Considerations When Modifying Loan Documents in Response to COVID-19 Disruptions
The coronavirus (COVID-19) pandemic has impacted almost all industries on a global scale and has profoundly affected global financial markets. As the virus has continued to spread, many businesses have been forced to curtail or cease operations and are faced with the harsh reality that COVID-19 will continue to negatively impact operations and interrupt supply chains for an extended and increasingly unpredictable period. As such, borrowers will face increased challenges in complying with obligations under their credit documents, and lenders have seen and will continue to see a flood of requests for loan modifications and other relief. It is in the best interest of both lenders and borrowers to arrive at constructive solutions when navigating disruptions as a result of the COVID-19 pandemic, while preserving the lender’s legitimate interests in remaining informed, preserving its collateral, and ultimately being repaid on its loans. Both parties should approach these discussions with open minds, while borrowers should strive for transparency. This article summarizes guidance for both lenders and borrowers to help facilitate constructive conversations and aid in formulating solutions that help both sides navigate this difficult time.
Lenders and borrowers should consider the items below when structuring and negotiating loan modifications to help borrowers affected by the ripple effects of the COVID-19 pandemic.
1. PAYMENT DEFERRALS
Many borrowers across all sectors are facing material disruptions to cash flow from both sharp decreases in demand and stretched customer payment terms. When working on payment deferrals, lenders and borrowers should assess all options and creatively approach solutions that work for both parties (such as keeping lenders within the recently promulgated joint guidance issued by bank regulators (See Federal and State Banking Regulators Issue Joint Guidance on Loan Modifications for Borrowers Impacted by the Coronavirus)). These options include:
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Temporary Principal Deferrals
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Defer principal amortization payments to a specified date or maturity
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Whether short-term payment deferrals should increase principal amortization payments when payments resume
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Temporary Interest Deferrals
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Defer interest payments to a specified date or maturity
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Change interest payment dates from monthly to quarterly
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Convert cash pay interest to paid-in-kind interest
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Temporary Fee Payment Deferrals
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Deferring fees due under the credit documents to a specified date or maturity
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Change fee payment dates from monthly to quarterly
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When senior lenders agree to payment deferrals (or other relief), they also should consider whether any subordinated debt holders also are making analogous payment deferrals and otherwise providing corresponding relief, as applicable.
2. FINANCIAL COVENANTS
Financial covenants often include leverage ratios and interest or fixed charge coverage ratios, based on earnings before interest, taxes, depreciation, and amortization or cash flow measured over a historical period (typically the last four fiscal quarters). The impacts of COVID-19 likely will mean that lenders and borrowers will need to assess borrowers’ abilities to comply with their financial covenants, given the expected impact of COVID-19-related disruptions on revenue and cash flow.
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Temporarily eliminate or waive financial covenant tests
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When testing resumes, consider a ramp-up period for historical calculations (e.g., beginning with trailing one month, followed by trailing two months, and so forth) rather than immediately returning to a trailing twelve-month calculation to avoid including the most negatively impacted periods
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Consider which EBITDA-add backs may be available for COVID-19-related expenses and disruptions to net income (such as extraordinary expenses, proceeds of business interruption insurance, or lost profits in connection with COVID-19, which may or may not be capped at a hard dollar amount or percentage of unadjusted EBITDA)
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Consider revising liquidity covenants that require the borrower to maintain a certain amount of cash or cash equivalents on hand (or in a designated account)
3. FINANCIAL REPORTING REQUIREMENTS
Shelter-in-place orders and social distancing guidelines may result in delays in borrowers’ abilities to deliver required financial statements, audits, and other reports. To preempt defaults arising from any anticipated delays, borrowers and lenders should review reporting and notice deadlines and consider the following:
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Determine whether any grace periods are applicable
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Consider temporarily extending deadlines for affected periods or adding blanket language permitting the lender to extend deadlines without the need to formally amend the agreement (e.g., “or such later time as lender shall agree to in writing”)
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Consider adding requirements for the borrower to deliver rolling budgets/forecasts, which typically cover 13-week periods, along with a reconciliation of actual receipts and cash outlays to the forecast
4. BORROWING BASE
Liquidity challenges facing many borrowers may be amplified by disruptions to their supply-chain, typical revenue cycle, or customer-related challenges. In revolving credit facilities with a borrowing base (typically calculated based on accounts receivables and inventory), these issues are amplified to a greater degree as inventory remains unsold for longer periods and receivables age, causing more assets to become ineligible. Temporarily relaxing eligibility criteria or adjusting borrowing base formulas can be effective tools in boosting liquidity. In addition, shelter-in-place orders may disrupt the lender’s ability to perform field examinations and other collateral audits and to verify receivables. When dealing with liquidity challenges, lenders and borrowers should consider flexibility to, among other things, temporarily:
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Increase concentration and aging limits
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Increase advance rates
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Reduce availability blocks
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Increase the frequency of reporting of borrowing base and availability
5. DEFINITIONS OF MATERIAL ADVERSE EFFECT/MATERIAL ADVERSE CHANGE
Credit agreements often require the borrower to represent and warrant that there have been no (or there is no expectation of) circumstances which could result in a material adverse effect on the operation or financial condition of the borrower’s business.
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Check these definitions to determine whether they cover only the borrower’s financial condition and past performance, or also include prospective performance, and if applicable, consider modifying such definitions to exclude the impact of COVID-19 from the definitions
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Review these definitions to determine whether the representations and warranties apply to general economic and market events, and if applicable, consider amending the documents to exclude the impacts of COVID-19
6. ANTI-CASH HOARDING
To mitigate concerns shared by lenders that borrowers may draw down revolving credit facilities and sit on the loan proceeds, lenders can consider including anti-cash hoarding provisions in the credit documents, which typically involve a mandatory prepayment of outstanding loans if the borrower holds cash (or cash equivalents) in excess of a specified dollar amount for a certain period of time.
7. CARES ACT
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) created an opportunity for eligible borrowers to participate in a Small Business Administration loan program known as the Paycheck Protection Program (PPP) which makes unsecured loans available to certain eligible borrowers on below market terms (including a possibility for loan forgiveness). Since many borrowers are eager to participate in the PPP loan program, borrowers and lenders should discuss this possibility when contemplating loan modifications, including the following considerations:
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Ensuring (where appropriate) that the credit documents allow borrowers to avail themselves of the PPP loan program (including permitting the associated debt under applicable negative covenants)
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Considering whether to include covenants requiring the borrower to comply with the PPP loan program criteria to make it eligible for loan forgiveness under the program
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Adding notice provisions related to the borrower’s participation in the PPP
8. BORROWER’S MATERIAL CONTRACTS
The credit agreement may include provisions that require a borrower to represent and warrant that it is not in breach of or in default under any material contract. These provisions should be reviewed, as borrowers in certain industries may be faced with situations where they cannot perform under other material contracts, thus leading to litigation and disputes or cross-defaults under other loan documents.
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Consider modifying provisions in the credit agreement that provide that a breach of any such provision (if related to the effects of COVID-19) would trigger a default under the credit documents
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Determine whether there are cross-defaults to other financing agreements, and if so, consider modifying such provisions to circumvent the effects of COVID-19
9. ADDITIONAL CONSIDERATIONS
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Cessation of Business. Recent business closings may affect covenants in the credit agreement that trigger a default if the borrower ceases to operate.
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Check the credit agreement for covenants that trigger a default if the borrower ceases operating a substantial (or material) portion of its business
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Guarantor Acknowledgements. Whenever modifying loan documents, it is a best practice to have guarantors and other third-party collateral pledgors acknowledge the amendment and reaffirm their guaranty in light of the amendment.
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Ancillary Loan Documents. Consider whether ancillary documents in addition to the primary loan agreement may require modification.
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Title Insurance. Consider whether the terms of the modification have any adverse impacts on applicable title insurance policies or if a date-down endorsement should be requested.
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Closing Procedures. Standard closing procedures may be interrupted due to shelter-in-place orders and should be considered by the parties prior to closing any loan modification.
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Confirm whether electronic signatures are acceptable from the lender’s perspective at the institutional level (for example, platforms such as DocuSign may require lenders also to participate in the platform to be effective under applicable electronic signature statutes)
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Review documents to determine whether any third-party consents are required, and if so, consider email consents and waivers
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If original documents or notarization is required, plan for extra time and consider whether state law permits notaries to witness signatures electronically (many states, including New York, are adopting temporary procedures to permit notaries to perform these actions remotely)
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Post-Closing. Lenders providing modifications also should consider whether all post-closing deliveries have been completed.