One of the few certainties coming out of the COVID-19 pandemic is that the economic impact will be felt for a long time to come. Not just weeks and months, but likely years.
The crisis has presented two fundamental challenges from an insolvency perspective: a short-term liquidity crisis while companies deal with the widespread suspension of economic activity; and a mid- to long-term viability threat resulting from not only the crisis itself, but also from the response to the crisis.
We have seen a variety of responses to the liquidity crisis, including down-sizing, suspension or termination of employment, cost-cutting, and increased borrowing (including through government relief programs). But when economic activity fully resumes, what then?
The viability threat encompasses efforts by companies to normalize and sustain operations—that is, remain solvent—after the pandemic has ended but the long tail of its effects continue to be felt.
The long-term viability threat: what are the challenges?
Planning in uncharted waters. What will the new "normal" be coming out of this crisis? Spending and consumption patterns may take a long time to revert to pre-pandemic levels and patterns, and in many sectors may have changed permanently. The result for many companies will be sluggish earnings, and in many cases, higher costs. Companies will struggle to determine what stabilized revenues and costs looks like for several quarters to come. Forecasting and planning—including working capital management and capital expenditures programs—will be a challenge.
The coming downturn. A recession is all but certain, due to elevated unemployment levels, decreased consumer spending, increased personal loan defaults and bankruptcies, decimated industries (e.g., retail, oil and gas), and shocks to real estate markets, among other factors. Governments have few tools in the toolbox to mitigate a recession that have not already been engaged, such as lowering interest rates and government-backed lending programs. A prolonged recession is an obvious threat to the long-term viability of many companies already weakened by the liquidity crisis.
Addressing contracts. There is a glut of contractual breaches that need to be addressed, both monetary and non-monetary. Companies are faced with both numerous contracts in which they are in default, and numerous contracts in which their counterparties are in default. In each case, existing defaults raise the spectre of contract terminations, enforcement, default rates of interest and the exercise of other rights and remedies.
- Monetary defaults will attract immediate and obvious attention. For example, tenants who haven't been paying rent will need to reckon with landlords, and unpaid suppliers will expect to be brought current.
- Lenders and bondholders that have shown short-term forbearance will need to catch up on missed interest and maturity payments. And there will be numerous outstanding non-monetary contractual defaults—including covenant defaults—resulting from the pandemic.
- Formal restructuring or insolvency proceedings may be necessary to deal with widespread contractual defaults, but the most prudent companies may be those that engage legal and financial advisors early in order to proactively seek out a negotiated informal restructuring. Renegotiation, waivers, and amendments will be the order of the day—and those companies that cannot work out these issues consensually with contractual counterparties may end up facing a long-term viability threat.
Litigation risk. There may also be a significant increase in related litigation as parties dispute their contractual rights and remedies, including material adverse event clauses and termination rights.
Post-pandemic activism. Companies—and directors and officers—may face scrutiny and litigation from shareholders and other stakeholders for their handling of the company's response to the pandemic and losses suffered.
Financing. A key component of the viability threat will be the status of public debt and equity markets. Companies need capital to survive, including in order to obtain new debt financing and equity investment to fund operations, capital expenditure programs and the repayment of existing obligations. Some companies will have successfully implemented liquidity facilities during the initial months of the crisis. But those companies with debt that is maturing will need access to new financing or refinancing in order to remain viable, failing which forbearance or restructuring may be required. Some lenders and investors may see this period as one of great opportunity. But they will certainly approach risk in a more conservative fashion, including more expensive pricing for money they do make available. This tightening and increased cost of credit may push some companies into insolvency.
Surge in strategic M&A. Long-term viability for companies in distress may be predicated on strategic transactions, including debt-to-equity swaps and distressed M&A transactions. This will present opportunities to industry participants that are viable and well-capitalized even while proving a threat to companies that are not (and to their shareholders, who stand to lose most). Money-side participants such as private equity firms and pension funds will see both new opportunities for growth as well as challenges with some existing portfolio companies. The end result may be further concentration and consolidation, particularly in certain industries such as oil and gas/exploration and production companies, cannabis and retail (read our article on post-COVID-19 oil and gas in Canada here).
In the face of so much uncertainty, what is clear is that the companies that will fare best will be forward-looking and engage proactively to address these challenges while viability may still be ensured or restored with thoughtful restructuring steps. Discussions and negotiations with lenders, contractual counterparties and other key creditors should be pursued early and often, with a view to informal contractual solutions rather than court-supervised insolvency proceedings. Even where these challenges call for formal insolvency proceedings, a timely and strategic response to the viability threat may make all the difference between restructuring instead of liquidation and bankruptcy.
Originally published May 7, 2020.
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