Capital Call Agreements As Credit Enhancement

by Joel F. Brown and Randall L. Klein

The capital call agreement is a popular device, especially in tight credit markets, for accommodating the divergent goals of secured lenders, their borrowers and shareholders. Sometimes called a support agreement or make-whole agreement, the essence of a capital call agreement is simply an agreement by an investor to make certain investments in an entity, typically in this context a borrower. This formulation understates a number of important and sometimes complex business and legal considerations that must be addressed in order to craft a meaningful and legally enforceable document. This article will outline and analyze these considerations, and will also present a number of relevant drafting recommendations.

It may be helpful to briefly discuss credit situations in which capital call agreements are commonly used. In new transactions, capital call agreements may be used to bridge opposing requirements and goals of shareholders and lenders. For example, a lender may require financial projections that demonstrate total leverage below 3.0 to 1.0 in one year's time. One way to achieve this result would be for the borrower to decrease its initial borrowings and increase its reliance on equity financing. While satisfying the lender's concern, this strategy would decrease returns on shareholders' equity. As a means of maximizing return on equity, the shareholders might agree at deal inception to commit future additional funds in their company, if necessary, to satisfy the lender's future target leverage ratio.

Capital call agreements are also useful devices when lender and shareholder underwriting criteria differ. For example, in a credit facility that contemplates future acquisitions, shareholders might expect their lender to advance funds against a multiple of earnings on a pre-corporate overhead basis. In theory, that overhead will be disproportionately high in early years, but should become significantly less material over time as acquisitions are booked. The lender, however, may wish to underwrite the transaction more conservatively by advancing against actual earnings, net of overhead. In this scenario, a lender might become comfortable lending against the more aggressive pre-corporate overhead basis in exchange for a capital call agreement that would require increased future equity contributions in the absence of improved cash flow through the consummation of future acquisitions.

Capital call agreements are also increasingly popular devices in loan restructurings and workouts. The willingness of a key shareholder to pledge future funds may be a significant determinant for a lender deciding whether to grant a forbearance in the face of existing defaults. In this context, the capital call agreement also serves as its own self-effecting future restructuring. For example, rather than force all major transaction parties back to negotiations if a workout fails, a lender may require a capital call agreement at the inception of the workout, thereby triggering a prenegotiated second-stage workout.

Contrasts with other credit enhancements

Capital call agreements as credit enhancements should be compared to and contrasted with other common credit-enhancement devices, such as letters of credit and guaranties. Some of the important legal differences among these instruments and documents are discussed below.

Letters of credit typically, though not necessarily, issued by banks are highly valued by beneficiaries due to the reserve requirements and regulated status of bank issuers. The law and practices governing letters of credit are also generally favorable to beneficiaries, inasmuch as they tightly limit the grounds on which an issuer may dishonor a draw on a properly issued letter of credit. Letters of credit establish tri-party legal relations among the issuer, the applicant and the beneficiary. The issuer of the letter of credit has no direct interest in or recourse to the beneficiary as a consequence of a draw by the beneficiary. Instead, the issuer's recourse is to the letter of credit applicant, which enters into a reimbursement agreement with the issuer. The reimbursement obligation is often collateralized.

A guaranty creates a direct legal relationship between the guarantor and the recipient of the guaranty. The honoring of a guaranty by a guarantor creates an equitable right of subrogation in favor of the guarantor - that is, the guarantor's right to assume the claims of the recipient of the guaranty as a creditor of the beneficiary. For example, an investor executing a guaranty in favor of a lender would, upon payment under the guaranty, have certain rights to enforce the lender's loan documents against the beneficiary/borrower to the extent of payment on the guaranty. Lenders customarily require guarantors either to waive or deeply subordinate this right of subrogation. From the investor's perspective, this legal right of subrogation, conferring upon the investor only a contingent interest in the beneficiary as a creditor, is the sole common law compensation for the investor entering into the guaranty. In other words, the investor will not be entitled to an increased equity interest in the beneficiary merely by performing under the guaranty, although the guarantor may separately acquire a contingent equity interest in the beneficiary as a fee for the issuance of the guaranty.

Guarantors, also called "sureties," are generally referred to as being favored at law. This means that the law governing suretyship, which is common law rather than statutory law, has evolved over many years to be protective of the interests of sureties, and has created many grounds for excusing surety performance because of (among other things) changed circumstances following the date of execution of the guaranty. For instance, if a borrower and lender agree to release collateral without obtaining the guarantor's consent, the change in the underlying credit without the guarantor's consent may excuse the guarantor from some or even all of its obligations under the guaranty. As a result of this risk of guarantor discharge, many commercial lenders draft sophisticated guaranties containing extensive waivers and releases of all these common law protections.

By way of contrast, capital call agreements are generally governed by the common law of contracts. In a capital call agreement, the investor (the obligor under the capital call agreement) bargains to receive some form of instrument or security in the beneficiary upon performing under the capital call agreement by making an investment in the beneficiary. This investment may take the form of debt or equity or a hybrid thereof. The investor should not be entitled to any common law right of subrogation as against any third-party beneficiaries of the capital call agreement, where capital call agreements are used as credit enhancements. In other words, an investor that has agreed to invest funds in a borrower, even where such funds are earmarked to repay indebtedness of the borrower for borrowed money, has no right to assume an interest in the lender's loan documents upon performance. Instead, the investor bargains in advance with the borrower for its consideration in exchange for the capital call agreement.

The capital call investor also should not be entitled to suretyship...

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