With concerns around the potential economic impact of the COVID-19 coronavirus developing a momentum similar to the spread of cases, some key implications for debt finance documents are becoming clearer.
Loans made to businesses on the basis of projected cashflows are receiving particular attention due to their correlation with the performance of the economy in particular sectors. Generally, more leverage in a business will amplify and potentially accelerate the adverse effects of an economic shock.
However, our analysis has wider application than leveraged loans alone, extending to other types of financing such as bonds, private placement notes and structured financial products.
There will also be a spectrum of impact felt by borrowers and issuers – with those most closely linked to more challenged sectors at one end, for example: those exposed to China as a supplier or end market; domestic or European based businesses predicated on movement of consumers such as travel, hospitality and leisure; and bricks and mortar retail businesses contemplating a decrease in footfall or even the imposition of restrictions or an outright ban on public gatherings.
In each case it will be necessary to examine, at a granular level, how deteriorating economics and changes in customer or consumer behaviour could adversely impact the ability of borrowers and issuers to comply with their contractual obligations.
What are the most relevant implications for loan finance documents?
Likely issues for borrowers – which also translate into concerns for lenders – can be broadly categorised as:
- Stemming from deteriorating cashflow and other adverse financial impacts on the borrower group.
- Relating to wider circumstances that could constitute a "material adverse effect" (MAE).
- Structural and operational issues.
In relation to the first category:
- Breach of financial covenants: Where these are included in a financing agreement, they act as an early warning signal for lenders of borrower financial distress – in particular, "cashflow", "interest cover" and similar covenants that focus on a borrower’s ability to service interest on, or make scheduled repayments of, outstanding debt. A request for a waiver might focus on the specific effects of coronavirus fallout over a limited period and/or point to equivalent trading periods in other financial years (see below on "shock adjustment").
- Difficulty or even inability to meet scheduled payments of interest and principal: With very limited scope for relief (see "Overriding legal considerations" below), this will constitute an event of default unless a waiver, amendment and/or wider restructuring can be agreed with lenders.
- Insolvency-related events of default: Being unable to pay creditors as debts fall due (not just meeting debt service as above) would be a default trigger – and could also give rise to more general insolvency concerns. The wider legal implications for each company within a group, and each of its directors, would also require careful analysis from an insolvency and a directors’ duties perspective.
In relation to the second category:
- MAE: Lenders are generally reluctant to rely solely on an event (or series of events) having or being reasonably likely to have an MAE as the sole event of default entitling them to accelerate debt and enforce security. What constitutes an MAE is often generically defined (see below on the potential for specific exclusions) and is typically expected to be narrowly construed by the courts. Consequently, its chief purpose tends to be seen as bringing a borrower to the table with lenders in order to address possible concerns around the borrower’s ability to weather the adverse economic consequences of the coronavirus. Given the global nature of those economic consequences, it could be difficult for lenders to maintain without challenge that this event of default has occurred in respect of less than all comparable financings to which they are party. That said, a sufficiently granular examination of a particular borrower’s ability to perform its contractual obligations (of the sort mentioned above) might justify a lender’s selective invoking of this event of default in light of what it regards as challenges specific to that business.
- Cessation of business: In extremis, an event of default triggered by a "suspension or cessation of all or a material part of the borrower group’s business" could be in play – for example, should a "social-distancing" strategy of the sort described below restrict or prohibit public gatherings (such as visiting the cinema or a retail centre, or going to a conference).
In relation to the third category:
- Access to working capital facilities: Revolving credit facilities (RCFs), which provide access to working capital, typically "drawstop" the borrowing of new loans if there is a potential (as well as an actual) event of default extant. Obviously access to working capital is key at a time of depressed cashflow. Usually, borrowers are able to "rollover" on a cashless basis (i.e. without repaying and redrawing) RCF loans that have already been drawn, unless an actual event of default is continuing or even unless lenders have also taken acceleration action in respect of that event of default (a "declared default"). The impact of these potential constraints on access to its working capital facility, along with mitigants such as cash conservation and drawing down working capital ahead of need to stockpile on balance sheet, should be carefully considered by borrowers and their lenders.
- Cross default: Specific to defaults (payment and otherwise) arising under other financing arrangements of the borrower group, this event of default is intended to ensure that those other financings are not given an earlier opportunity to accelerate their debt and enforce any credit support. Equally, those other financings may have an equivalent event of default that can trigger into an RCF as above and cut off access to working capital.
- Indemnities: Given by the borrower group for the fees, costs and expenses (and potentially also losses and liabilities) of the facility agent and its professional advisers incurred as a result of investigating and addressing events of default. Such demands can add significantly to the financial burden on a cash-constrained business.
- Information undertakings: An obligation on the borrower to provide "such further information regarding the financial, assets and operations of its group as lenders may reasonably require" can enable lenders to obtain extra detail on the performance of the business in the face of a sharp downturn in trading (if the parties are not already engaged in full dialogue by that stage). Where lenders have particular concerns with the business, this provision can enable them to request the information they need to evaluate the risk – although of course in a healthy relationship one would expect dialogue in any event.
Putting in place new (or refinancing) debt facilities
Borrowers and lenders currently in, or about to enter, negotiations regarding new debt facilities will be well served by a refreshed focus on the provisions highlighted above.
In particular, depending on its assessment of how the evolving political and economic landscape related to the coronavirus will bear upon its business, a borrower may seek to introduce specific mitigating provisions, such as:
- Specific additional short to medium term headroom under its financial covenants, geared to the period of most acute anticipated coronavirus impact.
- Add-backs to covenants, perhaps including a degree of anticipated loss in certain tightly defined elements of projected revenues versus historic or comparative performance.
- Specific additional equity cure flexibility for the expected impact period, perhaps with an ability to apply cash on balance sheet; or including the ability to substitute other quarterly numbers for an affected quarter (so-called "shock adjustments", previously seen in a natural disaster or terrorism context).
- Setting lower minimum assets under management (AUM) for financial services borrowers that are tested on that metric and are exposed to falls in the market value of publicly traded securities. Such falls have followed the markets coming to terms with the economic implications of the coronavirus outbreak, and there may be more to come. The lower level could be permanent or – in similar fashion to a "shock adjustment" described above – temporary.
- Providing that the effects of the coronavirus will not constitute an MAE (which, if ever accepted, is likely to be where there is less uncertainty as to how the economic situation will develop).
Notwithstanding the above, many lenders may prefer not to include prescriptive mechanics in loan documentation, but to simultaneously monitor the situation and maintain a pragmatic approach. It seems likely that lenders will be encouraged in this by financial regulators and governments, whose public discussion of mitigating measures already includes lowering interest rates, giving vulnerable businesses more scope to manage the timing of tax payments and urging lenders to act responsibly in relation to coronavirus-specific (as opposed to more general underlying business-specific) issues.
Assessing the likelihood and effect of the UK government (or another relevant jurisdiction’s authorities) taking action to reduce contact between people as part of a so-called "social-distancing" strategy for coronavirus – as already implemented in some hot spots abroad and mooted in the UK – will obviously be important for businesses which depend on people congregating and/or footfall such as in the hospitality and leisure sectors, including sports venues, cinemas, bingo halls, music establishments, pubs and restaurants.
Of course, many businesses may not wait for governments to act before taking their own protective measures, and the impact of individual decisions to reduce face-to-face social and professional contact will be even harder to model. There appears already to have been a significant financial effect on airlines, as attested by Flybe’s eventual collapse into administration following widely reported financial difficulties, although private jets may buck the trend if business and wealthy private international travellers seek out their exclusive offering. Bricks and mortar retailers could be doubly hit: through coronavirus-induced disruption to their supply chains (for those who rely on offsite manufacturing) and the reticence of customers to set foot in stores.
Manufacturing in China in February recorded its worst month since the country created its purchasing managers’ index 15 years ago (which was before the global financial crisis). The obvious supply chain concerns that follow such announcements are exacerbated by businesses that manufacture goods away from China also being exposed to the dramatic slowdown in activity where (as often) they buy components and raw materials from China, or market their luxury goods there.
There are also concerns in the wholesale debt markets. The Financial Times reported this week that Micro Focus, one of the UK’s largest technology businesses, withdrew from an intended refinancing of its loan facilities due to “adverse market conditions” in the wake of the growing economic impact of the coronavirus.
However, for those businesses not able to postpone the putting in place of new (or refinanced) debt facilities, a careful appraisal of the potential financial and legal risks will be key to setting balanced financing terms that adequately protect lenders without exposing borrowers to punitive pricing or every macro-economic twist and turn of the developing coronavirus situation.
Overriding legal considerations
We should also consider state intervention of a different kind: that which seeks to interfere with the freedom of parties to contract on whatever terms they agree.
There are reports of the Chinese state implementing measures to ensure banks continue lending to local manufacturing and other troubled businesses. The Chinese authorities have also been issuing "force majeure certificates", to partially or completely absolve a contractual party of liability for non-performance, defective performance or late performance of the contract due to the effects of the coronavirus outbreak.
We understand that the related Chinese legal doctrine of "changed circumstance" might also offer relief as an alternative to claiming force majeure, because it does not require that the party claiming it be unable to perform; rather, it applies a principle of fairness to whether the party should be held strictly to its bargain.
This is of interest to English lawyers, who are deeply attached to the principle of freedom of contract and accepting of a limited scope for the law to revisit contractual rights and obligations after creation. In contracts governed by English law, invoking force majeure would require there to be an appropriate right to do so granted by the contract – something not generally seen in finance documents, and arguably inappropriate to qualify key payment obligations (save for time-limited exceptions for material disruptions to payment systems that prevent payments being made).
The English common law doctrine of frustration is also available, but difficult to invoke. Its essence is circumstances having made performance of contractual obligations impossible, or a radically different prospect from that envisaged when the contract was entered into. A loan becoming more onerous to service and repay as a result of a poor trading environment is not likely to be sufficient. We understand that Hong Kong law has developed in similar fashion to English law in these areas.
Of course, new laws of this land can always be made by act of parliament. It has not (yet) been announced by the UK government that there will be, nor is there a strong UK legal tradition to support, an equivalent degree of state interference with contracts as that which seems broadly accepted in mainland China.
However, the coronavirus outbreak has been declared a global public health emergency “on an unprecedented scale” by the World Health Organisation. Unprecedented economic and legal measures may be considered necessary should the UK fall subject to a sufficiently perilous and broadly felt economic shock caused by widespread quarantining and reduced output at home and abroad. We continue to monitor further developments.