March 26, 2020 - On March 25th the LSTA hosted a webinar, “COVID-19 and Credit Agreements – What You Need to Know”, which was  presented by Michael Chernick and Josh Thompson  of Shearman & Sterling, Samantha Good of Kirkland & Ellis, Justin Forlenza of Covenant Review, and Jason Kyrwood of Davis Polk.  The impact of the COVID-19 outbreak is having broad economic repercussions around the globe. The pandemic will adversely impact businesses in most industries with certain industries such as hospitality, gaming, retail, energy and industrials being the most affected.  Credit markets have tightened in response to the outbreak, and financial institutions need to be aware of the evolving impact of the COVID-19 outbreak on their borrower’s ongoing short-term liquidity and financing needs and understand the evolving landscape of the various government intervention programs and their potential impact on credit supply.  Consequently, lenders should review their portfolio to identify which loans may suffer long-term value degradation, ratings declines, covenant breaches, and other defaults and try to manage those borrower relationships by analysing the outbreak’s impact on a borrower’s supply chain and on the demand for its products and services.

Importantly, lenders are honoring revolving borrowing requests, and certain industries even continue to be open for new loan opportunities such as software, IT services, food-related businesses and healthcare.  It seems that direct lenders in the middle market are moving forward on new deals, and many investment grade borrowers, including those in significantly adversely affected industries, have been able to procure additional liquidity facilities from their banks. Borrowers report that lenders are approaching the situation constructively, recognizing that nearly every player is distressed at this stage, which will reduce transaction costs and maximize value where common interest solutions can be found. 

Now is the time for lenders carefully to review their credit agreements and focus on those representations that will be required to be brought down and thus be true and complete at the time of any new borrowing request. Although the package of representations in every credit agreement will be different, there are ones that are common to most loans, including no default, no litigation, solvency, and the no “Material Adverse Effect” representations. In many credit agreements, certain representations and warranties are qualified such that there will not be a breach unless a “Material Adverse Effect” (MAE) has occurred and that will require fact- and situation-specific analysis. The MAE case law is mostly acquisition-related, but an MAE generally will comprise a downturn in the specific business of the borrower, that has occurred and/or is expected to continue for a substantial/significant period of time.  Materiality is a complicated standard with no brightline rule so lenders should note that rarely is it litigated in a drawdown context.

A borrower must also be cognizant of its affirmative covenants which will typically include tailored reporting obligations, including delivery of certain financials.  For many borrowers, this presents challenges because audits commonly require on-site visits, and where those have not been completed, the delay may be a result of auditing firms being grounded because of shelter-in-place orders.  Most budgets were prepared pre-COVID-19, and as a result auditors may look harder and deeper at liquidity and financial covenant compliance, but for most businesses, it is too soon to predict the full impact of COVID-19.  Borrowers will likely seek a one year holiday on delivering audits free from a going concern qualification and extensions of deliverables that require cooperation from an unaffiliated third party. 

Although a decline in financial performance may not have immediate effect on negative covenants, there could be an adverse impact on the ability of a borrower to operate its business and execute on its business plan.  In credit facilities for many larger loan deals, a decline in EBITDA would adversely impact a borrower’s ability to incur debt and grant liens where baskets are based on leverage ratios or have grower baskets based on EBITDA and similar issues arise if there are CNI-based grower baskets.   In certain credit facilities, leverage ratios are based on a “net debt” construct, and if a borrower’s liquidity is reduced as liquidity tightens there would be less cushion for that category of covenants as net debt would likely increase.  For “springing” financial covenants, tighter liquidity may require a borrower to borrow more under its revolver, thereby triggering the requirement to test the covenant. Equity cure provisions should also be reviewed to determine when and how often they can be utilized, what equity counts towards the cure and whether over-cures may be allowed.  In many cases EBITDA will be measured on a last-twelve-month basis, so a borrower’s reduced EBITDA over the next couple of quarters will have implications at least into the middle of 2021. Careful review of the definition of EBITDA needs to be done to understand what add-backs and adjustments may be made. Please click here for the slides and replay. Click here to read Shearman & Sterling’s alert on the topic.

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