Legal risk is credit risk now

At our Covenant Exchange dinner in Amsterdam, the question that kept coming up wasn't about any single provision. It was about who owned the risk. When a term in the documents determines whether you get repaid, is it a legal point or a commercial one? The answer around the table was unanimous – the front office owns the risk. The documents set the yield, and it's the deal team that explains itself if the credit goes wrong.

Why the question has changed

The possibility of a liability management exercise is now written into deals at signing. Litigation has become a tool in Europe, cooperation agreements are being challenged in court, and anti-cooperation language has appeared in loans and, briefly, in a high yield bond before it was removed. That's the biggest shift in documentation risk in a decade. The question for a credit team is what the borrower could do with the flexibility, and when.

Aston Martin started the discussion. The company used a non-guarantor to move assets, the third deal I've seen go around a J.Crew blocker by another route, after Pfleiderer sold the asset to an unrestricted subsidiary instead of investing it and Xerox, which used a joint venture. Lenders who asked which assets had moved were told the company wouldn't discuss it, and some have since applied to a New York court for discovery. Nothing in the documents required the company to say more. That's a reporting covenant point, and reporting has eroded along with everything else.

Terms that produce losses – like guarantor coverage, transfer provisions, change of control carve-outs, investments capacity and the EBITDA definition – are read by the lawyers, but need to be priced by the credit teams.

What the room described

In-house legal teams have less time for transactions than they used to, with projects and regulatory work competing for it. On a large syndication the team relies on external counsel appointed and paid by the borrower. Risk teams have their own non-negotiables on documentation. Anti-cooperation clauses and uncapped EBITDA adjustments were the two that came up.

Risk also has to accept the market. One participant described a deal where 20 terms the team considered significant flexibility were set out in the credit memo, each with an explanation of why it was acceptable or expected to be flexed out in syndication, two pages of a credit paper that went to board level. That's the overlap between legal and commercial in practice: risk reads the provision from a risk perspective, legal from a legal one, the business from a commercial one, and all of them are reading the same clause.

The harder part is trust. Deal teams ask risk to believe them when they say the market won't accept a term. Risk has to make the call without being at the negotiating table, and a few participants said their risk colleagues are having to become legal experts.

One lender put the trade-off this way: given the choice between a strong credit with weak terms and a weak credit with strong terms, they'd take the strong credit, because the terms don't save you from a year at the table with a company that isn't performing.

Where it leaves the checklist

Someone said outright that checklists and traditional risk approaches don't keep up with this market, and the Aston Martin discussion is the reason. A checklist confirms the document includes a J.Crew blocker. It doesn't tell you whether the asset you're relying on can leave through a non-guarantor, a sale or a joint venture. When there is an opportunity to ask for something, focus on the asset instead of the words. A single paragraph providing that a named asset or division can't be sold, invested or contributed to a joint venture does what fifty pages of blockers attempt. That opportunity is rare in a broadly syndicated deal. The amend-and-extend, when the borrower needs something from you, is the other moment to use it.

One participant said senior secured has come to mean senior. We agreed to reconvene in a year and ask whether anything has shifted it back. That's a credit question, and it belongs with the people who own the risk.