Recently we had a bank client ask us to declare a default and demand immediate repayment of the full balance owed on a loan. The bank’s goal was to encourage the borrower to cure the defaults and return the loan to a “performing” loan status or to find a new lender and exit the bank.
In asking us to make such a demand, the lender had not focused on the implications of declaring a default in regard to a SWAP covering the loan. Thankfully, before we made demand, we learned from our discussions with the lender that the borrower and the bank had entered into a SWAP when the loan was made. This permitted us to have a frank discussion with the lender about the consequences of accelerating and demanding the loan and the impact that demand may have had on both the bank and the borrower.
Ordinarily under conventional SWAP agreements, demand/acceleration of a note with a SWAP appurtenant to it would trigger an automatic early termination of the SWAP. Early termination of a SWAP in turn triggers the calculation of an early termination fee (called SWAP breakage fee). Whether upon termination of the SWAP the borrower pays a breakage fee to the bank or the bank pays a breakage fee to the borrower depends on which way interest rates have moved as measured from the date the loan was closed until the SWAP early termination date. If, as has been the case during 2020, interest rates have declined from the closing date, then the borrower will owe a breakage fee to the bank and that fee will be immediately due and payable. In this particular case due to the size of the loan and the decrease in rates, the SWAP breakage fee that would have been due from the borrower was estimated to be more than $500,000. If the borrower failed to pay the breakage fee then the bank would still be required to pay that fee under the SWAP agreements to a counter-party. Such a considerable additional liability would have interfered with the Bank’s goal of preserving alternative workout scenarios likely to result in a better outcome for the bank. In this case, the lender elected to have our firm send a Reservation of Rights letter rather than demand the loan, so as to permit continued exploration of workout alternatives without triggering an early SWAP termination.
A SWAP breakage fee is not only triggered by a declaration of default and acceleration of the debt. If a borrower finds another bank willing to refinance its loan, that intentional termination by the borrower of the existing loan when the loan is refinanced will also result in a SWAP breakage fee. If that SWAP breakage fee is substantial, the option of a refinance as a way for the borrower to exit the bank may no longer be feasible. Unless a workout arrangement can be fashioned whereby the borrower’s loan can be returned to performing loan status, the breakage fee liability is likely to remain a problem for bank and borrower.
Moral of the story is always check for the existence of a SWAP before sending out a demand letter or when seeking to arrive at a viable workout plan.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.