Briefing

March 23 2020

COVID-19 concerns for borrowers and lenders: 11 points to keep top of mind for US financings

The COVID-19 pandemic has wreaked havoc on the global economy. The equity markets, the travel and tourism industry, and retail establishments of all stripes have been hit hard. In addition to manufacturing, shipping, and other operational and supply chain disruptions, companies will need to address their borrowing requirements. Likewise, lenders, bondholders and alternative capital providers will need to consider what their rights and obligations are under their financing documents. These financing providers may also want to take advantage of the opportunities that the financial dislocation caused by COVID-19 will invariably present.

In the current environment, liquidity is precious and borrowers are focused on drawing down on their credit facilities (while they still can) to address near term liquidity needs. At the same time, “cov-lite” lending has prevailed for the past several years. This is a relief for borrowers who have the breathing room to formulate a strategy to present to lenders without undue pressure. Without maintenance covenants to provide lenders with early warning signs regarding the health of their borrowers, however, lenders must be especially vigilant and request a strategy from their borrowers. Lenders will want to consider all of the tools at their disposal to bring borrowers to the table preemptively and early in order to gain insight into their borrowers’ financial condition and to embark on a dialogue with their borrowers about the path forward.

Against this backdrop, 11 of the issues that should be top of mind for borrowers and lenders are as follows:

1. Lending facility draws, the need for liquidity, and incurrence tests
   
   A) Facility draw - borrower considerations

   Borrowers are seeking to bolster their liquidity positions by drawing down (and in some cases maxing out) on their delayed draw and revolving credit facilities. Boeing, for example, has announced that it will seek to draw as much as $13.8 billion under its facilities. In addition to the perceived need for additional cash in the face of what could be a sustained health and economic crisis, borrowers have been motivated by several factors to bolster their liquidity positions.

   • Borrowers are drawing on their facilities as a precautionary measure while they can still meet their incurrence tests (e.g., financial condition requirements that are a prerequisite to a draw).
   • Market participants have systemic concerns about whether the credit markets will continue to function or whether the system will freeze up.
   • Borrowers’ officers and directors may believe that at the present time they are able to make and defend the representations and warranties that are required in order for borrowers to draw on their lending facilities – e.g., no material adverse effect, no material adverse change and no insolvency – whereas the future is uncertain. 

   Borrowers will also want to carefully monitor the amount of draws and watch for any ‘springing’ financial maintenance covenants that are tested after a borrower’s revolving facility is drawn above a certain threshold.
   
   B) Facility draw - lender considerations

   Incurrence covenants, such as leverage tests and fixed charge coverage ratios, afford lenders an opportunity to test the financial health of their borrowers. To receive the full benefit, lenders should rigorously monitor and inspect whether all incurrence covenants have been satisfied before honoring a draw. Lenders should also be aware that while most tests may be pro forma (in that they assume the draw has occurred for purposes of calculating compliance with the test), the ratio tests are nonetheless historical – i.e. based on trailing 12-month EBITDA. The historical nature of these tests gives the borrower the benefit of the prior 12 months of (healthier) revenue and may not reflect current (weaker) conditions. 

   Because the value of incurrence tests is limited in that the earnings calculations are backwards looking, lenders should also scrutinize all data and information that their borrowers are required to deliver under the loan documents, including pursuant to lenders’ reasonable requests. Such information may include representations and warranties that that there is no MAC/MAE (material adverse change/material adverse event) and that the borrower is not insolvent.   These items are discussed more fully below.

2. Lender oversight – maintenance covenants and other tools
   
   

   Some “Cov-lite” loans do not contain any maintenance covenants (e.g., maximum debt to EBITDA and other financial tests) that allow lenders insight into the financial condition (albeit on a historical basis – because measurements of earnings are backwards looking) of their borrowers. Without maintenance covenants, lenders should monitor strictly whether the other covenants under their loan documents have been satisfied, because such covenants may provide the best (and, in some cases, the only) means of evaluating their borrowers’ financial condition. For example, covenants requiring the timely delivery of financials or projections may afford lenders the opportunity to engage with their borrowers before a payment default is imminent.

3. Calculation of EBITDA and consolidated net income
   
   

   Reduced revenue would ordinarily adversely affect a borrower’s calculation of EBITDA or consolidated net income (CNI).  Borrowers and lenders should scrutinize the definitions of EBITDA and CNI contained in the loan documents to determine whether the borrower is entitled to make any adjustments to EBITDA or CNI based on COVID-19. For example, some definitions will permit add backs to EBITDA and CNI for extraordinary or one-time events.  

4. Material adverse change / material adverse effect
   
   

   Lenders have historically been reluctant to refuse to fund a draw on the basis of a perceived MAC/MAE for several reasons, including:

   • They want to support the financial system and appease regulators, politicians and “main street”.
   • Fears about lender liability claims.
   • They do not want to be put at a reputational disadvantage relative to competitors.

   We are not currently aware of widespread instances of lenders refusing to fund based on a MAC/MAE resulting from COVID-19. Nevertheless, lenders should scrutinize the specific terms of their MAC/MAE language both to ensure compliance and also because these provisions may provide a basis to request additional information.

5. Solvency
   
   

   A draw under a credit facility may require the borrower to bring down a representation and warranty concerning solvency. Lenders may decide to push back on a borrower’s solvency representation, particularly if cash flow solvency is thought to be an issue in view of economic conditions precipitated by the COVID-19 crisis. Lenders may wish to consider requiring borrowers to produce projections demonstrating that their anticipated cash flows are sufficient to meet upcoming cash needs during the next 12 months. 

6. Ratings downgrades
   
   

   A ratings trigger contained in bond indentures and swap agreements requires a borrower to maintain a credit rating above a specified threshold level. 

   • Investment grade debt often requires the borrower to offer to repurchase the notes if there is a change of control. Some investment grade bonds require the borrower to offer to repurchase only if there is both a change of control and a ratings downgrade related to the change of control.
   • High yield debt deals sometimes provide that if the ratings achieve investment grade, many covenants fall away. If the rating then falls below investment grade again, the covenants return.
   • Ratings downgrades can be a termination event in swap agreements.

   Ratings downgrades will typically put downward pressure on the trading price of the bond or loan that is the subject of the downgrade. The downgrade signifies greater credit risk, which may go uncompensated. Also contributing to the downward pricing pressure is the fact that certain investment vehicles may be forced to sell bonds or loans that do not maintain certain credit ratings. These forced sales contribute to downward pressure on prices.

   Lenders that find themselves unable to fund valid draw requests may choose to sell out of their position rather than be a defaulting lender. These circumstances may put further downward pressure on loan prices.

7. Deadlines for financial reporting
   
   

   For many companies, the end of their fiscal year coincides with the end of the calendar year (December 31). Those companies are likely obligated by the terms of their indentures and credit documents to deliver audited annual financials on or about March 31 or shortly after that date. Given the need for the involvement of outside auditors in the preparation of the financials coupled with the current challenges of people working from home, many companies will struggle to meet the deadline for delivery of financials. (Borrowers may also struggle to get a clean audit without a going concern qualification if credit markets freeze and borrowers find it difficult to refinance debt maturing in the next 12 months.) The inability to deliver timely financials may afford borrowers and lenders the opportunity to discuss the borrower’s plan, including anticipated liquidity, projections and performance. (Note that to the extent the documentation requires financial statements to be provided in accordance with SEC deadlines, the SEC has announced a 45-day grace period for filings that cannot be made in accordance with otherwise applicable deadlines due to COVID-19.)

8. Projections
   
   

   Lenders may wish to insist that borrowers comply with their covenants, if applicable, to deliver a budget. Lenders should run their own sensitivity analyses over the budget and financials to:

   • Assess whether liquidity is sufficient.
   • Consider whether borrowers will meet required debt service.
   • Otherwise evaluate potential covenant compliance or defaults.
9. Mandatory insolvency filing requirements
   
   

   Companies with global operations should consider whether they have statutory obligations in certain countries to report financial distress. For example, as a matter of German law, management of a joint stock corporation such as a German AG is under an obligation to file for insolvency without undue delay if a company is cash flow insolvent or balance sheet insolvent.  Failure to comply with this obligation may expose management to personal liability risk and criminal sanctions. Note that the German government is expected to suspend the mandatory filing obligation until September 30 or even next year. Other countries (such as Spain and France) may adopt similar measures.

10. Special concerns for CLOs
    
    

    CLOs are cashflow securitizations constructed to be unaffected by changes in market value of the underlying collateral loans. The failure of overcollateralization ("OC") tests generally requires cashflows that would otherwise be used to make distributions to equity (and to pay interest on junior tranches) to instead be used to pay down one or more senior tranches (and, in extreme circumstances, may constitute an Event of Default). For OC test purposes, an underlying collateral loan is generally carried at its par value, except when (a) it or pari passu or senior debt experiences a payment default, (b) the borrower is insolvent or rated distressed or (c) a CCC/Caa rating basket fills up. Concern over this haircut (particularly due to the CCC/Caa basket filling up as underlying borrowers are downgraded) is causing outstanding CLO subordinated debt tranches to trade at a significant discount. CLO sales of underlying loans not carried at par (which can frequently be sold above the price at which they are carried for OC test purposes) puts downward pressure on loan prices. Furthermore, few, if any, new CLOs are being issued, which significantly constrains the market for newly originated loans.

11. Special concerns for project finance
    
    

    Lenders will want to understand what their borrowers’ particular vulnerabilities are in the context of the pandemic.

    • How are supply chains likely to be affected? 
    • To what extent are suppliers and customers permitted to claim force majeure or other excuses to performance? 
    • Are force majeure provisions consistent across all project documents to ensure that borrowers do not find themselves without sufficient supplies of feedstock but nonetheless still obligated to deliver to offtakers?

    An excuse based on force majeure principles does not typically apply to a borrower’s debt service obligations to its lender nor does force majeure usually excuse payment obligations (as opposed to performance obligations) to project contract counterparties. Lenders will want to consider whether any events of default have occurred that would give the lender step in rights to prevent the termination of key contracts relating to the project.  Lender should consider the nature of the default, as many projects are now suffering from performance disruptions owing to a shortage of labor and materials. Typically, a force majeure event needs to be prolonged (as determined in accordance with the loan documents) in order for it to constitute an event of default. Lenders should review carefully the terms of their loan agreements as well as the underlying project documents to understand how these documents fit together and what can be achieved as a practical matter.