In recent years, there has been much written about the rise of borrower-friendly loan terms in leveraged lending. But overlooked in the literature is a set of unorthodox practices outside of the loan documents that may also undermine lender protections. Specifically, sponsors who borrow for their leveraged buy-outs routinely designate and pay their lenders’ counsel. This process, called borrower-designated lenders’ counsel (or simply “designation”), has been labeled “insidious” by the New York Times and “the most problematic issue in corporate law” by Law.com. It has also sparked regulatory concern in Europe.

In “Lend Me Your Counsel,” we provide the literature’s first detailed examination of designation in the United States. Relying on proprietary training materials for lawyers and original interviews with leading lawyers in this space, we flesh out the contours of designation, explain why it arose and has endured, and consider its implications, including for attorney ethics and transactional efficiency.

The Bake-Off

When private equity sponsors make bids for target companies, they are engaged in two parallel transactions. In the first—the M&A auction—sponsors bid for the target company. In the second, sponsors conduct a parallel financing auction in which lenders compete to offer the best loan terms to them.

During this second “bake-off” process, a sponsor designates one single law firm to represent all potential lenders. Different teams at that one law firm then negotiate loan terms on behalf of each potential lender. The winner (or winners) of the bake-off provides a commitment letter to the sponsor, who will present it as part of its bid in the M&A. And if the sponsor wins the M&A auction, the winning lender or lenders finance that deal.

For lawyers, being designated can be a lucrative business: If the M&A occurs, there will be follow-on work involving the same target company, including amendments, recapitalizations, and tack-on acquisitions. The designated law firm can also expect repeat designations if the sponsor is satisfied with its work. Since designation has become the norm in mid- and large-cap leveraged buy-outs in the United States, the fate of lender-side lawyers depends heavily on how many designations they secure from sponsors.

Why Designation Arose and Endures

The article provides a nuanced explanation of designation. To do so, it draws on attorney training materials, practitioners’ literature, and original interviews with leading lawyers. We identify several explanations for designation’s prevalence.

Efficiency. Designated law firms generally have one central team of lawyers that conducts due diligence on the target company and shares the results with all lenders, which cuts costs. In addition, designated counsel may be more familiar with market norms and sponsors’ standard loan documents because they are repeat players.

Bargaining power. Borrowers have gained more power than lenders in recent years, and many lawyers reported that this change in bargaining power cemented the practice of designation. Lenders have been flush with funds and chased lending opportunities, which generate fees.

Industry recognition. Banks compete aggressively for “lead-left” lender status—that is, the status of being the primary lender for a transaction. Lead-left status improves rankings in league tables, which banks rely on when pitching clients or reporting to shareholders. For many banks, acquiescing to the sponsor’s designated counsel for them is one price they pay to win the lead-left status.

Syndication. Banks often syndicate their loan interests, meaning that they rarely end up holding the debt. With less skin in the game, they’re less concerned about legal representation and the loan protections eventually agreed—except to the extent that these provisions matter to buyers of the debt. As one interviewee noted, “These [lenders] are really thinking, ‘What can we sell to the market?’ not ‘What do we have to take the risk on?’”

Counsel’s incentives. Lender-side counsel are better compensated under designation. Without designation, lender-side counsel would be compensated only if (1) the sponsor wins the M&A bid, and (2) the counsel’s client (a particular lender) is selected in the bake-off. But with designation, one law firm represents all lenders in a bake-off, so that firm is sure to be paid as long as the sponsor wins the M&A bid. Designation also provides lucrative follow-on work for designated counsel.

Perhaps because of these incentives, lawyers on both sides reported that sponsors expect designated counsel to be “user-friendly” to sponsors. According to one deal lawyer, the point of designation is to make sure that lenders’ counsel “do not bust our [sponsors’ counsels’] chops too much when we ask for certain terms.” Or, as another lawyer put it, designation “keeps [designated] lawyers from trying to be heroes and raising a million points [during the negotiation].”

Even lender-side lawyers made clear that sponsors can discipline designated counsel. As one lawyer put it: “My client is the lender, but who’s going to give me future work? . . . It’s going to be from the sponsor.”

And when lenders’ counsel fall short, they face the “penalty box” and may not be designated for some time.

Accordingly, our interview evidence suggests that lenders’ counsel often succumb to their incentives. The risk is greatest for firms dependent on the business of a small number of sponsors. Interviewees reported that designated counsel “know what side their bread is buttered on . . . and they want the next designation.” Several lenders’ counsel regarded “other firms,” but not their own, as bowing to sponsors’ demands. Still, as one admitted, “[t]he shadow of the sponsor has to be having some kind of impact on the process” for all firms.

Implications

The complex incentives surrounding designation have theoretical and practical implications, which we discuss more deeply in our article.

Attorney ethics. Can lawyers selected and paid for by a client’s bargaining opponent be zealous, loyal counselors? While the New York State Bar has blessed designation, it did so based on simplified assumptions. In the article, we suggest that designation is fraught and that more careful attorney disclosures and regulator investigation may be in order. We also highlight the role of sponsors’ counsel, some of whom have the power to make or break the careers of lenders’ counsel.

Bargaining and process. Designation’s incentives may create impediments to bargaining, undermining the optimality of deals between sponsors and lenders. Sponsors often expressly limit how much lenders can use designated counsel and designated counsel who are perceived by sponsors as over-lawyering may not be designated again in the future. As a result, designated counsel may feel pressure to under-lawyer, skewing bargains in favor of the sponsor-borrower.

Law and economics has long held that, given the right conditions, sophisticated parties will reach optimal nonprice terms in their contracts, thus maximizing joint surplus. Yet emerging scholarship critiques this position, and designation lends further credence to that critique.

Financial stability and systemic risk. Suboptimal credit terms resulting from transactions with designated counsel may adversely affect the financial health of lenders and other leveraged-loan holders. Lenders that syndicate their loans are not directly exposed to the risk of those loans. Instead, they offload their loan exposure to others. This offloading of risk may weaken banks’ resistance to designation and any excessively lenient loan terms that result. More broadly, given the mammoth size of the leveraged-lending sector, poor lending standards may portend financial instability throughout markets, affecting banks, direct lenders, and others.

The article, forthcoming in the Southern California Law Review, is available here.