Scrutiny in Private Credit – Potential Disputes Market Participants Should Watch Out For

The private credit market has quickly expanded to a multi-trillion dollar industry, but the legal landscape is still evolving, and recent scrutiny of the asset class could result in litigation that shapes the framework for years to come. Understanding and proactively mitigating potential areas of litigation can help market participants avoid costly disputes. O’Melveny has assembled an interdepartmental group addressing the private credit issues discussed below.

Key Takeaways:

• The increased attention on the private credit market may result in rising litigation risks in areas like securities fraud, inter-lender disputes, fraudulent transfers, fund manager claims, and ERISA violations.
• Market participants can mitigate risk now by ensuring accurate disclosures, carefully conducting lender due diligence and continual monitoring of borrowers’ financial health, and ensuring precision in credit agreement and amendments.

Background

As discussed in prior client alerts, private credit involves a loan outside of the public markets, underwritten and provided by non-bank lenders. The key features of flexibility, confidentiality, and speed of execution, are particularly advantageous to middle-market borrowers seeking capital through alternatives to traditional bank loans. Typical private credit lenders include asset managers, private funds, and other non-bank entities, whose investors often include pension funds, insurance companies, private wealth funds, and high net worth individuals, but private credit has also expanded to enable retail investors and institutions to take advantage of the market. Business development companies, or “BDCs”, pool private credit loans and can trade shares on public exchanges like the NASDAQ and the New York Stock Exchange. Over the last few years, the market has rapidly increased and is projected to become a $5 trillion industry in the coming years. 

The last few months have brought increased scrutiny. According to Fitch Ratings, private credit redemption rates are experiencing increasing upward pressure, and non-traded BDCs are receiving redemption requests that exceed their standard 5% limits.  Markdowns of BDCs’ net asset values have increased attention on how private credit fund managers value their portfolios, and recent advances in artificial intelligence have raised investor concern about the private credit market’s exposure to the risk of disruption in the software sector.

BDCs, alternative asset managers, investment banks, and borrowers should be aware that this increased attention could result in amplified litigation risk that can be mitigated now, particularly in five primary areas.

Litigation Risks

1) Securities Fraud Litigation 

BDCs and their executives have seen an uptick in class action lawsuits bringing securities-related claims under Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. Plaintiffs who have brought such claims in recent months have argued, for example, that BDCs made material misrepresentations in their public disclosures about the firm’s liquidity and net asset value, and the general health of the portfolio. 

Companies can mitigate this risk by carefully evaluating the accuracy of their disclosures. Companies should ensure that their public communications appropriately reflect the value of the portfolio and its qualities, the current redemption environment, liquidity constraints, and their valuation methodology and process. Firms should also implement robust disclosure procedures and maintain D&O insurance sufficient to match the risk of potential disclosure-related litigation.

2) Inter-Lender Litigation 

Private credit lenders may see a potential rise in inter-lender litigation stemming from liability management exercises (or “LMEs”), whereby lenders restructure credit arrangements through credit agreement amendments. As discussed in prior client alerts, liability management exercises are more prevalent in the broadly syndicated loan market than in private credit, where lender groups tend to be relationship-driven and thus less motivated to be adversarial. But, since the private credit market has expanded to include larger groups of lenders, liability management maneuvers may grow and can quickly result in various litigation claims such as breach of contract, breach of the implied covenant of good faith and fair dealing, and tortious interference. 

Clarity in credit agreement and amendment drafting is key to mitigating risk of LME litigation, and parties should carefully consider their tactics when engaged in an LME.

3) Fraudulent Transfer Litigation 

If distressed private credit borrowers file for bankruptcy, private credit lenders that received transfers from the debtor could be targeted by bankruptcy trustees in fraudulent transfer litigation. Although defenses may exist, the theory would be that the borrower made these transfers while it was insolvent without receiving reasonably equivalent value in return. To avoid this litigation risk, lenders should consistently monitor borrowers’ financial health, and consider structures for lending that can mitigate fraudulent transfer risk.

4) Claims Against Fund Managers 

Fund managers may face the potential claims of breach of fiduciary duty on the theory that they failed to conduct adequate due diligence of borrowers, failed to sufficiently monitor borrower and portfolio health, or delayed a restructuring or enforcement of remedies. 

To mitigate against such claims, funds should ensure accurate disclosures to the public, robust due diligence procedures of borrowers, consistent and documented valuation procedures, and close monitoring of borrowers’ financial health. 

5) Potential ERISA Claims 

If private credit funds experience increased stress, there may be increased litigation under the Employee Retirement Income Security Act of 1974 (ERISA), claiming plan fiduciaries breached fiduciary duties with respect to private credit investments. 

Plan fiduciaries should ensure they have a robust due diligence process and properly evaluate liquidity restrictions and fee structures to ensure compliance with their duties. 

Implications 

Given the current increased attention to the private credit market, some litigation has already been filed against BDCs and asset managers, and market participants should watch for similar litigation to arise in the coming months. These early cases will be key in setting the legal landscape, but in the meantime, market participants can significantly mitigate exposure.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Matthew W. Close, an O’Melveny partner licensed to practice law in California; Pamela A. Miller, an O’Melveny partner licensed to practice law in New York; Jennifer Taylor, an O’Melveny partner licensed to practice law in California; Meaghan VerGow, an O’Melveny partner licensed to practice law in the District of Columbia and New York; Glen Lim, an O’Melveny partner licensed to practice law in California and New York; and Lauren M. Wagner, an O’Melveny partner licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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