COVID-19 (coronavirus): Potential for default triggers in finance arrangements

Introduction

The purpose of this note is to address the specific issues in financing agreements that lenders and borrowers alike will need consider in light of COVID-19. The list below is not exhaustive of the issues but hopefully highlight the need to consider and take advice on loan agreements given the current coronavirus crisis.

Non-payment: Depending on the length of interest periods, it may not take long before businesses incur payment defaults. It could be argued that likelihood of being unable to meet a payment known in advance is an indicator of insolvency or a Default but facility agreements typically give debtors the benefit of the doubt until the payment default actually occurs – there is always the chance of an improvement in liquidity or other possible solutions such as third party funding which will mean when the time comes the payment is made. However, one of the challenges with highly structured financing is that the ability to introduce new money or bring about measures to ease short term cash flow issues may be constrained by the existing financing arrangements. The expectation is that lenders, including new lenders, will try to be supportive of any borrower facing short-term liquidity issues but the nature of a borrower’s capital structure may be the problem, rather than lenders’ willingness to lend or provide further support. For this reason, borrowers need to be considering now how any new money could be injected into their group, whilst also being alive to the fact that depending on the nature of the discussions it has with its lenders, it may be that negotiations which are with a view to rescheduling any existing indebtedness could trigger Events of Default under existing facilities.

Non-payment may also be an act of repudiation if it evidences an intention not to repay the facility although any lender should be careful upon placing too much reliance upon repudiation clauses, particularly where it is a temporary state of affairs or where, as is often the case, a borrower is not making an unequivocal statement that would be required to evidence a repudiation event of default.

Financial covenants: If set correctly, financial tests will indicate early signs that a business is not performing as planned and are always a more comfortable default for lenders to rely on without risk of challenge or need to prove materiality. Loss of income and deterioration in asset values are likely to negatively affect financial covenant compliance. Lenders may be kept waiting though by test dates and timely provision of financial information, and they are commonly backward looking outside of the leveraged market.  Furthermore, borrower friendly markets in recent years have resulted in many “cov-lite” facilities being agreed and as a consequence breaches of the financial covenants may never be triggered except in extreme circumstances and long after the borrower has requested new money. If borrowers predict breaches, they may have contractual rights to cure by equity injection or be able to raise subordinated group debt to apply in partial prepayment, failing which they will need to reset covenants with lender support.

Cross-default: No lender wants to be left out in the cold whilst other creditors are exercising their rights to refinance, require early repayment and/or take enforcement action, and neither do they want to be under a continuing obligation to lend where other creditors are seeking to make recoveries, so most finance transactions will include cross default provisions by reference to widely defined concepts of borrowing and transactions having a similar commercial effect. These often include cross-defaults in derivatives transactions, finance leases, and counter-indemnity obligations for guarantees and letters of credit issued in support of borrower payment obligations to counterparties.

Insolvency: Once formal insolvency procedures are underway, restructuring options have usually been exhausted unless they are part of a restructuring plan (for example, an arrangement with creditors or pre-packaged administration) but earlier cash-flow or balance sheet insolvency default events may result quite quickly from a drop off in business where a company’s working capital is finely balanced, or where there is a sharp drop in the value of key assets (for example, real estate or aircraft). However, for the reasons stated above in the non-payment section, determining whether a company is balance sheet or cash flow insolvent is not always straightforward and there can be different rules from an accounting or legal perspective.

Cessation of business: A mere threatened suspension of a material part of a business will trigger an LMA-style cessation of business event of default – grounded aircraft, ships remaining in port, developments halted by lack of workers all have the potential to force a temporary suspension of business.

Expropriation: Often overlooked as an event unlikely to occur, but expropriation provisions are usually widely drafted to include business curtailment resulting from any restriction or other action by a governmental, regulatory or other authority.

Breach of laws: If government advice on business conduct during an epidemic or pandemic is not adhered to, a representation as to compliance with applicable laws and regulations may be breached on deemed repeat dates, but this isn’t usually an evergreen provision so lenders could be left waiting for interest payment dates before an event of default is triggered. Some facilities also include representations as to there being no threatened labour disputes, which might result from periods of quarantine and isolated working, as well as confirming that there are no other events or circumstance outstanding which would constitute a default or termination event under any other agreement where this has, or is reasonably like to have, an MAE (see below).

Material adverse effect (MAE): Many of the above defaults may be expected over time, but for lenders wanting to approach borrowers to consider refinancing options without waiting for payment defaults, financial covenant test dates, cross-defaults or deemed repetition of representations, the material adverse change event of default can be a useful catalyst. Their terms vary widely as borrowers view them as an unnecessary stick with which to beat them but most will be triggered by circumstances resulting in a deterioration in financial condition likely to adversely impact a borrower or group’s ability to service its debt. Less borrower friendly versions will extend to any material adverse effect on a borrower’s business, operations, property, condition (financial or otherwise) or prospects. It would not be difficult to predict that COVID-19 will adversely impact the prospects of most businesses in a hard hit location.

Audit qualification: Borrowers which have to file their audited accounts shortly will need to be consider whether any qualification to that audit will trigger an event of default. Auditors will, we assume, take a cautious view on the ability of companies to continue as going concerns and therefore whether any accounts can be provided on a clean basis or, for example, may require parental company support or some form of forbearance or support from lenders.

Information undertakings: Loan and security terms will require borrowers to keep their lenders informed of material contracts and potential breaches, amendments or waivers in relation to them  where those contracts are key to debt coverage, security packages or ongoing business. It is likely that loss of trade, supply shortages and the domino effect from business to business will trigger breaches or termination rights in material contracts which borrowers need to keep under review and disclose to lenders.

Next steps

If borrowers do not comply with their obligation to inform lenders of a breach, lenders are left in a difficult position – they do not want to risk wrongful enforcement but they do need to reassess credit risk and consider protecting their position and restructuring options to hopefully avoid a formal insolvency process, and ultimately achieve a better return by keeping the borrower trading. Some events of default must be continuing unwaived and unremedied before a lender can rely on them – this drafting is optional in the Loan Market Association templates and although when negotiated seem harmless, can be a block to restructuring options. Lenders need to be careful before waiving defaults in order to keep their options open and ensure they reserve their rights to take action in the future without needing to await further default events.