The widespread reach of the coronavirus (“Covid-19”) outbreak has unfavorably impacted numerous industries all over the world and sent shock waves across the global financial markets. As the outbreak has spread globally, a growing list of some of the world’s biggest companies have started to warn markets about the adverse impact the Covid-19 outbreak will have on their results and financial condition. As a result of the disruption to supply chains which has and will continue to negatively impact manufacturing operations and reduced consumer demand for various products and services as more countries implement strategies to contain the spread of the virus, it is highly probable that a significant number of businesses will generate lower earnings in the near term.
The negative impacts of the Covid-19 outbreak will result in greater difficulty for borrowers in complying with any financial covenants in their debt documents and, in certain instances, possibly servicing their debt as well as increased risks for their lenders and for arrangers of new debt financing. Arrangers of any potential new financings will need to perform enhanced due diligence to examine the risks of the Covid-19 outbreak on a prospective borrower’s business, including the potential risks related to any such business’ supply and/or customer contracts. Borrowers and lenders will also need to examine their loan documentation closely to review, among other things, any financial covenants (including the definitions of financial terms), grace periods and potential penalties for breaches of representations and warranties, covenants and notice requirements in these documents. Companies may also need to assess their ability to draw on existing facilities, refinance or access interim financing or consider alternatives such as delaying non-essential investments and/or selling assets as a way of raising cash to address short-term liquidity requirements.
Breaches of covenants generally allow lenders to declare a default under loan documents and demand early repayment of loans and/or act as a draw-stop, so that borrowers will not have access to their liquidity facilities. As a result, borrowers faced with prospective breaches must consider further steps on a timely basis to determine whether it can or should draw on existing available debt commitments (and lenders will need to pay closer attention as to whether the conditions to borrowing have been satisfied) or whether it would be prudent to proactively seek waivers in advance.
Although “covenant-lite” credit facilities have become more common in the U.S. and Europe in recent years, a material drop in a borrower’s earnings will have an adverse impact on its cash flows and may drive companies to become more reliant on their revolving facilities for future liquidity needs. This increased usage by borrowers of their revolving facilities could trigger related springing maintenance test thresholds in loan financing documents.
Lenders and borrowers will need to assess the impact of Covid-19 on borrowers’ ability to comply with their financial covenants. Since many credit facilities, when testing financial covenants for compliance purposes, measure EBITDA over the last four fiscal quarter period, the negative impact of the Covid-19 outbreak could last well into 2021 for a business.
Borrowers and lenders will need to scrutinize certain financial covenant related definitions (such as “consolidated net income” and “consolidated EBITDA” and similar terms) in loan documents carefully to determine if add-backs (such as for cost savings, synergies or other permitted initiatives) could be utilized to limit the amount of covenant impact resulting from decreased net income or EBITDA. Adjustments to the definition of “consolidated EBITDA” may have implications beyond financial covenant compliance such as step-downs for the asset sale and excess cash flow mandatory prepayment provisions, certain covenant baskets (such as additional debt and lien incurrences) and possibly pricing step-downs.
In addition to possible waivers or amendments to covenants that are at risk of being tripped, borrowers and their owners may consider pre-emptive injections of equity to ensure covenant compliance and designate the same proceeds as cure amounts to equity cure a covenant breach. Accordingly, careful consideration will need to be given to the parameters of the equity cure provisions.
Depending on how prolonged a period Covid-19 adversely impacts supply chains, manufacturing and the revenues of businesses, such events could negatively impact the available “borrowing base” for businesses reliant on asset based liquidity facilities as the value of such businesses’ inventory and receivables decline. In addition, as excess availability under these facilities declines, borrowers may be faced with increased reporting obligations, more stringent limitations on their cash management and required compliance with additional financial covenants.
Reporting and notification obligations to lenders vary between credit agreements, but typically include:
- financial information and auditors reports
- compliance certificates
- changes in credit rating
- matters relating to litigation and material contracts and/or developments expected to have a material adverse effect.
Information requirements may also include a catch-all for information requested by the lenders.
Borrowers should review their obligations to provide notices under their debt documents and any deadlines by which they are obliged to deliver any such information and notices. Even where a grace period applies, a notice may still be required.
Representations and Warranties
Borrower and lenders should review a number of customary representations and warranties contained in debt documents that should be given consideration in the context of Covid-19:
- Material Adverse Effect: If not an event of default (see below), it is common for credit agreements to contain a representation and warranty that there have been no (or are not expected to be) circumstances having a material adverse effect on assets, business or financial condition of the group since a specified prior date (often the most recent financial statements). Borrowers are generally required to certify to their lenders that the representations and warranties in the loan documents are true and correct as one of the conditions to borrowing. Bringing down the “material adverse effect” representation may be troublesome for a borrower with a temporary, but material dip in performance and could result in a breach despite the fact that it is not violating its covenants. Material adverse effect definitions are negotiated heavily and differ from debt document to debt document so the precise wording would need to be analyzed carefully. Common distinctions include the degree of certainty that the circumstances “might” or “will” have a Material Adverse Effect required to trigger the provision or whether the occurrence is determined by an objective test or in the sole discretion of the lenders. As further discussed under Events of Default below, parties should be cautious as to whether a short-term economic downturn constitutes a material adverse event and such determination must be made on a case-by-case, fact and language specific basis.
- No Default: This representation typically pertains to defaults under the loan documents as well as defaults or termination events under other material agreements. This representation could be relevant where a company’s performance under third party contracts (including supply and commercial contracts) is materially adversely affected by the Covid-19 outbreak.
- Disputes: Depending on the facts and circumstances of a particular borrower, the representations relating to litigation and judgments may need to be reviewed. In particular, careful review should be made for businesses that are subject to litigation as a result of the failure to perform under material contracts (for instance, litigation relating to assertion that Covid-19 constitutes a force majeure event under the relevant contract).
There may also be other deal-specific representations that need to be reviewed.
Generally, borrowers and lenders should be aware of the timing for when borrowers are required to make representations, such as when delivering any certificates or borrowing requests, or whether any such representations are continuing, in order to determine whether the borrower is in compliance at the relevant times.
Events of Default
A breach of any payment obligation and/or other covenants (after the expiry of any applicable grace periods), including financial and notification covenants, or the failure of any representation to be correct in all material respects when made could trigger an event of default under the relevant loan documents. In addition to such breaches, the following customary events of default may be relevant in the context of the Covid-19 outbreak (however, the extent to which the impact of Covid-19 might give rise to an event of default will depends on the description of such events in the relevant loan documentation and any applicable grace periods):
- Payment Defaults and Cross-Defaults: A borrower’s failure to pay principal, interest and fees when due will generally trigger an immediate event of default (with respect to failures to pay principal) or have very short cure periods. Further loan documents typically contain a cross-default in respect of events of default and/or failures to make payments under other indebtedness above a certain threshold. Borrowers and their lenders, therefore, should be aware of the relevant terms and thresholds across their loan documents and such borrower’s other debt instruments. Additionally, some loan documentation may contain business specific cross-defaults relating to defaults or suspension in respect of of performance under material third party contracts.
- Material Adverse Effect: Although many broadly syndicated loan facilities will not contain a stand-alone “Material Adverse Effect” (also called “Material Adverse Change”) event of default, there still are some loan documents, particularly for middle market facilities that may contain such a provision . There is no bright-line test to establishing a Material Adverse Effect under New York law. While there have been more cases under Delaware law in the mergers and acquisition context, New York courts have looked to those decisions for purposes of determining whether a “Material Adverse Effect” has occurred and in both jurisdictions there is limited case law and guidance from the courts on enforcing Material Adverse Effect clauses, as each case is fact and wording specific. However, in both jurisdictions, enforcing a Material Adverse Effect clause requires the party relying on the provision to meet a high burden of proof in evidencing that there has been an event that has caused a persistent and continual decline specific to a borrower’s business. The courts may also consider factors such as the intentions and prior knowledge of the parties, the wording of the provision, the surrounding terms of the contract, market benchmarks and expert testimony. Under New York and Delaware case law, steep declines in a company’s year on year (or, in a limited number of cases, even shorter-term) performance could constitute a Material Adverse Effect, the relevant case law generally indicates that materiality should be based on a substantial threat to the overall earnings potential of the business in a durationally significant manner. In general, the precedents demonstrate that New York courts will apply a fact specific analysis and short-term events or adverse economic conditions having a temporary adverse effect on a borrower would likely not constitute a Material Adverse Effect. In addition to the high hurdle to show that a Material Adverse Effect has occurred, lenders must also consider potential liability to a borrower if they improperly invoke this provision. Accordingly, borrowers and lenders should seek advice from their counsel to assist them in analyzing the particular facts and circumstances of the business and the specific language contained in the applicable loan documents.
- Audit: Under certain leveraged loan facilities, if the auditors qualify their report with a “going concern” qualification it could constitute a covenant violation of the financial statement delivery covenant that would constitute an event of default. Typically, a “going concern” qualification would result from an auditor’s view that the company will not be able to satisfy all of its short-term (i.e., one year or less) obligations, including the potential acceleration of indebtedness and maturities of indebtedness without a likelihood of refinancing.
- Insolvency: Borrowers and lenders should also carefully review the applicable provisions for the “bankruptcy event of default” as there may be circumstances other than an actual bankruptcy proceeding that could cause there to be an event of default. For instance, certain credit facilities provide that if the borrower admits in writing its inability to pay its debts, such event would constitute an event of default. Another example is that in certain credit facilities “insolvency proceedings” may include negotiations with creditors. Companies with non-U.S. subsidiaries should be especially vigilant about the risk that local subsidiary bankruptcies would be triggered by balance sheet insolvencies.
Applicable grace periods would need to be considered for all events of default. In some cases, the event of default may have no grace period. Borrowers should also be aware that the notification requirements may be triggered when the grace period commences rather than at its expiry.
Liquidity, Refinancing or Alternative Funding
While waivers and extensions may be effective for borrowers with a projected one-off financial covenant breach, borrowers in directly affected sectors projecting more than a one-off problem may need to seek to reset their covenants and other provisions governing their loan documents or seek alternative financing. This is especially true if the waiver were needed in or around an audit, because as noted above, going concern qualifications typically arise when auditors view a material risk of default within the subsequent 12-month period, which could mean a waiver that would expire in the short term could give rise to a going concern qualification. Arriving at an agreement on an amendment may lead to longer negotiation processes but may allow for sufficient headroom for distressed borrowers. Recent trends in the market indicate that any refinancing may see higher margins, LIBOR floors above zero and less room for step-downs in the short-term. Underwriters and arrangers may also seek to include additional conditions and significant flex in commitment papers.
Additionally, lenders may also want to perform increased diligence on termination and force majeure provisions in material supply and customer contracts in regions and sectors affected by Covid-19 as well as insurance policies covering business suspensions (which may or may not apply to Covid-19).
In the event a company is not able or chooses not to refinance its debt, such company in the alternative may be required to delay capital expenditure programs and/or forced to sell assets on a distressed basis, either of which could have an adverse effect on such company’s business.