Despite continued challenges in the fundraising market for sponsors of real estate, private equity and other investment funds (each, a “Fund”), the positive momentum capital call subscription credit facilities (each, a “Facility”) experienced in 2012 has continued and perhaps accelerated in early 2013. And for good reason: on all the panels at the Subscription Credit Facility and Fund Finance Symposium in January of 2013 in New York City (the “SCF Conference”), mention by panelists of institutional investor funding delinquencies could be counted on one hand.

This type of historical investor (each, an “Investor”) funding performance of course translated to near perfect Facility performance through and coming out of the financial crisis. Yet despite the excellent Facility performance and the measured growth of the Facility market generally, there is growing recognition that certain trends in the market are creating very real challenges. Below we set out our views on the Facility market’s key trends, where they intersect and the resulting challenges and opportunities we see on the horizon.

Key Trends

There are four key trends in the market we see creating material impact: (i) the general maturation of the Facility product and market; (ii) the continuing expansion of Facilities from their real estate Fund roots into other Fund asset classes, and particularly, private equity; (iii) Fund structural evolution, largely responsive to the challenging fundraising environment and Investor demands; and (iv) an entrepreneurial approach among Funds to identify new Investor bases and new sources of capital commitments (“Capital Commitments”). We analyze each below

The Maturing Facility Market

Many Facility lenders (each, a “Lender”), Funds and other Facility market participants have for a long time benefited from the under-the-radar nature of the Facility market. While the market was certainly sizeable—for example, in 2011 Mayer Brown LLP alone worked on Facilities with Lender commitments in excess of $16 billion—it remained a niche in which only a subset of Lenders participated and was largely unknown to the greater financial community. That has certainly changed. The Facility product and its market recognition have matured and are continuing to grow rapidly for a variety of reasons, not the least of which was the publicity created by the sale of the WestLB AG, New York Branch Facility platform to Wells Fargo Bank, N.A. in 2012. Five years ago, the Facility market was operating in virtual obscurity; today it is a common staple familiar to nearly the entire finance community. DBRS has published rating criteria, an insurance company has approached Lenders offering to write credit enhancement on transactions or even individual Investor Capital Commitments and 400 people registered for the SCF Conference, up from 60 in 2010. There are certainly benefits to being in a more recognized market, but there are also growing challenges. On the plus side, management now fully understands the product, and has context when considering requests for resource allocations. A Fund sponsor’s (each, a “Sponsor”) CFO no longer needs to explain the product to his partners; they now understand the timing and internal rate of return benefits. Credit personnel analyzing Facilities now have a better grasp of both the embedded risks and the practical performance, leading to better structured and more accurately priced Facilities. But challenges abound. New entrants (Lenders, law firms, etc.) are eager to join the market, some with extensive understanding from lateral hiring and others with more limited degrees of experience. This creates pricing pressure (a positive or negative, depending on your side of the aisle), as new entrants are often forced to compete on price when they cannot credibly demonstrate execution capabilities. It also tends to lead to Facilities being consummated with security structures and collateral enforceability issues that are different or weaker than what has traditionally been deemed “market,” as newer participants are less tied to historical structures. Further, as the product matures and garners increased managerial attention, the inherent channel conflict at certain Lenders as to where within the institution to house the product often surfaces. Such channel conflict often leads to centralization of execution, as management realizes the disparities of credit standards and structures in different areas within the institution. Centralization of course leads to challenges, as both Fund relationships and execution experience are critical to a successful overall platform. Finally, a number of Lenders have become quite adept at providing Facilities, and have amassed impressive portfolios. In connection with these increasing exposures, these Lenders have rightfully garnered increased attention from the credit and risk management departments within their institutions. This increased attention often results in the creation of policies and procedures setting guidelines for what a Lender is able to do for the product and what items are outside of policy and require special considerations. Not surprisingly, these types of policies are being tested by the next several material trends.

Continued Expansion into Private Equity

Facilities are sometimes seen as a commodity product in the real estate Fund space, as some real estate Sponsors have been using the product for many years. This extensive experience has lead to provisions in limited partnership agreements (“Partnership Agreements”) that tend to adequately contemplate a potential Facility and incorporate the Investor acknowledgments and agreements that a Lender would like to see for a Facility. As real estate Fund Sponsors form new Funds, the precedent Partnership Agreement typically already has these provisions, they carry forward, and the new Fund is ready for a Facility upon its initial Investor closing. But other asset classes are different. As private equity, mezzanine, infrastructure, energy, venture and other Funds (and especially buyout Funds) have traditionally enhanced returns with asset level leverage and less so with Fund level debt (if they used leverage in the first instance), their predecessor Fund Partnership Agreements are frequently less explicit or developed with respect to a Facility. And, of course, when the next Fund is to be formed, Sponsors naturally want to keep revisions to the precedent Partnership Agreement as limited as possible so as to minimize the changes that need to be presented to prospective (and in many instances recurring) Investors. This often leads to a minimal language insertion authorizing the incurrence of debt and the pledge of Capital Commitments; language far less robust compared to what Lenders are traditionally used to seeing and relying on from real estate Funds. Further, Sponsors outside of real estate have more frequently included overcall limitations and other structural complexities, which prove challenging for Lenders.1 Thus, as Lenders continue to expand Facilities into Funds focused on private equity and other asset classes, they are increasingly challenged by Partnership Agreements that are less conducive to the Facility structure Lenders have grown to expect. This challenge is presenting almost weekly and standard setting for acceptability is going to be a key element for any Lender in the near future.

Fund Structural Evolution

Depending on your data source and region, 2012 fundraising was between flat globally and at best up just incrementally, especially in the United States. And while our fund formation practices have certainly seen some robust activity in early 2013, we remain guarded as to whether 2013 fundraising will materially outpace last year. The increased negotiation leverage of Investors derived from a difficult fundraising environment and their increased coordination facilitated in material part by the formation and advocacy of the Institutional Limited Partners Association is resulting in significant structural evolutions for Funds (especially outside of the real estate space, where traditional structures seem to be holding more firmly). Funds are increasingly structuring more tailored options for particular Investors (often to accommodate their particular tax or regulatory needs), leading to more Fund entities and more complicated Fund structures. We continue to see Investors making larger commitments to fewer, more seasoned Funds, increased use of separate accounts, sidecars and other co-investment vehicles, Investors committing through special purpose vehicles (each, an “SPV”), formation of Funds as open-ended or evergreen, and extensive concessions provided to material Investors. We have seen structures where certain parallel funds are “funds of one” that cannot be cross-collateralized, where Investors have cease-funding rights in the event the Sponsor fails to fund a capital call (a “Capital Call”), and where an Investor invests directly into a separate, newly formed SPV, created specifically for such Investor on a deal-by-deal basis. These are just a few examples of some of the trends.

To a Facility Lender, of course, “fund structural evolution” means: “Your collateral package is changing.” And, when you have a Lender-led trend toward the centralization of the product and the establishment of policies and guidelines, combined with a Fund trend of increased structural complexity designed to accommodate Investors (i.e., not accommodate Lenders), you have a natural tension. Thus, Lenders are working on getting their arms around things like the credit linkage between an SPV and the actual creditworthy Investor, how to efficiently add alternative investment vehicles as borrowers, and how to handle withdrawal rights related to violations of placement agent regulations. So an emerging challenge—and opportunity—is how to best manage this natural tension. How do Lenders develop policies that incorporate optionality into their product suite to accommodate a rapidly evolving Fund structural environment? For example, how does a securitization group tackle a Facility with a parallel fund of one that cannot be joint and severally liable but which has an investment grade Investor? How do Facilities with tight overcall limitations price compared to standard Funds without overcalls? How do you structure a Facility to an open-ended fund?3 And while these issues are certainly challenging, they clearly trend away from a commodity product, and, thereby, create opportunity. Bespoke structures require customized solutions, and because customized solutions cannot be provided by all, they afford the potential for attractive returns.

New Sources of Capital

As Sponsors have sought to expand their sources of capital, the private wealth divisions of the major banks have not missed a beat and have created a variety of product offerings to bridge the gap between high net worth individual Investors (“HNWs”) and Funds. Many major banks have created or are creating feeder funds (“Aggregator Vehicles”) whereby a large number of HNWs can commit directly to the Aggregator Vehicle (or make an upfront one-time investment in the Aggregator Vehicle) and the Aggregator Vehicle in turn commits to the Fund.2 This enables the HNWs to obtain exposure to Funds whose minimum Capital Commitment threshold they could not otherwise meet. In certain circumstances Aggregator Vehicles can even offer more liquidity than a traditional investment in a Fund by including redemption and transfer rights that would be atypical at the Fund itself. The banks sponsoring Aggregator Vehicles customize the opportunity to the wishes of the Sponsor and the HNWs, and Aggregator Vehicles may be structured to facilitate participation by the HNWs in a single Fund, in a series of Funds sponsored by the same Sponsor, or in multiple Funds sponsored by unrelated Sponsors. There are Aggregator Vehicles being marketed with minimums as low as $50,000. The Aggregator Vehicles often make material Capital Commitments to Funds, and hence their inclusion or exclusion from a Facility’s borrowing base can have a material impact on Facility availability. While Aggregator Vehicles are not rated institutions and can be challenging for traditional Facility underwriting guidelines with respect to Investors (including for those Lenders that advance against HNWs that commit directly), they clearly have inherent value worthy of some level of advance or overcollateralization benefit. In fact, it could be argued that in some ways they could be more creditworthy than a traditional institutional Investor, as their source of funds comes from a diversified pool, typically with overcall rights to cover shortfalls created by any particular HNW’s failure to fund. Figuring out the right level of advance rate and concentration limit for Aggregator Vehicles is clearly an emerging challenge and opportunity. And the development of similar vehicles and concepts that deliver HNW Investor Capital Commitments to Funds is likely to continue and increase.

Along similar lines, we expect that the continuing shift from defined benefit plans to defined contribution plans will ultimately lead Sponsors and their advisors to create products that allow defined contribution plans and related individual investor savings accounts access to Funds. While the challenges are real: the lack of redemptions does not sync well with the portability of 401(k)s, the accredited investor standard, etc., we believe the challenges are not insurmountable. And while we do not anticipate a sudden change anytime soon to open access to this source of funds, it does seem that the historically favorable rate of return provided by Funds, combined with the sheer size of long-horizon assets invested in IRAs and 401(k)s, makes their eventual connection somewhat inevitable over the long term. Whether the ultimate vehicles and structures formed to facilitate this source of funding involve Capital Commitments or something similar that would enable application for a Facility remains to be seen.

Conclusion

The Facility market is maturing and evolving in ways that create challenges and significant opportunities. We expect that the Facility market will continue to grow at a solid clip as fundraising improves, Fund formation increases and the product further penetrates the various private equity and other asset classes. But we expect that the evolution of Fund structures and new sources of Capital Commitments will challenge the historical Facility structures, leading to more customized and tailored and less standardized Facility constructs. Those Lenders nimble enough to move with these tides will have significant opportunities.

Endnotes

1 For an in-depth review of overcall limitations, please see Mayer Brown’s Legal Update, “Subscription Facilities: Analyzing Overcall Limitations Linked to Fund Concentration Limits.” on page 24.

2 Sponsors tend to refer to these HNW vehicles as “feeder funds.” We prefer to refer to them as “Aggregator Vehicles” to avoid confusion with traditional feeder funds formed by a Sponsor itself.

3 For further information about open-ended funds, please see Mayer Brown’s Legal Update, “Structuring a Subscription Facility for Open-Ended Funds.” on page 31.

A subscription credit facility (a “Facility”), also frequently referred to as a capital call facility, is a loan made by a bank or other credit institution (the “Lender”) to a private equity fund (the “Fund”). The defining characteristic of such Facilities is the collateral package, which is composed not of the underlying investment assets of the Fund, but instead by the unfunded commitments (the “Capital Commitments”) of the limited partners of the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund or the Fund’s general partner.

The loan documents for the Facility contain provisions securing the rights of the Lender, including a pledge of (i) the Capital Commitments of the Investors, (ii) the right of the Fund or the Fund’s general partner to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default accompanied by the right to enforce the payment thereof and (iii) the account into which the Investors fund Capital Contributions in response to a Capital Call.

As recovery from the financial crisis continues, fundraising activity is up markedly, due to increases in both the Capital Commitments made by Investors to existing Funds and the number of new Funds being formed. Consequently, this activity is driving an increase in the number of Facilities sought by such Funds given (i) the flexibility such Facilities provide to Funds (in terms of liquidity and consolidating Capital Calls made to Investors) and (ii) the proven track record in regards to Capital Commitment collateral’s reliability. The reliability of such collateral is due in part to the typically high credit quality of Investors in such Funds and low default rates of such Investors.

Many Funds are at least partially comprised of Investors that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and/or Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”). As discussed below, understanding a Fund’s status under ERISA, as well as the status of individual Fund Investors under ERISA and Section 4975 of the Code, is critical from a Lender’s perspective because of the prohibited transaction rules contained in these statutes.1 A violation of the prohibited transaction rules under ERISA could result in severe consequences to the Fund and to Lenders under a Facility, including the possibility that the Facility be unwound and/or of excise tax penalties equal to 100% of the interest paid under the Facility being imposed on the Lender. Despite these potential pitfalls, ERISA issues can be effectively managed through awareness of these rules and regulations and guidance from seasoned counsel specializing in ERISA and experienced in these Facilities. This newsletter outlines some of the basic ERISA considerations of which Lenders and Fund borrowers should be aware in connection with these Facilities.

Background

ERISA was adopted by Congress to protect the interests of participants in employee benefit plans that are subject to ERISA. Concerned with the difficulty of enforcing a law based on good faith or arm’s-length standards, Congress imposed:

1. fiduciary status on all persons who exercise control over employee benefit plan assets (whether or not they intend or agree to be fiduciaries); 2.stringent fiduciary standards and conflict of interest rules on such fiduciaries;

3.except where specifically exempted by statute or by the Department of Labor, prohibitions on all transactions between employee benefit plans and a wide class of persons (referred to as “parties in interest” in ERISA and “disqualified persons” in the Code)2 who, by reason of position or relationship, might, in Congress’ view, be in a position to influence a fiduciary’s exercise of discretion over plan assets; and

4.onerous liabilities and penalties on both fiduciaries who breach ERISA and third parties who enter into transactions that violate the prohibited transaction rules.

ERISA Prohibited Transaction Rules

The most significant issue for a Lender to a Fund that is or may be subject to ERISA is the impact of the prohibited transaction rules under ERISA, which strictly prohibit a wide range of transactions, including loans or other extensions of credit, between an ERISA plan and a person who is a “party in interest” with respect to such plan, unless an exemption is available (as described below). Financial institutions often have relationships with ERISA plans that cause them to be parties in interest, such as providing trustee, custodian, investment management, brokerage, escrow or other services to the ERISA plan.

A party in interest that enters into a nonexempt prohibited transaction with an ERISA plan is subject to an initial excise tax penalty under the Code equal to 15% of the amount involved in the transaction and a second tier excise tax of 100% of the amount involved in the transaction, if the prohibited transaction is not timely corrected. In order to correct the prohibited transaction, the transaction must be unwound, to the extent possible, and the ERISA plan must be made whole for any losses. In addition, if a transaction is prohibited under ERISA, it may not be enforceable against the ERISA plan.

As discussed below, a Fund that accepts ERISA plan Investors could, itself, become subject to these prohibited transaction rules under ERISA. During the negotiation of the term sheet and initial due diligence for a Facility, it is critical to understand the Fund’s structure, the current ERISA status of the Fund and, if the Fund has not closed in all of its Investors and/or made its first investment, the intended ERISA status of the entities within the Fund’s structure. Such information is necessary to draft appropriate representations and covenants in the loan documents. The representations and covenants will assure the Lender that either the Fund is not subject to ERISA or the Fund may rely on an exemption from the prohibited transaction rules under ERISA that will apply to the transactions contemplated by the Facility. Lenders may also require certain ERISA-related deliveries as a condition to the initial borrowing under the Facility, as well as annual deliveries thereafter.

Plan Asset Rules

A Fund that accepts ERISA Investors could itself become subject to ERISA if the assets of the Fund are deemed to be “plan assets” of such ERISA Investors. The rules governing the circumstances under which the assets of a Fund are treated as plan assets are generally set forth in Section 3(42) of ERISA and a regulation, known as the “plan asset regulation,” published by the Department of Labor. Section 3(42) of ERISA and the plan asset regulation set forth a number of exceptions on which a Fund may rely to avoid being deemed to hold the plan assets of its ERISA Investors.

COMMON EXCEPTIONS TO HOLDING PLAN ASSETS

The exceptions to holding plan assets most commonly relied on by Funds3 seeking to admit Investors subject to ERISA are the “less than 25%” exception and the “operating company” exception. Prior to permitting the initial borrowing under a Facility, a Lender may require evidence of compliance by the Fund with these exceptions in the form of a certificate from the Fund’s general partner (in the case of the less than 25% exception) or an opinion of qualified ERISA counsel to the Fund (in situations involving the “operating company” exception). In addition, the Facility may require annual certificate deliveries by the Fund to confirm the Fund’s continued satisfaction of the conditions of an exception to holding plan assets. Regardless of the deliveries requested by the Lender, the Facility should contain representations, warranties and covenants from the Fund to the effect that the Fund satisfies an exception to holding plan assets and will continue to satisfy such an exception throughout the period any obligations under the Facility remain outstanding.

Less Than 25% Exception

The less than 25% exception is available to a Fund4 if less than 25% of each class of equity interests in the Fund are owned by benefit plan investors. For the purpose of the less than 25% exception, Investors that are treated as “benefit plan investors” include, among others, private pension plans, union-sponsored (or Taft Hartley) pension plans, individual retirement accounts, and certain trusts or commingled vehicles comprised of assets of such plans. Government plans and non-US plans are not subject to ERISA or Section 4975 of the Code and are not counted as benefit plan investors for the purpose of the less than 25% exception. In addition, when determining the size of the class of equity interests against which benefit plan investor participation will be measured, the interests of the Fund manager or general partner and other persons who exercise discretion over Fund investment or provide investment advice to the Fund, and affiliates of such persons, are disregarded. The percentage ownership of the Fund is measured immediately after any transfer of an interest in the Fund. Accordingly, a Fund relying on the less than 25% exception must monitor the percentage of its benefit plan investors throughout the life of the Fund.

Operating Company Exception

A Fund5 relying on the operating company exception will typically do so by seeking to qualify as either a “real estate operating company” or a “venture capital operating company.” A real estate operating company (“REOC”) is an entity that is primarily invested in actively managed or developed real estate with respect to which the entity participates directly in the management or development activities. A venture capital operating company (“VCOC”) is an entity that is primarily invested in operating companies (which may include REOCs) with respect to which the entity has the right to participate substantially in management decisions. It is common for real estate-targeted Funds to rely on the VCOC exception by investing in real estate through subsidiary entities that qualify as REOCs. Both VCOCs and REOCs must qualify as such on the date of their first long-term investment and each year thereafter by satisfying annual tests that measure their ownership of qualifying assets and their management activities with respect to those assets. If a Fund does not qualify as a VCOC or REOC on the date of its initial long-term investment or fails to continue to qualify as a VCOC or REOC, as applicable, on an annual testing date, the Fund is precluded from qualifying as a VCOC or REOC, as applicable, from that date forward. Accordingly, a Fund relying on an operating company exception must properly structure and monitor investments and test for compliance annually.

Certain Timing Considerations Related to Exceptions to Holding Plan Assets

To avoid the application of the prohibited transaction rules and risks described above to the transactions contemplated by a Facility, the Fund must satisfy an exception to holding plan assets at the time of the initial borrowing under the Facility and throughout the period any obligation under the Facility remains outstanding.6 With respect to the operating company exception, the timing of the initial investment, the initial Capital Call from Investors and the initial borrowing must be carefully monitored.

As noted above, a Fund cannot qualify as a VCOC or a REOC until the date of its initial long-term investment. Accordingly, benefit plan investors typically will not make Capital Contributions to a Fund intending to qualify as a VCOC or REOC until the date such Fund makes its first investment that qualifies the Fund as a VCOC or REOC, as applicable. To call capital in advance of the initial investment, such a Fund would need to establish an escrow account to hold the Capital Contributions from its benefit plan investors outside of the Fund until the first qualifying investment is made by the Fund. Since the escrowed funds have not been contributed to the Fund, the escrow account may not be pledged by the Fund as security to the Facility. The escrow account used for this purpose needs to satisfy certain conditions set forth in an advisory opinion issued by the Department of Labor in order to avoid causing the Fund to be deemed to hold plan assets. Depending on the facts and circumstances, a Fund may not be able to make an affirmative representation in the Facility documents that it does not hold ERISA plan assets until the date on which the Fund makes its initial investment that qualifies the Fund for an operating company plan asset exception.7

PROHIBITED TRANSACTION EXEMPTIONS FOR PL AN ASSET FUNDS TO ACCESS A FACILITY

A Fund that has admitted ERISA Investors and does not satisfy the conditions of an exception to holding plan assets is subject to ERISA. An ERISA Fund would not necessarily be precluded from accessing a Facility if such Fund could rely on one of the prohibited transaction exemptions described below. As noted above, financial institutions provide a variety of services to many ERISA plans, causing such institutions to be parties in interest to such ERISA plans. Accordingly, in connection with a Facility with an ERISA Fund, it is imperative that the Facility documents contain representations and covenants from the ERISA Fund to support the conclusion that a prohibited transaction exemption is available for the transaction.

QPAM Exemption

One frequently used exemption is referred to as the “QPAM exemption.”8 This class exemption from the prohibited transaction restrictions of ERISA was granted by the Department of Labor for certain transactions between a plan and a party in interest where a qualified professional asset manager or “QPAM” has the responsibility for negotiating the terms of and causing the plan to enter into the transaction. If a loan constitutes a prohibited transaction, ERISA would preclude the ERISA plan from indemnifying the Lender for the excise taxes or other losses incurred by the Lender as a result of the violation of the prohibited transaction rules. For this reason, the Lender may require the QPAM itself to make representations and covenants confirming compliance with the QPAM exemption and to indemnify the Lender for any breach of such representations and covenants.

Service Provider Exemption

Another exemption potentially available is a statutory exemption (the “Service Provider exemption”)9 that provides broad exemptive relief from ERISA’s prohibited transaction rules for certain transactions between a plan and a person who is a party in interest solely by reason of providing services to the plan, or by 42 Fund Finance | compendium 2011-2018 subscription credit facilities: certain erisa considerations reason of certain relationships to a service provider, provided that the plan receives no less or pays no more than adequate consideration. The Service Provider Exemption is available for a broad range of transactions, including loans or a Facility. As noted above, one of the conditions of the Service Provider Exemption is that the plan neither receives less nor pays more than “adequate consideration.” In the case of an asset other than a security for which there is a generally recognized market, “adequate consideration” is the fair market value of the asset as determined in good faith by one or more fiduciaries in accordance with regulations to be issued by the Department of Labor.10 To date, the Department of Labor has not issued such regulations. Until applicable regulations are promulgated by the Department of Labor, Lenders may not be comfortable relying on the Service Provider Exemption.

STRUCTURING ALTERNATIVES FOR INCLUDING INVESTORS: MASTER/FEEDER FUNDS

Certain Funds are structured with one or more feeder funds through which Investors invest in the Fund. Frequently, the feeder funds may not limit investment by benefit plan investors and may be deemed to hold the plan assets of such Investors. Accordingly, the prohibited transaction rules will apply to any feeder fund that does not satisfy the less than 25% exception to holding plan assets discussed above. The activity of such feeder funds is typically limited to investment into the master Fund, which is designed to satisfy an exception to holding plan assets. Since the Fund manager does not have discretion over feeder fund investments and transactions, the QPAM exemption would not be available for loans to the feeder fund. In such cases, the feeder funds generally do not enter into lending transactions directly, or even provide guarantees of master Fund loans. However, there are structures that can be established to make sure the Fund receives credit/borrowing base capacity for the feeder fund. For instance, the feeder fund may pledge the unfunded Capital Commitments of its Investors to the master Fund. The master Fund, in turn, pledges those assets to the Lenders. Accordingly, the Lenders are entering into a transaction only with the master Fund, which does not hold plan assets, but the Lenders still have access to the feeder fund Capital Commitments to the extent included in the pledged assets.

Investor Consents

For various reasons, Lenders may require an Investor consent letter (also commonly referred to as an Investor letter or Investor acknowledgment), where an Investor confirms its obligations to fund Capital Contributions after a default to repay the Facility. To the extent that these Investor consents are sought from benefit plan investors, it is important to consider the ramifications of the plan asset regulation.

Even if a Fund satisfies one of the exceptions to holding plan assets set forth in Section 3(42) of ERISA or the plan asset regulation, an Investor consent directly between a Lender and a benefit plan investor could be deemed to be a separate transaction that may give rise to prohibited transaction concerns under ERISA and/or Section 4975 of the Code. Certain Lenders have obtained individual prohibited transaction exemptions from the Department of Labor to eliminate this prohibited transaction risk in connection with Investor consents, provided the conditions of the exemption are satisfied. Each of these individual prohibited transaction exemptions assumed that the assets of the Fund were not deemed to be ERISA plan assets. Without an individual prohibited transaction exemption, it is essential that the Investor consents with benefit plan investors be structured so that such Investors are merely acknowledging their obligations under the governing documents of the Fund. Investor consents carefully drafted so Investors are acknowledging obligations arising under the Fund documentation (instead of being styled as an agreement between such Investor and the Lender) should not be viewed as “transactions” with the Lender for prohibited transaction purposes under ERISA or Section 4975 of the Code.

Loans Funded With Plan Assets

Typically Facilities are funded out of general assets of one or more Lenders, and not with ERISA plan assets. However, it is important to note that if a loan were funded in full or in part from, or participated to an account or fund comprised of ERISA plan assets, the ERISA prohibited transaction considerations discussed above would be triggered, regardless of whether the borrower Fund is deemed to hold plan assets. For this reason, borrowers often request Lenders to represent and covenant that the loan will not be funded with ERISA plan assets.

Conclusion

A Fund that contemplates taking advantage of the benefits associated with a Facility must be mindful of ERISA issues. Beginning with structuring the Fund with an eye towards the inclusion of ERISA Investors, through the selection and timing of Fund investments coinciding with the term of the Facility, careful consideration of the impact ERISA rules and regulations may have on the Fund can increase (or limit entirely) the available amount of the loan. Lenders must also pay particular attention to ERISA issues commencing with due diligence of the Fund and Investor documentation, through execution of final loan documents for the Facility and the necessary representations, warranties, covenants and required deliverables related thereto for purposes of limiting exposure to a violation of ERISA rules and regulations. With careful planning and attention to ERISA issues (including to those described above), the closing and execution of a Facility should not be hindered by these complex rules and regulations.

Endnotes

1 The prohibited transaction rules under ERISA are similar to the prohibited transaction rules of Section 4975 of the Code. For ease of reference, this newsletter will discuss ERISA.

2 The definition of “disqualified persons” in the Code differs from the definition of “parties in interest” under ERISA. For ease of reference, this newsletter will only refer to parties in interest.

3 In this newsletter, we discuss the Fund as though it is a single entity. If a Fund is comprised of multiple parallel funds, feeder funds and/or alternative investment vehicles, each entity that is a party to the Facility would need to satisfy an exception to holding plan assets or would need to rely on a prohibited transaction exemption in connection with the Facility.

4 For this discussion of the less than 25% test, we assume that the Fund is a single entity. If a Fund were comprised of multiple parallel funds and each parallel fund intended to rely on the less than 25% exception to holding plan assets, each parallel fund would be tested separately.

5 Again, we assume that the Fund is a single entity. If a Fund were comprised of multiple parallel funds, for example, and more than one parallel fund intends to operate as a VCOC, each such parallel fund would be tested separately.

6 We are assuming that the Lender did not fund the loan with plan assets of any benefit plan investor. See Section VI.

7 Nevertheless, a Lender may permit a Fund to make a small borrowing under the Facility (typically for purposes of paying costs and expenses incurred prior to closing of the Facility) before such initial qualifying investment, with the balance of the Facility available after the Fund demonstrates that it qualifies for an operating company plan asset exception following the qualifying investment.

8 See Class Exemption for Plan Asset Transaction Determined by Independent Qualified Professional Asset Managers, 49 Fed. Reg. 9494 (Mar. 13, 1984), amended by 70 Fed. Reg. 49,305 (Aug. 23, 2005) and 75 Fed. Reg. 38,837 (July 6, 2010).

9 See ERISA § 408(b)(17) and Code § 4975(d)(20).

10 See ERISA § 408(b)(17)(B)(ii) and Code § 4975(f)(10).

The use of managed accounts as an investment vehicle has been widely publicized of late with institutional investors such as the California State Teachers’ Retirement System and the New York State Common Retirement Fund (referring to such vehicles as “separate accounts”), and the Teacher Retirement System of Texas and the New Jersey Division of Investment (referring to such vehicles as “strategic partnerships”) making sizeable investments with high-profile private equity firms such as Apollo Global Management, LLC, Kohlberg Kravis Roberts & Co. and the Blackstone Group.1

Regardless of name, these tailored investment vehicles represent a significant trend, with 32% of surveyed fund managers indicating they were intending to invest more from separate accounts during 2013.2 And although structurally divergent from commingled real estate or private equity funds (“Funds”), these separate accounts share a common objective with Funds: to produce strong returns with respect to invested capital in the most efficient manner possible.

In many situations, accessing a credit facility can facilitate achieving investment objectives. This is quite clear in the context of Funds establishing subscription credit facilities, also frequently referred to as a capital call facility (a “Facility”). These Facilities are popular for Funds because of the flexibility they provide to the general partner of the Fund in terms of liquidity and the efficiency associated with consolidating the number of capital calls made upon limited partners. These benefits would equally apply to institutional investors establishing separate accounts with private equity firms and, despite fundamental differences between separate accounts and Funds, a separate account may be structured to take advantage of the flexibility afforded by a similar credit facility.

Definition of “Separate Account”

The term “separate account” has been used generically to describe an arrangement whereby a single investor provides virtually all of the necessary equity capital for accomplishing a specified investment objective. It is important, however, to distinguish a “separate account” from a joint venture or partnership in which there is an additional party (frequently the investment manager) with an equity interest in the owner of the investment. The equity provided (or earned) by the investment manager may be slight in comparison to the equity capital provided by the institutional investor. However, despite the imbalance of economic interests, these joint ventures and partnerships involve two or more equity stakeholders and generally require careful consideration with respect to many of the same issues which arise in the context of Funds (whether such Fund includes just a few, or a few hundred, investors). And confusion arises when these joint ventures and partnerships are incorrectly referred to as a “separate account.”

In fact, a separate account (“Separate Account”) is an investment vehicle with only one (1) commonly institutional investor (“Investor”) willing to commit significant capital to a manager (which may also simultaneously manage a Fund or Funds (“Manager”)) subject to the terms set forth in a two (2) party agreement (commonly referred to as an Investment Management Agreement or the “IMA”). The IMA is structured to meet specific goals of the Investor, which may be strategic, tax-driven or relate to specific needs (such as excluding investments in a particular type of asset or market). As a result, it is not atypical for a Separate Account to be non-discretionary in terms of investment decisions made by the Manager (with Investor approval being required on a deal-by-deal basis). Separate Accounts can also be tailored to match the specific investment policies and reporting requirements of the Investor.

Separate Accounts vs. Commingled Funds

Aside from fundamental differences such as the number of investors and the potential lack of Manager discretion in making investment decisions (described above), several key distinctions exist between Separate Accounts and Funds. Notably, fees paid to the Manager under Separate Account arrangements are typically lower than those paid to a Manager operating a Fund (in part because of the leverage maintained by an Investor willing to commit significant capital to a Separate Account), and any performance fees must be carefully structured to ensure they do not violate applicable law relating to conflicts of interest.

The popularity of Separate Accounts may be attributable to the greater flexibility they provide to the Investor. In addition to Investor input related to investment decisions, IMAs are sometimes structured to be terminable at will upon advance notice to the Manager (although there may be penalties associated with early termination), while termination of a Fund Manager ordinarily requires the consent of a majority or supermajority of the other limited partners, and oftentimes must be supported by “cause” attributable to the action (or inaction) of the Manager. However, there are also significant costs and trade-offs associated with this flexibility, including that the Investor must identify and agree upon terms with a suitable Manager, and the time commitment and expertise required by the Investor to be actively involved in analyzing and approving investment recommendations made by the Manager. Likewise, the Manager will require a sizeable commitment to the Separate Account to overcome the inefficiency of a Separate Account as compared to operating a Fund with a larger pool of committed capital, more beneficial fee structures, and discretion over investment decisions.

Benefits of Credit Facilities for Separate Accounts

Notwithstanding the differences between Separate Accounts and Funds, Investors and Managers alike would benefit from access to a credit facility in connection with a Separate Account. To begin with, credit facilities provide a ready source of capital so that investment opportunities (once approved) can be quickly closed. Timing considerations are critical in a competitive environment for quality investments, particularly if internal Investor approvals are difficult to obtain quickly. The liquidity offered by a credit facility can decrease Investor burden and shorten the overall investment process by eliminating the need for simultaneous arrangement of funding by the Investor. The closing of an investment through a credit facility minimizes administration by both the Investor and Manager, as funding of the obligations to the Separate Account can be consolidated into a routine call for capital (instead of multiple draws taxing the human capital of both the Manager and Investor executing the objectives of the IMA). And, perhaps most importantly from the Investor’s perspective, a credit facility may eliminate the need to continually maintain liquidity for the capital required to fund investments contemplated by the Separate Account.

Although alternatives exist (including asset level financing arrangements), many Funds have established Facilities for purposes of obtaining liquidity, flexibility and efficiency in connection with portfolio management. The most common form of Facility is a loan by a bank or other credit institution (the “Creditor”) to a Fund, with the loan obligations being secured by the unfunded capital commitments (the “Unfunded Commitments”) of the limited partners of the Fund. Under a Facility, the Creditor’s primary and intended source of repayment is the funding of capital contributions by such limited partners, instead of collateral support being derived from the actual investments made by the Fund. The proven track record of Unfunded Commitments as collateral has generally enabled Creditors to provide favorable Facility pricing as compared to asset-level financing, although many Funds utilize both forms of credit in order to increase overall leverage of the investment portfolio.

Assuming the Investor is a creditworthy institution, the IMA can be drafted to take advantage of the flexibility afforded by a Facility by including certain provisions found in most Fund documents supporting the loan.3 More specifically, the IMA should expressly permit the Manager to obtain a Facility and provide as collateral all or a portion of the unfunded commitment of the Investor (the “Required Commitment”) to supply a capital contribution for approved investments (“Account Contributions”) contemplated by the Separate Account. Then, as part of the Investor’s approval of an investment under the IMA, the Investor may elect to authorize the Manager to make a draw upon the Facility for the relevant investment(s) and cause the Required Commitment to be pledged, along with the right to request and receive the related Account Contribution when called by the Manager (a “Capital Call”), to the Creditor. If so, the Investor retains discretion with respect to both investment selection and Facility utilization and, when drawn upon the Facility, would be supported by a pledge of: (a) the Required Commitment; (b) the right of the Manager to make a Capital Call upon the Required Commitment after an event of default under the Facility (and the right of the Creditor to enforce payment thereof); and (c) the account into which the Investor is required to fund Account Contributions in response to a Capital Call. Creditors may also require investor letters from the Investor acknowledging the rights and obligations associated with this structure from time to time. As mentioned above, most Investors and Managers are familiar with these terms and recognize the benefits afforded by establishing a Facility for purposes of flexibility, efficient execution, and administration of private equity investments.

Conclusion

The number of Funds seeking a Facility is steadily increasing due to the benefits these loans provide to Investors and Managers in terms of liquidity and facilitating investment execution, while simultaneously decreasing the administrative burden associated with numerous and/or infrequent capital calls. Likewise, Creditors have benefitted from the reliability of unfunded capital commitment collateral and the low default rates associated with these Facilities.

These same attributes apply in the context of Separate Accounts and, with careful attention to Facility requirements at the onset of Separate Account formation, similar loans may be provided for the benefit of parties to an IMA. Please contact any of the authors with questions regarding these issues and the various methods for effectively establishing a Facility in connection with Separate Accounts.

Endnotes

1 “CalSTRS Joins Chorus Favoring Separate Accounts Over Funds”, Pension & Investments, March 5, 2012.

2 “The Rise of Private Equity Separate Account Mandates”, Preqin, February 21, 2013.

3 In the context of a Separate Account structured so the Investor does not maintain any form of commitment (and instead merely funds individual investments with equity capital in connection with approval and closing thereof), this Facility support structure would not apply.

A subscription credit facility (a “Facility”), also frequently referred to as a capital call facility, is a loan made by a bank or other credit institution (the “Lender”) to a private equity fund (the “Fund”). The defining characteristic of such Facilities is the collateral package, which is composed not of the underlying investment assets of the Fund, but instead by the unfunded commitments (the “Capital Commitments”) of the limited partners in the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund’s general partner.

The loan documents for the Facility contain provisions securing the rights of the Lender, including a pledge of (i) the Capital Commitments of the Investors, (ii) the right of the Fund’s general partner to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default accompanied by the right to enforce the payment thereof, and (iii) the account into which the Investors fund Capital Contributions in response to a Capital Call.

The number of Facilities is rapidly growing due to the flexibility they provide to Funds (in terms of liquidity and consolidating Capital Calls made to Investors) and the reliability of the Capital Commitment collateral from the Lender’s perspective. As the Facility market continues to grow and evolve, both Lenders and Fund sponsors seek to put in place Facilities for fund structures that vary from the typical closed-end Funds that have historically dominated the Facility market. As recovery from the financial crisis continues, Investors are increasingly investing in open-end Funds due to the Investors’ interest in increased liquidity due to the availability of voluntary Investor redemptions in open-end Funds. Historically, Lenders have not pursued open-end Funds for Facilities because of concerns surrounding the transient nature of the Capital Commitments in those Funds. As discussed below, however, with a few structural tweaks, Facilities can be provided to open-end Funds, offering Lenders the same comforts of a traditional Facility while providing Funds convenient and costeffective fund-level financing. Such financing can be used for leveraging investments, liquidity and bridging Capital Calls. This newsletter provides background on how open-end Funds generally differ from a typical closed-end Fund, and proposes solutions for structuring a Facility for open-end Funds.

Background

While there are many types of open-end Funds, there are a number of common characteristics that generally distinguish an open-end Fund from a typical closed-end Fund. These include: the long-term fund-raising period during which it can accept additional Capital Commitments and close in new Investors, the extended or perpetual investment period during which it can make Capital Calls, and most important and potentially concerning for purposes of Facilities, the increased flexibility for Investors to redeem their interests. Unlike a closed-end Fund, where redemption and withdrawal rights are generally not available to Investors, or, to the extent that they are available to Investors, are generally limited to specific legal or regulatory issues, Investors in an open-end Fund are generally free, subject to notice and timing restrictions, to redeem their interests in the Fund. True open-end Funds by their nature permit redemption of equity at the election of the Investor (and, in some circumstances, the remaining unfunded Capital Commitment of the redeeming Investor may be cancelled). It is important to note that some open-end Funds require Investors to fully fund all Capital Contributions concurrently with closing into the fund and, thus, do not retain the concept of an unfunded Capital Commitment. A traditional Facility would not be feasible for such a Fund. For purposes of this newsletter we will focus on structuring issues related to the expanded redemption and withdrawal rights of Investors in open-end Funds that retain unfunded Capital Commitments.

Structuring and Documentation Concerns

A Facility for an open-end Fund should contain a representation, warranty, covenant and an event of default package that is generally consistent with that seen in Facility documentation for a closed-end Fund. The collateral package would also be similar, if not identical, to that for a closed-end Fund. As a gating issue, it is important to review the constituent documents of the open-end Fund to ensure that the timing of requests for redemption and the timing for satisfying redemptions allows for Capital Calls to be made and the proceeds thereof applied to make any mandatory prepayment that would result from any such redemption. Notwithstanding the generality of the foregoing, there are a few structural changes that should be noted in a Facility for an open-end Fund.

COLLATERAL ISSUES

As discussed above, the collateral and expected source of repayment in a Facility is the Capital Commitments of the Investors. Given the nature of open-end Funds, the potential fluidity with respect to the Investors and, therefore, the collateral for the Facility raise potential concerns. Notwithstanding the issues related to a changing pool of Investors, with a careful review of the Fund’s constituent documentation and attention to the redemption timing and mechanics, a Facility could be structured to address a Lender’s concerns while still providing flexibility (in terms of liquidity and consolidating Capital Calls made to Investors) to an open-end Fund. As described in more detail below, the Facility documentation can address the foregoing concerns with some minor changes, including additional exclusion events, mandatory clean-up calls, additional events of defaults and/or additional covenants.

An exclusion event tied to any request by an Investor to redeem its interest in the Fund must be structured so as to remove any such requesting Investor from the borrowing base while also allowing sufficient time to make a Capital Call to cure any resulting borrowing base mismatch in the time period between receipt of such request from an Investor to the time the Investor has been redeemed from the Fund. Tying the exclusion event to a request for redemption, rather than to an actual redemption, is important not only for timing concerns, but also because an Investor that has redeemed its equity in a Fund, even if it is not also seeking to cancel its unfunded Capital Commitment, may not be as concerned by the defaulting investor penalties in the constituent documents of the open-end Fund as an Investor that still has equity at stake. Additional Lender protection can be obtained by requiring cleanup calls (to reduce amounts outstanding under a Facility) in advance of each regularly occurring redemption window under the constituent documents of the open-end Fund. An event of default can be mayer brown 33 structuring a subscription credit facility for open-end funds added that is triggered upon a threshold percentage of Investors requesting redemption of their interests in the Fund. Such event of default can be structured to be cumulative or with respect to any redemption window. A net asset value covenant can be inserted to provide additional early warning of any Fund problems.

ADDITIONAL REPORTING

Because of the potential for changes in the Investor base and the collateral package associated with an open-end Fund, Facilities should be structured to provide additional reporting as to borrowing bases and Investor events, including notice of redemption requests, cues of Investors seeking admission to the Fund and net asset values. Additional delivery of borrowing base certificates and notices of redemption requests should coincide with the time periods under the constituent documents of the open-end Fund such that the Lender can properly monitor borrowing base changes and anticipate any necessary mandatory prepayments resulting from Investor redemptions, while maintaining time to issue any necessary Capital Calls before the effectiveness of any requested redemptions. Tracking redemption requests and Investor cues should provide a Lender with an early indication of underlying problems with a Fund. We note that reporting and documentation required in connection with a Facility for an open-end Fund may be more administratively burdensome than a Facility in a typical closed-end Fund. Beyond the additional reporting with respect to borrowing bases and Investor redemptions discussed above, deliverables (such as constituent document changes, new side letters and subscription agreements) with respect to additional Investors can continue for a longer period than in a typical closed-end Fund. Moreover, given the increased potential for Investor turnover, it may be burdensome for both Lenders and Fund sponsors to negotiate and obtain investor letters and opinions from Investors. Lenders may want to consider addressing any additional administrative burden related to an open-end Fund Facility by increasing the administrative fees under the Facility. Even with an incremental increase in fees or the interest rate, a Facility still likely provides cheaper liquidity than many asset-level financings.

FACILITY TENOR

Because of its long-term nature, there are a number of options to structure the tenor of a Facility for an open-end Fund. Since open-end Funds typically are not subject to limited investment periods during which they may make Capital Calls for investments and repay Facility obligations, there are more options available to Lenders and Fund sponsors in terms of the tenor of the Facility. Some open-end Funds prohibit initial Investors from redeeming their interests and/or withdrawing from the Fund for a predetermined period of time (often one or two years). Such lock-out periods help the Fund achieve and maintain a critical size during its ramp-up period. During the early stages of such an open-end Fund, a Facility could be structured with a tenor equal to any applicable redemption lock-out period for the Investors. A Facility of this type would look very similar to a Facility for a typical closed-end Fund. Secondly, a Facility could have a longer tenor, even in excess of five years or more, to match the long-term investment period and life-span of an open-end Fund. Although rare in this market, such a long-term tenor is regularly seen in other leveraged lending products. Lastly, a Facility could be structured with a 364-day tenor, subject to any number of one-year extensions, allowing the Lender and Fund sponsor to re-evaluate their respective needs on an ongoing basis during the life of the Fund.

Conclusion

While Facilities for true open-end Funds have to date been relatively rare, the opportunity is ripe for new market entrants. With a careful review of an open-end Fund’s constituent documentation and some modifications to the 34 Fund Finance | compendium 2011-2018 Facility documentation, a Facility can be structured to provide the traditional benefits of a Facility for an open-end Fund while still addressing a Lender’s standard Facility credit criteria. Please contact any of the authors with questions regarding open-end Funds and the various structures for effectively establishing Facilities for such entities.

Subscription credit facilities have become a popular form of financing for private equity and real estate funds. Governmental pension plans, state endowment funds, sovereign wealth funds and other instrumentalities of foreign and domestic governments are frequent Investors that may possess certain sovereign immunity rights against enforcement proceedings rooted in the common law concept that “the King can do no wrong.” Governmental Investors must be evaluated on a case-by-case basis to ascertain if any sovereign rights apply and, if so, whether such Investor has effectively waived its immunity. This Legal Update seeks to set forth the basic legal framework of sovereign immunity in the United States relevant to subscription credit facilities.

Credit Facilities

Subscription credit facilities (a Facility) have become a popular form of financing for private equity and real estate funds (Funds). The Facility’s lenders (the Lenders) are granted a security interest in the uncalled capital commitments of the Fund’s limited partners (the Investors) and the Lenders rely on the Investors’ obligations to fund capital contributions as the primary source of repayment. Governmental pension plans, state endowment funds, sovereign wealth funds and other instrumentalities of foreign and domestic governments are frequent Investors that may possess certain sovereign immunity rights against enforcement proceedings rooted in the common law concept that “the King can do no wrong.”1

Sovereign immunity in its purist form could shield a governmental entity from all liability—e.g., enforcement by a Lender seeking to collect uncalled capital commitments contractually owed by the Investor to the Fund. Thus, as Lenders evaluate the creditworthiness of governmental Investors for inclusion in a Facility’s borrowing base, they naturally inquire into how sovereign immunity may impact the enforceability of such Investors’ capital commitments.

Governmental Investors must be evaluated on a case-by-case basis to ascertain if any sovereign rights apply and, if so, whether such Investor has effectively waived its immunity. Given the financial troubles facing many governmental Investors as a result of the ongoing economic crisis and sovereign debt concerns, Lenders are increasing their scrutiny of the credit wherewithal of such Investors and their potential ability to raise sovereign immunity as a defense in subsequent litigation. This Legal Update seeks to set forth the basic legal framework of sovereign immunity in the United States relevant to a Facility.

Basis of Immunity

At its most basic level, the doctrine of sovereign immunity states that the government cannot be sued in its own courts unless it has otherwise consented to waive its sovereign immunity. As it relates to governmental Investors organized under the laws of the United States or a political subdivision thereof (a US governmental Investor), the doctrine of sovereign immunity comes in two flavors: (i) sovereign immunity of the federal government2 and (ii) sovereign immunity of state governments and their instrumentalities pursuant to the Eleventh Amendment of the US Constitution, and in some states, through the state’s Constitution.

Sovereign immunity of the US federal government is a concept that has existed in US jurisprudence since the country’s founding.3 Through the Tucker Act,4 however, it is well settled that the US federal government has waived sovereign immunity with respect to any express or implied contract. With respect to state governments, the Eleventh Amendment, along with US Supreme Court jurisprudence on the issue, provides that states generally are immune from being sued in federal or state court without their consent.5 Recognizing the inequities of such a rule in the commercial context however, many state constitutions, legislatures and high courts have eroded the sovereign immunity of state governments to permit actions based on contractual claims.

The doctrine of sovereign immunity also protects certain foreign governments and international organizations of a quasi-governmental nature, such as the United Nations, against claims in US courts. The Foreign Sovereign Immunities Act of 1976 (the FSIA) generally shields such Investors, but provides an exclusive basis and means to bring a lawsuit against a foreign sovereign in the US for certain commercial claims.6

Waivers of Immunity—US Investors

There are three ways that sovereign immunity is generally waived by US governmental Investors: (i) an Investor expressly and unequivocally waiving such immunity in a writing that can be relied upon by the Lender (i.e., an “Investor Letter” delivered to the Lenders in connection with the Facility or a side letter provision running to the benefit of the Lenders), (ii) a statute enacted by the applicable governing legislature that explicitly waives immunity for contract claims in commercial transactions, such as the Tucker Act7 in the case of the US federal government, or (iii) controlling case law, typically from a federal or the applicable state’s highest court, that precludes governmental Investors from effectively raising sovereign immunity as a defense to contractual claims.

WRITTEN WAIVERS FROM INVESTORS

The best case scenario for the Lenders is an explicit waiver from the Investor or an express statement that sovereign immunity does not apply. Often in an Investor Letter, the subject Investor: (i) acknowledges and agrees that, to the extent it is entitled to sovereign immunity now or at any time in the future, it irrevocably waives such immunity to the fullest extent permitted by law and/or (ii) represents that it is not subject to, or cannot claim, immunity from suit in respect of contractual claims to enforce its obligations under the applicable partnership agreement and subscription agreement.

A second variety of waiver is an implicit waiver. With an implicit waiver, the Lenders are provided with an affirmative representation that the Investor is subject to commercial law and that its performance under the partnership agreement, the subscription agreement and the Investor Letter (if applicable), constitutes private and commercial acts, not governmental acts. While this form of waiver is not as strong as the explicit waiver, it puts the Investor at a severe disadvantage when distinguishing itself from a private actor in the marketplace and when attempting to argue that it should be entitled to immunity as a governmental actor (note: the comfort afforded by this waiver to a Lender certainly pivots on whether applicable law has abrogated immunity for commercial transactions).

In transactions where Lenders receive Investor Letters and Investor opinions as a condition to including a particular Investor in the borrowing base, it is best practice that the Investor’s counsel opine, among other things, that the Investor has effectively waived immunity or that such Investor does not enjoy sovereign immunity in connection with its obligation to fund capital contributions to the Fund.

A third variation of waiver language common in the Facility market involves neither an explicit nor an implicit waiver, but rather a statement by the governmental Investor that despite the Investor’s sovereign immunity and its express reservation thereof, such immunity does not in any way limit the Investor’s obligations to make capital contributions under the partnership agreement. While this seemingly contradictory language is not really a waiver at all, it provides some comfort to the Lenders that the Investor has agreed to fund its capital contributions. The Facility market seems to accept this language cautiously, and then only after a careful review of the underlying law to determine whether the applicable Investor could potentially raise a successful immunity defense in the context of a Facility.

STATUTORY WAIVERS

While it is ideal for Lenders to receive a written waiver as discussed above, Investors often are unwilling to provide such a waiver, or the Facility does not permit Lenders to request and rely on Investor Letters. US governmental Investors will frequently reserve their Eleventh Amendment rights in a side letter; hence, it is very important to carefully review and vet governmental immunity provisions in side letters against applicable law. Many states, however, have waived sovereign immunity for commercial contract claims by constitution, statute or case law. Several states, including California and New York, have passed statutes explicitly waiving sovereign immunity with respect to contractual claims.8 In these states, a plaintiff may proceed against the state government just as if it were proceeding against a private citizen. If obtainable, Lenders should seek an explicit statement from the Investor acknowledging that the Facility qualifies under the applicable sovereign immunity waiver statute of that state. An example of such language would be: “Each of the Partnership Agreement, the Subscription Agreement and the Investor Letter constitute a contract within the meaning of [insert applicable state statute (e.g., Cal. Gov. Code Section 814, New York Court of Claims Act §8 (L. 1939, c 860), Section 12-201, State Gov. Article, Ann. Code of Maryland and ORS Section 30.320)].”

These state statutes often contain a specific set of requirements and procedures that must be complied with in order to bring suit and obtain a judgment. For example, statutes that waive sovereign immunity for contractual claims often require that a claimant show that the contract was validly authorized and entered into by the governmental Investor.9 Additionally, it is not uncommon for such statutes to require that a claimant bring the claim within a certain period of time and in a particular venue, often a certain county or an administrative law court within the applicable state.10

Given the variations among statutes with respect to waivers of sovereign immunity, it is prudent for Funds, Lenders and their respective counsel to examine each individual state’s statute on a case-by-case basis.

COMMON LAW WAIVERS

Some state high courts have rendered decisions eliminating sovereign immunity with respect to contractual claims. For example, the South Carolina Supreme Court held that when the state enters into a contract, the state implicitly consents to be sued and waives its sovereign immunity to the extent of its contractual obligations.11 Similarly, in 2006, the Missouri Supreme Court held that sovereign immunity does not apply to breach of contract claims against state agencies.12 State courts are continuing to follow such decisions. In 2010, the Virginia Supreme Court reaffirmed its prior ruling that sovereign immunity is not a defense to a valid contract entered into by a duly authorized agent of the state.13 State courts, like state legislatures, have taken varying approaches with respect to the procedures and timelines that must be followed for a claimant to bring an action based on a contractual claim.14

We note, however, that a minority of states have bucked the trend to waive immunity for contract and thus leave Lenders at risk of enforcement uncertainty if the state defaults. While not entirely clear, the general rule in Texas may still be that state government entities cannot be sued for a breach of contract, even with evidence of a waiver to the contrary.15 At least one appellate court in Texas has attempted to reverse course, holding that there is a waiver-by-conduct exception to sovereign immunity in breach of contract cases against state entities.16 However, the Texas Supreme Court denied review of this holding, leaving the viability of such an exception unsettled.

Waivers of Immunity—Non-US Investors

Foreign governments and their instrumentalities are also frequent Investors, often with sizable capital commitments. Lenders should carefully review such Investor’s credit, as well as the procedural requirements for enforcement of their capital commitments, including with respect to immunities.

The general premise of the FSIA is that a foreign government has immunity and cannot be sued in the United States. There are, however, three exceptions to this rule. First, waivers where the Investor has expressly waived immunity by contract, including any such waivers that arise from language in applicable international agreements.17 Second, implied waivers where the Investor (i) agrees in a choice of law provision to be “governed by” US law,18 (ii) agrees to arbitration with the expectation of enforcement of an award in the United States,19 (iii) affirmatively files a suit or responds to a pleading without raising an immunity defense20 or (iv) has signed an international convention permitting the enforcement of an award in the United States.21 Third, the “commercial activity” exception.22

Under the commercial activity exception, a claimant may sue a foreign government in a US court when the claim is based on (i) a commercial activity carried on in the United States by the foreign government, (ii) an act by a foreign government that is performed in the United States in connection with a commercial activity outside the United States or (iii) an act by a foreign government that is performed outside the United States in connection with commercial activity that occurs outside the United States, if such action “causes a direct effect” in the United States.23

Absent an express written waiver, a valid submission to jurisdiction in the United States or an agreement to binding arbitration,24 non-US governmental Investors in the context of a Facility should fall into the commercial activity exception. In Republic of Argentina v. Weltover Inc.,25 bond holders sued the Government of Argentina for breach of contract. The US Supreme Court articulated the applicable legal standard: “[w]hen a foreign government acts, not as a regulator of a market, but in the manner of a private player within it, the foreign sovereign’s actions are ‘commercial’ within the meaning of the FSIA.”

Argentina argued that that the commercial activity exception did not apply because (i) the issuance of sovereign debt should not constitute commercial activity and (ii) the alleged breach did not have a “direct effect” on the United States. The Court disagreed on both counts. First, the Court concluded that the issuance of the bonds was of sufficient commercial character. Second, the Court rejected the argument that the FSIA required the direct effect to be “substantial” or “foreseeable,” instead concluding that it need only follow “as an immediate consequence” of the sovereign’s activity. Despite the fact that none of the bondholders were situated in New York, the Court held that the effect was direct because New York was the designated place for payment.26 This is certainly helpful precedent for Facility Lenders. For a more in-depth review of the “commercial activity” exception, please see Mayer Brown’s White Paper, “Sovereign Immunity and Enforcement of Arbitral Awards: Navigating International Boundaries,” available at http://www.mayerbrown.com/ publications/detail.aspx?publication=5048.

Satisfaction of a Judgment Against a Sovereign Entity

While a governmental Investor may have waived sovereign immunity by one of the means identified above, enforcing a judgment against a governmental Investor merits additional discussion.

First, side letter provisions may prescribe a particular jurisdiction (other than New York or Delaware) or a means of alternative dispute resolution (e.g., binding arbitration by the International Chamber of Commerce or similar body), and such provisions will affect how a Lender should pursue the Investor.

Further, once a judgment is obtained from the proper tribunal, satisfying a judgment against a governmental Investor may differ from satisfying a judgment against a private person. Due to public policy concerns, some government entities that do not enjoy immunity from suit may nonetheless argue they are effectively exempt from monetary judgments.27 In these cases, a Lender can initiate enforcement proceedings but may not be able to collect on a judgment. In other cases, payment of the judgment may require that a specific appropriation be made by the appropriate legislative body of the governmental Investor, or statutory limits may exist on the amount of the judgment that may be satisfied.

For example, in Kentucky, while the state has waived its sovereign immunity with respect to contract claims, damages are capped at twice the amount of the original contract.28 Certain states, including West Virginia, Louisiana and Connecticut, require the special approval of the legislature or some other administrative body before paying a claim.29 Obviously, a Lender needs to be familiar with these particularities.

Seeking satisfaction of a judgment against a foreign governmental Investor that has defaulted on its capital commitment poses an additional set of issues, including whether or not such Investor has any commercial assets in the United States upon which a Lender can levy in the event the governmental Investor does not voluntarily settle a judgment awarded. In the event that the foreign governmental Investor does not have any commercial assets within the United States, a Lender may need to go abroad to seek enforcement of a judgment. Enforcing a US judgment abroad requires an analysis of whether or not the applicable foreign court will respect the judgment of the US court and if not, how such foreign court will rule if contractual liability needs to be re-litigated.

PRACTICAL CONSIDERATIONS

The good news is that Facilities have been around for many years and anecdotal evidence from active Lenders in the market during the financial crisis indicates that there have been no material governmental Investor defaults, despite significant budget issues faced by many governmental Investors. Additionally, there are practical reasons mitigating the likelihood that a state pension fund or other governmental Investor would renege on its commitment to fund capital contributions. These include the often severe default penalties found in partnership agreements, the bad publicity such Investor would likely receive and the damage the default might cause to the Investor’s credit rating and reputation in the market. Thus, while the potential for such an Investor to claim immunity when a Lender exercises default remedies is nonetheless real and must be considered in connection with formulating each Facility’s borrowing base, the practical likelihood of this happening with frequency in practice may be remote.

Conclusion

There are numerous avenues by which governmental Investors have waived sovereign immunity with respect to commercial contracts. While there are complex legal issues surrounding the interplay between the doctrine of sovereign immunity and the capital commitments of governmental Investors, Funds, Lenders and their respective counsel have vetted many of these issues in connection with prior investments and often have the analysis readily available. Accordingly, after careful review, Lenders are typically getting the comfort they need to include the majority of such Investors in the borrowing base. As no two jurisdictions are the same and the law continues to evolve, it is important for both Funds and Lenders to evaluate governmental Investors individually and stay current on sovereign immunity analysis.

Endnotes

1 See 5 Kenneth Culp Davis, Administrative Law Treatise 6-7 (2d. ed. 1984) (quoting William Blackstone’s Commentaries Book III, Chapter 17 (1765-1769)).

2 Gray v. Bell, 712 F.2d 490, 507 (D.C. Cir. 1983).

3 See Cohens v. Virginia, 19 U.S. 264 (1821).

4 28 U.S.C. §1491.

5 See Hans v. Louisiana, 134 U.S. 1 (1890), Blatchford v. Native Village of Noatak, 501 U.S. 775 (1991) and Alden v. Maine, 527 U.S. 706 (1999) (establishing that the immunity extends to state court).

6 28 U.S.C. §§ 1330, 1332, 1391(f), 1441(d), and 1602-1611.

7 28 U.S.C. §1491.

8 NY Ct of Claims Act §8 (L. 1939, c 860); Cal. Gov. Code §814.

9 See Or. Rev. Stat. §30.320, which requires a government agency to be “acting within the scope of its authority”.

10 For example, New York has vested exclusive jurisdiction in the New York Court of Claims for actions brought against the state of New York (See NY Ct. of Claims Act §8 (L. 1939, c 860)), Michigan, Pennsylvania, West Virginia, Ohio and Connecticut are among other states that have established judicial bodies to hear claims against the state (See Mich. Comp. Laws. Ann.. 600.605; 62 Pa. Consol. Stat. §§1721-1726; W. Va. Code §14-2-1; Ohio Rev. Code §2744.01 et seq.; and Ct. Gen. Stat. §4.142). In order to bring an action against the state of New Mexico under its statutory waiver of contractual immunity (N.M. Stat. Ann. §37-1-23), a plaintiff must (i) bring the claim within two years from the time of accrual, (ii) show that the contract is legally enforceable by pleading the basic elements of contract claims—offer, acceptance, consideration and mutual assent(See Hartbarger v. Frank Paxton Co., 115 N.M. 665, 669 (1993))—and (ii) show that the governmental entity was not acting outside of its designated authority or power (See Spray v. City of Albuquerque, 94 N.M. 199, 201 (N.M. 1980)).

11 Hodges v. Rainey, 533 S.E. 2d 578, 585 (S.C. 2000).

12 Kunzie v. Olivette, 184 S.W. 3d 570 (Mo. 2006).

13 Commonwealth v. AMEC Civil, LLC, 699 S.E. 2d 499, 516 (Va. 2010).

14 Supra note 11.

15 See Tooke v. City of Mexia, 197 S.W.3d 325 (Tex. 2006), which held that a public entity does not waive immunity despite a statutory provision permitting such entity to “sue and be sued.”

16 TSU v. State Street Bank and Trust Company, 212 S.W.3d 893 (Tex. App. 1st Dist. Jan. 11, 2007).

17 Harris Corp. v. Nat’l Iranian Radio & Television, 691 F.2d 1344 (11th Cir. 1982).

18 Marlowe v. Argentine Naval Commission, 1985 WL 8258 (D.D.C. 1985).

19 Creighton v. Qatar, 181 F.3d 118 (D.C. Cir. 1999).

20 See, e.g., Drexel Burnham Lambert v. Committee of Receivers, 12 F.3d 317 (2d Cir. 1993).

21 Seetransport Wiking Trader v. Navimpex Centrala Navala, 989 F.2d 572 (2d Cir. 1993).

22 28 U.S.C. §1605(a)(2).

23 Id.

24 In order to limit its exposure to the US courts, it has been our experience that a number of foreign sovereigns will submit to binding arbitration with the Fund or a Lender.

25 504 U.S. 607 (1992).

26 Id. at 619.

27 See Section 31452 of the California County Employees Retirement Law (Cal. Gov. Code §31450 et seq.), which suggests that the assets of a California county retirement system are generally exempt from levy, execution, assignment, and any other collection process. Notwithstanding the express language of Section 31452 and a lack of certainty related thereto, we think there are good arguments that Section 31452 was intended to protect the pension benefits of the underlying beneficiaries from garnishment and not to shield a California county pension fund from liability for breach of contract.

28 Ky. Rev. Stat. Ann. 45A.245 et seq

29 See W. Va. Code § 14-2-3 (An award by the Court of Claims is a recommendation by the court to the legislature, and is not binding); La. Const Art. XII, §10 (provides for the appropriation of funds by the legislature); and Ct. Gen. Stat. §4.158-160 (for claims in excess of $7,500, the Claims Commissioner may either (i) grant the claimant permission to sue the state agency, in which case the state has waived sovereign immunity or (ii) recommend payment of the claim to the General Assembly, in which case the Assembly may accept, modify or reject the recommendation. Upon rejection, the Assembly may authorize the claimant to sue, or it may reject the claim altogether.).