Welcome to the second of three joint editions of On Target and Collateral. Our April edition covered the key grounds on which directors of cash-strapped companies could be held liable for their or the company's acts, and in this newsletter we focus on five aspects of a company's third party credit facilities (term loans, revolving credit facilities etc.) that could now, or soon, cause concern in light of the hardships caused by COVID-19. Individual loan terms and circumstances will vary so this information below is not intended to be exhaustive, and (of course!) we advise seeking professional advice. The next and final edition in the series will consider how a borrower might approach negotiations with its lender to refinance or relax the terms of its facilities.
1. Can the company pay?
Borrowers need to quickly work out whether their cash flows are affected to such an extent that they will be unable to meet scheduled interest payments and repayments of principal.
External support may be a short-term solution if funding is available, but the ability to introduce third party funding or bring about measures to ease cash flow issues may be hindered by loan terms prohibiting or restricting other financial indebtedness and the condition of the business itself (given that external investors are likely to have less appetite to help fund an insolvent or near insolvent business). For these reasons, borrowers need to urgently evaluate how new money could be injected into the business while complying with the terms of their existing facilities.
2. Return of the MAC
A material adverse change default provision (MAC) is common in most finance agreements. Frequently the clause provides that a MAC will occur when there is a material adverse effect on the business, operations, assets or prospects of the borrower (or its group), the value or enforceability of any security, or the ability of the borrower (or its group) to perform their obligations.
The English courts have held that, for an event to be material, it must not be temporary and must significantly affect the party's ability to perform its obligations under the contract. In the context of the current crisis, it seems unlikely that a borrower simply being located in an area which is affected by the outbreak would, of itself, constitute a MAC in its financial condition (although, depending on the surrounding facts, it is likely that COVID-19 adversely impacts the prospects of most businesses in the worst hit areas).
Moreover, establishing a MAC is a highly subjective process involving careful consideration of the finance document's drafting and surrounding circumstances. As a result lenders have, historically, been reluctant to rely on a MAC as the sole basis for withdrawing loan or demanding repayment of monies advanced. Our experience is that many lenders are still nervous about relying on a MAC to support an acceleration of their loans, but that could change in the post-COVID era.
3. Financial Covenants...or lack of them
As a result of COVID-19, a borrower may experience a material deterioration in cashflow, asset values or other measures of financial performance, thereby affecting its ability to adhere to the financial covenants included in its loan documentation.
But these days it is not inevitable that financial stresses will result in borrowers defaulting under their financing arrangements. This is mainly because of the so called "covenant-lite" structures and documentary flexibility in loan agreements that have emerged over the past few years against the background of a significant supply of capital, meaning that breaches of financial covenants may never be triggered except in extreme circumstances.
In particular, in the context of revolving credit facilities (RCFs), financial maintenance covenants requiring a borrower to maintain certain coverage ratios during each reporting period have been largely replaced by 'springing' financial covenants that are only tested when the facility has been sufficiently drawn on the testing date (usually above 40%). This partly explains why there has been a recent trend for businesses to draw their revolving facilities in anticipation of challenges ahead, repay a proportion in the days before the testing period, and then draw again.
On the other hand the willingness of RCF lenders, especially in the small to mid-market space, to allow their borrowers to repay and redraw amounts in this manner is diminishing, and lenders are increasingly scrutinising whether borrowers are utilising their loans for a permitted purpose. If the use of proceeds is not permitted, that could be a justifiable reason for a lender to refuse further advances.
4. Insolvency and recent measures
Loan agreements of all sizes and complexity commonly contain extensive default provisions in the area of insolvency which, as well as covering the borrower's cash flow insolvency, are intended to bite when an insolvency situation arises in respect of the borrower. This can include suspension of payments, winding up, dissolution, administration or reorganisation. Sometimes simply the threat of an insolvency process being initiated against the borrower can be enough to trigger this event of default.
The government announcement on 23 April 2020 that any winding-up petition that claims that the company is unable to pay its debts must first be reviewed by the court and the temporary ban on the presentation of winding up petitions and making of winding-up orders (until at least 30 June 2020) where the inability to pay has arisen because of the COVID-19 pandemic means that the threat of formal insolvency procedures is likely to be mitigated somewhat, at least in the near-term.
5. Who is the Lender?
Lender assignment and transfer provisions in loan agreements have been a key focus for Borrowers over the last few years, largely as a result of the increasing involvement of non-bank lenders in the lending market.
It is customary for a lender to be able to assign or transfer its rights to a wide class of permitted assignees and transferees, including not just banks but any entity that is (using a typical definition) "regularly engaged in or established for the purpose of making, purchasing or investing in loans, securities or other financial assets". This class is often very broad, and includes for example CLOs, hedge funds and distressed debt specialists.
In the current climate it is important that borrowers keep a close eye on the change of lender provisions in their documents. In some cases, borrowers are afforded consultation rights to enable them to seek and suggest alternatives to an objectionable transferee, or a borrower can veto a transfer to an institution that is not on a periodic pre-approved lender list.
However, that is not always the case and in recent weeks we have seen a number of funds that specialise in distressed debt investments racing to gather increasingly large pools of money to buy distressed or bruised corporate loans and assets. It is still too early to say how the strategy of these participants might play out over the medium to longer term, and it should be emphasised that these institutions are also often willing to provide rescue financing or underwrite a new capital injection where banks are unable to provide such funding. Nonetheless, borrowers should take heed of the expected re-emergence among these groups of 'loan-to-own' strategies, buying loans at discounts on the secondary market and seeking to swap debt for equity to build controlling positions.
Originally published May 2020.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.