With the spread of COVID-19, businesses all over the world have seen their operations affected and their cash flow and production decreased, putting them at risk for potential default on their credit obligations. The prediction is that the global economy will enter into a recession, which will continue to affect the financial situation of millions of businesses. All businesses should consider the available options to remedy any borrowing deficits in light of specific circumstances.
When providing financing for business enterprises of any kind, it is standard practice for financial institutions to require that borrowers commit to certain obligations and financial covenants beyond merely making payments on time. As a result, even if a business is able to stay current on loan payments or if it falls out of covenant on a non-payment obligation, this could expose the business to the risk that its lender might declare an Event of Default and exercise extreme remedies, including acceleration of the loan and rights against the collateral.
In credit arrangements, a crisis of this kind will not only cause delays in payments by borrowers but will also affect the value of the borrower’s collateral. We recommend that our clients conduct an analysis of their current credit arrangements to determine whether delays or potential breaches caused by the pandemic could be excused under the notion of force majeure, or are otherwise excusable under the loan documents and, if not, identify what specific obligations will be affected and how to potentially mitigate the impact of an inadvertent default.
The first step should be to evaluate your covenants and obligations. Is your business at risk of default?
If the answer to this question is yes, confirm whether the agreement includes a force majeure exception. Does this provide relief to your situation? Does the force majeure provision specifically apply in cases of pandemics or widespread health crises?
If not, talk to your lender proactively about what they can do to help. Banks may be able to work with their clients in finding alternative ways to avoid default. These alternatives could include arranging for payments of interest only, allowing for deferment of certain payments for some period of time, waiving certain requirements, or even amending the documentation to allow for some additional flexibility.
Below are some of the covenants that may be worth reassessing and renegotiating with lenders in order to prevent an Event of Default and possible acceleration of the debt should you not have other protections through an applicable force majeure clause:
- Borrowing Base. This is the amount a lender is willing to loan a business, taking into account the value of certain assets. Usually, the definition of borrowing base sets forth threshold values for each item. Generally, lenders require borrowers to provide monthly or quarterly borrowing base certificates as evidence of the value of the assets forming the borrowing base. Any COVID-19-related analysis should keep in mind how the global situation would affect the value of those assets, for example: collectability of accounts receivable and/or value of inventory, as these are items typically included as part of the borrowing base.
- Valuation of Collateral. Instead of or in addition to committing to a borrowing base, the borrower may have provided property as collateral. This can range from real property, to the balance of investment accounts, or pledges of equity in other businesses. A material decrease in value of any of these could result in an Event of Default.
- Financial Covenants. These covenants are based on certain metrics related to the borrower’s earnings, cash flow, etc. Some of these financial covenants include the commitment to maintain a certain debt to equity ratio or EBITDA. The impact to revenues resulting from the pandemic could result in a borrower falling out of compliance with these covenants.
After having evaluated all possibilities, it is advisable that business owners approach their lenders to consult on what level of flexibility, if any, the lender would be in a position to offer and, to the extent lenders are not able to waive the applicable requirements, a renegotiation of the relationship may be required. This could result in a lender conducting further and enhanced diligence, reevaluating the credit risk, and asking for different or additional protections (such as additional collateral, personal guarantees, etc.) or reducing the available financing limits in the case of revolving facilities.