Both borrowers and lenders need to be aware of issues arising from a new US government loan program for small businesses relative to existing capital structures, although some guidance also is not yet available. Both borrowers and lenders may also request negotiations of various terms.
The Keeping Workers Paid and Employed Act (the Act), enacted in March 2020 in light of the pandemic-related economic downturn, provides new and increased federally guaranteed Paycheck Protection Program (PPP) loans through the Small Business Administration (SBA) to small businesses that keep their workers employed. The new PPP loans, which do not require collateral to be provided as security for loan repayment, raise considerations for both borrowers and lenders relative to existing capital structures. While SBA guidance exists relative to SBA Section 7(a) loans and intercreditor arrangements, guidance is not yet available in connection with PPP loans and their intersection with existing credit structures. We examine some of the considerations here.
Existing Credit Facilities: Potential Issues—In cases where a borrower has existing credit facilities in place prior to obtaining a PPP loan, the borrower and existing lenders would need to consider carefully the terms of a borrower’s existing credit facility.
- Is the borrower permitted to obtain a PPP loan under existing negative covenants restricting the incurrence of indebtedness? In many cases, there are a variety of “baskets” or covenant exceptions permitting a borrower to incur different types of indebtedness. These baskets may include those permitting an unlimited amount of additional indebtedness subject to certain conditions, or capped amounts in other cases. One example may be what is commonly referred to as a “miscellaneous” or “general” unsecured debt basket.
- Is the borrower required to cause the PPP loans to be contractually subordinated to existing credit facility indebtedness? While PPP loans are unsecured, some credit facilities may only permit the incurrence of additional unsecured debt if it is contractually subordinated in right of repayment to the payment of senior credit facility debt.
- Is the borrower required to prepay existing credit facility loans with all or a portion of the proceeds of the PPP loan? PPP loans are not permitted to be applied to repaying principal on mortgage loans or other indebtedness.
- Is the borrower required to maintain the proceeds in a commingled deposit account subject to an account control agreement? Some credit facilities require the concentration of borrower cash into a deposit account subject to control of the secured creditors. This could result in the proceeds of the PPP loan being seized or “swept” and applied to satisfy principal on other indebtedness. As noted above, application of the proceeds of PPP loans for this purpose are not permitted.
- Is the borrower prohibited from repaying (or prepaying) the PPP loans when due because of restrictions on the repayment (or prepayment) of other indebtedness (e.g., “restricted payment” covenants).
- Do the borrower’s credit facilities contain financial maintenance covenants, such as a total leverage ratio covenant or a fixed charge coverage ratio covenant? If these covenants exist, careful scrutiny would need to be applied to assess various factors. These include whether (1) the PPP loans would be captured in the covenant definitions as indebtedness for purposes of calculating the amount of leverage on the borrower, (2) any principal or interest payments might be considered a fixed charge, and (3) whether PPP loans and/or the interest expense incurred with respect to them might be an addition (add-back) in calculating EBITDA (normalized earnings) of the borrower. Given that all or a portion of PPP loans may be forgiven, different credit documents may exclude PPP loans as indebtedness for financial covenant purposes. Or, they may only include the portion of PPP loans not forgiven as indebtedness at such time as the PPP loans become due and payable, similar to the treatment of contingent earn out obligations in many credit agreements.
- The PPP loan documents to be used by SBA lenders have not yet been circulated and it is unclear whether such documents will require certifications and representations from borrowers about there being no existing credit facility defaults as a condition to execution and drawing down the funds. If borrowers are in default under existing credit facilities and seek to borrow PPP loans anyway, it is possible this will be problematic under the PPP loan program documents. For example, it is possible that SBA Section 7(a) lenders will themselves be required to make a certification on this subject matter to the SBA.
Amendment or Consent Process
In light of these considerations, it is possible that borrowers would need to amend or obtain consents from their existing creditor groups to facilitate borrowing PPP loans. Each credit agreement has different rules governing needed lender approvals for amendments or consents and these rules would still apply in connection with such requests. Borrowers are encouraged to be in early communication with their existing lenders to avoid delays in funding.
Ranking and Treatment of PPP Loans
The Act does not undo or modify existing SBA rules or practices regarding the relative priority of SBA 7(a) loans (see e.g., the SBA’s SOP 50 57 2 of December 1, 2015 (the SOP)). However, current rules and practices primarily relate to the lien priority of SBA 7(a) loans, not payment priority. As a result, in the absence of any contractual subordination requirements in existing credit facility documents and further guidance from the SBA, PPP loans would be pari passu (equal) in right of payment with such facilities, although “structurally” subordinated to the extent that existing credit facilities benefit from collateral security (since the PPP loans will be unsecured). If an existing credit facility required PPP loans to be contractually subordinated in right of payment, it should be determined on a case-by-case basis if SBA guidance would suffice to govern the parameters of such subordination.
Ranking and Treatment of Other SBA 7(a) Loans
Other SBA 7(a) loans are, in some cases, required to be secured by collateral. The SBA’s rules and practices in respect of other existing credit facilities that are not SBA 7(a) loan facilities broadly provide that the SBA has an interest in ensuring an equal recovery for any SBA 7(a) loan relative to other credit facilities in the Borrower’s capital structure. In this situation, the SOP should be consulted to determine what types of subordination the SBA will consider.
Anticipated Credit Facility Requirements
As borrowers obtain PPP loans, we anticipate existing lenders will provide flexibility in terms and conditions in their credit facilities relative to the PPP loans given that PPP loans are an attractive source of liquidity for borrowers with low risk to a senior secured creditor from a creditor’s rights perspective. Both borrowers and lenders may request various terms to be negotiated.
Lenders may request that:
- PPP loans are counted as indebtedness for purposes of calculating financial covenant compliance, whether from initial incurrence by the borrower, or when such PPP loans are due and payable per their terms;
- the borrower will apply for forgiveness of the maximum forgivable portion of the PPP loan in accordance with the SBA guidance;
- the borrower will only use the proceeds of the PPP loans in accordance with the specified permitted use of proceeds provisions set forth in the Act (Section 1102(a)(F)(i)(I-VII));
- the PPP loans must be contractually subordinated to the payment in full of existing senior debt. The approach across creditors may well vary in structures in which there are multiple existing creditor groups. For example, existing senior secured creditors in a “first lien” position (that is, lenders with prior rights relative to collateral ahead of all other creditors) may well have a different view about a borrower obtaining PPP loans than an unsecured lender lending at a contractually or structurally subordinated position in the credit structure, such as a “mezzanine” creditor lending to a holding company and not to the operating business itself;
- the borrower may only repay the loans if certain conditions are satisfied, including, among other things, no event of default under the existing credit facility;
- a default under the PPP loans would trigger a cross-default to the existing senior debt;
- and an equivalent amount of senior debt should be prepaid when the PPP loans are repaid in full.
Borrowers may request that:
- PPP loans are treated as financial covenant “neutral” for purposes of its financial covenants. That is, the borrower may agree that PPP loans would not increase its EBITDA (other than in respect of interest expense) but also request that PPP loans would not count as indebtedness or fixed charges for these calculations;
- the borrower may segregate the proceeds of the PPP loans into a separate deposit account not subject to secured creditor account control requirements, so as to avoid having them applied to other indebtedness;
- there should be no conditions around repaying or prepaying the PPP loans, including servicing interest payments when due under the PPP loans, given that the interest rate is expected to be capped at 1.00%, and therefore not a significant impact on the borrower’s on-going liquidity position.
- A default under the PPP loans would not trigger a cross-default to the existing senior debt given that PPP loans are unsecured and are likely to be partially or wholly forgiven.
Coronavirus COVID-19 Task Force
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 In many second lien or subordinated credit agreements in capital structures with multiple groups of creditors, there are “anti-layering” covenants. For example, a second lien creditor’s credit agreement may stipulate that a borrower may not incur indebtedness which is subordinated to the first lien creditor’s indebtedness but senior to the second lien creditor’s indebtedness, including by way of a modification to the first lien creditor’s credit agreement to incorporate new unsecured indebtedness within that facility. We would anticipate that requests for contractual subordination of PPP loans would be on a case-by-case basis and analyzed in the context of the specific borrower’s financial situation and its credit structure.