Communicating With Your Lenders Early and Often Is More Important Than Ever
Date: April 01, 2020
With the onslaught of news that changes almost hourly describing the extent and impact of the COVID-19 virus, there can be no doubt that this outbreak is a global event that will impact most businesses and most industries, including yours. That means that now is the time to (1) take a candid look at your business to try and determine the short-, medium- and long-term effects of COVID-19, (2) thoroughly review your loan agreements to see if there are modifications that may be needed as a result of your business assessment and (3) develop a plan to speak with your lenders. Besides getting ahead of the issues that might arise in the future as a result of COVID-19, now is a good time to open up a dialogue with your lenders because they have specifically been encouraged by their government regulators to work with their borrowers who are or may be unable to meet their obligations, including their payment obligations, under their loan agreements as a result of the pandemic.
On March 20, 2020, the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, among other federal and state banking regulators, issued an Interagency Statement on Loan Modifications and Reports for Financial Institutions Working with Customers Affected by the Coronavirus. Specifically, the agencies said they would not criticize financial institutions that make prudent efforts to modify the terms of existing loans to borrowers impacted by the virus. In addition, the agencies confirmed with the Financial Accounting Standards Board that short-term (e.g., six months) modifications, including payment deferrals, fee waivers or other delays in payments that are insignificant and made on a good-faith basis in response to COVID-19, would not be classified as troubled debt restructuring so long as the borrower was “current” at the time of the modifications. A borrower will be considered “current” if it is less than 30 days past due on its contractual payments at the time the loan modification is made. Clearly, that means the time to act is now, starting with a thorough review of your loan agreements.
Reviewing the Loan Agreements
Representations and Warranties
Virtually all loan agreements require the borrower to make certain representations and warranties at certain times. Of perhaps primary importance under the current circumstances is the requirement that the representations and warranties be true at the time of each borrowing. Failure of a representation to be true and correct usually constitutes an event of default and, as a result, the possible suspension or termination of the ability to borrow and obtain letters of credit. Here are some of the representations that might be impacted by the effects of COVID-19 on your business:
- No default
- No litigation
- Compliance with material contracts and agreements
- True and complete disclosure of all material information
- No material adverse change or material adverse effect (MAE)
With regard to representations about a borrower’s financial condition or the absence of a MAE, the analysis is very fact and circumstance specific. Typically, courts have ruled that a significant downturn in the borrower’s industry, on its own, would not constitute a MAE. More often, it requires a downturn in the specific business of the borrower that has occurred and/or is expected to continue for a substantial period of time (e.g., longer than one quarter). Moreover, the decline in financial metrics (EBITDA, revenue, etc.) must be significant. Also important to the analysis is whether the MAE provision is written on a prospective or forward-looking basis or if it is retroactive. It is probably cold comfort to know that lenders tend to use violations of a MAE representation or a MAE event of default, if applicable, to stop borrowings and not necessarily to accelerate the maturity of loans unless other events of default also exist.
Affirmative covenants in loan agreements set forth the actions that a borrower must take at various times during the term of the loan. Here are some of the affirmative covenants likely to be implicated because of COVID-19:
- Financial reporting obligations – particularly audited financial statements and excess cash flow calculations
- Notice of certain events like defaults, occurrence of MAE, litigation and breaches of material contracts
- Delivery of budgets
- Third party deliverables (e.g., insurance)
Of particular note with respect to audited financial statements is whether such statements can be delivered on time if the borrower’s auditors are unable to access the materials they need because they can’t get to the borrower’s locations. In addition, auditors likely will be looking more critically at the borrower’s liquidity and probable financial covenant compliance in the future, which increases the likelihood of a “going concern” qualification that may not be permitted under the loan agreement.
Companies with asset-based loans (ABL) should carefully review their borrowing base certificates with a particular emphasis on the eligibility criteria. Any or all of the following circumstances could put pressure on borrowing availability:
- Granting payment extensions to customers
- Increased concentration levels
- Customer solvency
- Slow-moving inventory
As negative covenants restrict actions that can or can’t be taken by a borrower, during this pandemic period, these can have a particularly adverse impact on the ability of the borrower to operate its business and execute its business plan. Therefore, obtaining some cushion on one or more of these covenants may provide needed flexibility to support continuing operations.
One of the first things to understand is whether the financial covenants, if any, in your loan agreement are regular maintenance covenants or covenants that spring into application because of the occurrence of one or more specified events. If they are springing covenants, have the specified circumstances such as EBITDA and debt level triggers occurred or are they likely to occur? It may well be the case that a drop in operating performance will create a decline in EBITDA levels, putting pressure on leverage and, potentially, liquidity. A thorough analysis of the permitted add-backs to EBITDA, the definition of consolidated net income and other related definitions will be necessary to fully understand the impact of operating performance on the financial covenants. And keep in mind that most financial covenants are calculated on a trailing 12-month or four-quarter basis, so the impact sustained in 2020 will continue to be felt for at least some portion of 2021.
Formulating the Ask
Following the assessment of the current circumstances and likely prospects for the business and the precise review of your loan agreements, it’s time to formulate a plan of communication with your lenders about potential loan modifications designed to ease the impact of COVID-19. Here are some suggestions for modifications to consider:
- Deferral of interest payments or insertion of payment in kind (PIK) – toggle for some period of time (note that the capital structure of the business might not allow for PIK interest, but perhaps accrual of interest would work)
- Change frequency of interest payments from monthly to quarterly
- Deferral of amortization payments of principal for some limited period of time or to the end of maturity (perhaps with a cap or balloon)
- Mandatory prepayment relief
- No excess cash flow payment
- No prepayment from proceeds of extraordinary receipts or insurance proceeds (e.g., business interruption insurance)
- No prepayment with proceeds from an equity issuance
- For ABL facilities, temporary changes to advance rates or eligibility criteria and/or no prepayment required if a reserve causes the borrowing base to be out of compliance
- Potential add-backs toEBITDA
- Lost revenue related to pandemic
- Goodwill impairment
- Expenses related to certain business optimization activities
- Costs and expenses related to establishing a new supply source, finding replacement goods or hard costs specifically incurred in connection with COVID-19
- OtherEBITDA suggestions
- Establish a “deemed” EBITDA for one or more future quarters
- Allow add-backs specifically related to the impact of COVID-19, whether or not deducted from the calculation of consolidated net income (increased hygiene and cleaning costs, temporary shut-down costs, costs associated with retaining people not utilized, other non-recurring, unusual costs)
- Provide for a holiday from compliance with financial covenants for some period of time (e.g., two or more quarters, with discretion of agent to extend)
- Implement or expand equity cures
- Other miscellaneous suggestions
- Allow borrower to buy back debt and/or sponsor to purchase debt perhaps with limited voting rights
- Permit temporary equity infusion (no mandatory prepayment) that can be taken back out when the business stabilizes
- To the extent the borrower takes advantage of any government’s relief plans, the proceeds should not have to be used for mandatory prepayments, and if in the form of debt, the relief should be permitted, and the debt should not count for purposes of financial covenant calculations
- At least for borrowing purposes, eliminate the impact of a MAE representation and/or event of default caused by COVID-19 events
- Have a frank discussion with your lenders about eliminating or minimizing the impact of future events of default under material agreements and cross defaults that occur as a result of COVID-19
- Ensure that mechanisms for consents and waiver by email will be effective
The prevailing message across the country right now is that “we are all in this together,” so now is the time to contact your lenders and work collaboratively to develop a plan to get through this pandemic together. After all, the lenders will have their own liquidity and business issues, so they will have some sense of the concerns facing their borrowers. Conduct a thorough and realistic assessment of your current business operations and prospects, carefully review your loan agreements and then develop a reasonable set of “asks” for your lenders that will best ensure your company’s ability to withstand these volatile times.
For assistance reviewing your loan agreements or to exchange views on potential loan modification requests, please contact one of the Thompson Hine lawyers listed below.
FOR MORE INFORMATION
For more information, please contact:
Katherine D. Brandt
Thomas R. Butchko
David J. Naftzinger
Thompson Hine has assembled a firmwide multidisciplinary task force to address clients’ business and legal concerns and needs related to the COVID-19 pandemic. Please see our COVID-19 Task Force web page for additional information and resources.
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