conflicts of interest

Preparing for Potential Inquiries into Designated Lender Counsel in PE Sponsored Syndicated Loans

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Recent media reports have expressed alarm at the use of “designated lender counsel” in private equity-sponsored leveraged loan transactions.[1]  The phrase refers to the practice of a private equity firm instructing the investment bank arranging its syndicated loan as to which law firm the private equity firm would like the investment bank to use as the bank’s counsel.  According to the press reports, the practice (also known as “sponsor designated counsel”) has become prevalent in the syndicated loan market.  The question raised in the press is whether this practice creates a material conflict of interest, because the law firm representing the investment bank arguably generates fees based on the strength of its relationship with the private equity firm across the table.  If it does, the next question is whether that conflict could be argued to adversely affect the lending arrangement, with potential negative consequences for investors in the loan.

The attention this issue is attracting in the media will likely spark regulatory interest as well as interest among participants in the syndicated loan market.  Prominent lead arrangers in the syndicated loan market should expect inquiries from any number of potential government authorities, including the Federal Reserve, the Office of the Comptroller of the Currency (the “OCC“), the Federal Deposit Insurance Corporation (the “FDIC“) and state authorities such as attorneys general and financial supervisory agencies.  Below we offer guidance for preparing for potential inquiries and responding to any inquiries made.

Potential Regulatory Issues and Inquiries from Market Participants

Over the past several years, the most prominent regulatory guidance in the leveraged loan market has been the Interagency Guidance on Leveraged Lending that the OCC, the Federal Reserve and the FDIC jointly issued in March 2013 (the “Leveraged Lending Guidelines“), as well as various interpretative updates published by the agencies since then.[2]  The Leveraged Lending Guidelines urge banks to implement “a risk management framework that has an intensive and frequent review and monitoring process.”[3]  The general purpose of the Leveraged Lending Guidelines is to keep regulated financial institutions from “unnecessarily heighten[ing] risks by originating poorly underwritten loans,”[4] which could result in risks that “find their way into a wide variety of investment instruments and exacerbate systemic risks within the general economy.”[5]

Although the Leveraged Lending Guidelines do not address the practice described in the press reports, they do instruct regulated financial institutions to put in place policies and procedures that define conflicts of interest, provide risk management controls, permit employees to report conflicts without fear of reprisals, ensure compliance with relevant laws and provide for adequate employee training in this area.[6]   For this reason, regulated lead arrangers of syndicated loans may expect the Federal Reserve, the OCC and the FDIC to inquire whether the practice of sponsor designated counsel creates a conflict and, if so, whether the institution managed that conflict in compliance with the Leveraged Lending Guidelines.

Outside of Federal banking regulators, other government actors – particularly state attorneys general and financial supervisory agencies – might choose to focus on the practice as well. State regulators, for instance, might opt to investigate whether the practice described in the press constitutes a deceptive trade practice. New York’s statute prohibiting deceptive business practices, for example, makes unlawful “deceptive acts or practices in the conduct of any business” and authorizes the attorney general to bring an action to enjoin such acts and to “obtain restitution of any moneys or property obtained”.[7] The statute does not define “deceptive acts or practices,” so all that is necessary is that the attorney general “believe from evidence satisfactory to him” that a deceptive act or practice has occurred. (Federal and other states’ statutes have similar language.) This broad authority would permit such a government authority to launch an investigation following this media driven story.

In addition to regulatory scrutiny, lead arrangers should prepare for potential inquiries from syndicated loan purchasers, who may read the press stories and want to know whether the loans they purchased from the financial institution were reviewed by sponsor designated counsel.

Internal Review

Against this backdrop, there are certain considerations that a financial institution acting as lead arranger for syndicated loans should contemplate in order to address any questions that the institution’s various constituencies may raise and to ensure the institution employs best practices going forward.

  • The press reports fail to distinguish between “left lead arrangers” and other investment banks involved in syndicated loans, but substantially all loan market participants know that on any particular transaction, the “left lead arranger” assumes primary responsibility for the negotiation of loan documents with legal counsel.  As a result, financial institutions should focus their review primarily on transactions where they served as “left lead arranger” and thus directed the relationship with outside counsel.    
  • The press reports allege that a designated law firm might be serving two masters when designated by a private equity sponsor. However, if a designated law firm has a strong, historical relationship with the financial institution, the allegation is difficult to sustain. For example, if Law Firm X generates three times more revenue from its overall relationship with the financial institution than it does from its relationship with the private equity firm, the allegation that the law firm would prioritize the private equity firm’s interests over the bank’s on any particular transaction is implausible.
  • The conflict of interest being alleged is principally the law firm’s and not that of the financial institution.  Financial institutions should consider whether each law firm involved can be reasonably relied upon to manage responsibly any conflicts that may arise, taking into account the firm’s reputation and the financial institution’s own historical experience with, and knowledge of, the firm.
  • A financial institution should also review whether it has ever rejected a sponsor’s designated counsel, or hired “shadow counsel” to review the designated counsel’s documents for any reason.  If so, this would indicate that the financial institution was monitoring the risk alleged by the press articles and mitigating that risk where appropriate.
  • Although time intensive, a financial institution might wish to take a sample of recent top tier sponsor transactions where designated counsel was used and compare the loan documentation in that sample to a similar group of top tier sponsor transactions where outside counsel was not designated.  A finding that the respective sets of loan documents did not differ substantially in lender protection would go a long way toward proving the press allegations spurious.
  • Financial institutions should assess whether appropriate internal constituencies were apprised of this practice, had considered any associated risks and were monitoring on an ongoing basis whether those risks remained contained.   In a financial institution with a product group overseeing leveraged lending, one would want to know whether that group and its associated legal and supervisory functions were monitoring and mitigating those risks on an ongoing basis.

[1] Andrew Ross Sorkin, A Growing Conflict in Wall St. Buyouts, N.Y. Times, Jan. 5, 2016, http://www.nytimes.com/2016/01/05/business/dealbook/a-growing-conflict-in-wall-st-buyouts.html?ref=dealbook;

see also Dan Primack, A Private Equity Conflict Grows on Wall Street, Fortune, Jan. 5, 2016, http://fortune.com/2016/01/05/a-private-equity-conflict-grows-on-wall-street/

[2] 78 Fed. Reg. 17766 (March 22, 2013).

[3] Id. at 17771.

[4] Id.

[5] Id. at 17772.

[6] Id. at 17776.

[7] N.Y. GEN. BUS. LAW § 349(a)-(b).

SEC Proposal to Prohibit Material Conflicts of Interest in Securitization – Advancing Legislative Intent Without Constraining Legitimate Risk Mitigation

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SAVE THE DATE: On October 7th in our New York office, Orrick partners will review the SEC’s proposed regulatory framework to prohibit certain conflicts of interest and assess whether the SEC effectively differentiates between legitimate risk mitigation and deceptive practices. We will also consider alternative approaches to manage these conflicts.

SEC Rule on Conflicts of Interest in ABS Transactions

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On September 19, the SEC issued proposed Rule 127B, as required under Section 621of the Dodd-Frank Act, to prohibit material conflicts of interest in connection with ABS transactions. Under the proposed rule, entities that package and sell ABS would be prohibited from engaging in transactions that would involve or result in a material conflict of interest with respect to any investor in the ABS. The prohibition would end one year after the first closing date of the ABS sale. Comments to the proposed rule must be submitted by December 19. SEC Release. Proposed Rule.

SEC Proposed Clearing Agency Standards for Operations and Governance

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On March 3, the SEC proposed rules, as required under the Dodd-Frank Act, regarding the operation and governance of clearing agencies. Under the proposed rules, clearing agencies would be required to: (i) maintain standards with respect to risk management and operations; (ii) have adequate safeguards and procedures to protect the confidentiality of trading information; (iii) have procedures to identify and address conflicts of interest; (iv) require minimum governance standards for their boards of directors; (v) designate a chief compliance officer; and (vi) disseminate pricing and valuation information if they are a central counterparty for security-based swaps. The SEC also reopened the public comment period for rules proposed in October to mitigate conflicts of interest for security-based swap clearing agencies and execution facilities and national securities exchanges that post or make available for trading security-based swaps. Comments on the proposed rules must be submitted by April 29. SEC Release. SEC Proposed Rule. SEC Proposed October Rules.

SEC Proposes Rules to Mitigate Conflicts of Interest for Security-Based Swaps

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On October 13, the SEC proposed rules, known as Proposed Regulation MC, to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading, by requiring them to adopt ownership and voting limitations and certain governance requirements. Comments to the rule should be submitted within 30 days after publication in the Federal Register. SEC Release.