On July 29, 2016, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”) and the Office of the Comptroller of the Currency (the “OCC,” and together with the Federal Reserve and the FDIC, the “Regulators”) released the results of the most recent Shared National Credit (“SNC”) Program Review, the process by which the Regulators assess credit risk and trends and risk management practices with respect to the largest and most complex credits shared by multiple regulated banks.
While the SNC Program reviews have been conducted since 1977 on an annual basis, beginning in 2016, the Regulators began conducting SNC bank examinations on a semiannual basis during the first and third calendar quarters (with some banks receiving two examinations per year and others continuing to receive only a single examination). The review released on July 29, 2016, relates to the review during the first quarter of 2016.
The highlights of the SNC Program Review include findings by the Regulators of improved underwriting and risk management practices by the regulated banks in leveraged loan originations, that regulated banks are originating minimal levels of non-pass loans, and of continued progress toward full compliance with the 2013 Interagency Guidance on Leveraged Lending (the “Leveraged Lending Guidance”). However, the Regulators noted that credit risk remains elevated, with the percentage of the SNC portfolio rated “special mention” (having potential deficiencies that deserve management’s close attention) or “classified” (rated “substandard,” “doubtful” or “loss”) at 17.2% as compared to 15.3% in 2015. The Regulators also noted that borrowers have not used the post-financial crisis period of low interest rates to de-lever their balance sheets as was typical in past business cycles, but instead have taken on additional debt, which may be more difficult to service in the future in a recessionary or higher interest rate environment.
In connection with the latest SNC Program Review, there have been a number of anecdotal reports, both in the press and among practitioners, of how the Regulators are applying the Leveraged Lending Guidance (which can be found here). Notwithstanding the issuance of Frequently Asked Questions for implementing the Leveraged Lending Guidance on November 7, 2014 (which can be found here), many misconceptions regarding the application of the Leveraged Lending Guidance remain.
Set forth below are a number of the more prominent misconceptions regarding the Leveraged Lending Guidance, together with how, in reality, the guidance is being applied by the
- Misconception: There is a category of loans within “pass” loans known as a “close pass,” and a bank cannot accumulate too many close passes without an adverse regulatory consequence.
Reality: There is no rating category of close pass. Loans are rated pass, special mention or classified, with the classified category consisting of substantial, doubtful or loss loans. This is not to say that the Regulators are not mindful of loans that are at a higher risk of falling into a special motion or classified category. Regulators expect banks to have policies and procedures in place to monitor such loans, particularly when a recessionary environment or rising interest rate environment would meaningfully adversely affect the credit.
- Misconception: Non-bank entities are free from any consequences in noncompliance with the Leveraged Lending Guidance.
Reality: This is likely not the case. While non-bank entities and their affiliates may not be subject to direct regulation by the Federal Reserve, FDIC or OCC, the Regulators monitor the activity of non-bank entities in the leveraged lending market, and most non-banks or one or more of their affiliates are regulated by either the Securities and Exchange Commission, state insurance regulators, foreign banking regulators and/or pension regulators. If the Federal Reserve, FDIC or OCC is concerned with the conduct of a non-bank entity in the leveraged lending market, it may, among other actions, communicate those concerns to other regulatory authorities that may have the ability to exert influence over the non-bank entity.
- Misconception: If a borrower is more than a certain multiple above 6x total leverage, the loan will almost certainly be criticized.
Reality: There is no initial leverage level at which a loan will be automatically criticized. A large percentage of loans of borrowers that are greater than 6x leveraged are SNC passes. Conversely, many loans of borrowers that are less than 6x leveraged are SNC non-passes. If the expectation for large cash flow growth and rapid paydown is reasonable, initial leverage well in excess of 6x will not necessarily result in criticism; and if the borrower is in an industry where decreasing free cash flow is expected, significantly lower leverage levels may be at risk of criticism by the Regulators.
- Misconception: If EBITDA add-backs exceed a certain percentage of base EBITDA, the loan is more likely to be criticized.
Reality: There is no specified percentage of EBITDA add-backs above which the Regulators will not give credit. The standard for all add-backs, be they large or small, is whether they represent reasonable, bona fide, achievable adjustments. Loans relying on a large percentage of EBITDA add-backs have been SNC passes, and loans with minimal add-backs have been SNC non-passes. There is no correlation that lenders can rely on for guidance in this regard.
- Misconception: A bank can inform a borrower that its loan has been criticized by the Regulators to enable it to plan how it intends to remedy the deficiencies or arrange for non-bank entities to replace regulated banks in a refinancing.
Reality: The rating of loans by the Regulators is confidential, and the rating (or matters giving rise to a particular criticism of a loan) communicated to a bank by a Regulator cannot lawfully be disclosed by a regulated bank to the borrower.
- Misconception: There is a substantial risk that borrowers will be unable to refinance non-pass loans with regulated banks, which may result in the unavailability of revolving credit facilities, given the limited capacity of non-bank entities to provide revolving credit facilities.
Reality: The Regulators are well-aware of the refinancing cliff and have indicated a willingness to be flexible in the context of a refinancing of a non-pass loan. However, action must be taken in the refinancing to correct or mitigate the concerns that resulted in the non-pass rating, and there is no “one size fits all” prescription to the correction/mitigation. Possible measures include the contribution of additional equity or junior debt to the borrower; enhancing the collateral for the loan; adding guarantors of the loan; reducing the size of the incremental facility or other additional indebtedness baskets or conditioning access to such baskets on credit improvement (such as a lower leverage ratio); and reducing the size of restricted payments and/or investment baskets or conditioning access to such baskets on credit improvement.
- Misconception: If the borrower is not initially leveraged greater than 6x and base cash flow projections prepared reasonably and in good faith show all secured debt and 50% of total debt being repaid in five to seven years, the loan will not be criticized based on the leverage and paydown character of the credit.
Reality: By their very nature, out-year cash flow projections are more uncertain than near-term projections. If the projected paydown is heavily weighted toward later years, the loan may be criticized on this basis. In addition, despite projected available cash flow for debt repayment, if the sponsor is expected to distribute available cash flow as dividends or incur debt to pay dividends notwithstanding the capacity to repay debt, a portion of available cash flow projected to reduce debt might be assumed to be utilized for distributions to equity holders to the extent permitted by the credit agreement covenants.
- Misconception: If the “free and clear” incremental facility basket is more than a certain multiple of closing-date EBITDA, it will be assumed to be fully drawn and the loan is more likely to be criticized.
Reality: There is no acceptable or unacceptable size of the free-and-clear incremental facility basket, and whether it will be assumed to be drawn for purposes of the paydown analysis depends on the particular circumstances of the borrower and its business plan. The amounts of debt and secured debt permitted by the credit agreement are considered as a whole and in the context of the borrower’s business plan.
- Misconception: A checklist regarding acceptable/unacceptable negative covenant exceptions and baskets is utilized in the loan review process.
Reality: There are no lists or standard metrics used in evaluating covenant protections in the loan review process. Restricted payments, additional debt, additional liens, etc., that are permitted up to certain dollar amounts, percentages of total assets, tangible assets, EBITDA or similar benchmarks, or if certain leverage levels are not exceeded are not inherently acceptable or unacceptable. As discussed above, what the covenants permit is viewed as a whole and is certainly relevant in the review process, particularly in terms of impact on debt repayment, distributions to equity holders and other payments outside the credit, and the ability to increase leverage or dilute or prime the lenders’ claims against collateral.
- Misconception: A leveraged buyout with an equity contribution less than a certain percentage of total capitalization is likely to result in the loans financing the buyout being criticized.
Reality: There is no minimum equity contribution percentage below which the loans will be criticized. While the failure of a bank to adhere to its own underwriting standards (which may require a minimum equity contribution in leveraged buyout financings) is a factor taken into account in determining whether a loan will be criticized, the Regulators have no standard metric for minimum equity contributions.