Subscription Credit Facilities: The Importance of an Investor’s Agreement to Fund Without “Setoff, Counterclaim or Defense”

Executive Summary

Subscription credit facilities rely on the obligations of investors to a private investment fund (“Fund”) to contribute their capital commitments to the Fund when called. From a subscription credit facility lender’s perspective, it is essential that the Fund’s limited partnership agreement (“LPA”) include an express agreement of its investors to fund their capital commitment obligations without setoff, counterclaim, or defense. In this Legal Update, we explain the rationale behind this required LPA language and its related implications for an efficient and effective pursuit of enforcement remedies under a subscription credit facility, potential ramifications of and solutions to address any LPA deficiencies regarding this provision, and related drafting considerations for a facility’s loan documentation.

Background

A subscription credit facility relies upon the obligations of a Fund’s investors to contribute their capital commitments to the Fund as and when called by the Fund or its general partner in accordance with the terms of the Fund’s LPA. The investors’ uncalled capital commitments comprise the facility’s security package, borrowing base, and anticipated source of repayment and are, therefore, central to a lender’s credit underwrite for the facility.

If an event of default exists under the facility, one of the lender’s primary enforcement remedies is to call capital from the Fund’s investors. The lender can either instruct the Fund to call capital from its investors or step into the shoes of the Fund and issue a capital call directly to the investors. In either case, the capital contribution proceeds would be applied to repay the facility.

The core terms governing investors’ capital commitments are found in a Fund’s LPA and subscription documents. As the subscription credit facility market evolved, the industry developed robust LPA provisions specific to subscription credit facilities.¹ Since a lender’s underwriting for and remedies under a subscription credit facility are closely linked to the rights of a Fund and its general partner under the Fund’s LPA in relation to the investors and their capital commitments, lenders and their counsel closely analyze whether the LPA contains these customary LPA provisions—in particular, authorization of a subscription credit facility (and a lender’s necessary related rights)—and identify provisions that could adversely affect a lender’s ability to be repaid via the investors’ capital contributions.

In connection with a subscription credit facility, lenders require an explicit agreement by the Fund’s investors to unconditionally fund their capital contributions without setoff, counterclaim, or defense, including certain defenses under bankruptcy law (referred to herein as the “no setoff provision”). This type of waiver is permitted to be made under general contract law, which allows parties to contractually agree to waive rights or defenses and for courts to enforce such a waiver. As discussed below, the no setoff provision, which is often documented in a Fund’s LPA, increases a lender’s likelihood of effectively calling capital from investors in an enforcement scenario and efficiently pursuing its enforcement rights.

What Lenders Need to Know

Why the No Setoff Provision Is Essential for Lenders

The inclusion of an unambiguous no setoff provision in a Fund’s LPA is one metric for analyzing the strength of the investors’ capital commitment obligations. A key benefit of the no setoff provision is that it demonstrates that investors recognize the commitment to fund their capital commitment obligations regardless of the circumstances (i.e., that their obligation is absolute and unqualified). This is particularly relevant from a lender perspective in an enforcement scenario where an event of default under the facility has occurred. The no setoff provision bolsters the likelihood of a lender prevailing against the Fund and its investors if, should a facility event of default occur, the lender is left with a payment deficiency and must seek recourse against the Fund and/or any investor that challenges the lender’s right to call capital. A no setoff provision should aid a lender in efficiently pursuing its enforcement rights, mitigating the risk of delays and investor disputes and allowing lenders to exercise their rights with greater certainty of recovery.

While there are various theories of recovery that a lender could assert against investors (e.g., breach of contract, reliance, promissory estoppel, or unjust enrichment),² a breach of contract claim is the focus of the no setoff provision.

Material Breach Defense Under General Contract Law and Avoiding Potential Offsets:

The no setoff provision mitigates the potential risk of an investor raising a defense to funding a capital call to repay the subscription credit facility. An investor may argue that, as a matter of general contract law, the investor has a defense and should be excused from further performance of its obligations to the Fund because the Fund or its general partner has separately materially breached its obligations under the LPA or subscription documents (e.g., due to a key person event, mistake, gross negligence, mismanagement, or investor disappointment in the Fund’s performance). An investor may also challenge its obligation to fund in response to a lender’s capital call on the belief that the lender and the Fund should resolve the facility default between themselves rather than allow the lender to call directly upon the investor.

The no setoff provision furthers a lender’s goal of mitigating the risk of an investor’s capital commitment obligations being offset against obligations owed by the Fund or its general partner to the investor. Ultimately, from a lender’s perspective, disputes between investors and a Fund (or its general partner) should not be a risk allocated to a lender and should not reduce the amount of the available commitments that can be called to repay the facility, or otherwise delay the facility’s repayment via capital calls. Rather, those disputes should apply only between the Fund (or its general partner) and the investor (and the investor may expressly agree with the Fund to subordinate any such claims to a lender’s claim to prior repayment in full under the facility).

Both statutory law and case law are protective of creditors’ rights in this respect. Recognizing that lenders would be less willing to extend credit to a Fund without assurances that the investors are absolutely obligated to honor their capital commitments, courts have emphasized protection of the rights of outside parties that rely on investors’ capital commitments when making loans to a Fund and are reluctant to excuse an investor’s capital commitment obligations.³ A subscription credit facility’s loan documentation usually evidences this type of lender reliance via specific references in representations and warranties and covenants to capital commitments as credit support for the facility.

Although case law provides favorable authority supporting the enforceability of investors’ capital commitments, even in a scenario where the Fund or general partner has committed a material breach or where there is no contractual waiver by the investors, it is strongly recommended to require a no setoff provision in the LPA to further mitigate any material breach defense. If an investor raises a defense, counterclaim or offset argument to support its refusal to fund a capital call to repay a facility, it would benefit a lender to have an express no setoff provision in the LPA to effectively estop an investor’s assertion of a defense to funding a capital call to repay a facility.

Consequences of an LPA Without a No Setoff Provision:

In light of the benefits of the no setoff provision outlined above, many subscription credit facility lenders view an LPA that lacks a no setoff provision as un-“bankable” and will request an LPA amendment to address this deficiency.

In certain instances, a potential alternative to pursuing an LPA amendment may be for a lender to require delivery of individual investor letters. Each investor letter would run directly in favor of the lender and include a no setoff provision in connection with capital calls issued to repay the facility. Whether this solution is practicable depends on the profile of the Fund’s investor base (e.g., if its investor pool is relatively small or highly concentrated in a few key investors).

Why Investors Agree to a No Setoff Provision

Given the substantial growth of the fund finance market over the past few decades and the development of industry standard LPA provisions for subscription credit facilities, sophisticated investors experienced with the product recognize the no setoff provision as a standard industry measure that aligns with the subscription credit facility’s role in fund finance. In the absence of a subscription credit facility, investors would typically fund capital commitments earlier, directly assuming that timing risk. A subscription credit facility effectively defers this obligation, making the no setoff provision a fair requirement to support the lender’s rights in enforcement scenarios.

An investor can take comfort from the following circumstances:

1. Adherence to LPA Limitations. Typically, both the facility’s loan documentation and the LPA provisions require that any capital calls issued by a lender must adhere to the requirements of the LPA and subscription documents, including, for instance: (i) the timing for funding capital calls; (ii) any applicable protections against funding in excess of an investor’s unfunded capital commitment; and (iii) any applicable stipulations that an investor is not required to repay indebtedness incurred for a purpose for which the investor is not required under the LPA’s terms to fund.
2. Retention of Separate Claims. Frequently LPA language expressly provides that, despite the no setoff provision and an investor’s absolute requirement to fund a capital call to repay a subscription credit facility, the investor retains the right to separately bring a counterclaim, offset, or defense against the Fund or its general partner (subject to subordination of the claim in favor of the facility’s repayment).

Side Letter Issues

Even if the LPA includes a no setoff provision, lenders should be mindful that the agreement could be rescinded or limited via a side letter. A side letter provision stating that the investor does not agree to fund without setoff, counterclaim, or defense sometimes arises (1) due to tax or ERISA considerations or other state statutory limitations, or (2) in the context of a governmental investor or other actor that enjoys sovereign immunity under the Eleventh Amendment of the U.S. Constitution or a state constitution. Unless there is mitigating language for funding capital contributions in connection with a subscription credit facility or the investor separately delivers an investor letter that contains a no setoff provision, it may be appropriate to exclude the investor from the facility’s borrowing base.

Related Credit Agreement Drafting Points

While a lender can take comfort from an LPA’s inclusion of a no setoff provision, a subscription credit facility’s loan documentation often contains related protections to further enhance a lender’s certainty over and monitoring of the investors’ creditworthiness and the continued strength of their capital commitment obligations, including:

1. Representations. Representations and warranties that the loan parties do not have knowledge of (i) any defense or circumstance which, with the passage of time or giving of notice, could constitute a default under the LPA or subscription documents, which would constitute a defense to any investor’s obligation to fund capital contributions pursuant to a capital call; or (ii) any claims of offset or any other claims against any loan party that could diminish or adversely affect the obligations of any investor to fund capital contributions pursuant to a capital call.
2. Borrowing Base. Investor exclusion events tied to an investor (i) repudiating, challenging, or declaring unenforceable its capital commitment obligations or otherwise disaffirming any provision of the LPA or subscription documents; or (ii) becoming a “defaulting limited partner” under the LPA.

Key Takeaways

It is important for an LPA to include a no setoff provision—that is, an express, unconditional agreement of the investors to fund without setoff, counterclaim, or defense. This contractual waiver provides a subscription credit facility lender with comfort that the investors’ obligations to fund when called are absolute obligations and that the lender would be able to call capital from the investors for an efficient repayment of the facility. An LPA that lacks a no setoff provision presents a potential risk that undermines a lender’s expected efficient enforcement rights. The omission may, in an enforcement scenario, ultimately reduce the amount available to be called from the investors to repay the facility or otherwise delay the lender’s ability to obtain the funds from the investors. Requiring a no setoff provision in the LPA is recommended to strengthen a lender’s enforcement objectives.

¹ For additional information on customary subscription credit facility LPA provisions, please see our Legal Update: Model LPA Provisions for Subscription Credit Facilities.

² For more detail regarding theories of liability under which a Fund and a subscription credit facility lender can enforce capital commitments, please consult our Legal Update: Enforcement of Forms of Credit Support in Fund Finance.

³ For further detail about the enforceability of capital commitments in subscription credit facilities, please refer to our Legal Update: Enforceability of Capital Commitments in a Subscription Credit Facility.