Preparing for Potential Defaults under a Corporate Loan Agreement
As the coronavirus pandemic continues to depress large swaths of the economy, many businesses continue to experience significant revenue shortfall, and in some instances cash flow has ceased entirely. Unfortunately, for corporate borrowers, this raises the specter of a default on their loan obligations as they struggle to make timely payments and comply with financial covenants and other loan obligations. The repercussions of a lender declaring an “Event of Default” under a loan can be severe and may include such potential lender rights and remedies as:
- refusing to make any further advances of any undrawn portion of a committed loan facility
- increasing the applicable interest rate to a “default rate”
- accelerating the loan and demanding immediate repayment of all outstanding loan amounts
- commencing litigation seeking payment on the loan
- foreclosing on or exercising rights with respect to collateral securing the loan
In light of such adverse consequences, corporate borrowers that find themselves veering toward default would be wise to take a proactive approach to prevent a lender from declaring an Event of Default, including notifying their lenders of potential problems before a default occurs. This post provides an overview of certain issues borrowers should consider when confronted with the possibility of one or more defaults under their loan documents in order to be best prepared to remedy the situation.
In order to anticipate the risk of default, it is critical for borrowers to understand whether, and to what extent, they may soon be unable to comply with the terms of their loan documents and under what circumstances a lender might declare an Event of Default as a consequence. As an initial matter, borrowers should certainly review their loan documents in order to determine what circumstances or occurrences might constitute an Event of Default. For borrowers with more than one loan, this can become complicated as they must also consider “cross-default” issues whereby an Event of Default under one loan agreement may automatically trigger an Event of Default under another loan agreement in which the borrower is otherwise in full compliance with its obligations. Regardless, while the exact types of borrower default that may lead to a lender declaring an Event of Default will be specific to a borrower’s particular loan documents, the following is a list of common Events of Default under corporate loan agreements:
- Payment default. Left unresolved, failure to pay amounts when they become due (e.g. a monthly payment of loan principal and/or interest) will almost invariably trigger an Event of Default.
- Financial covenant default. Financial covenants are meant to regularly test the financial strength of a borrower, with a covenant breach acting as an early warning sign to a lender that a borrower’s financial position is deteriorating and that it may be unable to meet its repayment obligations. A borrower’s unresolved breach of one or more financial covenants may trigger an Event of Default.
- Negative covenant default. Negative covenants require borrowers to refrain from performing a particular act. Examples of negative covenants include incurring additional debt or making restricted payments without lender consent. A breach of a negative covenant will typically lead to an Event of Default.
- Other defaults. In addition to payment defaults and financial covenant defaults, borrowers should review their loan agreements for other general defaults that may trigger an Event of Default such as cross-defaults and misrepresentations.
- Insolvency. A borrower’s insolvency will invariably constitute an Event of Default, and in some instances the mere threat of insolvency, can be enough to trigger this Event of Default.
In addition to these common Events of Default, borrowers should also familiarize themselves with the types of actions that may become prohibited under their loan documents once a loan is in default, which may include making distributions or dividends, selling company assets outside the ordinary course of business and making certain kinds of investments or capital expenditures. Indeed, while borrowers may be tempted to dispose of company assets or invest in a new line of business in an effort to generate cash to meet its loan obligations, in reality, absent lender consent such actions may only serve to make matters worse as they may violate loan covenants and thus result in additional defaults.
Formulating a Plan
Once borrowers have a better understanding of their potential (or existing) loan defaults, they can then better consider the alternatives for addressing such defaults and prepare a plan of action. Typically, such planning will be focused on approaching their lenders to discuss a potential resolution. Borrowers may be reluctant to notify their lenders of potential problems before a default occurs; however, approaching lenders early and honestly will in most cases create less friction and more optionality for a favorable resolution.
In preparing for such discussions, borrowers should create a financial snapshot of their company and include such items as basic financial statements (e.g. income statement, balance sheet and cash flow statement) as well as documentation detailing the company’s planning processes such as budgets, forecasts, and long-term planning. Furthermore, borrowers should identify the default(s) that have occurred or are likely to occur and provide relevant details including what steps, if any, have been taken to remedy them. In taking these proactive steps, borrowers provide reassurance to their lenders that they are taking their company’s distressed financial condition seriously and competently. Moreover, given the economic distress caused by the coronavirus pandemic, lenders are grappling with a marked increase in existing and potential loan defaults in an environment of intense public scrutiny, and as a result they may be more willing to work with borrowers (particularly those that might be only temporarily affected by the COVID-19 crisis) to restructure or extend a loan or to agree to forbear on enforcement actions.
Approaching the Lender
In the next post in this blog series, we will address what borrowers may expect once they notify their lenders of a looming, or existing, default and begin the actual process of negotiating a formal resolution. Topics will include initial discussions, reservation of rights letters, forbearance agreements and other loan modifications to borrowers designed to avoid defaults.