In the current financial climate, with significant volatility in the stock market, financiers and borrowers will need to carefully consider the terms of their financing arrangements.
From both the financier's and borrower's perspective, the occurrence of external shocks such as dramatic reductions in the share price of a listed borrower or the value of borrowers whose assets consists significantly of listed securities, requires consideration to be given as to whether such circumstance triggers a right to review the terms applicable to debt facilities or trigger an event of default.
The purpose of this paper is to highlight some of the main issues arising from what is increasingly becoming a regular occurrence, including some possible changes in documentation.
Relevant Clauses
In many cases, substantial write-downs of a borrower's share price is disconnected with the underlying value of the assets of the borrower. Market sentiment plays a significant role in the value of the shares in a listed entity but generally does not have a significant or immediate impact on the underlying assets of the entity (particularly if those assets primarily consist of a real property). Nonetheless, a significant reduction in the share price of a listed borrower will cause concern to a financier to that borrower and is likely to result in the financier considering whether the terms of the facility should be renegotiated or whether or not an event of default has occurred.
From the borrower's perspective, certainty of continued funding in accordance with the facility documentation is paramount and it will wish to avoid any renegotiation of terms or the calling of an event of default.
Ultimately, the rights of a financier to review the terms of the facility or call an event of default will depend upon the terms of the loan and security documentation.
The main clauses which are relevant to considering the rights of a financier in these circumstances are:
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Review events and general rights of review
Review events are events entitling the financier to review the terms of the debt facility. They deal with matters which may affect the risk associated with a particular transaction from a financier's perspective. Such things as changes in control of a borrower or changes in the nature of underlying business or a change in the credit ratings of a borrower will often be expressly stated as being review events. In those circumstances, the financier will have the right to consider the particular facts and determine whether or not it is necessary to amend some or all of the terms of the facility to account for the change in circumstances.
The recent turmoil in the global stock markets may not trigger a review event for a borrower however the downgrading of credit ratings associated with a number of financial institutions around the world (as a result of their exposure to the sub-prime market in the US) may trigger such clauses in respect of their own funding. As this impacts on their own cost of funding, such institutions will be keen to determine their rights to pass on added funding costs to their borrowers and seek to renegotiate funding terms offered to their borrowers.
As a result, the inclusion of specific review events in loan facility documents (particularly for listed entities) may become more common and the breadth of the circumstances which constitute a review event may be increased.
From a borrower's perspective, the scope of review events should be as limited as possible and if a review event is triggered, the borrower should be given sufficient time to arrange for refinancing. Although this would normally be an acceptable outcome for a borrower, in the current climate, refinancing of existing debt (should the current financier seek to impose unacceptable terms and conditions as a result of the review) may not be possible or may cause more difficulties than accepting the revised terms.
In addition to specific review events, financiers generally retain a general right to review the facility from time to time or at specified intervals. Depending on how such clauses are drafted, financiers may seek to rely on such provisions to assess the impact of significant market falls on the borrowing group's business. If the outcome of such review is that the financier believes that the risk associated with the continuation of the facility on its current terms has increased, it may require the terms of the facility, including pricing, to be varied.
Borrowers need to ensure that reviews can only occur in limited circumstances or at set intervals and further that the criteria by reference to which the lender can assess whether or not the terms of the facility can changes are clearly stated in the review clause. Ideally, the borrower should have the right to demonstrate to the financier that its conclusions from the review are not justified. In addition, the borrower should have a period in which to refinance the facility if it is not satisfied with the proposed changed terms (as to which, see our comment above).
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Breaches of Loan to Valuation Ratios (LVR) and asset revaluations
As mentioned above, there is often a 'disconnect' between the value of the shares or units in a listed entity and the value of its underlying assets. This is particularly common in relation to listed property companies and property trusts.
Accordingly, notwithstanding a significant write-down in the value of the securities of a listed property trust or company, LVR conditions contained in facility documentation may not be breached. Nonetheless, financiers may wish to revalue property assets in those circumstances adding to the costs of the borrower.
Borrowers should ensure that the right of the financier to request revaluations of properties at the borrower's cost are only be triggered if an event of default occurs or otherwise occur no more regularly than yearly. If such clause is included in the facility documentation, the reduction in the value of the listed securities may not entitle the financier to require the borrower to revalue the underlying property assets.
Financier's may still be entitled to obtain their own valuations at their own cost and if such valuation indicates a reduction in the value of the underlying property, the consequences resulting from a breach of the LVR ratio or the occurrence of a review event (as mentioned in this paper) may apply.
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Security top-up
If the assets of the borrower offered as security to a financier include listed securities, the significant reduction in market prices may cause the LVR requirement to be breached. This will be an event of default and is also likely to trigger an obligation on the borrower to provide additional security so as to maintain the required LVR ratio.
As the top up security needs to be acceptable to the financier, other listed securities may no longer be acceptable or, given the volatility of the market, their value may be discounted by the financier. This may make it increasingly difficult for some borrowers to comply with these requirements making it more likely that there will be a need for the borrower to agree to amended terms suggested by the financier to avoid the occurrence of an event of default.
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Breach of financial ratios
In addition to LVR requirements, facility documentation will generally include other financial ratios which need to be satisfied by the borrower. These include interest cover ratios and often ratios of total tangible assets to total liabilities. These financial ratios may be breached as a result of a significant write-down in the value of listed securities.
In those circumstances, an event of default may be triggered which would entitle the financier to demand repayment of the facility. For the reasons mentioned above, the refinancing of debt may be difficult in the current climate with the result that the financier will be in a position to negotiate with the borrower to change the terms of the facility. In the absence of an agreement as to the terms applicable going forward, the financier may be entitled to exercise its rights to demand repayment of the facility and withhold future funding.
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Conditions precedent to further funding
In the case of un-drawn facilities, financiers will not be required to provide funding unless certain conditions precedent are satisfied. Generally, these conditions precedent include that all representations and warranties are correct as at the date of drawdown and that no events of default or potential events of default have occurred or will occur on the date of drawdown. If the documentation includes review events, these may also need to be absent for drawdown to occur.
If financial ratios such as those mentioned above have been breached as a result of market write-downs of the value of listed securities or other events of default have been triggered (or alternatively if representations are made as to shareholder capital or other matters which are adversely impacted upon by the market write-downs), the borrower may not be entitled to request the financier to provide funding (or further funding) as such conditions precedent will not be satisfied.
Going forward, the conditions precedent to be satisfied for drawdown (and/or the representations and warranties or events of default included in loan documentation) may be broadened to specifically deal with market shocks as are currently being experienced. This will make it more difficult for borrowers to drawdown funds under debt facilities. Clearly, from a borrower's perspective, the entry into a facility is intended to provide certainty of funding for a particular project and it will be important to ensure that the conditions precedent (as well as the representations and warranties and events of default) are not such as to significantly diminish such certainty of funding.
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Events of default
As already mentioned, the impact of a significant market write-down of the value of listed securities may trigger a breach of various financial ratios or LVR requirements which would be an event of default under the facility.
A further event of default which could be triggered is that dealing with the occurrence of a material adverse effect. Generally, financiers are loathe to rely on this event of default as it is often difficult to establish that such event has in fact occurred. Indeed, in circumstances where such clauses have been used in the context of M&A activities, authority exists for the proposition that courts will only accept that such clause has been triggered if the particular circumstance cannot have been reasonably foreseen and would have a material impact on the investment in the long term.
From a financier's perspective, if it proves that it cannot rely on such event of default, this may have negative consequences to it not only from a financial perspective (vis a vis the costs involved in determining whether or not it can rely on such an event of default) but potentially on its reputation in the market.
As a result of these difficulties, unless the circumstances would clearly have a material adverse effect on the ability of the borrower to satisfy its obligations under the loan facility (eg. as a result of significant reductions in its income or the value of its underlying assets), it is not likely that financiers would rely on this type of event of default.
Consequently, financiers may reconsider how to define material adverse effect and include specific circumstances so as to minimise the uncertainty as to whether or not such clause can triggered. For example, short term consequences may be specifically included so as to entitle the financier to rely on such event of default.
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Appointment of investigating accountants
Loan documents often allow a financier to appoint an investigating accountant if it is of the view that an event of default has occurred or a potential event of default has occurred. Once again, depending upon the circumstances which have arisen and the nature of the event of default clauses, the right of the financier to appoint such investigating accountant may be triggered by the current reduction in market prices of listed securities.
Going forward, even if no event of default or potential event of default has occurred (due to the wording of the relevant clauses), financiers may seek to amend documents to include such a right in circumstances where there are significant market movements.
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Assignment clauses
Financiers generally have a right to assign their interest in a facility to another financier. Financiers may wish to reduce their exposure to particular borrowers as a result of the impact of market volatility on a borrower or its assets or indeed on the financiers loan book generally.
If borrowers have existing relationships with financiers and do not wish to deal with a different financier, they will need to consider whether they have a right to approve such assignment in accordance with the terms of the loan documents. In addition, borrowers should make sure that any assignment does not increase the cost of the facility to the borrower.
Further Possible Changes To Finance Documents
We have already mentioned a number of possible changes to finance documents which financiers may require to improve their position in situations such as those currently being experienced in the marketplace. Borrowers need to be aware of any such proposed changes and the potential impact such changes will have on certainty of funding as well as the costs associated with a facility.
In addition to the matters already mentioned, a further possible change is that financiers may wish to have underwriting type 'outs' in their documents. In other words, financiers may seek to either have a right to review and/or request repayment of the facility if there are significant movements in the stock market or the value of listed securities issued by the borrower (even if such movement does not trigger either an event of default or other review event). Borrowers will need to be careful to resist any such moves as clearly such circumstances are beyond the control of a borrower and do not necessarily affect the underlying business or the value of its assets.
In the context of takeover financing, such clauses are not likely to be acceptable as it will be necessary for a bidder to have certainty of funding in order to be able to fund the takeover.
Conclusion
Clearly, in the current market, there is a significant degree of uncertainty in relation to the ongoing funding of various entities which have suffered significant write-downs in the value of their listed securities or assets.
Financiers have closely considered their rights in relation to their borrower clients and no doubt are considering whether or not their existing documents provide them with sufficient protection in what are (hopefully) unusual circumstances.
In such times, it is important to ensure that parties comply with the terms of the document as previously agreed. In addition, in relation to new documents entered into, it is important to ensure that clauses are not included which will cut across the intention of the borrower to obtain certainty of funding.
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