In a typical acquisition closing, the target company’s debt must be paid off, and related liens released. To facilitate this process, an acquiring company often has to absorb any target company letters of credit which exist in the hands of third-party beneficiaries, including unfavorable pricing or other adverse terms which may exist – a necessary tradeoff, with the adverse L/Cs later dealt with on a post-closing basis. However, if the number or amount of target L/Cs is large enough, another option exists: entering into new arrangements with the target L/C banks to improve terms by, essentially, importing the L/Cs into the acquiring company’s business.

In a recent large ($3b+) strategic acquisition in the engineering & construction space, we at Fried, Frank, Harris, Shriver & Jacobson LLP represented a Fortune 250 acquiring company faced with a large ($100m+) existing letter of credit usage at the target company. As is typical in this context, all of the target L/Cs had to be satisfied, and the companion liens released, as part of the overall payoff of the target’s main debt facility concurrent with the closing of the acquisition.
The L/C satisfaction process was flagged as a transaction gating item because some of the typical methods for dealing with target L/Cs were disfavored by the acquiring company.

Why are Target L/Cs a problem?
The presence of third-party L/C beneficiaries can create timing issues in connection with ‘satisfying’ target L/Cs as part of an acquisition closing. The L/C beneficiaries have little incentive to assist in facilitating a smooth transaction closing. The underlying business requirement (whether by contract, statute, regulation or other business arrangement) to which any L/C relates is generally unaffected by the target company’s change of ownership. In fact, the very nature of an L/C, as a type of cash substitute, inoculates the beneficiary and makes them indifferent to whether the closing occurs timely or at all. This creates a tension with the target company’s L/C provider, whose credit facility otherwise must typically be repaid due to the underlying ‘change of control’ that is occurring – because the payoff cannot proceed if L/Cs continue to exist in possession of uncooperative or transaction-indifferent third parties.

Typical solutions for satisfying target L/Cs – disfavored here
There are several methods typically used to, essentially, economically ‘defease’ the target company L/Cs as part of an acquisition closing. However, this normal playbook was not helpful in our transaction for the following reasons:
Rolling. Since the acquiring company was retaining its revolving credit facility on a post-closing basis in lieu of establishing a new or refinanced facility, the method of “rolling” target L/Cs into a new facility (by including them as specifically ‘covered’ L/Cs) could not be availed. Similarly, amending the acquiring company’s existing facility to accomplish the same result was not desired, since, (i) as a practical matter, not all of the target L/C issuers were party to the acquiring company’s facility, and (ii) more importantly, the acquiring company did not want to reduce its revolver availability by the $100m+ face amount of the Target L/Cs.
Backstop. The issuance of a ‘backstop’ L/C under the Acquiring Company’s revolver, in favor of the Target L/C issuing banks (as beneficiaries), in a face amount equal to the target L/C aggregate (or even slightly more – 105 percent is a common sizing in this situation), was not desired since this would also reduce the acquiring company’s revolver availability.
Replacement. It was similarly not possible to have replacement L/Cs issued by the acquiring company’s L/C issuer and available for a simultaneous swap at closing with each target L/C beneficiary due to issues involving administrative complexity and reduced revolver availability, as noted above.
Cash Collateral. Sometimes, for simplicity, cash collateral (at 105 percent of face amount) can be deposited at closing with the target’s L/C issuing bank in order to facilitate lien release and payoff mechanics, especially when the amount/number of Target L/Cs involved is small and the certainty of overall deal execution overrides the obvious economic inefficiency of this method. However, the use of cash collateral was not a practical solution in our situation due the economics involved.

New playbook – individualized bilateral arrangements
Since the above options were not favored by the acquiring company, the approach instead was to seek newly negotiated go-forward bilateral L/C agreements with the target’s L/C issuers. As a threshold matter, this necessitated cooperation from the target’s treasury function, the target’s agent bank (whose overriding concern was to obtain complete release from any liability relating to the target L/Cs), and the target L/C issuers themselves (which consisted of four major money center banks). The acquiring company felt (correctly) that the target L/C issuers would strongly desire a continued and expanded banking relationship with the new, much larger, post-acquisition company, and so as a first step sought confirmation of the following business terms:
Pricing. Target L/C pricing would be re-set to match the acquiring company’s existing L/Cs.
Unsecured. Target L/Cs would be changed in character from secured obligations to unsecured.
Conformity. Although the target L/Cs would exist as debt external to the acquiring company’s existing revolver (and thus not reduce revolver availability), any covenants, financial reporting, defaults or other deal terms in the target L/C bilaterals would track the acquiring company’s revolver for reasons of administrative simplicity.
Reimbursement vs. Continuing. A range of bilateral functionality was possible: the simplest was to structure just a reimbursement obligation in respect of the target L/Cs; more complex was to establish ‘continuing’ L/C agreements, which would allow for the amendment or continuation of the target L/Cs as well as the ongoing issuance of new L/Cs, either at the target or acquiring Company level, or both.

The Negotiated Result
Based on past experience, we were aware that L/C operations and practices among the different banks varied significantly. Thus we first offered a simplified approach to all banks and proceeded accordingly.

Simplest approach – reimbursement Only. The bank with the smallest L/C exposure (about 10 percent of the target L/Cs) readily agreed to the simplest form: a straightforward reimbursement obligation covering only the target L/Cs that existed at closing. For this agreement, we extracted the reimbursement mechanics contained in the target’s existing L/C agreement, as well as other existing tax gross-up, indemnity, ‘waiver of defense’ and customary legal protections, and built the language into a short and simple agreement (about five pages). The only new provision related to the L/C fees, to which we cross-referred to the acquiring company’s revolver as to fee amount and mechanics. Since this agreement offered limited go-forward utility, the acquiring company’s objective would be to ‘run-off’ these L/Cs over time, and replace them with L/Cs issued under one of the more robust agreements negotiated, as below.

‘Continuing’ agreement. The other banks sought more complex forms, in all cases covering not only the reimbursement of the Target L/Cs, but also allowing for the amendment/extension of such L/Cs and the issuance of new L/Cs on a go-forward basis, at each bank’s discretion or per other criteria specified in the applicable form. These bilaterals varied as to whether L/Cs could be issued for the account of the target only, or the acquiring company only, or both, and thus called into play whether an acquiring company guaranty or other supporting documentation was required. Each agreement also contained bespoke detail as to payment mechanics, as well as a negotiated suite of representations and warranties, covenants, defaults and reporting requirements. In some cases these tracked the acquiring company’s existing revolver (which was our desired approach), but in other cases they did not. The most common points negotiated across all facilities were: (i) our insistence that any ‘automatic debit and setoff’ provision be limited in applicability to the situation where a payment or other material breach had occurred and was continuing and (ii) qualification of the various covenants and defaults with materiality, or having such provisions relate only to the Acquiring Company and its material subsidiaries, rather than a broader applicability.

Payoff letter. The target debt facility agent followed the L/C negotiations closely, and at the closing required a provision in the payoff letter/lien release stating that the existing L/Cs would remain outstanding, but be subject to reimbursement arrangements satisfactory to each L/C Bank. All L/C banks signed the payoff letter and indicated their acceptance of the identified arrangements.

In summary, repositioning Target Company L/Cs into one or more bilateral agreements that exist external to the acquiring company’s own working capital (and L/C) facility is an option that can prove useful in an acquisition closing context.

Howard Fine is special counsel, and Brian Sullivan is an associate, in the corporate department and finance practice of Fried, Frank, Harris, Shriver & Jacobson LLP.