This is part one of a six-part series
As the COVID-19 pandemic continues to wreak havoc on businesses on a global scale, many sectors of the economy have been forced to operate on a limited basis while others have been effectively shut down altogether. The resulting conditions present a range of challenges to companies that may continue for some time. In this post, we examine the effect the pandemic might have on corporate loan agreements and identify some key issues that borrowers ought to consider.
Some loan agreements contain a borrowing base feature whereby the amount permitted to be borrowed is capped by the lesser of a hard dollar amount (the total committed amount) and a percentage of the value of eligible collateral pledged by the borrower or “borrowing base”. The borrowing base is usually comprised primarily of accounts receivable and inventory. Many borrowers are likely to experience reduced accounts receivable due to the negative impacts of COVID-19 on the economic climate that may affect the borrowing base and therefore diminish borrowing availability. Inventory may also suffer as a result of supply chain disruptions attributable to the pandemic. In addition, under certain loan agreements, reduced borrowing availability will trigger more frequent inspection and appraisal rights for lenders and/or the applicability of specific financial covenants. Borrowers would be wise to assess the impact of these potential events in advance of a future draw down on their existing credit facilities.
Representations and Warranties.
Loan agreements typically contain a representation on the part of the borrower stating that no Material Adverse Effect (MAE) has occurred or could be reasonably expected to occur. An MAE is generally defined to include events or circumstances having a material adverse effect on the business, operations, condition (and sometimes even “prospects”) of a borrower and its ability to meet its obligations under the loan agreement. Most loan agreements require that the representations and warranties (including the representation that no MAE has occurred) be true and correct as a condition precedent to each draw down of funds. As such, if it is determined that an MAE has occurred as a result of COVID-19, a borrower may be precluded from making a draw under its loan agreement. The determination of whether or not an MAE has occurred requires a “facts and circumstances” analysis for each individual borrower and may also depend on the specific wording of the MAE definition in its loan agreement.
Another representation, that the borrower is not in default under any of its contractual obligations, is also common in loan agreements and may, like the MAE representation, require careful scrutiny as a result of the pandemic. Borrowers should carefully monitor for potential breaches of material contracts with customers, suppliers and landlords (among others), as defaults under such contracts may result in a borrower being unable to make this representation, thus precluding the ability to draw under the loan agreement.
Loan agreements also contain other representations and warranties, often specifically tailored to a borrower’s business or financial condition on a case by case basis. Borrowers should therefore review their loan agreements for any other representations that may be affected by COVID-19.
Restrictions on Other Debt.
Borrowers seeking additional sources of funding in light of reduced revenue streams should focus on the limitations on debt incurrence contained in their loan agreements as the negative covenants may restrict such new debt or, where such debt is allowed, existing permitted “baskets” may not be sufficiently large. If lenders are willing, the loan agreement may be amended to permit additional debt under one or more governmental assistance programs (e.g., the SBA Paycheck Protection Program) or from another source. In any case, it is important for borrowers to be aware of these limitations and proactively address any necessary modifications with their lenders.
Many borrowers have experienced substantial reductions in revenues due to COVID-19 and, in turn, on their resulting EBITDA numbers. This may make it difficult or impossible to comply with the financial covenant limitations regarding leverage ratios, and “fixed charge coverage ratios” which measure the borrower’s ability to cover the business’s fixed expenses. Borrowers should carefully inspect the EBITDA definition in their loan agreements to determine if the definition permits any “add-backs” that might be relevant. For example, many loan agreements include an add-back that might, depending on the wording, cover extraordinary expense items relating to the pandemic, for example, costs associated with sanitizing workspaces, that might allow for any such expenditure to be added back to the borrower’s EBITDA for purposes of financial covenant calculations. In addition, borrowers may need to negotiate with their lenders to loosen financial covenant limits or to suspend covenant testing entirely for certain time periods. Given the unknown duration of the pandemic and its potential impact on business operations, such covenant relief may be necessary for several fiscal quarter periods. Lastly, in the case of loan agreements that contain “equity cure” provisions, borrowers may want to consider an equity contribution in order to achieve covenant compliance.
Loan agreements also typically contain affirmative reporting covenants requiring a borrower to provide notice to its lender of certain events. Relevant items that may result from the pandemic include defaults under any material contracts, material litigation, expected or potential MAE, and any default under the loan agreement. As the failure to provide any such notice to the lender is generally deemed an event of default under the loan agreement, borrowers should carefully check these reporting requirements for any deal-specific types of events that are included in their loan agreement.
Events of Default.
In addition to the representation regarding MAEs referred to above, some loan agreements provide that the occurrence of an MAE results in an automatic event of default. As stated previously, whether or not a borrower has suffered an MAE will require an individualized analysis of such borrower’s circumstances, as well as the way in which a “Material Adverse Effect” is defined in its loan agreement.
Other relevant events of default may include a “cross-default” to agreements evidencing other indebtedness of the borrower in excess of a specified principal amount and defaults under material contracts with third parties, each of which could be caused by the headwinds resulting from COVID-19.
Borrowers would be wise to remain aware of these issues as the pandemic continues to unfold and evolve over time. Doing so will go a long way towards ensuring loan agreement compliance and managing relationships with lenders.