Proposed Change to Rated Note Funds Could Disrupt Bankruptcies

Insurance companies deploying capital have increasingly accessed the private equity and private credit markets, using structures that allow such investors to take advantage of favorable regulatory capital treatment from insurance regulators. These transactions are typically set up using a rated note feeder structure.

With the growing popularity of the product, a subgroup of the National Association of Insurance Commissioners underwent a lengthy review process to determine whether any safeguards needed to be instituted. In addition, there was more scrutiny of the standard inclusion of an equity component in the structure to accompany the debt under the notes—as a separate way to access the capital.

This is because the favorable regulatory capital treatment afforded insurers is based on its debt holdings, not equity. The NAIC recently published proposed changes to its accounting guidance, with the goal of implementing new standards to go into effect next year.

Structure

Under the rated note feeder structure, insurance companies make their investments through rated notes issued pursuant to a note purchase agreement or an indenture. Lenders have been creative in structuring these deals to address certain enforceability issues.

Among these issues is the applicability of Section 365(c)(2) of the US Bankruptcy Code. Under the code, contracts to make equity payments are deemed executory contracts that will be recognized in bankruptcy, but contracts to make payments to fund a debt commitment aren’t.

Therefore, some lenders are concerned that the requirement for investors to fund capital calls pursuant to a rated note may not be enforceable in bankruptcy. The relevant code section indicates the trustee in bankruptcy may not assume or assign any executory contract if such contract “is a contract to make a loan, or extend other debt financing or financial accommodations for the benefit of the debtor or to issue a security of the debtor.”

To avoid this outcome, a common feature of a rated note feeder is a split in the insurer’s investment so that a small portion of the investment is in the form of equity, with a convertible component that allows the debt to be converted to equity at a designated time to avoid issues with bankruptcy courts in a default scenario. Though this structure has yet to be tested by a court, the structure is commonly used to blunt bankruptcy court concerns.

But this approach gives rise to a separate bankruptcy concern: If the conversion from a debt to an equity funding obligation is tied specifically to a bankruptcy, the mechanism may violate the code’s ipso facto clause, which negates provisions (other than acceleration) of debt documents that are activated by the filing of a bankruptcy case.

This convertible feature is a key issue that has raised concerns with insurance regulators. The favorable regulatory capital treatment is tied to the debt feature of the rated notes because a rated debt obligation is viewed as a place for insurers to invest premiums safely and ensure there are funds available to pay insurance claims.

When the NAIC signaled its intent to review this structure, there was some concern among lenders and sponsors regarding the outcome of this review and any potential adverse impact to the market. Those concerns can now be allayed.

Guidance Factors

The proposed changes to NAIC accounting guidance will require a test that each insurer must implement with respect to rated note feeder and similar products. The guidance sets out several factors to consider on a case-by-case basis in determining whether debt collateralized by equity interests can be characterized as a bond evidencing a creditor relationship.

The factors to consider in making this determination include, among others:

• Number and diversification of the underlying equity interests
• Characteristics of the underlying equity interests
• Liquidity facilities
• Overcollaterization

The new rules will go into effect in 2025. The guidance expressly states that “if the feeder fund debt ultimately relies on equity interests for repayment” then “the held debt instrument from the feeder fund would have to meet the requirements [set forth above] while looking at the substance of equity interests supporting the debt.”

The guidance suggests that each feeder fund structure, presumably even existing structures, will require an entity review and “the conclusion that a structure represents a feeder fund shall not automatically qualify the structure for bond classification but shall not automatically preclude bond classification. Substance over form should be the determining factor in these and similar situations.”

Time to Prepare

Because the new rules are still in process of being finalized and won’t be effective until next year, lenders, sponsors, and insurance providers have time to review their products to ensure compliance.

Lenders, insurers, and sponsors should anticipate the publication of the final changes to the accounting standards and review them carefully. This will help them determine if the rated note feeder fund structures on their books are properly structured to continue to yield the favorable regulatory capital treatment that its insurance company investors seek.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jim Lawlor is a member in the financial industry group at Reed Smith.

Chris Davis is partner in the financial industry group at Reed Smith.

Cheryl Lagay is partner at Reed Smith with focus on commercial lending transactions.

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