Episode #1: Trade Finance and the Complications of COVID-19 (Russell DaSilva)

Joel Simon: Russell, I’d like to ask you about something we’re seeing a lot of clients doing these days, which is to define or renegotiating payments for goods and services. It seems like an obvious thing for a company to do in a crisis, but what makes CFOs or general counsels wary when looking at this?

Russell DaSilva: We are, indeed, seeing that. Companies are contacting their suppliers and other trade creditors and asking for deferral of their customary trade credit term. For invoices that would normally be paid in 30 days, companies are asking that they pay in 60. This is a logical thing to do, but what companies need to be careful of is to check their other financing agreement.  The company has a bond issue. If the company has a syndicated credit agreement or even bilateral credit authority with the bank, it is likely that those financing agreements have financial covenants. Those financial covenants in turn frequently rely on a defined term “indebtedness.” There’s a typical exclusion for most indebtedness covenants for trade payables in the ordinary course of business, but the question is if you defer a trade payable, is it incurred in the ordinary course of business. Some definitions are even more specific and might refer to trade payable, no more than 90 days and not past due. So, it may be that by negotiating this kind of deferral with trade creditors, a company is in fact putting these items from an inclusion of firm indebtedness, into the definition of indebtedness, and they are thereby subject to financial covenants. 

Simon: So, when they calculate their ratios or other financial covenants, that could result in a dramatically different result then they might have been expecting without that. And it also sounds like it could apply to other types of differed payment arrangements, as well.
DaSilva: That’s right. And if it applies to trade payables, what about operating lease payments? What about equipment lease payments? These are items that the company might not have considered to be indebtedness but are they transformed into indebtedness by reusing these deferrals? Bear in mind that the treatment of these items under GAT is not necessarily the same as the treatment of these items in the contracts governing the company’s financing.

Simon: That’s a good point, Russel. That actually leads me to think of another point related to indebtedness: Obviously, in the current crisis, a lot of companies are looking at accepting financial assistance offered by the government. The CARES Act offers loans to large and small businesses, some of which can be forgiven in certain circumstances, and even outright grants or tax credits are available. Borrowers, as well as lenders, providing the new government-backed loans, need to review their existing debt instruments to make sure the occurrence of the new laws are permitted and that their terms don’t violate existing covenants. And although we won’t get into the weeds on issues like material adverse change today, companies should consider whether receiving or even applying for government-backed loan or a grant could be viewed as an admission of a down-turning business that could in turn trigger default under a current or prospective-looking covenant in their existing debt instruments. Particularly on the forward-looking aspect—it’s one thing to think about an existing default, but a lot of these covenants talk about prospects or some event that could happen in the future, and it will be interesting to see how that plays out.
DaSilva: It may put pressure on a definition in credit documents that people have not really been focusing on before.

Simon: Definitely. One thing you mentioned to me before we started this morning was a financial statement issue that might bubble up in the coming months now that the first quarter’s ended?
DaSilva: Companies that are on a December 31 fiscal year probably either have just completed, or are about to complete, the preparation of their financial statements and have delivery requirements under their credit documents. There are some situations where a company may be delayed in the preparation and delivery of financial statements because they rely on third-party providers for certain information and certain analysis. If that’s the case, the inability to deliver financial statements on a timely basis may actually constitute a default under credit documents. Now, there typically is a grace period in credit agreements, or the delivery of financial statements, but bear in mind that the grace period controls only whether or not an event of default has occurred, which results in remedy of acceleration. The failure to deliver the financial statements on time might, nonetheless, prevent a new borrowing under a revolving facility because a policy default has occurred.

Simon: There’s also the obvious issue of the substantive performance with a company and whether auditors might need to take some sort of exception, like a growing concern exception, but if an auditor can’t perform the normal procedures, what does that result in? There’s another qualification that auditors might have to take for that.
DaSilva: That’s right. If the auditors have to take a scope of audit qualification, that may render the financial statements less informative for lenders and it might even constitute a technical breach of credit agreements. Sometimes credit agreements provide, in detail, what the format or what the substance of the financial statements needs to provide. Sometimes it says that it needs to be consistent with the audit principles applied in previous years. Bear in mind, too, that there are other kinds of audits that may be relevant to a credit facility. As a base lending facility, the face on inventory and receivables frequently may require periodic audits of the inventory. The inability of the lender, or the lender’s representative, to come on premises and inspect the inventory, can end up in delays in the preparation of those financial statements and might, once again, render an ABL facility not usable.

Simon: I guess we’ll have to see how that unfolds, particularly as April rolls into May.
DaSilva: Bear in mind also, that there are companies that are not on a December 31 fiscal year, and they may not have bumped up against this yet, but it’s very good preparation to consider it now and if a company expects it to be an issue, contact the lender sooner than later to make appropriate arrangements, so that a sensible resolution is reached.

Simon: I couldn’t agree more. Russell, thank you for joining me and to all of you for listening to Pillsbury’s Industry Insights Podcast.