Side Letters (Part 1 of 2)

Side Letters (Part 1 of 2)

Side letters outline custom agreements among some or all participants in a financing deal, supplementing the terms outlined in the main documents. These letters are gaining popularity among stakeholders, providing advantages for both borrowers and lenders. This article will explore important factors to consider when utilizing side letters and how they interact with credit agreement terms.

Traditional lenders such as banks and large financial institutions typically utilize side letters to address specific internal policy points. Private credit funds have employed side letters for this purpose, but also to modify the terms of credit agreements to make them more lender- friendly. These letters enable sponsors to confidentially document lender-specific provisions without broad lender group involvement and, in a more general manner, without alerting the market to any particular concessions. Common provisions within side letters include rights of first offer/refusal, granting existing lenders priority in participating in future debt issuances, improved transferability rights for lenders, enhanced flexibility concerning confidentiality provisions, and stricter controls on key restrictive covenants like debt incurrence or leakage through permitted investments or restrictive payments.

Not Typically Considered a "Finance Document"

A side letter is generally not designated as a “Finance Document” within the context of a credit agreement due to its nature as a supplementary arrangement involving only a subset of the parties.

When a side letter lacks this designation, any breach of a side letter will not lead to an event of default in the credit agreement. Consequently, the protective measures embedded in the credit agreement (specifically, the ability to accelerate repayment and/or enforce security over collateral) will not be accessible. Instead, in an effort to deter any party from violating a side letter’s terms, lenders depend on a combination of: (1) remedies for breach of contract, which require meeting various legal standards that may not always be fulfilled, and (2) the moral influence that breaching such agreements among sophisticated investors carries—neither of which provides as definitive an outcome as invoking the event of default provision in the credit agreement.

Moreover, if the side letter addresses additional financial terms, those will not be classified as “secured obligations”. Therefore, if any other event of default occurs under a side letter, these additional terms will not comprise part of the secured claim.

Nevertheless, the fact that a side letter is not usually treated as a Finance Document offers certain benefits. For instance, if the lenders benefiting from a side letter do not represent the “majority lenders” (or any higher percentage required to modify the credit agreement's terms), there is a risk that a side arrangement in a Finance Document could be altered or waived by lenders who are not beneficiaries thereof. Additionally, it may be ineffective for a side letter to be designated as a Finance Document if the benefiting lenders do not constitute the Majority Lenders, as they would lack the ability to enforce the terms therein.

However, a side letter not being a Finance Document has its advantages – for example, if the lenders who benefit from a side letter do not constitute the majority lenders (or whatever higher percentage of lenders is required to amend the relevant terms of the credit agreement), there is a risk that a side arrangement documented in a Finance Document could be amended or waived by other lenders which are not beneficiaries thereof. In addition, it may prove pointless in a letter being designated a Finance Document if the lender beneficiaries thereof do not constitute the majority lenders, as they will not be able to direct any enforcement of its terms.