fee if the Noteholder responds very quickly to a proposed Resolution, this may have the effect of disenfranchising investors who have not had the benefit of private discussion with the CLO Manager and are only hearing about the proposal for the first time.
It may be tempting to simply rely on the fact that the contractual framework seems to permit a particular path to be taken but, unless consideration is given to the principles that underpin English case law, the parties may be all too quick to let market practice override the need for an equitable and transparent approach on consent fees.
One of the most fascinating elements of working on CLO transactions is that they require a fluid and commercial approach and an ability to nimbly adapt to difficult transactional requirements. What emerges from this melting pot could be a novel and inventive way of dealing with a problem or, if handled inappropriately, could result in undue risk being taken by risk-averse parties. A pragmatic and legally informed Trustee may end up being the difference between the two.
Author: Ciaran Vinaccia
