COVID-19 and Leveraged Finance: Some Issues to Consider

Liquidity Needs and Conditions to Borrowing

Borrowers are being stressed by the global disruption to the economy generally and the short term (and potential long-term) impact on revenues caused by plummeting or erratic demand for their products and services, general uncertainty in the market and disruptions in the supply chain. Many borrowers dependent on steady cash flow to fund operations are facing an immediate or imminent liquidity crunch. From the lender side, short term funding sources are challenged, even as the Federal government announces new steps to support the financial markets and inject funds into the system—through government bond buy-backs and support for the short-term commercial paper market and money market funds, as a start.

In light of this, borrowers and lenders must assess the availability of existing committed revolving credit lines. Practically all credit agreements will require two things in this regard: (1) a bring down of all the representations and warranties and (2) the absence of any default or event of default. Implicated in these two criteria will be a review of all covenants (in particular financial covenants, debt and lien covenants and notice covenants) and a determination of whether there has been a material adverse change (MAC) or material adverse effect (MAE) on the borrower and its subsidiaries. The specific language in the provisions and related defined terms is very important, as a borrower’s ability to borrow and a lender’s obligation to lend (or not) can turn on words that in normal times are often glossed over or viewed as legalese or nitpicking.

Issues raised by COVID and its effects may include:

• Representation and Warranty Bringdown
  • The financial condition representation may contain a no MAC or MAE clause
  • Are projections required to be made current on a continuous basis or is the representation limited to the previously delivered projections at the time they were made?
  • Is there a full disclosure representation (a 10b-5-type representation) and is it limited to information furnished or is it more general?

• MAC or MAE:
  • Does a MAC or MAE exist now?
  • Is a MAC or MAE reasonably likely to occur?
  • How far into the future is relevant?
  • What does “reasonable” mean when the scenario has no precedent?
  • Does the MAC or MAE definition include the word “prospects” and what does that mean?

• Covenants:
  • Is there a notice covenant that requires reporting a MAC or MAE or circumstances that could reasonably result in a MAC or MAE?
  • Are financial covenants required to be met at all times, or only as of the end of a reporting period?
  • If the borrower has sources of debt financing outside of its credit agreement (including, potentially, government loans proposed by the current federal stimulus package), does the credit agreement limit the incurrence of debt or the granting of liens?
  • Are there materiality qualifiers and/or time periods that are applicable?

• Events of Default
  • Will the borrower be able to make its next interest or amortization payment (and when is it due)?
  • Is there a MAC or MAE event of default provision and does it measure the present time or is it forward looking?
  • Is there a cessation of business or a curtailment of revenue producing activities event of default provision?

As of the current writing, we are not aware of lenders refusing to fund based on a MAC/MAE. In addition, with most shelter in place doctrines being implemented only within the last one to three weeks, it is generally perceived as being too early to determine whether a MAC/MAE has occurred. Any determination will, of course, be fact and company specific, with some industries likely being more adversely affected than others. Some factors and circumstances that will matter include the overlap of the borrower’s business locations with jurisdictions more severely affected by COVID-19, how long a downturn the borrower can sustain, the borrower’s cash position and short term cash burn rate, the extent to which the adverse conditions suffered by the borrower are disproportionate relative to other similarly situated market participants, whether there is insurance coverage for any borrower losses and the availability of government assistance. In the current environment, many borrowers have been able to fortify their balance sheets and draw down on their revolvers rather than face uncertainty if/when market or other conditions deteriorate further.

Before submitting a notice of borrowing, borrowers should carefully evaluate their loan documents. Officers signing a borrowing notice should be sure they are not withholding actual knowledge of a MAC/MAE, which could, in extreme circumstances, result in personal liability. Before lending or not lending, lenders should consider these same issues as well as the longer term prospects of their borrowers. Although the issues are complex, parties can draw on experience from past crises and should also keep lines of communication open with one another.

Business Interruption Insurance Proceeds

Borrowers should evaluate their insurance coverage not only with a view to understanding their scope of coverage, but also in order to understand the impact under their credit agreements. Especially in the case of business interruption insurance, there has been a lot of discussion on the internet and elsewhere about whether coverage applies for losses associated with COVID-19— and it has been based on very little information. There are significant differences in the triggers and scope of coverage of different insurance policies and policy forms; the circumstances for each insured are different and are constantly changing; and impactful government directives and civil authority orders are being issued and revised almost hourly. Against this backdrop, many insurers, brokers and other advisors have generalized that there is no coverage for these risks. In reality, that has to be evaluated on an individualized basis—and may have to be reevaluated as facts change. Companies suffering COVID-19 related business interruption losses should seek informed, confidential advice from qualified coverage lawyers, based on their own insurance policies and unique situations. Payment of insurance proceeds can be treated in a variety of ways under credit agreements, sometimes triggering mandatory prepayments (even in the case of business interruption insurance). In addition, receipt of business interruption insurance proceeds might not be included in net income which, absent an add-back to net income or EBITDA, could result in an undercounting of cash flow for EBITDA-linked financial covenants and other provisions contained in debt documents.

Opportunistic Deleveraging

Certain companies with otherwise healthy financial outlooks beyond the current market conditions may see an opportunity to de-lever via discounted buybacks at a time when their outstanding debt may be trading at a significant discount. However, those companies may need to consider non-traditional forms of obtaining additional liquidity beyond drawing on existing revolving lines of credit to finance these buy-backs while certain areas of the capital markets and syndicated loan markets remain largely frozen. For instance, some companies may have capacity under their debt and lien covenants to incur additional debt, including secured debt, which may be incurred from alternative or direct lenders (and may in certain cases be less likely to trigger a pricing “MFN” provision under existing credit agreements than would incurring syndicated loans). In addition, alternative forms of financing such as receivables financing or factoring facilities may be permitted under existing debt documents and may be available to be raised on a relatively short timeline to quickly raise cash based on the providing of “safe” collateral to the applicable lender. Or certain lenders might be willing to provide additional liquidity to borrowers in the form of a 364-day facility or other alternative form of loan or note that can be executed on a relatively fast timetable without requiring a marketing element. Beyond analyzing whether a borrower has the necessary capacity under its existing debt documents to incur such types of debt, borrowers will need to confirm that the buyback of such debt is permitted, including under any relevant restricted payments or other debt prepayment covenants (and, if in the form of a discounted loan buyback under pre-wired mechanics of a credit agreement, in accordance with those mechanics). In addition, the debt buyback would have to be executed in compliance with federal and state securities laws including, as applicable, tender offer rules and regulations.

Lower Interest Rates and LIBOR Floors

As of the date of this writing, 1-month LIBOR dropped to approximately half of its rate only one week prior. LIBOR floors were widely introduced in the market during, and in the aftermath of, the 2008 financial crisis. However, LIBOR floors have remained in many credit agreements and LIBOR floors can range from 0 percent to 2 percent, or higher. In this low-interest rate environment, it is likely that LIBOR floors will once again be a key point of focus in credit agreements, even with the anticipated phase out of LIBOR at the end of 2021. At this time, Borrowers should determine whether their credit agreements include any LIBOR floors and whether they are benefitting from or being harmed by the current drop in interest rates. Short-term as well as sustained interest rate swings can affect EBITDA calculations, impact interest rate hedges, and, in what is already an uncertain environment, potentially add to greater uncertainty for planning the financial road ahead.