Key Issues for Lenders to Consider in the COVID-19 Crisis
- The ongoing impact of COVID-19 has many businesses reviewing potential impacts to their cash flow and operations, as well as developing contingency plans to address disruptions that have or will inevitably arise, including how best to create or access any cash reserves that might be available through existing lines of credit.
- Particularly in the current regulatory environment, where regulators are encouraging financial institutions to work with their borrowers who may be impacted by the effects of COVID-19, lenders need to be prepared to assess funding requests and to evaluate the quickly changing credit risk to their portfolios brought about by the unprecedented developments caused by the coronavirus.
- This Holland & Knight alert reviews a few key areas on which lenders need to focus as they review their portfolios of borrowers and make sure they can fulfill their obligations to their customers.
The ongoing impact of COVID-19 and the international response to the virus has almost every business reviewing potential impacts to their cash flow and operations, as well as developing contingency plans to address disruptions that have or will inevitably arise, including how best to create or access any cash reserves that might be available through existing lines of credit.
Particularly in the current regulatory environment, where regulators are encouraging financial institutions to work with their borrowers who may be impacted by the effects of COVID-19 (see, for example, the March 22, 2020 Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus), lenders need to be prepared to assess funding requests and to evaluate the quickly changing credit risk to their portfolios brought about by the unprecedented developments stemming from the spread of the coronavirus and the national and international effort to slow its further spread.
Below are some of the areas that we expect to see lenders focus on as they review their portfolios of borrowers.
Loan Administration and Operational Issues: Will Agents and Lenders Be Able to Safely and Effectively Administer Their Loan Portfolios?
- Operationally, is the lender able to still timely process draw requests, Libor conversions, notices and other deliverables under loan documents? One thing to look at is what deliverables are coming due and whether there is an expectation that those things can/will in fact be delivered (such as audited financials discussed below).
- Generally, organizations and individuals need to exercise greater caution regarding hacking and data security as employees shift to remote work. Are all people who are working remotely doing so over a secure connection? What is the added risk of confidential or private information being inadvertently disclosed?
- Are third-party service providers (i.e., appraisers, auditors, etc.) also considered "essential businesses" that may continue to stay open and perform tasks the lender has outsourced (particularly with regard to any borrowing base calculations)? Does the lender have the current right to engage in a field audit or appraisal (whether pursuant to negotiated terms or because of the existence of a default) and can they be engaged in given any shelter-in-place type orders? Could a review of vendor relationships and agreements as part of the vendor management process be accomplished to ensure banks understand risks and rights under these agreements?
Loan Funding Concerns: Is the Borrower Able to Request Funds and, if So, Are They Available to Be Funded?
- Which facilities in a portfolio are likely to see draw requests? If an agented facility, does the agent, by practice or structure, prefund draw requests and, if so, can they opt out of any such practice under the agreement or is the pre-funding hardwired (i.e., is there a weekly true-up mechanism built in)?
- Are there any non-bank lenders in any agented facility that could have impacted their ability to call capital to fund loans? In addition, are any lenders in the facility at risk of becoming defaulting lenders? If a lender is not certain it will be able to fund, what do the loan documents provide for the agent's/other lenders' obligation to fund the difference?
- Do any draw requirements include as a condition the absence of a material adverse event (MAE) or material adverse change (MAC)? If so, does the MAE/MAC clause include any forward-looking language (i.e., prospects) or are there carve-outs for force majeure events that would exclude anything arising from general economic conditions as an MAE/MAC?
General Considerations for Representations, Covenants and Events of Default
- What items in the loan documents trigger a bring-down of the representations and warranties? Even in a term loan, the conversion/continuation of Libor tranches is often deemed a bring-down of the reps, in which case there will need to be a careful look so as not to inadvertently trigger a default or event of default.
- Are the representations and covenants (and any events of default) that rely on an MAE/MAC trigger reliant only on the actual event occurring or do they reach to capture anything that, for example, "could reasonably be expected, individually or in the aggregate, to result in a Material Adverse Effect"?
- Is there a "solvency" representation or covenant? Assuming so, does the lender have any concerns about the continued truth of such statement in general or at the time of any further funding request? Generally what has the impact of COVID-19 been to the borrower's industry sector, its supply chain, and demand for products and services?
Impact of Delayed Financial Statements
- Delivery of audited financials will likely be delayed because auditors may not be able to complete onsite audits or employees of the borrower working remotely may not have access to required materials. Even if audits are completed, they may be subject to additional qualifications (i.e., going concern) in light of COVID-19 uncertainty. Does the borrower have the ability to deliver unaudited or interim financial statements pending the audit if there would otherwise be a prolonged gap in financial reporting?
- What is the impact of delayed delivery of financial statements on financial covenant testing (i.e., does an "Applicable Margin" immediately change to the maximum margin rate)? How will waiver requests regarding these provisions be addressed?
- When and how frequently are financial covenants tested (i.e., monthly vs. quarterly vs. springing)? Will COVID-19 events result in any adjustments to earnings before interest, taxes, depreciation and amortization (EBITDA) add-backs. Particularly if the borrower is backed by a sponsor, are there equity cure rights that might delay any default trigger (and, if so, are draws blocked during any such equity cure window)?
Temporary Closure of the Borrower's Business
- If impacted by any government orders (i.e., essential business rules), what sort of business interruption insurance does the borrower have and have they attempted to access it yet, do they have plans for layoffs and, if so, have they reviewed the applicable laws?
- Is there a covenant default tied to the borrower's continuous operations? Even if the business remains open to some degree, would substantially all employees working from home or certain physical location closures nonetheless constitute a violation of the covenant? Lenders should also consider whether there are any limitations on the borrower's ability to engage in other lines of business, which might provide an avenue for continued revenue during the crisis but may not be permitted under the terms of the loan documents.
- Are there opportunities in the recently passed Coronavirus Aid, Relief, and Economic Security Act (CARES Act) for the borrower to access credit? If so, are those loans permitted, or will amendments or waivers be required for the borrower to access those opportunities?
Protecting the Lender's Collateral and Limitations on the Exercise of Remedies
- Are there any particular limitations of the use of proceeds of any loans, particularly on the borrower's ability to draw down and hold cash (anti-hoarding provisions)? If so, must cash be held in controlled accounts? If not, how much is potentially outside a perfected lien?
- Are there material assets that the lender determined at an earlier date were not worth perfecting a lien on which the lender has either a) discretion to perfect on, or b) a right to perfect on during an event of default? If so, consider whether it is necessary or desirable to begin the process of perfecting on any such assets.
- Are there any limitations on the agent's and/or lenders' ability to exercise remedies based on any likely events of default? Are there subordination or intercreditor arrangements going either way that could have event of default or incipient default triggers that should be abided by?
What About the Borrower's Pending Transactions?
- Is the borrower engaged in any "Permitted Acquisitions" currently? If so, what are the requirements to fund these (i.e., are there limited funding outs)? What are the implications for the business of either party's termination rights?
- Are there obligations of the borrower tied to the company earnings or value that require the company to use Dec. 31, 2019, earnings or value but need to be paid out in 2020 (i.e., a) Excess Cash Flow Payments, and b) any stock appreciation right (SAR) plans, synthetic equity, options, preferred stock, employee stock, employee stock ownership plan (ESOP) repurchase obligations, etc.)?
Conclusion and Considerations
Lenders need to stay on top of these rapidly changing circumstances, including both internal and credit assessments to make sure they can fulfill their obligations to their customers and anticipate issues before they arise. For questions, comments or additional information on any of these areas, please reach out to the Holland & Knight professional with whom you work or another member of our Financial Services Industry Group.
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 your responsible Holland & Knight lawyer or the author of this alert 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.