The COVID-19 pandemic has shocked financial markets around the world. As governments and private citizens implement drastic measures to slow the spread of the virus, the resulting economic dislocation to businesses and individuals will affect a wide range of contractual arrangements, including loan agreements. In this Advisory, we set forth some key issues that lenders and borrowers should consider carefully as they navigate this crisis.
Financial Covenants. Breaches of financial covenants based on calculations of EBITDA, net income or other similar measures of earnings will become more prevalent as borrowers face lower revenues and increased costs in dealing with the pandemic. Borrowing base calculations, which are often based on levels of accounts receivable, may reduce amounts available to borrowers under existing lines of credit. Borrowers should also be mindful of the accounting treatment of financial covenant defaults. Under certain circumstances, a financial covenant default might require a company's auditors to reclassify long-term debt as short-term debt, which in turn could cause violations of additional financial covenants, such as liquidity ratios. The measurement and reporting of financial covenant compliance is often done as of the end of each calendar quarter and may in some cases be based on annualized quarterly results. As the end of first quarter of 2020 approaches, borrowers who anticipate they may be in violation of financial covenants as a result of the economic effects of the pandemic should consider approaching their lenders to discuss the possibility of obtaining waivers or permanent amendments to such covenants as appropriate.
Information Delivery. Borrowers will often be required to deliver financial statements to the administrative agent or lenders, either directly or by reference to a public filing, such as with the Securities and Exchange Commission (SEC). This may present a challenge to some borrowers, particularly those located in cities, states or countries under full or partial shutdown, as many are expecting delays in timely finalizing their external audits. While the SEC has given SEC-reporting companies impacted by COVID-19 an additional 45 days to file certain disclosure reports that would otherwise have been due between March 1 and April 30, 2020, including annual and quarterly reports that contain financial statements, a delay in delivering those same financial statements to the administrative agent or lenders may nevertheless violate the information delivery covenant in a given loan agreement.
Material Adverse Effect. Loan agreements typically contain representations and warranties, conditions precedent to borrowing and events of default concerning "material adverse effects." The question whether the COVID-19 pandemic and/or its effects on a borrower constitute a "material adverse effect" is highly fact-specific and depends on a number of factors, including the express language contained in the loan agreement, the governing law of the loan documents, actions taken by governmental authorities, industry-wide effects of the pandemic and special circumstances affecting the borrower, among others. As the economic effects of the pandemic wear on, many borrowers will need to draw on existing lines of credit to fund their operations. These borrowers will assess whether they can represent to their lenders that no "material adverse effect" has occurred. In the face of a wave of borrowing notices, lenders similarly will need to assess whether they are satisfied that no "material adverse effect" has occurred for purposes of disbursing committed amounts. For loan agreements that contain a "material adverse effect" event of default, lenders may also need to assess whether the effect of the pandemic on a particular borrower rises to such a level that acceleration of the loan or other similar remedies is warranted.
Interest Rate Floors. As central banks around the world respond to the COVID-19 pandemic by slashing interest rates, the prospect of interest rate benchmarks, such as LIBOR, approaching zero or negative territory has increased. If variable-rate loan documentation does not include an interest rate floor, a request for an amendment or default waiver by a borrower may present the opportunity for such an amendment. As borrowers and lenders consider interest rate floors, careful attention should be paid to alternate base rate provisions that might be invoked in the event LIBOR does not adequately reflect a given lender's cost of funding the loan. In making such an amendment, the parties should consider whether any corresponding change should be made to any interest rate swap arrangements.
Amendments and Waivers. As the economic dislocation caused by the COVID-19 pandemic continues to affect businesses, lenders can expect a surge in amendment and waiver requests from their borrowers. Lenders and borrowers should be familiar with the amendment and waiver provisions in their loan documentation, including the voting requirements for different types of amendments or waivers. Lenders should be aware of so-called "yank-a-bank" provisions that may be invoked to replace lenders that cast dissenting votes on a requested amendment or waiver.
Collateral Top-Up Requirements. The COVID-19 pandemic is also having a significant impact on asset values and exchange rates. A loan agreement benefiting from a collateral package may have a "top up" clause, requiring the borrower to post additional collateral when the value of the collateral falls below a certain threshold. Borrowers that have posted collateral in the form of publicly-traded securities, particularly if the securities are traded abroad in a devaluating currency, may be called upon to top-up their collateral.
Assignments and Participations. If liquidity becomes scarce and borrower creditworthiness suffers as a result of the pandemic, assignments and participations of loans may become more prevalent. Parties to loan agreements should be mindful of the precise terms of the assignment and participation provisions in their loan documentation, which sometimes require borrower consent, qualifications for proposed assignees and other similar limitations.
Notification of Defaults. Loan agreements typically contain provisions which require the borrower to notify the lender of any defaults or events of default that have occurred. As noted above, the COVID-19 pandemic may cause borrowers to violate certain financial or information delivery covenants. In certain circumstances, the effects of the pandemic on a borrower might constitute a "material adverse effect" event of default. Borrowers will need to monitor and assess whether and at what point a notification requirement has been triggered as a result of the pandemic.
LIBOR Transition. The scheduled permanent discontinuation of LIBOR (and other IBORs) at the end of 2021 will require the amendment of thousands of loan agreements. Even before the onset of the COVID-19 pandemic, market participants, regulators and commentators characterized this effort as Herculean. The pandemic has further complicated the picture. As borrowers and lenders alike scramble to address the issues presented by COVID-19, LIBOR transition efforts run the risk of being put on the back burner. As borrowers and lenders consider amendments and waivers arising out of the pandemic, they should also consider LIBOR transition provisions as part of the process.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
