Federal Banking Agencies Revamp Guidance on
Leveraged Lending
Heightened Standards Set for Bank Underwriting Practices and Evaluating the Financial
Support of Private Equity Sponsors
March 27, 2013
The Board of Governors of the Federal Reserve System (“Federal Reserve”), the Office of theComptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”)(collectively, the “Agencies”) have jointly issued guidance on leveraged lending activities byfinancial institutions. 1 The guidance, which is similar to the proposal released by the Agencies
last year, 2 updates and replaces guidance that the Agencies issued in 2001. 3 According to aninteragency press release, the revised guidance applies to transactions that are “characterized
by a borrower with a degree of financial leverage that significantly exceeds industry norms,” asmeasured by various leverage ratios (for example, debt-to-assets, debt-to-net-worth, debt-tocash flow, or other similar standards common to particular industries or sectors).
The guidance, which does not constitute a formal rulemaking, outlines “minimum
expectations” for financial institutions with substantial exposures to leveraged lending
activities, focusing on several key areas, including:•credit policies and procedures that identify risk appetite as to both retention andunderwriting of leveraged loans;•

underwriting and valuation standards, as well as underwriting and monitoringstandards for purchased loan participations;•timely measurement of transactions “in the pipeline”;•

reporting and analytics that more accurately and more timely measure exposures; and•guidelines for evaluating the financial support of deal sponsors.

While the new guidance does not represent a fundamental change in the Agencies’ view ofleveraged lending (and much of the guidance generally describes management practices
followed today by many large financial institutions), it does reflect heightened regulatory focus
on sound and well-documented lending and risk management practices, including for loans
originated for distribution to investors. Moreover, in contrast to more general standards
1

See 78 Fed. Reg. 17766 (Mar. 22, 2013).

2

See 77 Fed. Reg. 19417 (Mar. 30, 2012).

3

See Federal Reserve SR Letter 01-9 (SUP); OCC Bulletin 2001-18; and FDIC PR-28-2001.

097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013provided in the 2001 guidance, the revised guidance contains some bright-line tests by whichleverage lending activities will be measured.
The Agencies have set May 21, 2013 as the “compliance date” for the new guidance.
A.

BACKGROUND

Since the issuance of interagency guidance in 2001 regarding sound practices for leveraged
lending activities, the Agencies have observed periods of “tremendous growth” in the volumeof leveraged credit—particularly in the build-up to the financial crisis but also more recently—
and in the participation of unregulated investors. With burgeoning demand from institutional
investors, the pipeline of aggressively priced and structured commitments grew rapidly, withsome financial institutions lacking adequate information systems to accurately assess both
portfolio and pipeline risk exposures. These risk concerns have been heightened by market
developments such as “covenant-lite” loan agreements and pay-in-kind (PIK) toggle features,
which the Agencies recognize as having a place in the overall leveraged lending product set but
also worthy of closer supervisory review.
In light of these concerns, the Agencies proposed last year to replace the existing guidance from
more than a decade ago with new guidance that reiterates proven credit management
principles, while addressing current industry practices. The new guidance includes, forexample, several presumptive standards for leveraged lending 4 or acceptable underwriting
standards. 5
The new guidance also is consistent with a post-Dodd-Frank focus on accurately measuring
through management information systems (MIS) enterprise-wide exposures at multiple levels
and anticipating downside risk through stress testing. Overall, the guidance represents anattempt by the Agencies to rein in practices perceived as aggressive by imposing heightenedrisk management expectations.
B.

FINANCIAL INSTITUTIONS SUBJECT TO THE REVISED GUIDANCE

The guidance applies to any Agency-supervised financial institution that originates orparticipates in leveraged lending transactions. The term “financial institution” includes
national banks, federal savings associations, and federal branches and agencies supervised by
the OCC; state member banks, bank holding companies, savings and loan holding companies,
and all other institutions for which the Federal Reserve is the primary federal supervisor; andstate nonmember insured banks and other institutions supervised by the FDIC. Subsidiaries

4

One factor includes transactions where the borrower’s total debt-to-EBITDA (earnings before
interest, taxes, depreciation, and amortization) or senior debt-to-EBITDA exceed 4.0x or 3.0x,
respectively.

5

In assessing ability to repay, for example, the guidance provides that base case cash flow
projections show the ability to fully amortize senior secured debt or repay a “significant portion”
of total debt over the medium term. In addition, the guidance notes that a leveraged level afterplanned asset sales in excess of 6x total debt-to-EBITDA “raises concerns.”
Page 2097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

and affiliates of financial institutions involved in leveraged lending are also covered. In short,the Agencies will apply the guidance broadly to U.S. banking and nonbanking entities ofdomestic and foreign financial institutions that are subject to supervision by one or more of the
Agencies.
Because leveraged loans tend to be held primarily by very large or global financial institutions,
the Agencies believe the vast majority of smaller institutions, including community banks,
should be unaffected by the guidance, and the smaller institutions that do originate a small
number of less complex leveraged loans would not be expected to have policies and procedures
commensurate with those of a larger financial institution with a more complex leveraged loan
origination business. Apart from origination, any financial institution that participates inleveraged lending transactions should follow applicable supervisory guidance regarding
purchased participations, 6 and the new guidance also addresses such transactions.
C.

HIGHLIGHTS OF THE REVISED LEVERAGED LENDING GUIDANCE
1.

Defining “Leveraged Lending”

The guidance reinforces the need for financial institutions to adopt a definition of “leveraged
lending” in sufficient detail to ensure consistent application across all of their business lines.
While noting the diversity of definitions used within the financial services industry, theguidance notes that some combination of four factors—transactions where proceeds are used
for buyouts, acquisitions, or capital distributions; transactions where a borrower’s total debt-toEBITDA or senior debt-to-EBITDA exceeds 4.0x or 3.0x, respectively; a borrower recognized in
the debt markets as a highly leveraged firm; and transactions when a borrower’s post-financing
leverage exceeds industry norms—generally constitutes leveraged lending. A financial
institution’s definition “should describe clearly the purposes and financial characteristics
common to [leveraged lending] transactions,” while taking into account the institution’s direct
and indirect exposure from limited recourse financing secured by leveraged loans, or financing
extended to financial intermediaries (such as conduits and special purpose entities (SPEs)) that
hold leveraged loans.”
Importantly, the Agencies have confirmed in the new guidance that a loan should be designatedas leveraged only at the time of origination, modification, extension, or refinancing.
Accordingly, loans to so-called “fallen angels” are not subject to the guidance. These are loans
to borrowers that did not meet the definition of a leveraged loan at origination but that later
migrated into the definition due to deterioration in the borrower’s financial condition.
6

See, e.g., OCC Loan Portfolio Management Handbook, available at
http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/lpm.pdf;
Federal Reserve Commercial Bank Examination Manual, Section 2045.1 (Loan Participations, theAgreements and Participants), available at
http://www.federalreserve.gov/boarddocs/supmanual/cbem/cbem.pdf; and FDIC Risk
Management Manual of Examination Policies, Section 3.2 (Loans), available at
http://www.fdic.gov/regulations/safety/manual/section3-2.html#otherCredit, Loan
Participations (last updated Feb. 2, 2005).
Page 3097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

2.

General Policy Expectations

According to the guidance, institutions should adopt credit policies and procedures forleveraged lending that address, among other things: risk appetite (supported by an analysis ofpotential effect on earnings, capital, liquidity, and other risks); a limit framework (including
limits for single obligors and transactions, aggregate hold portfolio, aggregate pipeline
exposure, and industry and geographic concentrations); an appropriate reflection of risks ofleveraged lending in allowance for loan and lease losses (“ALLL”) and capital adequacy
analyses; expected risk-adjusted returns for leveraged transactions; and minimum underwriting
standards.
3.

Participations Purchased

Consistent with the guidance from 2001, the revised guidance reminds financial institutions tomake a “thorough, independent evaluation” of the risks involved when purchasing
participations and assignments in leveraged lending transactions. They should generally apply
the same standards that would be employed as if they were originating the loan, and policies
should be in place that, at a minimum, include requirements for:•Obtaining and independently analyzing full credit information both before theparticipation is purchased and on a timely basis thereafter.

•

Obtaining from the lead lender copies of all executed and proposed loan documents,
legal opinions, title policies, Uniform Commercial Code (UCC) searches, and otherrelevant documents.

•

Carefully monitoring the borrower’s performance throughout the life of the loan.

•

Establishing appropriate risk management guidelines.

4.

Underwriting Standards

Financial institutions need “clear, written and measurable” underwriting standards that
accurately reflect their risk appetite for leveraged lending transactions, including size limits on
an individual and aggregate basis. Unlike the 2001 guidance, the new guidance includes awarning regarding the “reputational risks” from “poorly underwritten transactions, as theserisks may find their way into a wide variety of investment instruments and exacerbate systemicrisks within the general economy.” While clarifying that the guidance is not intended to
discourage financing to borrowers engaged in workout negotiations or debtor-in-possession(DIP) financing packages, nor asset-based credit facilities that include strong lender monitoring
and controls, the Agencies note that underwriting standards should, at a minimum, address
such things as:•

Whether a transaction (including both underwritten deals and those intended for
distribution) is based on a sound business premise and sustainable capital structure.

Page 4097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013•

Ability of the borrower to fully amortize senior secured debt or repay a “significant
portion” of total debt over the medium term, based on projections that include realistic
downside scenarios.

•

The depth and breadth of due diligence undertaken, including with respect tocollateral.

•

Standards for evaluating expected risk-adjusted returns that account for funding anddisposing of positions during market disruptions.

•

Sponsor support of borrowers in light of sponsors’ financial capacity, initial capital
contribution, and “other motivating factors” (as further described below). Financial
institutions seeking to rely on sponsor support as a secondary source of repayment fora loan (for example, where a sponsor provides a financial guaranty) should be able toprovide documentation, including financial or liquidity statements, showing recently
documented evidence of the sponsor’s willingness and ability to support the credit.

•

Whether the covenants require lender approval for material dilution, sale, or exchangeof collateral or cash flow-producing assets.

•

Credit agreement covenant protections, including financial covenants such as debt-tocash flow ratios and interest or fixed charge coverage ratios, as well as reporting
requirements, distribution of ongoing financial and other credit information, andcompliance monitoring. The Agencies caution that leverage in excess of 6x for total
debt-to-EBITDA will raise supervisory concerns.

•

Collateral valuation, controls, and monitoring.

5.

Valuation Standards

The guidance recognizes that lenders often rely on enterprise value and other intangibles when(i) evaluating the feasibility of a loan request, (ii) determining the debt reduction potential ofplanned asset sales, (iii) assessing a borrower’s ability to access the capital markets, and (iv)estimating the strength of a secondary source of repayment. In addition, financial institutions
may view enterprise value as a useful benchmark for assessing a sponsor’s economic incentive
to provide financial support. In light of the importance of enterprise valuation in theunderwriting process, the guidance notes that enterprise valuations should be performed orvalidated independently from the origination function. Valuations should be centered on
sound methodologies, with enterprise values (including their underlying assumptions) subject
to stress testing under a range of stress scenarios, both at origination and periodically thereafter.
The guidance notes that while all three commonly accepted valuation methods (asset, income,and market) should be used and reconciled, the income method is generally considered themost reliable.
6.

Pipeline Management

Because market disruptions may impede the ability of an originating organization to
consummate syndications or otherwise sell down exposures, financial institutions must havestrong risk management and controls over transactions “in the pipeline.” They should be able
Page 5097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

to differentiate transactions according to tenor, investor class, structure, and key borrower
characteristics. Importantly, strong pipeline management involves having policies andprocedures that, among other things, provide for real-time information on pipeline exposuresand limits on aggregate pipeline commitments, as well as exceptions to the timing of expecteddistributions and approved hold levels. Consistent with other parts of the revised guidance, theAgencies expect financial institutions to develop and maintain guidelines for conducting
periodic stress tests on pipeline exposures to quantify the potential impact of changing
economic or market conditions on their asset quality, earnings, liquidity, and capital.
7.

Reporting and Analytics

The guidance emphasizes that financial institutions must have management information
systems that accurately capture key obligor characteristics and aggregate exposures on a timely
basis. Management should receive comprehensive reports about the characteristics and trends
at least quarterly, with summaries provided to the board of directors.
Several analytical components of a financial institution’s management information system are
identified in the guidance, including the following:•

Exposure and performance by deal sponsor. Deals introduced by sponsors may, insome cases, be considered exposure to related borrowers. A financial institution
should identify, aggregate, and monitor potential related exposures.

•

Portfolio performance measures, including noncompliance withrestructurings, delinquencies, nonperforming amounts, and charge-offs.

•

Amount of the ALLL attributable to leveraged lending.

•Exposure by collateral type, including unsecured transactions and those where
enterprise value will be the source for repayment for leveraged loans.

•

Actual versus projected distribution of the syndicated pipeline, with regular reports ofexcess levels over the hold targets for the syndication delivery. In particular, theguidance notes that pipeline definitions should identify the type of exposure (e.g.,committed exposures that have not been accepted by the borrower, commitments
accepted but not closed, and funded and unfunded commitments that have closed but
have not been distributed).

8.

covenants,

Risk Rating Leveraged Loans

The guidance describes the risk rating of leveraged loans as involving “the use of realistic
repayment assumptions to determine a borrower’s ability to de-lever to a sustainable levelwithin a reasonable period of time.” As an example, the guidance notes that banking
supervisors commonly assume that the ability to fully amortize senior secured debt or theability to repay at least 50% of total debt over a five-to-seven year period provides evidence ofadequate repayment capacity.
When assessing a borrower’s capacity to service its debt, a financial institution should scrutinize
extensions and restructurings “to ensure that the institution is not merely masking repayment
Page 6097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

capacity problems by extending or restructuring the loan.” The guidance also warns
institutions that if the capacity to pay down debt from cash flow is “nominal,” with refinancing
the only viable option, the credit will usually be adversely rated, even if it has been recently
underwritten, and if there are no reasonable prospects for the borrower to de-lever, asubstandard rating is likely. Also, if the primary source of repayment becomes inadequate it
would generally be inappropriate to consider enterprise value as a secondary source of
repayment, absent solid support regarding the value of the enterprise (such as a binding
purchase and sale agreement with a qualified third party). For such credits, when a portion of
the loan may not be protected by pledged assets or well-supported evidence of enterprise value,
examiners will generally rate that portion “doubtful” or “loss” and place the loan on nonaccrual
status.
The guidance does not revise separately issued guidance on the rating of credit exposures andthe use of credit rating systems, which apply to all credit transactions, including leveraged
lending transactions. 7
9.

Other Areas for Enhanced Risk Managementa.

Evaluating the Support of Deal Sponsors

The new guidance states that financial institutions that rely on sponsor support as a secondary
source of repayment should formulate guidelines for evaluating the qualifications of financial
sponsors and implement a way of monitoring performance. The Agencies recognize that deal
sponsors may provide valuable support to borrowers, including not only strategic planning,
management and “other tangible and intangible benefits” but also financial support forborrowers that fail to achieve projections. Under the new guidance, and consistent with the2001 guidance, such sponsor support may be considered by financial institutions as long as theinstitution can document the sponsor’s history of demonstrated support as well as the economic
incentive, capacity, and stated intent to continue to support the transaction. Unlike the 2001
guidance, however, the new guidance details more specifically those items that should beconsidered in evaluating a sponsor’s financial support, including the:7•sponsor’s historical performance in supporting its investments, financially andotherwise;•sponsor’s economic incentive to provide support, including the nature and amount of
capital contributed at inception, as well as the degree of support (guarantee, comfort
letter, or verbal assurance);•

available financial information on the sponsor and analysis of its liquidity and ability
to fund multiple deals;

See Federal Reserve SR Letter 98-25, “Sound Credit Risk Management and the Use of Internal
Credit Risk Ratings at Large Banking Organizations”; OCC Comptroller’s Handbooks “Rating
Credit Risk” and “Leveraged Lending”; and the FDIC Risk Management Manual of Examination
Policies, “Loan Appraisal and Classification.”
Page 7097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013•

sponsor’s overall portfolio (to determine likelihood of supporting the borrower as
opposed to sponsor’s other deals);•sponsor’s contractual investment limitations; and•sponsor’s dividend and capital contribution practices.
b.

Credit Analysis

Central to effective underwriting and management of leveraged lending risk is the quality ofcredit analysis by an institution, both initially and on an ongoing basis. Financial institutions
should have policies that address financial, business, industry, and management risks,
including whether:•

Cash flow analyses rely on overly optimistic or unsubstantiated projections of sales,margins, and merger and acquisition synergies.

•

Liquidity analyses include performance metrics appropriate for the borrower’s
industry, predictability of the borrower’s cash flow, measurement of the borrower’s
operating cash needs, and ability to meet debt maturities.

•

Projections exhibit an adequate margin for unanticipated merger-related integration
costs.

•

Projections are stress tested for one or more downside scenarios, including a covenantbreach.

•Transactions are reviewed at least quarterly to determine variance from plan, therelated risk implications thereof, and the accuracy of risk ratings and accrual status. In
addition, from inception, a borrower’s credit file should contain a chronologicalrationale for and analysis of all substantive changes to the borrower’s operating planand variance from expected financial performance.

•

Enterprise and collateral valuations are independently derived or validated outside of
the origination function, are timely, and consider potential value erosion.

•

Collateral liquidation and asset sale estimates are based on current market conditions
and trends.

•

Potential collateral shortfalls are identified and factored into risk rating and accrual
decisions.

•Contingency plans anticipate changing conditions in debt or equity markets when
exposures rely on refinancing or the issuance of new equity.

•

The borrower is adequately protected from interest rate and foreign exchange rate risk.
c.

Credit Reviews

Generally, financial institutions should review credit portfolios at least annually. However, inlight of the “elevated risks inherent in leveraged lending,” the guidance notes that an
institution’s credit review function should assess the performance of the leveraged loan
Page 8097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

portfolio more frequently, and in greater depth, than other segments. Financial institutions arealso advised that portfolio assessments should be performed by individuals with the expertiseand experience for these types of loans and the particular borrower’s industry. The guidance
does not specify any particular qualifications, but notes that institutions should staff their credit
review function “appropriately” and with “sufficient resources to ensure timely, independent,
and accurate assessments” of transactions.
d.

Stress Testing

Financial institutions should develop guidelines for conducting periodic portfolio stress tests onloans originated to hold, as well as loans originated to distribute, and sensitivity analyses toquantify the potential impact of changing economic or market practices on asset quality,
earnings, liquidity, and capital. The sophistication of stress testing practices will vary according
to the size, complexity, and risk characteristics of a financial institution’s leveraged loan
portfolio. The leveraged portfolio should also be included in any enterprise-wide stress tests
that a financial institution is required to conduct.
e.

Problem Credit Management

The Agencies warn that weak initial underwriting along with poor capital structure and limited
covenants may make problem credit discussions and restructurings more difficult for lenders.
Accordingly, the guidance urges institutions to develop action plans and policies for working
with borrowers experiencing diminished cash flows or other plan variances, such as by defining
expectations for the management of adversely rated and other high-risk borrowers andformulating workout plans that contain quantifiable objectives and measureable time frames.
f.

Compliance with Anti-Tying Regulations

The guidance reminds financial institutions that leveraged lending transactions, which typicallyinvolve a number of types of debt and bank-offered products, will need to comply with antitying regulations. These regulations, subject to important exceptions and qualifications,generally prohibit a bank from conditioning the availability or price of one product (such as aloan) on the customer obtaining another nonbank product from the bank or an affiliate of thebank. The Agencies expect policies to incorporate safeguards to prevent such coercive
behavior.
***

Page 9097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

For more information about the new interagency guidance on leveraged lending, please contact
any of the members of our Financial Institutions or Banking and Credit groups, including thoselisted below.
FINANCIAL INSTITUTIONS
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

BANKING AND CREDIT
Patrick Ryan
(212) 455-3463
pryan@stblaw.com

James D. Cross(212) 455-3386
jcross@stblaw.com

Christopher O. Bell(212) 455-3295
cbell@stblaw.com

This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

Page 10097777-0167-13895-Active.13888336.2

05/16/2014 9:50 AM

Memorandum – March 27, 2013

UNITED STATESASIANew York

Beijing

425 Lexington Avenue

3919 China World Tower

New York, NY 10017+1-212-455-2000

1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999

Palo Alto
2475 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

Houston2 Houston Center
909 Fannin Street
Houston, TX 77010+1-713-821-5650

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Seoul
West Tower, Mirae Asset Center 1
26 Eulji-ro 5-gil, Jung-gu
Seoul 100-210
Korea+82-2-6030-3800

Tokyo
Washington, D.C.

Ark Hills Sengokuyama Mori Tower

1155 F Street, N.W.

9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032
Japan+81-3-5562-6200

Washington, D.C. 20004+1-202-636-5500

EUROPE
LondonCityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

SOUTH AMERICA
São Paulo
Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

www.simpsonthacher.com
097777-0167-13895-Active.13888336.205/16/2014 9:50 AM