Covenants 101: Controlling the Vote – Disqualified Lenders – Part 2

Legal Research: Magnus Wieslander; Julian Bulaon

In this special Covenants 101 series, we explore the evolution of the various tools that borrowers and sponsors can use to “control the vote” in connection with a majority-led “consensual” liability management exercise, such as anti-cooperation provisions, voting caps, affiliated lender assignments and yank-a-bank provisions.

In this latest installment, we discuss the provisions governing assignments of term loans to “disqualified lenders,” which have taken on new relevance in light of recent years’ LME exercises where the borrowers can proactively prohibit particular entities from becoming lenders, thereby shaping the composition of the lender group.

Part one of this installment, published on Aug. 5, outlined the common architecture of disqualified‑lender provisions found in most credit agreements. In this part two, we examine aggressive, borrower‑friendly deviations from the standard regime and their implications for the parties and the wider market.

***

Key Takeaways

• Disqualified lender, or DQ lender, provisions are an important tool for sponsors and borrowers to prevent competitors or other opposing interests from gaining access to sensitive information about the borrower’s business and from becoming lenders or participants under the credit agreement.
   
• Almost all U.S. credit agreements include DQ lender provisions that generally follow the LSTA’s general structure, but during the seller’s market in recent years, more borrower-friendly DQ lender provisions have been incorporated in many U.S. credit agreements.
   
• The market is rife with borrower-friendly DQ lender provisions, many of which may not pose material risks in isolation but, when combined, can create a minefield for lenders. Key examples include: (1) the ability to disqualify lenders at any time, (2) automatic disqualification of certain lender categories, (3) retroactive disqualification of existing lenders, (4) the right to force out DQ lenders at the current trading price, and (5) restrictions on DQ lenders obtaining exposure through derivatives.
   
• Lenders, especially in the distressed space, should educate themselves on aggressive DQ lender provisions and develop standards for acceptable provisions as part of their covenant review in connection with potential investments.
   

Increasingly Bespoke and Aggressive Disqualified Lender Provisions in US Leveraged Loan Documentation

As a quick recap of part one’s exploration of disqualified lender, or DQ lender, provisions, the LSTA model provisions generally allow the borrower to disqualify, or DQ, any institutions prior to the signing of the commitment letter or credit agreement and also lets the borrower DQ competitors of the borrower after signing. Assignments to DQ lenders are not null and void, but the borrower can exercise certain remedies against DQ lenders, including to “yank” them out of the lender group at the lower of par and the price for which the DQ lender acquired the loan.

In recent years, sponsors and borrowers pushed for more borrower-friendly DQ lender provisions, many of which have made their way into the market. In light of the increased focus on DQ lender provisions in 2025, Octus analyzed the DQ lender provisions in 167 broadly syndicated loan agreements that were executed in the first half of 2025. Out of these, 115 were substantive amendments to existing credit agreements and 52 were new credit agreements (or amendments and restatements), of which 21 were acquisition financings, 25 were refinancings and six were dividend recaps. We have excluded pure term loans repricings from our sample since the terms of the repriced term loans typically otherwise remain unchanged.

In this article, we report on the aggressive deviations from the LSTA model we have seen, the prevalence of such deviations and their implications for the market.

Expanding the Scope of Disqualified Lenders

One way in which sponsors and borrowers have sought to expand their ability to use the DQ lender provisions is to expand the definition of “Disqualified Lender,” thereby increasing the borrower’s control over who can become a lender. Below, we discuss the two primary ways we have observed in which the borrower may expand the DQ list: (1) allowing the borrower to designate noncompetitors as DQ lenders post-closing, and (2) the automatic disqualification of certain lender categories, which requires no action on the part of the borrower.

Ability to Designate DQ Lenders Post-Closing

As shown in the table below, it has become common for the borrower to be able to DQ noncompetitors from time to time (including after signing). About 46% of all credit agreements in the entire sample allow the borrower to add noncompetitor institutions to the DQ list post-closing, of which approximately one-third (or 15% of the total sample) allow disqualification without the agent’s consent. Of new credit agreements in the first half of 2025, the share that allows for post-closing designations of noncompetitors is even greater (58%, of which approximately one-third (19% of all new credit agreements) allow disqualification without the agent’s consent). Notably, although far less common, certain credit agreements include a more targeted post-closing designation right, letting the borrower disqualify distressed investors at any time (about 1% of the total sample).^[1]

Automatic Disqualifications

It is also relatively common for credit agreements to automatically disqualify certain categories of entities – that is, without the borrower having to specifically DQ any particular entity within that category.

Lenders should make sure to be aware of any automatic disqualifications, since any lender that falls or may fall into an automatically disqualified category is effectively retroactively disqualified from the moment they become lenders (which, as discussed below, could have very onerous consequences). Further, formulations disqualifying a group of lenders without naming any lenders individually may introduce uncertainty and subjectivity as to who is, in fact, a DQ lender.

As shown in the table below, the most common automatically disqualified lender categories are (1) affiliates of the arrangers/lenders that are either sell-side advisors or engaged as principals in private equity, mezzanine financings or venture capital (often referred to in the documentation as “Excluded Affiliates” or “Excluded Parties”; 14% of total sample, 25% of new credit agreements), and (2) lenders that have misrepresented their status as net short lenders (8% of total sample, 21% of new credit agreements). Less common, but more aggressive, are automatic disqualifications of distressed investors (1% of total sample, 4% of new credit agreements). Other uncommon categories of automatically disqualified lenders include (1) lenders that have assigned, or sold or purchased participations in, the loans in violation of the assignment provisions, (2) entities that become competitors after the closing date, (3) major suppliers, (4) entities that have been, or threaten to be, in material litigation with the borrower, and (5) entities that fail to meet industry-specific requirements such as having requisite regulatory licenses or approvals.

Expanded Consequences of DQ Designations and Remedies Against DQ Lenders

Sponsors and borrowers have also sought to expand the effects of DQ’ing a lender, thus making it a more effective tool to exert influence. Below, we discuss four of the primary expansions we have observed of the use and consequences of DQ lender designations: (1) allowing the borrower to DQ existing lenders by giving DQ lender designations retroactive effect, (2) allowing the borrower to yank DQ lenders from the lender group at the current trading price, (3) prohibitions on entering into derivative arrangements with DQ lenders, and (4) stripping DQ lenders of various fundamental rights, such as rights to share in the collateral and receive interest payments.

Giving Disqualifications Retroactive Effect

Most credit agreements provide that DQ designations do not have “retroactive effect,” i.e., the borrower is not allowed to treat an existing lender as a DQ lender by adding it to the DQ list (although there are nuances to this – a competitor of the borrower can usually, including in the LSTA’s model language – be DQ’ed even in the rare situation where an existing lender subsequently becomes a competitor).^[2]

In recent years, however, the “no retroactive effect” language has been limited or removed from some credit agreements, thereby allowing retroactive disqualifications of all or a subset of noncompetitor categories of DQ lenders. This gives the borrower the ability to kick existing lenders out of the lender group at any time.

As shown in the table below, 15% of the documents in our sample (and 29% of new credit agreements) lack “no retroactive effect” language for at least one noncompetitor category (most commonly only for sell-side advisors, net short lenders or other narrow, less aggressive, categories). A few credit agreements in our sample (2% of the total sample and 6% of new credit agreements), however, permit the borrower to retroactively DQ any noncompetitor lender, or any loan-to-own investor, post-closing. In addition, any automatically disqualified lender categories are typically not subject to “no retroactive effect” language, which effectively means that they can be yanked out of the lender group at any time.

The ability of the borrower to yank existing lenders out of the lender group could be a powerful lever for borrowers, for example if a lender does not want to go along with a proposed transaction. Therefore, lenders should make sure that they are aware of any categories of lenders that can be DQ’ed retroactively that they may fall into.

Ability to Yank DQ Lenders at Current Trading Price

As explained in part one of this article, the LSTA model language, as well as most credit agreements, permit the borrower to yank DQ lenders at the lesser of (1) par and (2) the price at which the DQ lender acquired its term loans. However, 19% of the documents in our sample (and 21% of new credit agreements) expand this menu to the lesser of (1) par, (2) the price at which the DQ lender acquired its term loans, and (3) the current trading price of the term loans. This feature arms the borrower with the ability to potentially force DQ lenders out at a loss.

The ability to yank a lender at the current trading price, in combination with the ability of the borrower to DQ a lender with retroactive effect, constitutes a powerful weapon in the borrower’s hands. While rare, a handful of credit agreements in the market (only 2% in our total sample and 4% of new credit agreements) permit the borrower to yank existing lenders that are distressed/“loan-to-own” investors out of the lender group at any time, at the current trading price. As such, lenders – especially in the distressed space – should be very careful to make sure that these features are not both included in deals they consider entering into.

Prohibition on Entering into Derivative Arrangements With DQ Lenders

A common way for certain lenders to obtain exposure to a credit, especially in the distressed space in situations where they sense a risk of becoming DQ’ed, is by taking a derivative position that replicates the position of a lender, rather than becoming a lender of record or buying a participation. Most credit agreements (and LSTA’s model language) do not prohibit lenders from entering into such derivative arrangements with third parties. However, our survey shows that sponsors have started to counter this strategy by prohibiting lenders from entering into such arrangements with entities on the DQ list. In our sample, 7% of all credit agreements (and 8% of new credit agreements) included such provisions.

Other Consequences

Other aggressive but rare consequences of a DQ lender designation include stripping DQ lenders of their right to receive any cost reimbursement or interest or other payments, except the final principal payment at maturity, and stripping DQ lenders of their right to share in the collateral.

Deviations From the LSTA Model’s Operational Framework

There are also credit agreements in the market that deviate from the LSTA’s model’s more operational provisions around DQ lenders, which can create significant execution and operational uncertainty.

Reduced Access to the DQ List

As explained in part one of this article, the LSTA framework recommends that any new addition to or removal from the DQ list take a few days to take effect, to allow the agent and the lenders time to inform their teams of the latest list. This delayed effect is being removed from certain credit agreements, which introduces the risk that assignees that have signed assignment agreements get DQ’ed while their assignments are pending.

Another aggressive modification seen in the market is to prohibit the agent from publishing the DQ list on the lender platform or otherwise providing it to individual lenders, only allowing the agent to confirm or deny specific trades with specific counterparties requested by lenders based on whether the intended assignee is on the DQ list. Sponsors are often seeking these types of changes on the argument that, for large sponsors with a large number of loan transactions out in the market, it may be harmful if the market knows which institutions it puts on DQ lists.

The LSTA and many lenders, on the other hand, have made the argument that these modifications reduce transparency for the lenders and slow down settlement of trades. These types of changes also increase the risk that lenders will unintentionally buy into credits where they are DQ’ed. Depending on the consequences of being DQ’ed under that specific credit agreement, that could have very onerous consequences for such lenders.

Assignments to DQ Lenders Null and Void

Another deviation from the LSTA’s operational framework is to provide that assignments to DQ lenders are null and void. This provision is common: It was found in 39% of all documents in our sample and in 44% of new credit agreements. Although this creates a clear-cut rule for the borrower, it contradicts LSTA’s standard terms (and, similarly, in England, LMA’s standard terms) for loan trades, which provide that if a trade cannot settle by closing the relevant assignment/participation (e.g., because the assignee is a DQ lender), the trade is not null and void. Instead, the parties are obligated to seek an economically equivalent arrangement in accordance with a set of pre-determined alternative solutions set out in LSTA’s standard terms. If the credit agreement attempts to override this mechanism by simply voiding the transaction, that can lead to increased execution and operational uncertainty for the lenders.

Discussion

Octus’ review of credit documentation executed in the first-half 2025 shows a wide array of borrower-friendly features in the DQ lender provisions, and almost all of these provisions are more common in de novo credit agreements than in amendments to existing deals, indicating that DQ lender provisions have moved in a more borrower-friendly direction in 2025.

In isolation, the individual borrower-friendly DQ lender features seen in the market may not pose material risks. However, in combination, they may add up to a minefield for lenders – especially in the distressed space.

In the first-half 2025, a majority (58%) of analyzed new credit agreements permit the borrower to update the DQ list post-closing for noncompetitors. A meaningful minority of analyzed new credit agreements in the first-half 2025 (21%) permit the borrower to yank DQ lenders out of the lender group at the current trading price. A smaller, but not negligible, minority of analyzed new credit agreements in the first-half 2025 (6%) allow retroactive disqualification of any noncompetitor institutions or distressed lenders.

These features in isolation may not pose a material threat; for example, the threat of being yanked out of the lender group retroactively may not work as an effective stick if the borrower can yank “only” lenders at the lesser of par and the acquisition price loans, and the loans have traded down significantly since the lenders acquired the loans.

Similarly, the threat of being yanked out at the current trading price may not constitute an effective stick if the credit agreement does not permit retroactive disqualification of existing noncompetitor lenders, and the existing lenders were not on the DQ list when they acquired their loans.

However, 4% of analyzed new credit agreements in the first-half 2025 include all of the above features, meaning that they permit the borrower to DQ any existing lender (or, in some cases, any distressed investor) at any time, and force that lender to sell its position at the current trading price. Needless to say, no lender wants to find itself in workout negotiation with a distressed borrower armed with that kind of weapon (whether or not it is waved as an explicit threat or is only in the documentation as an implicit threat).

When reviewing DQ lender provisions, lenders should be mindful that in addition to isolated individual aggressive features (whether in the form of expanded DQ lender definitions, expanded consequences of DQ designations and/or increased uncertainty through deviations from LSTA’s operational framework), these types of combinations may pose an unacceptably high risk.

For certain distressed investors, a strategy for circumventing prohibitively aggressive DQ lender provisions (or if they have been DQ’ed already and therefore cannot buy into the deal), is to gain exposure to a credit by entering into a total return swap or similar derivative arrangement with existing lenders. As a result of such a swap, the lender of record is merely acting as pass-through intermediary, with the borrower’s real economic counterparty in a workout scenario being the distressed investor.

Our survey shows, however, that sponsors and borrowers have started to counter this strategy by prohibiting lenders from entering into these types of derivative arrangements with DQ lenders: 8% of analyzed new credit agreements in the first-half 2025 include such a prohibition.

In light of these developments in DQ lender provisions, which we expect will continue, investors that are looking at buying into a credit (whether through assignment, participation and/or derivatives) should develop and maintain internal standards for evaluating these risks, both in connection with primary issuances and in the secondary market.

***

In summary, disqualified lender provisions can have a significant impact on the borrower’s ability to influence the lender group and voting dynamics, both by proactive DQ lender designations to shape the lender collective and the threat of disqualifying lenders to influence lenders’ actions. In recent years, sponsors have increasingly expanded borrowers’ ability to use the DQ lender provisions to exert influence on the lender collective. The landscape that has emerged in Octus’ survey of aggressive DQ lender provisions in the first half of 2025 is one where combinations of aggressive provisions are starting to look like a potential mine field, especially for distressed investors. Given the overwhelming dominance of consensual LMEs over deal-away LMEs, we expect that sponsors will be looking for ways to influence the vote by favoring preferred lender groups and seeking to exclude lenders they view as antagonistic using DQ lender provisions.

***

[1] Another version of this, which lies outside the DQ lender provisions but which is worth mentioning in this context since it is also an attempt at keeping loan-to-own investors out of the lender group, is that some credit agreements specify that it will be reasonable for the borrower to use its general consent right to withhold its consent to assignments to distressed investors and “loan-to-own” investors.
[2] As a drafting note on “no retroactive effect” provisions, it is important that such provisions are clearly drafted to state that if the borrower adds an existing noncompetitor lender to the DQ list, such lenders may still continue to hold and vote on loans that they had acquired before getting DQ’ed. In some credit agreements, however, the drafting is not as clear and simply states that DQ designations may not be made “retroactively.” In those cases, there is a risk that parties may interpret the word “retroactively” differently. Therefore, it is important to analyze the specific language in a given document, rather than just relying on whether the word “retroactive” is present. To illustrate this, the LSTA model language (which only covers competitors as DQ lenders) states that DQ designations will “not apply retroactively.” However, that language is simply meant to make clear that DQ designations do not render trades with DQ lenders null and void. The LSTA language indeed permits DQ’ing an existing lender in the rare instance where an existing lender subsequently becomes a competitor of the borrower. On a first read of the LSTA model language, it may not be apparent how the prohibition against “retroactive” application of an updated DQ list is meant to be read. The clause reads as follows:

“For the avoidance of doubt, with respect to any assignee or participant that becomes a Disqualified Institution after the Trade Date or any Person that the Borrower removes from the DQ List (including as a result of the delivery of a notice pursuant to the definition of ‘Disqualified Institution’), (x) any additional designation or removal permitted by the foregoing shall not apply retroactively to any prior or pending assignment or participation, as applicable, to any Lender or Participant and (y) any designation or removal after the Closing Date of a Person as a Disqualified Institution shall become effective [three] Business Days after such designation or removal” (emphasis added).

The language above is meant to clarify that an assignment agreement with an entity that becomes added to the DQ List while the trade is pending is not voided. However, the LSTA model does not prohibit the borrower from exercising remedies (including yanking such lender out of the lender group) against an existing lender that the borrower has subsequently DQ’ed. The rationale for this is of course that the only DQ lender category that the borrower can add to post-closing under the LSTA provisions is competitors, and the borrower needs to be able to protect its confidential information from competitors regardless of whether they acquired term loans before the borrower added them to the DQ list.