When Cash is King: Can a Reserve-Based Lender Block Borrower Cash Hoarding?
- Weakened demand for oil coupled with the coronavirus outbreak have placed considerable stress on U.S. producers and raised the specter of restructurings. Large private equity firms have instructed borrowers to engage in proactive credit draws to boost cash positions.
- During the last downturn, producers fully drew on reserve-based loans (RBLs) leading lenders to adopt two critical protections: "anti-cash hoarding" provisions and mandatory deposit account control agreements to perfect lenders' liens on cash.
- With oil's resurgence, borrowers chipped away at these protections, and now lenders must reassess whether grounds exist for dishonoring a draw request.
Weakened demand for oil coupled with the coronavirus outbreak and Saudi Arabia's and Russia's crude production disagreement have caused steep declines in the oil markets. These price pressures have placed considerable stress on U.S. producers and raised the specter of restructurings. In a restructuring, cash is always king and large private equity firms have instructed borrowers to engage in proactive credit draws to boost cash positions.
During the last downturn, producers fully drew on reserve-based loans (RBLs) before lenders triggered rights to limit borrowings via a borrowing base redetermination. These defensive draws caught RBL lenders off-guard and, because lenders had not insisted on deposit account control agreements to perfect liens on cash, provided borrowers with critical liquidity and leverage heading into bankruptcy negotiations.
In response, RBL lenders demanded two critical protections: (i) "anti-cash hoarding" provisions and (ii) deposit account control agreements to perfect lenders' liens on cash. Anti-cash hoarding provisions typically involve a mandatory prepayment if the borrower has cash and cash equivalents in excess of a specified dollar amount in its bank accounts and prevent a draw if the borrowing would place the borrower in effective breach of the prepayment covenant.
Memories are, for better or worse, short and as oil markets rebounded from 2014-2016 lows, borrowers chipped away at these protections. What aided borrowers in these efforts was that most RBLs escaped the last downturn without any economic impairment. With these protections now lacking, and the risk of RBL impairment greater in this market environment, it is critical for lenders to consider whether grounds exist for dishonoring a draw request. Absent anti-cash hoarding protections, lenders should focus on (i) their ability to adjust a borrowing base taking into account the new "normal" and (ii) financial-related covenants that serve as a condition precedent to a draw.
Exercising Discretion in Calculating a New Borrowing Base Reduces Access to Cash
Redeterminations of borrowing bases typically occur in April and October of each year and become effective approximately one month after redetermination. Importantly, the April report is backward-looking and uses information as of December 31 of the prior year. As of December 31, 2019, the West Texas intermediate (WTI) price for barrel of oil closed at $61. Today, it is roughly $27 a barrel. Accordingly, there are material consequences if a borrower can base a reserve report on data from December 31 as opposed to April 1.
Once a borrower submits a reserve report, typically, the administrative agent proposes a new borrowing base in good faith using the backward-looking reserve report and other information that the agent may request. Many loans do not specify if the agent can take into account pricing information that post-dates the reserve report. In the event the agent proposes reducing the borrowing base, the "required lenders" have a right to approve the same. Again, lenders would have to act in good faith in exercising this discretion. To exercise this discretion, lenders should carefully consider whether, in setting the borrowing base, the credit agreement does not contain a temporal limitation on what information lenders can utilize. For example, if a credit agreement allows the agent and lenders to consider data and supplemental or other information "as may be reasonably requested from time to time" untethered to the date of the reserve report, lenders have a good argument that the borrowing base may take into account price movements that post-date the reserve report. Reducing the borrowing base in such a manner would protect against cash hoarding.
Utilizing a Material Adverse Change, Solvency Provision or Financial Covenant to Block a Draw
Knowing that a borrowing base redetermination could limit borrowings, borrowers are likely to engage in a protective draw prior to a borrowing base redetermination. In such an instance, lenders may have to rely on a material adverse change clause. These clauses require the borrower to represent that no "material adverse change" has occurred as a condition to borrowing. Unfortunately, there is scant juridical interpretation of material adverse change provisions. While a 50 percent price decline and a World Health Organization (WHO)-certified global pandemic would seemingly qualify as a material adverse change, the analysis is not that simple. Lenders would have to consider the effect of borrowers' hedges and the duration of the price decline, among other things, in making such a determination.
Similarly, in order to access funds, a borrower must represent that it is "solvent." These provisions are highly negotiated and may provide grounds to prevent a draw depending on their formulation and the borrower's financial condition.
Finally, borrowers must also satisfy financial covenants. Many financial covenant calculations are also calculated on a backward looking, as opposed to a pro forma basis. A draw that only results in a pro forma breach, may not prevent a borrower's defensive draw. Lenders should pay careful attention to financial covenant calculation and determination.
Sorry, That Deposit Account Control Agreement Requirement May Not Protect You
Lenders who did not bargain for anti-cash hoarding but insisted on a deposit account control agreement to perfect a lien on unnecessary cash draws may still feel the effects of cash hoarding. RBLs that require deposit account control agreements often give the borrower a 30-day grace period to have that agreement in place after the opening of a new account. In other words, a borrower could transfer funds to an account that is not subject to a lien without triggering a default under the RBL. That transfer could impair a lenders' cash collateral position and provide the borrower with needed leverage.
Risks of Failing to Fund
Lenders who refuse to fund a draw face risks. During the 2008 economic downturn, lenders under a construction loan to Fountainbleau Las Vegas dishonored a borrower's draw request under a $1.85 billion credit facility. Ultimately, the borrower filed for bankruptcy and litigation followed that resulted in a $300 million settlement on account of the lender's breach of its funding obligation.
Contractually, a defaulting lender also forfeits its right to vote its loans as a required lender, subjects itself to having to post cash collateral for undrawn letters of credit and may have interest payments set off against unfunded draws. Accordingly, when determining to honor a draw request, lenders must carefully consider their contractual rights alongside the potential legal exposure that may follow.
Lenders concerned about RBL exposure should carefully consider their rights under an RBL facility and state laws to assess damages that may result from a failure to fund. Moreover, lenders may wish to alert their treasury departments that new accounts in favor of a borrower should require a deposit account control agreement to prevent the creation of a new account free of that limitation.
If you would like more information about RBLs and how they may affect your business, contact the authors.
DISCLAIMER: Please note that the situation surrounding COVID-19 is evolving and that the subject matter discussed in these publications may change on a daily basis. Please contact the author or your responsible Holland & Knight lawyer for timely advice.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.