The COVID-19 outbreak that is inducing intense volatility in global financial markets and dramatically impacting operations and revenues in numerous industries around the world raises several questions concerning the impacts on lenders and borrowers. We have prepared these frequently asked questions (FAQs) as a reference to help borrowers and lenders identify, anticipate and respond to some of the key questions, issues and considerations that may arise in their existing or prospective financings, including:

• Will the crisis impede a borrower’s ability to access committed credit? Should/will borrowers make preemptive draws to support liquidity?
• What if a lender improperly refuses to lend?
• What about uncommitted lines of credit?
• Will COVID-19-related circumstances constitute a material adverse change or material adverse effect (referred to together as an “MAE”)? What impacts might an MAE have?
• How are financial covenants affected?
• What other key covenants or “events of default” may be implicated?
• If an event of default has occurred, what then?
• When do lenders and borrowers need to talk?
• How will COVID-19 impact new debt or refinancings?

Whether you are a borrower or a lender, BakerHostetler’s cross-disciplinary Debt Finance team, supported by the firm’s full-service practice – with nearly 1,000 attorneys throughout the country – can help you navigate the issues we discuss here. In addition to those covered by these FAQs, the evolution of the global, domestic and local circumstances will likely create unprecedented issues, as each new crisis before it has. Whatever your situation, we are here as a resource for any financing needs in this challenging environment.

Will the crisis impede a borrower’s ability to access committed credit? Should/will borrowers make preemptive draws to support liquidity?

Borrowers that rely on committed revolving credit facilities, working capital lines of credit and term loans may be evaluating whether their lenders will fund new borrowing requests. Lenders involved with struggling borrowers may, in good faith, question the wisdom of making advances to distressed companies in a dire situation.

Borrowers should scrutinize their exposure to several circumstances that may limit their access to committed lines of credit or term loans, including:

• As discussed in more detail below, the occurrence of an MAE that could cause an event of default or otherwise prevent a borrower from satisfying conditions precedent to a new loan advance.
• Financial covenants and budget projections that could be strained or breached in ways unanticipated just weeks ago, leading to default risk.
• Actual or imminent events of default that terminate lenders’ obligations to fund advances.
• Systemic concerns with lenders’ ability or willingness to fund (particularly non-bank lenders, which may have less capital in reserve).
• For borrowing base facilities, supply chain and customer issues that may cause borrowing availability to shrink.

As a result, borrowers may consider defensively drawing on credit facilities before cash needs arise to ensure availability of adequate cash reserves. Defensive borrowings raise a number of questions that borrowers should closely consider:

• Are more desirable alternatives available to build cash reserves to address short-term liquidity requirements, such as extended vendor payment terms, delaying nonessential investments, selling assets or obtaining equity investments?
• After borrowing, where will cash be invested or maintained? If in a bank account, the borrower must continue to rely on a bank providing funds in the future. The bank account, if collateral, can be blocked by a secured lender after a default.
• Does the lender have the right (either at all times, after a default or upon failure to maintain specified financial covenant levels) to require “excess cash” (which may include new loan advances) to be automatically used to pay down the loan? If so, over-borrowing provides little value unless cash is deployed directly into non-cash assets or the lender waives this requirement.
• Do the loan documents have covenants with builder baskets or other covenant exceptions that may be used only if minimum availability levels are maintained?
• Does the lender have the right to impose additional reserves on borrowing base facilities, which would reduce availability?
• Will the borrowing and additional debt service create significant additional risk of a financial covenant default?
• Will a substantial borrowing induce premature or unwarranted concern or scrutiny from lenders?

What if a lender improperly refuses to lend?

At the outset of the Great Recession, some lenders chose to violate commitments made to borrowers to fund loans even when the borrower was in compliance with all the terms of the loan documents. Those lenders opted to risk a lawsuit by a borrower (or other lenders) rather than fund into a certain loss. Lenders adopting that approach must be aware of the potential ramifications, including substantial reputational damage and legal actions by regulators, borrowers or even other creditors of a borrower.

What about uncommitted lines of credit?

Many lenders and borrowers have uncommitted, discretionary lines of credit, particularly in the energy industry and other commodity industries and for trade finance facilities. Those lines of credit, on their face, provide the lender with the option to refuse to fund any loan request and the option to declare outstanding loans to be immediately due whether or not any material adverse change or other default has occurred. Most borrowers who sign up for those facilities tend to understand the commercial exposure. But lenders should be aware that even an “uncommitted” loan is not entirely free of obligations to borrowers. Lenders may be expected under applicable law to not act arbitrarily, capriciously or in bad faith (notwithstanding the broad terms of their documents), and a lender’s past conduct or reassuring communications with a borrower could lead a borrower to conclude that it can rely on a lender’s promise. The chance for a conflict between borrowers and lenders over these lines of credit is clear.

Will COVID-19-related circumstances constitute an MAE? What impacts might an MAE have?

Borrowers and lenders should closely review the definition and usage of MAE in their loan documents. MAEs are typically highly negotiated, structured terms that, by design, retain a subjective element. Determining whether an MAE exists in any instance is based on applying the terms of the definition to the facts and circumstances at hand and where the term is used in the loan documents. It is possible that a lender, seeking to restrict credit, could take a position that the broad effect on the economy creates an MAE even if a company is not directly materially adversely affected. Past economic crises led to litigation disputing whether an MAE had occurred. Generally, courts’ interpretations of the term require the party relying on the provision to meet a high burden of proof to demonstrate an MAE specific to a borrower’s business. Precedent in New York state, for example, suggests that short-term events or adverse economic conditions having temporary adverse effects on a borrower should not constitute an MAE. In addition to that high hurdle, lenders must weigh reputational impacts and potential liability to borrowers if they improperly invoke an MAE provision.

The occurrence of an MAE triggers or limits several rights and obligations in loan documents, including:

• As discussed above, a borrower’s ability to draw on a line of credit for either a revolving loan or, if applicable, a letter of credit, or a new term loan will likely require a bring-down of representations, including a no-MAE representation.
• Borrowers may be required to notify the lender of events or circumstances that have or may have an MAE.
• A lender’s ability to call an event of default and exercise remedies through MAE defaults (though MAE defaults are rare outside of the lower end of the middle market).

How are financial covenants affected?

Corporate credit facilities will often closely monitor a borrower’s fiscal health through covenants or funding conditions that require maintenance of leverage, fixed charge or interest coverage, minimum EBITDA, or liquidity ratios. Lenders usually view unforeseen material breaches of financial covenants to be serious defaults. Failure to comply with covenants usually causes immediate events of default, leading to a loss of credit or acceleration of outstanding loans. And financial covenant levels are used as conditions in other covenants to limit a borrower’s ability to take various actions, like incurring other debt, making restricted payments to equity holders or other lenders, completing permitted acquisitions or investments, or entering into other significant transactions.

Borrowers and lenders should closely evaluate EBITDA-based covenants for add-backs for extraordinary, non-recurring or unusual events or losses. They should consider specifically whether lost earnings attributable to COVID-19 may be utilized as an add-back. Owners, including private equity sponsors, may consider providing additional capital to a borrower to bridge it through the crisis and boost its ability to comply with financial covenants. This option, sometimes referred to as an “equity cure,” is usually welcomed by lenders and may be demanded as part of a loan restructuring. But equity cure rights are typically limited in amount and frequency so lenders are not forced to refrain from action for too long while the fundamentals of a business continue to deteriorate.

Specific to commercial real estate financings, net worth covenants may be significantly impacted by the recent substantial losses in value in the financial markets. Commercial real estate guarantors should review covenant levels and refresh personal financial statements to get ahead of any potential issues.

Financial covenants are often tested at fiscal quarter end dates. The impact of COVID-19 on EBITDA and other key metrics may not be relevant for FYE 2019 or even Q1 2020. But parties should prepare for any material future impact.

What other key covenants or events of default may be implicated?

The scope of covenants and defaults that may by implicated by COVID-19 business impacts will vary widely based on a number of factors, such as debt facility type and size, type of lender (big bank or distressed debt fund, as two extremes), and borrower industry, size and creditworthiness. Common potentially affected covenants and defaults include the following:

• Payment and cross-defaults: Borrowers and lenders should be aware of the relevant terms and thresholds across loan documents and borrowers’ other debt instruments and material agreements. Cross-defaults can be particularly broad and may be triggered by financial distress of material vendors or customers.
• Delay, cessation, or interruption and business interruption insurance: Loan documents may include covenants or defaults triggered by a material delay, interruption or cessation of operations or a project (particularly in industries heavily impacted by “social distancing” strategies). If a borrower is exploring accessing business interruption insurance, it should review its loan documents to determine (i) whether business interruption insurance proceeds may, for financial covenant purposes, be included in net income or added back to EBITDA, and (ii) whether mandatory prepayment provisions require prepayment with the insurance proceeds. This insurance may also constitute a lender’s collateral and may need to be formally assigned to the lender.
• Liquidity-related provisions: Reductions in liquidity and line of credit availability can trigger minimum liquidity covenants, cash dominion covenants or conditions to covenant exceptions. With the currently low interest rates, LIBOR floor provisions may also be influential to the analysis of liquidity.
• Notice provisions: Borrowers may be required to notify lenders of:
  • Existing or potential MAEs or events of default.
  • Changes in credit ratings for publicly rated companies.
  • Financial information and auditor reports (clear of any “going concern qualification” that may appear based on an auditor’s view that the borrower will not be able to satisfy all of its short-term obligations).
  • Material delays, interruptions or cessations of business operations or projects.
• General information requirements: Lenders may consider using general information covenants to request additional information regarding the finances, assets and operations of borrowers to better evaluate the extent of risk when lenders have particular concerns with the business. From the borrower’s perspective, proactive dialogue may comfort lenders.

If an event of default has occurred, what then?

The effects of the pandemic will cause events of default under many credit facilities. Some will be technical, and some will be material. How lenders will and should react to these events of default will be determined on a case-by-case basis related to the severity of the default and the lenders’ judgment as to how future events will affect a borrower’s ability to repay a loan.

For borrowers that suffer a material event of default, a lender will likely take remedial action sooner than later. Remedies may include terminating lines of credit and funding commitments and demanding immediate repayment of loans. Many lenders, particularly those with strong relationships with their borrowers and those lending to borrowers with sound fundamentals, will apply less drastic remedies, which may include forbearing or waiving the default, amending the loan documents to provide for greater protection to the lender, or working on a restructuring plan with the borrower to aid continuing operations.

Syndicated credit facilities usually require the lead lender (known as the agent) to obtain the approval of at least a majority of the other lenders before agreeing to any waivers, amendments or formal forbearance. Syndicated facilities may also restrict the lender group’s ability to react to an event of default unless the requisite lenders instruct certain action. These dynamics should also be taken into account when planning strategy and timing of any relief or accommodation a borrower needs under a credit facility.

Where a borrower has multiple secured credit facilities, it is possible that the lenders under those credit facilities are parties to intercreditor agreements that impact amendments, waivers or lenders’ determination to take other action. For example, many intercreditor agreements restrict a junior lender from taking enforcement actions, which can provide a borrower and a senior lender time to arrange a resolution.

When do lenders and borrowers need to talk?

Assuming a positive and functioning relationship between a lender and a borrower, now is the time for borrowers to reach out to their lenders to discuss availability of future funds, risks and losses and to make contingency plans. Generally, borrowers most exposed to likely adverse effects on financial covenants or their ability to service debt obligations should open the dialogue with lenders soon regarding the expected impacts on the borrower’s financial condition; how the borrower is managing or mitigating the impacts; and waivers, extensions or other modifications that may be available for relief. Some borrowers will find their circumstances deteriorating quickly and may need to seek bankruptcy protection. An existing lender may be a borrower’s best financing option, even in a bankruptcy.

We have already seen numerous lenders notify borrowers of continuity plans to prevent or mitigate any disruptions that may impact their ability to fund and service loans. Lenders should continue proactive communications with borrowers to ease any concerns relating to lenders’ ability to fund, and should notify borrowers immediately of any funding disruptions to enable borrowers to mitigate liquidity constraints.

How will COVID-19 impact new debt or refinancings?

Borrowers approaching a financing or refinancing should prepare for a more cautious or restrictive lending environment.

Lenders and borrowers exploring or negotiating new debt arrangements should maintain a close focus on the key provisions and considerations highlighted above. In addition to the effects on forecasts and financial underwriting, parties should consider the following risk mitigants that may be beneficial or raised by a counterparty in negotiations:

• Increased due diligence and stress testing by lenders related to borrowers’ exposure to COVID-19 and social distancing strategies as well as potential aggravating or mitigating factors such as termination and force majeure provisions in material customer or vendor contracts and coverage of business interruption insurance.
• Higher margins or rate floors, and less room for financial covenant-based step-downs in the near term.
• Other conditions added to and more significant flex in commitment papers.
• Additional short- to mid-term headroom under financial covenants, or the ability to stipulate results from a different period for a testing period that has been significantly impacted in an adverse way.
• COVID-19-specific add-backs to EBITDA (and lender resistance to robust add-back packages).
• Specific additional equity cure flexibility for the expected adversely impacted period.
• Eliminating from MAE definitions the effects of COVID-19 generally, or a subset of those effects.