Introduction
When businesses are facing unprecedented economic challenges it is more important than ever to review all obligations under existing loan and other types of financing agreements. Facilities may well have been extended on the basis of cash-flow projections and contain financial and non-financial covenants. In an economic downturn, the assumptions upon which a facility has been extended to a borrower may no longer be valid.
Borrowers may face both decreased asset values and reduced liquidity and, hence, may have a different risk profile to the one they had at the time when the loan was initially agreed. The issues faced by borrowers are likely to be more acute if the business is highly leveraged. Some businesses may carry fixed costs while their ability to generate income to service debt is significantly reduced. This tension is likely to go to the very heart of some of the loan covenants and may impact a borrower’s ability to meet its contractual obligations.
In an environment where “business as usual” is no longer feasible, borrowers need to look at new ways to operate and engage with their lender group. In this paper, we look at some of the commercial challenges that businesses may face in times of economic challenge and key points that borrower’s in-house counsel should consider when reviewing finance agreements.
Scheduled Repayment of Principal and Interest
The obligation to pay is fundamental to any loan agreement. Therefore, non-payment will trigger an event of default (“EOD”). All other EODs are broadly indications of difficulty to meet the payment obligation. Short grace periods are typically only provided for technical or administrative error in transmission.
Borrowers should consider all revenue streams and assess their ability to meet impending and upcoming payment obligations. It is also important to check if different grace periods apply to different types of payments i.e. principal, interest, indemnities and fees. Where difficulties are identified, a waiver will be required. This may precipitate a restructuring of the facilities in general.
Financial Covenants
Where a loan agreement includes financial covenants, these provide clear parameters within which the borrower’s business is expected to operate. The financial covenants consider the stress factors within a business and measure a range of items including:
(a) the ratio of borrowings to tangible net worth;
(b) the ratio of debt service to earnings before interest, tax, depreciation and amortisation (“EBITDA”);
(c) the ratio of current assets to current liabilities; and
(d) tangible net worth.
Borrowers should undertake a detailed review of all financial covenants in order to determine the following:
(a) which aspects of its financial condition will be tested;
(b) to which period will the tests be applied;
(c) which group companies do the tests apply to; and
(d) what are the consequences of breach.
Covenants are typically set at levels which provide lenders with an early warning sign of deterioration in credit risk. Therefore, breach of a financial ratio is not always drafted to immediately trigger an EOD. Sometimes, this may simply affect the margin. Borrowers should consider whether the loan agreement provides any adjustments, e.g. to EBITDA, which may be helpful in current market conditions. There may also be provision for an equity cure, allowing sponsors or shareholders to inject additional capital to remedy a financial covenant breach.
Where a loan contains a security cover ratio, borrowers may have the option to either prepay the facility or to provide additional security as part of the overall package. If cash is held in a blocked account, a borrower may argue that the ratio should take into account the amount of cash cover.
Material Adverse Change
Parties may consider whether current market conditions trigger the material adverse change (“MAC”) (or material adverse effect) clause. Lenders use the MAC clause as a matter of risk allocation and to “catch all”.
Given the uncertainty of the clause, its effectiveness is questionable. English courts are generally reluctant to find that an EOD had been successfully called in the absence of a more specific EOD dealing with the particular issue of concern to the lender. Lenders therefore rarely rely on MAC EODs.
The MAC clause is more likely to be used as a tool to prompt discussion and further negotiation with the borrower. However, depending on the borrower’s specific business and sector, the prevailing market conditions and the ability of the borrower to meet its obligations, a lender may feel sufficiently comfortable to use this clause.
The drafting of MAC clauses differ from loan to loan and borrowers should review this clause very carefully. Questions to ask include:
(a) What circumstances does the MAC address?
(b) How likely must the MAC be?
(c) Who will decide if a MAC has occurred?
Uncertain and forward looking clauses that refer to a borrower’s “prospects” for example, may give a lender greater flexibility when considering whether to call a MAC. A reference to a borrower’s “condition (financial or otherwise)” is also wide in scope.
Cross-Default
Borrowers who have a number of outstanding credit facilities should review all relevant cross-default provisions. If any one of these provisions is triggered, this may trip all of a borrower’s facilities causing what was originally a local problem in a single loan agreement to be a wider problem affecting all of its facilities and lenders. This is the very intention of the cross-default clause - to warn of financial difficulty and to ensure that a lender is treated equally with other unsecured creditors of the borrower.
Borrowers should consider the scope of the cross default clause and, particularly, the definition of indebtedness. Borrowers should also check which obligors/member of its group the clause catches. Other questions to ask include:
(a) Has the clause been drafted as a cross acceleration clause rather than a cross-default clause?
(b) What are the applicable monetary thresholds?
(c) What are the applicable grace periods?
If events constitute a default but not yet an EOD, the borrower may have the opportunity to find a solution with an individual lender before triggering the cross-default clause.
Cash Flow and Liquidity
In challenging economic climates, borrowers are likely to be concerned about the liquidity in the business. Access to working capital to keep the business trading will be crucial. First, consider if any existing facilities have headroom for drawing down additional funds. Note that there are likely to be related conditions precedent including confirmation that no EOD has occurred and is continuing. For revolving credit facilities, borrowers may wish to “rollover” loans provided that they can meet the relevant conditions.
If the loan agreement contains a debt covenant restricting the incurrence of additional financial indebtedness, check to see if there are any carve outs or relevant thresholds. Most importantly, corporate borrowers and directors must be confident as to the solvency of the business when drawing on additional credit lines.
Asset disposals in an effort to get cash into the business will also likely be prohibited. Review all carve-outs for permitted disposals. Covenants related to the payment of dividends are also a way for lenders to control assets and to keep cash in the business and will thus likely be subject to restrictions. Note that amalgamations, mergers and other corporate reconstructions may also be controlled.
Insolvency Related Events
The loan agreement is likely to have a number of insolvency related EODs, which capture the inability of the borrower to pay its debts as they fall due. Beginning negotiations with creditors with respect to debt restructuring may fall within this provision and therefore borrowers may be inadvertently caught if not careful.
In times of financial difficulty, borrowers should run the numbers and ensure that the business passes both the cash flow and balance sheet tests of insolvency as appropriate. Where the value of assets is required to exceed liabilities, check whether this takes into account contingent liabilities. In structures involving group guarantees, confirm that the contingent liability does not trip the balance sheet test.
Cessation and Change of Business
Despite tough market conditions if, for any reason, the borrower suspends or ceases to carry on all or a material part of its business this is likely to be an EOD. Check to see if this EOD also relates to any “threats” to suspend or cease to carry on business in which case care should be taken with statements that may be perceived as such a threat.
Note that the loan agreement is also likely to capture any material changes in the general nature of business from that carried out as at the date of the agreement. Again, this goes to the credit risk of the Lender.
Representations
The representations and warranties are typically given as at the date of the loan agreement. However, depending on drafting, some may repeat each day, which effectively makes them covenants. Borrowers should examine all representations which are deemed to be repeated and whether they are said to be made by reference to the facts and circumstances then existing. If utilisation of a loan is about to be made or the first day of an interest period is approaching, ensure that all relevant representations and warranties remain true, particularly those that go to the solvency of the business.
Information Undertakings
The information undertakings are included to allow lenders to verify certain information about the borrower and to check the business and financial condition of the borrower and the group as relevant. These covenants will most likely permit lenders to ask the borrower to provide additional information to support financial statements and/or for the lender to corroborate financial ratios.
If in difficulty, borrowers should consider if they are required to share any additional information with lenders regarding their current financial situation. Most loan agreements will require notification of any potential default or EOD. Steps taken to remedy any default may also need to be shared with lenders.
What to do when Faced with a Potential or Actual Default
When faced with a potential or actual default, borrowers should communicate with lenders as soon as possible. Questions that should be considered include:
(d) Is the default required to be “continuing”?
(e) Can the default be remedied?
(f) What is the relative seriousness of the default - i.e. is it minor of a technical nature (although consistent minor defaults may cumulatively indicate a bigger problem) or more significant?
(g) What fees, cost, expenses and indemnities are the lenders entitled to in conjunction with investigating the default? These may significantly increase the borrower’s indebtedness.
The contractual remedies on an EOD typically allow lenders to call in the loan. Commitments may be cancelled and/or the loan may be accelerated so that it becomes immediately due and payable. Any security held may also be enforced.
However, in times of serious economic pressures, particularly in climates where governments are providing support and incentives to business and encouraging lenders to take all measures to accommodate their borrowers, lenders are more likely to work with borrowers in order to try to find a mutually acceptable solution to any issues faced.
Borrowers may seek a temporary or permanent waiver with respect to the potential or actual breach. With syndicated facilities, check the consent levels required for a waiver (usually 50% or 75% of lenders). Certain amendments to the loan agreement, including requests for extension of time may be put forward. Where repayment obligations are onerous, review the existing amortisation schedule and consider extending repayment instalment dates or the final maturity date. This may lead to interest being capitalised. Lenders may impose additional conditions as part of giving their consent to any waiver and will likely reserve their rights in respect of the default and in relation to other provisions of the loan agreement.
In circumstances where lenders are reluctant to agree a waiver for default, borrowers may wish to request a standstill on enforcement, which will buy some time to plan next steps. Terms of a standstill may include:
(i) no demand, acceleration or enforcement of security;
(ii) no set-off or institution of insolvency proceedings;
(iii) cash conservation requirements;
(iii) cash generation provisions, including agreed asset disposals and agreement to bring in new money; and
(iv) mutual undertakings of co-operation and good faith negotiation towards a restructure.
Standstills are usually granted only for a limited time and parties should think about how the business will exit the arrangements.
Negotiating a Restructuring of Debt Facilities
Typically, an EOD leads to negotiations. In such circumstances, lenders are more likely to have greater access to information concerning the business, which can influence strategy. During negotiations it is important to have clear objectives as to what is achievable and in what time frame. Accountants, legal advisers and other stakeholders should be engaged to review the company's legal obligations, cash flow projections and other financial metrics in order to assess the overall viability and performance of the business. An assessment should also be made as to the availability of security for creditors in the event of insolvency.
If there are upcoming liquidity requirements in order to keep the business trading or to cover increased costs arising out of business distress, e.g. delays and/or suspensions of projects, consider if these can be requested from existing lenders or whether new credit lines are available. However, keep in mind that, particularly in difficult economic climates, lenders will not want to take all of the risk and will want to know how equity is contributing to the solution.
Finally, as part of the negotiations to restructure, lenders are also likely to undertake some due diligence and analysis as to the adequacy and performance of the company's management. It will be critical for management to hold regular board meetings in order to stay fully informed as to the financial health of the business. Directors should also remind themselves of their duties, responsibilities and potential liabilities during times of economic stress.
Conclusion
In an environment of unprecedented economic challenge, businesses may face a number of difficulties and scenarios which are not contemplated by their existing facility arrangements. Whether a company chooses to restructure or refinance will depend on the specific business and market conditions prevailing at the time. Borrowers should also consider the true costs and implications of insolvency.
There are often a number of options available to borrowers and borrowers should engage with and communicate with their lenders early in order to find a solution that best fits the business. Unfortunately, there are also some common pitfalls to debt restructuring arrangements and legal advice should be sought in each case.
