Covid-19 – What borrowers and CFOs should watch out for
The outbreak of Covid-19 is having a large impact on the global economy. With the introduction of unprecedented disease control measures, businesses and supply chains around the world are finding themselves under an ever-increasing amount of stress. The financial markets around the world are volatile and the lack of visibility on how long this situation will be on-going puts stress on liquidity and financing needs. To deal with this, companies are likely to turn to their existing bank relations and loan agreements to safeguard already drawn loans from prepayments and to explore the possibilities of increasing credit. However, the negative impacts on business due to the global pandemic will at the same time result in borrowers finding it challenging to comply with the terms of their loan agreements. Borrowers wishing to keep their loan financings in place should carefully review certain key provisions in their loan agreements which may be triggered as a result of an economic downturn and adversely affect access to debt and liquidity.
We will in this newsletter discuss some of the key terms and conditions set out in a loan agreement, based on the LMA (Loan Market Association) standard terms and conditions, which borrowers carefully should review to secure continued access to loan financing.
Key provisions to watch
There are several clauses in loan agreements that protect lenders´ position, limit their exposure to loans utilised and potentially require early prepayment and enforcement of security. Further, there are provisions that, if not complied with, prevent borrowers from making additional drawings under loan agreements.
Often based on borrowers’ “base case models” financial covenants facilitate for lenders to monitor the business and they also function as early warnings in case of breaches. Financial covenants vary on a case-by-case basis and include defined accounting terms and ratios such as interest cover ratio, net debt cover and loan to value ratio that must be complied with during the life of the agreement. Changes to net income, decreased value of underlying assets and other financial metrics can result in defaults or require prepayments and impede the chances of drawing new loans. Borrowers having maintenance covenants need to report their compliance (or non-compliance) with such financial covenants on a regular basis and are hence under constant supervision by their banks, whilst borrowers with covenant light or incurrence-based covenants may have more room to manoeuvre.
An additional effect of worsened financial performance is a potential increased margin for borrowers with loan agreements containing margin ratchets.
Information requirements under a loan agreement may include financial reports and information, notification of a default, any changes to borrowers’ credit ratings, matters relating to any litigation or other changes which are expected to have a material adverse effect (see below). Borrowers should review any obligations to provide notices to lenders and the relevant deadlines since failure to provide such notices result in defaults. Also, lenders may have additional rights to request certain information from borrowers.
Material Adverse Effect
Virtually all loan agreements contain a material adverse effect (or material adverse change) representation and warranty. Such clause requires borrowers to certify that no circumstances having a material adverse effect on its business, assets, financial position or its ability to perform the payment obligations towards the lenders has occurred since a certain date. Complying with a material adverse effect representation may be difficult for borrowers experiencing a temporary but significant change in its financial position. Qualifying words such as “likely to have”, “might” or “will” are important to study since they impact the applicability of a material adverse effect provision.
Events of default
The events of default catalogue in a loan agreement is generally extensive and sets out certain events that give lenders the right to declare all outstanding loans immediately due and payable, cancel future utilisations and potentially also enforce security.
Borrowers should not only closely monitor their performance of payment obligations and compliance with the material provisions of the loan agreement, but also be aware of any material litigation or labour disputes as well as any insolvency proceedings. An insolvency event of default under a loan agreement may be triggered by other circumstances than formal insolvency proceedings. Borrowers should also pay extra attention to any cross-default provisions which may trigger an event of default under the loan agreement if there is a default under certain third-party agreements.
Loan agreements usually contain negative pledge provisions, meaning that borrowers may not pledge any assets, grant any security or similar to any third-party. Suppliers or any other third parties may, particularly during recessions, request borrowers to grant security, so the negative pledge restriction should be noted in such situations.
Lenders generally have certain transfer rights under loan agreements and borrowers in financial difficulties may be exposed to new lenders should banks syndicate or transfer loans made. White- and blacklists and other provisions may limit borrowers’ exposure in this respect.
Key actions to take
Below are some key actions that borrowers may take to prevent or mitigate exposure to the above mentioned risks.
- Initiate discussions with your lender at an early stage. While obvious, this should not be understated. Lenders are generally willing to work through financial issues together with their borrowers. Since accelerating loans and enforcing security often results in losses to all parties, lenders are generally reluctant to take such action before discussing work outs and out-of-court restructurings. Getting lenders on board to any significant amendments or waivers may be time consuming and initiating the process early is advantageous.
- Is your loan agreement based on the LMA standard terms and conditions or not? Loan agreements based on the LMA standard terms and conditions are generally more extensive and balanced than agreements based on a lender’s simplified precedents. The latter are often very lender friendly and may give the lender unilateral right to accelerate loans and enforce security if the lender in its sole discretion believes that the borrower will not be able to fulfil its obligations to the lender.
- Are the necessary funds available when needed? It is important to make sure that loans can be utilised when needed. Any events of defaults or defaults are likely to become draw-stops for further utilisation under a loan agreement. Borrowers should therefore be pro-active in planning when to utilise existing credit facilities to avoid issues that now may be months ahead to materialise and prevent future draw-downs when needed the most. Borrowers should also carefully consider existing terms for their credit facilities to make sure that lender friendly provisions and lender friendly precedents do not limit options if the Covid-19 pandemic lasts for a longer period and/or the economy goes into recession.
Please note that the information published in this article is only intended as general information and does not constitute, and is nor to be used as, professional legal advice.
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