With market pressures likely to lead to many businesses triggering events of default and material adverse change clauses, it is essential to understand how breaches might be avoided, cured, or tolerated by lenders.
The corporate treasurers of any business that could potentially suffer from the adverse financial impact of Covid-19 will be acutely aware of the need to carefully manage any financing arrangements with each key creditor.
The impact on industries such as airlines, manufacturing, retail and tourism has been widely reported. With the potential of port and travel restrictions, increased pressure on bandwidth, a reduction in consumer spending in China and beyond, a decline in energy demand, and factory, retail and office closures, businesses in almost any sector could be affected.
Events of default
A company suffering, or anticipating, financial distress will be at risk of triggering one, or likely several, events of default in its loan documents. Cashflow and other typical financial covenants may be breached as income deteriorates. Financial covenants are tested at set dates throughout the year, but loan agreements are designed to ensure the lender becomes aware of any financial distress as early as possible. A failure to make an interest or capital repayment on its due date will in most cases be an immediate event of default.
Cross default provisions ensure that if one loan is breached, it is likely that loans with other creditors will be affected. A breach of a loan agreement is also likely to constitute a ‘draw stop’ event, which will impact the availability of new financing.
Material adverse change
A loan agreement will also usually contain a ‘material adverse change’ (MAC) clause which allows a lender to call in the loan and enforce any credit support provided, if the relevant circumstances in that provision apply. The Loan Market Association’s template documents for leveraged finance transactions contain very widely drafted (albeit optional) language which could quite foreseeably be engaged: this refers to a material adverse change in the “business, operations, property, condition or prospects of the borrower” or “on the ability of the borrower to perform its obligations under the finance documents”.
However, MAC clauses tend to be heavily negotiated in loan agreements and the precise wording will therefore need to be carefully analysed to establish whether a MAC could be called. It remains to be seen whether strong borrowers will attempt to specifically carve the direct effects of Covid-19 out of the MAC clause when negotiating new deals, as we have seen in some recent M&A deals.
Affected businesses should check the terms of their business interruption insurance (if any) to establish how that might affect working capital and compliance with financial covenants. Some loan documents allow financial covenant breaches to be cured (such as by the injection of new equity), which borrowers may wish to consider ahead of engaging with their creditors.
A lender’s response will depend upon the severity of the financial impact on the business. We expect lenders to engage positively with customers in an effort to help support the business, but this will be balanced by the need to preserve the lender’s risk profile. Agreements may be reached that waive breaches for a short period (while reserving a lender’s rights) during which time increased reporting is likely to be required of the borrower so that the lender remains fully in the picture as regards the progress of the business.
We anticipate a slowdown in new lending deals over the coming months as M&A activity decreases as a result of the spread of Covid-19, although this may be counteracted to an extent by opportunistic M&A as companies and investors seek to benefit from decreasing asset values. Lenders may also be considering whether any specific due diligence should be carried out where there is (or potentially could be) a specific coronavirus-related risk. Bespoke conditions precedents may be required, or the deal may be put on hold until this period of uncertainty passes.
Finance parties (especially those active in the syndicated loan markets) will focus on their ability to avoid taking on financing commitments at pricing that doesn’t reflect the risk to the business presented by Covid-19 or allow them to de-risk their underwriting; or which leaves them over-exposed to sectors themselves exposed to the risk the virus presents. This may result in pricing or other terms being ‘flexed’ by arrangers and underwriters to mitigate such a risk.
‘Market Flex’ is a tool used by arrangers and underwriters to provide flexibility on pricing and other terms of the loan arrangement with a view to achieving a successful syndication during the loan life-cycle. Conversely, borrowers and financial sponsors will be mindful of lender ‘get-outs’ in loan commitment documentation which may act as an impediment to executing debt-financed transactions, as well as the scope of any such flex provisions.
Finally, although most finance documents are carefully drafted to provide for appropriate rights and protections, as well as appropriate remedies for breach, the application of more general legal principles, such as force majeure and frustration, should be kept under review.