How does Coronavirus impact borrowing arrangements?

COVID-19 is forcing businesses to fundamentally alter the way they do business in an unprecedented manner. Consequently businesses ability to meet contractual obligations and particularly obligations in relation to their finance arrangements should be a key risk management area for borrowers as we navigate through the COVID-19 crisis in the coming months. It is now therefore important that borrowers are carefully reviewing existing loan documentation and understand the provisions which will be key in terms of understanding your facility arrangements. The two key areas of focus should really be provisions in relation to financial covenants, events of default, cross default and material adverse change (‘MAC’)clauses.

1. Financial Covenants

Lenders use financial covenants to monitor the health of borrower’s businesses using financial calculations based on EBITDA or net income. Such calculations allow lenders to monitor a borrower’s performance and provides them with warning indicators where a business may not be performing as it should be, giving lenders a straightforward early exit option should they wish to exercise such a right.

The recent dramatic drop in income receipts that businesses are facing as a direct result of COVID-19 will inevitably negatively impact its ability to comply with any stringent financial covenant provisions in finance documents.

Therefore, where borrowers anticipate they will be breaching the financial covenants in their finance documents, they should be communicating with their lenders at the earliest opportunity and reviewing facility documentation to consider what remedies may be available. It is commonplace for the financial test dates to occur at the end of each financial quarter and with the end of the first quarter of 2020 fast approaching, borrowers should review documents and engage with the lenders as soon as possible. Some remedies that borrowers should be looking for within their loan documentation may include:

  1. the possibility of adjustments to the financial covenant calculations or rescheduling the repayments, negotiate payment holidays or defer principal payments within documentation to account for current market conditions and realistic performance expectations;
  2. waiver of breach rights whereby the lender may be willing for an interim period to allow the borrower to underperform in terms of the requirements of the financial covenants; or
  3. any equity cure rights whereby shareholders of the borrower have the right to volunteer to inject further capital into the borrowing company to enable the borrower to meet the requirements of the financial covenants for such period;

2. Material Adverse Change Clauses (‘MAC Clauses’)

It is commonplace for facility agreements to include MAC clauses which effectively operate as a catch all protective provision for lenders where unforeseen circumstances have, or may have, an adverse effect on a borrower’s business, assets and financial health. If a MAC clause is triggered, dependent on how the clause is drafted, it may allow the lender to place a draw stop on the facility. It can also amount to an event of default under the finance arrangements permitting the lender to demand early repayment of the loan. Borrowers need to be aware of their entire lending portfolio as a triggered MAC clause with one facility may trigger cross-default provisions in other agreements and a breach of an obligation to notify other third party lenders of a default.

Whilst MAC provisions are commonly included within facility documents, they are rarely relied upon in practice by lenders due to heavy evidential burdens. There is minimal precedent as to how they are dealt with in the circumstances of a pandemic. It is unclear if COVID-19 could constitute a MAC that will lead to lenders taking a more aggressive approach in terms of their interpretation of MAC clauses. A lenders ability to rely on a trigger of a MAC clause in these circumstances will ultimately depend on the wording within the finance documents between borrower and lender and it is therefore essential that borrowers are reviewing their lending portfolio documents thoroughly with the following considerations in mind:

  1. Does the MAC clause expressly provide that the occurrence of pandemics or natural disasters constitute a material adverse change? Such a provision could be considered much more likely to trigger a material adverse change in comparison to a more vague provision that refers solely to financial performance at the lender’s discretion.
  2. Will the impact of COVID-19 be temporary for the business whilst considering the industry in which the business operates in? Certain industries such as the hospitality industry are likely to experience more extensive disruption for a longer period due to COVID-19 than other industries and the extent and timescales of such disruption are relevant in considering whether or not a lender could rely on a trigger of a MAC clause in these circumstances.
  3. Borrowers will need to be able to ascertain and collate information that any deterioration in financial performance was a direct consequence of COVID-19 and not caused by other pre-existing financial issues the business was facing prior to the outbreak.

Lenders are aware of the impact COVID-19 is having on businesses worldwide and will want to work collaboratively with borrowers to provide support and flexibility in terms of finance arrangements. With the end of the first end of quarter dates for 2020 being just around the corner, engaging with your lenders in open dialogue about your businesses current financial position has never been more important.

For more information contact commercialdept@woodfines.co.uk

-Lily Burton

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