01 May 2014

US court rules that distressed debt fund is not a "financial institution"

by Nick Poole, Peter Bowden, Talia Lirosi

Lenders need to ensure that assignment clauses in loan and security documents are broadly drafted so they can assign their rights uninhibited.

The secondary debt market in Australia has grown substantially in recent years.

Consequently, stakeholders are becoming increasingly mindful of the need to give due attention to assignment provisions in loan and security documentation. This has led to assignment provisions being heavily negotiated. In many cases, the most contentious points are if borrower consent is required to assign and the class of entities that the lender may assign to (ie. the proposed assignee). In this context, what constitutes a financial institution has been a point of contention.

It's important for lenders that the potential assignee provision is drafted as broadly as possible so that a lender may assign to anyone it wishes (including for example, a distressed debt fund).

Unfortunately, there are no Australian decisions that deal directly with the interpretation of assignment clauses in loan and security documents in this context. Guidance must therefore be sought from overseas decisions, particularly in respect of what constitutes a "financial institution".

Assignment clauses in loan and security documents: the view overseas

The 2004 Hong Kong Court of First Instance decision Re Legend International Resorts Limited [2005] 3 HKLRD 16 is one such example. Following the UK decision of Argo Fund Ltd v Essar Steel Ltd [2005] EWHC 600 (Comm), the Court held that a substantial proportion of the transferee's business does not need to be the provision of finance in the primary lending market for it to be "financial institution".

Subsequent to Legend, the decision in Argo v Essar was appealed by Essar Steel Limited. In Essar Steel Limited v The Argo Fund Limited [2006] EWCA Civ 241 (Argo), the UK Court of Appeal held that a "financial institution" need not be a bank or be akin to bank or a lender. Instead, the Court accepted one of five principles which the first instance judge claimed to be characteristics of a "financial institution". In particular, the principle that "financial institution" includes "a legally recognised form or being, which carries on its business in accordance with laws of its place of creation and whose business concerns commercial finance" was accepted. Ultimately, Essar Steel Limited's appeal was dismissed.

Argo and Legend are generally recognised as providing appropriate guidance in determining what a "financial institution" is in the Australian market. It has been accepted that, on this interpretation, a distressed debt fund would (subject to meeting the requirements set out in those decisions) be a financial institution.

The value of clear drafting when it comes to assignment clauses

The uncertainty caused by the possible interpretations can be addressed in clear drafting. For example, the Asia Pacific Loan Market Association's (APLMA) Investment Grade Syndicated Facility Agreement (2013 Revision) provides (in clause 24.1) that:

"a Lender may assign any of its rights to another bank or financial institution [or to a trust, fund or other entity which is regularly engaged in or established for the purpose of making, purchasing or investing in loans, securities or other financial assets (including credit derivatives)]."

The broad wording of the APLMA document (including the wording in square brackets) does not necessarily rely on distressed funds falling within the definition of "financial institution". However, it is implicit in the optional wording that this may be negotiated out in some instances.

Lenders are advised to include wording similar to the full wording of the APLMA clause in loan and security documents, especially in light of the recent US decision in Meridian Sunrise Village v NB Distressed Debt Investment Fund Ltd (2014) WL 909219.

The Meridian decision: a distressed debt fund is not a financial institution

In Meridian, the United States District Court found that a distressed debt fund was not a financial institution in relation to an assignment provision in a loan agreement.

Meridian (as borrower) entered into a loan agreement with U.S. Bank. Meridian sought to limit assignment by U.S. Bank by negotiating a provision in the loan agreement that provided that the lender could only assign to a "commercial bank, insurance company, financial institution or institutional lender".

U.S. Bank assigned part of its interest to a range of parties, including Bank of America, after drawdown of the loan. Subsequently, Meridian breached a non-monetary default. At this point, the lenders urged Meridian to waive the limitations on assignment. However, Meridian refused. The lenders then attempted to persuade Meridian to waive its rights through an election to impose a default interest rate. Meridian once again refused but when the default rate of interest was charged, Meridian was forced to file for protection under the United States Bankruptcy Code.

Despite Meridian's opposition, Bank of America chose to assign its interest to a distressed debt fund that subsequently assigned its rights to two other similar funds (not an unusual consequence once distressed debt becomes traded).

In March 2013, Meridian asked the Bankruptcy Court to restrict the distressed debt funds from exercising their rights as they were not eligible assignees. In particular, Meridian sought to restrict the distressed debt funds' right to vote on Meridian's reorganisation plan. Meridian's motion was granted.

On appeal, the District Court rejected the distressed debt funds' argument that "financial institutions" includes any institutions that handle and invest funds. It was held that this definition drains any force from the limitation in the assignment clause, "as any person could start an LLC online and could be a "financial institution" to which Bank of America could assign to".

"Financial institution" had to be read in conjunction with "commercial bank, insurance company and institutional lender" who all deal with money lending. Further considering extrinsic evidence, the Court found that as a result of the distressed debt funds asking Meridian to waive limitations in the assignment clause, they intended that the phrase "financial institutions" was to be read narrowly.

What does this mean for lenders?

While international decisions are not strictly binding on Australian courts, they can be persuasive (particularly in the absence of any other clear guidance). For example, although not exactly on point, Argo v Essar was referred to in the Australian case of Leveraged Equities Ltd v Goodridge (2011) 274 ALR 655.

Accordingly, lenders must exercise care from the outset of negotiations with borrowers and contemplate whom they may wish to assign to in the future (including distressed debt funds). Otherwise, they may limit the pool of potential assignees. Lenders should also, to the extent possible, follow the full suggested wording of the APLMA documents or alternatively seek to negotiate provisions which are broad but envisage distressed funds in order to capture all possible assignees.


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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.