COVID-19 - Considerations for Borrowers

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COVID-19: Considerations for Borrowers

Published 20 marzo 2020

Introduction

The full economic fall-out from Covid-19 is still to be seen but it seems clear that businesses directly or indirectly involved in (among many others) the travel, leisure, hospitality and retail sectors are going to be hard hit.

This briefing sets out some high-level considerations for borrowers to assist them in considering the impact of the business disruption from the Covid-19 outbreak on their debt financings. It is not intended to be focussed on any one particular product or sector nor does it constitute an exhaustive analysis of every point to be considered.

We would be happy to arrange a call to go through this and other questions you have on this briefing or other debt financing related issues (including product specific questions) in further detail.

Cash is king

Even in good times, liquidity is an important issue for most businesses but in times of economic uncertainty liquidity is one of the most critical considerations. The hit to consumer demand resulting from the Covid-19 outbreak will likely result in material operating cashflow reductions for some businesses.

Access to debt facilities is usually conditional on the absence of continuing defaults at the time of drawdown and the accuracy of a suite of representations (including, in some cases, as to the absence of any events having a material adverse effect on the borrower group’s business or assets or its ability to perform its obligations under the finance documentation (referred to, broadly, as a “MAC”) and no insolvency events). “Insolvency events” are generally widely drawn and include, in addition to actual inability to pay debts as they fall due, commencement of discussions with creditors.

Potential drawstops could also affect cashless rollovers of revolving credit facilities (“RCF”). This will be particularly relevant on deals were the rollover is conditional on the absence of an event of default rather than the absence of an actual acceleration event.

Lenders under receivables-backed lending structures (e.g. receivables backed loans, invoice discounting or debt factoring lines) typically have a broad right to limit the amount the borrower can draw against the underlying receivables (e.g. by adding a discretionary reserve to the face value of the receivables). In addition, if the borrower’s underlying debtors themselves face stress and delay payment on debts owed to the borrower, this may render such debts ineligible for financing purposes and as a result further reduce the borrower’s access to funding.

Default considerations

The fall-out from the Covid-19 outbreak could result in a number of events of default:

  • Non-payment – a borrower’s focus here should be on the drafting to assess the applicability of any agreed carve-outs (typically this will be limited to an assessment of any applicable grace periods, bearing in mind the level and type of disruption required before a disruption will constitute a “Disruption Event” under the LMA standard form documentation).
  • Insolvency – cashflow insolvency (i.e. inability to pay debts as they fall due), balance sheet insolvency and other trigger events such as commencement of rescheduling discussions with creditors typically constitute events of default.
    • Financial Covenant Breach – business underperformance may put pressure on financial covenants. EBITDA add-backs for exceptional items may provide some comfort but are unlikely to address losses caused by business underperformance resulting from, for example, in the case of a restaurant business, fewer people deciding to eat in a restaurant. If a borrower breaches or forecasts a breach a financial covenant, it should assess whether the breach can be cured (e.g. through equity cures or pre-emptive actions). The availability of such cures will depend on the terms of the financing. We are aware of financial sponsors in larger cap neutralise the impact of losses resulting from regional epidemics or global pandemics. Whether these terms gain traction will be interesting to see.Borrowers should carefully assess the terms of their financial covenants to assess current and projected compliance.
    • Audit qualification – extended periods of disruption (including potentially in the period after the end of the relevant accounting period) could affect the willingness of auditors to give clean audit opinions. In many deals, any form of audit qualification results in an event of default. Even in transactions with a more limited set of events of defaults, an audit qualification is still give rise to a risk of loss of counterparty, regulator or other stakeholder confidence in the borrower’s financial position.
    • Litigation – disputes resulting from the impact of Covid-19 (especially in commercial contracts, e.g. force majeure) could trigger material litigation events of default. As with most other defaults, this will turn on the exact wording but materiality qualifiers and / or other negotiated limitations could help alleviate pressure.
    • Cessation of businessthe cessation of business by a borrower group constitutes an event of default in many deals. Again the drafting will be key.
    • Delays / cost increases – delays or cost increases resulting from Covid-19 are potentially particularly relevant for project or real estate finance transactions:

- depending on the terms of the relevant build contract, cost increase claims could result in cost overruns exposing the borrower group to default risk if the cost overrun is not funded. Whether any contingency or cost savings elsewhere in the project can help here will depend on the terms of the financing.

- disruption to development programmes caused by Covid-19 (e.g. from site closure following an outbreak) could put pressure on practical completion and other milestone covenants.

    • MAC – many (but not all) transactions include a general event of default triggered by the occurrence of an event / circumstance that has a material adverse effect on the borrower’s business or its ability to perform under the financing.

- The effect of this will turn on the drafting – loosely drafted MAC clauses may extend to, among other things, an assessment of the impact of the event / circumstance on the “prospects” of the borrower group which could exacerbate a borrower’s liquidity constraints (e.g. if lenders refuse to lend under an RCF) or expose the borrower group to risk of enforcement where it is otherwise not currently suffering any material adverse impact. Apparent drafting nuances can make a difference (e.g. whether an event “has” or “could reasonably be expected to have” a material adverse effect or whether the materiality of the effect of an event is objective or subjective).

- Nevertheless, we think lenders are very unlikely to rely on a MAC event of default to demand repayment or enforce their security but they may be (relatively) more inclined to attempt to rely on it to refuse to fund under RCFs or similar lines. Any such assessment would always be fact specific.

Likely lender response to defaults resulting from Covid-19

  • Our sense is that:

- most lenders will tread very carefully before taking affirmative enforcement action on the basis of defaults resulting from Covid-19 (given the reputation impact of doing so); and

- other than in respect of very short term life saving fixes, lenders will require management information on the impact of Covid-19 and borrowers should provide this with any waiver / consent request to pre-empt the dialogue.

  • Distressed debt and other opportunistic investors may not be held back by similar concerns and borrower groups should bear this in mind particularly in deals with unrestricted transfer rights although borrowers with restrictive transfer regimes should also bear this in mind given techniques exist for motivated buyers / sellers to circumvent transfer restrictions.

Other documentary considerations

  • Obligation to notify of default – lending documentation will likely contain an obligation on the borrower group to notify its lenders of any actual or potential event of default and, upon request, to confirm the absence of such events. Borrowers will need to consider carefully their obligations under such clauses.
  • Insurance claims – weak (from the borrower’s perspective) mandatory prepayment provisions in loan documentation may require borrowers to apply the proceeds received from business interruption insurance towards pay down of their debt. Borrowers should check their obligations to prepay debt from insurance claims.
  • Key-person clauses – extended periods of self-isolation / absence through illness could trigger key-person events, the consequences of which may include a requirement to replace the relevant key-person with a lender approved alternative (query whether senior level recruitment within the agreed timelines will be feasible in the current climate) or an immediate event of default.
  • Listed borrowers – whilst not specific to financing situations, listed borrowers will need to carefully consider their MAR and other disclosure obligations to the extent Covid-19 has a material impact.

Practical and other considerations

  • Early engagement – if issues are foreseen borrowers should engage early with lenders and provide information pre-emptively given that lender engagement will likely be coupled with information requests as lenders try to understand the impact of Covid-19 on the borrower’s business.
  • Impact on reporting and treasury functions – consider the impact of self-isolation / illness of key personnel on information reporting and treasury functions. In more restrictive financing terms, breach of information undertakings can give rise to an immediate event of default.
  • Requirements for physical board meetings – the holders of board seat/observer rights may have the right to require a minimum number of physical meetings per year. Borrower groups subject to such regimes will need to consider their ability to comply with such requirements in light of government or borrower enforced isolation measures.
  • Personal protective protocols – borrowers may have introduced personal protective measures for employees. If lenders or their representatives have the right to access the borrower’s property to perform audits (e.g. in ABL deals) or perform observer functions, borrowers should make their protocols clear to their lenders to help ensure compliance by the lender and its representatives when on-site.
  • Tax clearances – in cross border deals, borrowers should consider the impact of delays to the processing of tax treaty passport clearances.
  • Director duties – directors will need to consider their own duties, particularly where the borrower’s solvency or ability to continue as a going concern is in question, and may need to take independent advice.

Borrower liquidity considerations

Borrowers might consider addressing their liquidity needs by:

  • Government support – accessing government backed funding initiatives for SMEs. Many SMEs we have spoken to are still awaiting clarity on the mechanics for accessing this cash – we are monitoring this carefully.    
  • Premptive draw down – drawing down existing RCFs / working capital lines now rather than later (when the subsequent occurrence of a default could prevent later drawings) although whether this makes sense should always be assessed on a case-by-case basis.
  • Delay interest payment – selecting longer interest periods on drawdown or rollover to alleviate the immediate cash drain resulting from impending interest payments and the potential rollover drawstop rise. This will not address any amortisation obligations.
  • Asset monetisation – through, among other options, outright assets sales, IP exploitation (e.g. licensing), sub-letting unused real estate, receivables discounting and / or sale and leasebacks) but note the potential need for lender consent / security releases / full or partial debt pay down from proceeds in more restrictive financings.
  • Identifying unencumbered assets – if the borrower group has the flexibility under its financing terms, it could consider whether it has encumbered assets it can offer to its existing lenders to encourage ongoing support or to new lenders to raise further liquidity or to leverage its negotiation with its existing lenders. Many larger cap or sponsor backed deals will provide for this flexibility but borrowers should review their financing documentation carefully to assess whether this is a possibility or if there are other liquidity options.

What we can do to help

The DAC Beachcroft banking and debt finance team advises borrowers, lenders and other stakeholders across a range of financing transactions including leveraged and acquisition financing, real estate finance, receivables backed lending, distressed refinancings/situations and growth capital lending. Some of the areas where the team stands ready to help clients include:

  • Live and ongoing discussion with current issues / horizon scanning with clients
  • Covenant assessments to determine breaches and potential documentary or other “creative” fixes and / or whether potential solutions are likely to be workable
  • Guiding clients through waiver / consent request processes
  • Assisting in structuring credit risk mitigation strategies (e.g. to mitigate trading counterparty credit risk)
  • Supporting stakeholders in distressed and restructuring situations
  • Devising and negotiating financings or refinancings in stressed, distressed or opportunistic circumstances (e.g. where the borrower is itself in financial difficulty or is raising debt financing to acquire distressed assets or to exploit an opportunity).
  • Advising boards of directors on their “zone of insolvency” duties in the context of debt financed structures.
  • Giving our insight on how new deals can be negotiated to afford protection against unforeseen issues over the life of a deal.

Authors

Christopher Wall

Christopher Wall

Bristol, London - Walbrook

+44 (0)117 366 2445

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