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By: Michael Chernick and Brittany Roger, Shearman & Sterling LLP
This article provides an overview of certain key provisions of credit agreements that will need to be reviewed to determine how the novel coronavirus (COVID-19) crisis—and the economic turmoil in its wake—affects a borrower’s ability to meet its ongoing obligations under such agreements and how borrowers and lenders may protect themselves going forward. It also considers provisions of credit agreements that may be utilized for cash preservation and liquidity purposes or to access alternative funding.
THE COVID-19 PANDEMIC CRISIS CONTINUES TO ADVERSELY affect and impact the results of operations and financial condition of businesses across almost every industry and sector globally. As a result of this, borrowers and lenders will need to consider multiple issues under their existing loan documents and any new loan facilities. Below we describe these issues and how they relate to specific provisions of a credit agreement.
Since the beginning of the crisis, borrowers have taken different approaches to accessing liquidity. These can include drawing down on an existing facility, amending their facilities, or entering into new facilities, taking into account the new landscape. As described below, each approach raises distinct, and in some cases overlapping issues.
Many borrowers have accessed their revolving facilities and other committed undrawn facilities to maximize their liquidity position. The key conditions that a borrower must usually satisfy in order to borrow under these types of facilities are (1) there is no default or event of default and (2) the representations and warranties are true and correct, in each case, on the date of, and after giving effect to, such borrowing. These representations and warranties may also need to be repeated by borrowers at the time of granting waivers by lenders or amending existing loan documents. Given the widespread and varied impacts of COVID-19 on businesses, certain borrowers may be apprehensive about bringing down representations without certain carve-outs for known or unknown impacts of COVID-19. The impacts on a particular borrower and the specific terms of the relevant representations in the loan documents will need to be considered in order to determine the approach to making such representations.
In addition to concerns in the context of bringing down representations, many borrowers impacted by the COVID-19 pandemic have begun to seek amendments to their existing loan documents to provide covenant relief, covenant or amortization suspensions, and/or increases in commitments or incremental facilities and/or have sought to obtain needed liquidity through new facilities. In this context, the terms of the applicable loan documentation will need to be considered carefully to accommodate the impact of COVID-19 on the borrower, while lenders facing their own fallouts from the impacts of COVID-19 also seek to protect their position and priority.
These issues are taken in turn below.
The specific language of representations and warranties varies widely, but most credit agreements contain the below representations and warranties that may need to be considered by borrowers and lenders on a case-by-case basis.
Material Adverse Effect
Most credit agreements contain some form of material adverse effect (or material adverse change) representation. There have been numerous questions raised by borrowers and lenders alike about whether the current lockdown restrictions that have been widely imposed throughout the United States and in many other countries, and the resulting impact (in terms of closures and suspensions of many businesses and related drops in revenue), have caused a material adverse effect to occur that would allow lenders to refuse a drawdown or accelerate a loan.
What constitutes a material adverse effect is not specifically defined in any New York statute, and there is limited judicial guidance available under New York law interpreting whether a material adverse effect has occurred. Based on judicial interpretations of similar provisions in acquisition agreements (which are primarily governed by Delaware law, but New York courts have looked to the Delaware cases on this subject in providing guidance in interpreting these provisions), it is generally considered that for a material adverse effect to occur in relation to a borrower’s business or financial condition:
While there is no bright-line test, it is generally understood that lenders seeking to rely on the impacts of an economic downturn as a drawstop or default will have to meet a high burden of proof in evidencing that there has been a material adverse effect. Such determination must be made on a fact-specific basis, based on the wording in the credit agreement and the specific factors affecting the borrower. This is a difficult determination in light of the current uncertainty over how long lockdown restrictions may remain in place and their resulting impact on financial statements and balance sheets, and how quickly business operations will be able to resume as normal. Given this uncertainty, lenders in practice have been cautious of invoking the occurrence of a material adverse effect as an excuse not to fund a draw request as a lender that does not fulfill its obligations under a credit agreement faces the risk of litigation for a breach of contract claim and potential reputational damage.
The definition of what constitutes a material adverse effect will vary widely across credit agreements and should be reviewed carefully. Customarily, material adverse effect refers to materially adverse impacts on (1) the borrower’s business or financial condition, (2) the borrower’s obligations, and/or (3) the agent’s rights and remedies. In some cases, one or more of these limbs may not apply, thereby the limiting the scope of analysis. Other items to consider include:
Generally, the more forward-looking and subjective elements there are in the representation and the broader the scope of the obligations to which the representation applies, the greater difficulty a borrower may have in determining its ability to make the representation.
Notwithstanding the high bar for determining that a material adverse effect on a business has occurred, due to the significant, unprecedented, and ongoing nature of the COVID-19 pandemic and its aftermath, it has not been uncommon for borrowers to seek to carve out COVID-19’s effects from bringing down material adverse effect representations in a drawdown, waiver, or amendment agreement, or more generally from the material adverse effect definition in its loan documents. Issues to consider for any such carve-out include:
Examples of Carve-Outs in Publicly Filed Deals
The context and timing of the material adverse effect carve-out may make certain considerations more relevant than others. For instance, the period during which a carve-out applies may not need to be defined in a proviso to a one-off bring down representation made as of a draw-down date, whereas lenders may seek to specify a period during which the proviso applies if it is to apply to the material adverse effect representations and covenants under the loan documents generally. Some recent examples of both types of carve-out include:
“Material Adverse Change means (a) a material adverse change in the business, operations, results of operations, assets, liabilities or condition (financial or otherwise) of any Obligor…; provided, however, that until the fiscal quarter ending September 30, 2020, and thereafter for such period or periods as may be agreed to in writing by the Bank in its sole discretion, the declaration on March 13, 2020, of the national emergency relating to COVID-19 and related measures and the financial impact thereof on the Borrower and the Obligors shall not constitute a material adverse change in the condition (financial or otherwise) or operations of the Borrower and the Obligors.”
Quorum Health Corporation2
“’Material Adverse Effect’ shall mean (a) a materially adverse effect on the business, assets, operations, financial condition or operating results of the Borrower and the Subsidiaries, taken as a whole, (b) a material impairment of the ability of the Loan Parties, taken as a whole, to perform their obligations under the Loan Document to which they are or will be a party or (c) a material impairment of the rights and remedies of or benefits available to the Lenders under the Loan Documents, other than, in each case, as a result of the events leading up to, and following the commencement of a proceeding under Chapter 11 and the continuation and prosecution thereof, including circumstances or conditions resulting from, or incidental to, such events, commencement, continuation and prosecution, which shall not, individually or in the aggregate, constitute a Material Adverse Effect; provided that no effect on the business, assets, operations, financial condition or operating results of the Borrower and the Subsidiaries as a result of the Coronavirus Disease 2019 (COVID-19) shall constitute a Material Adverse Effect under clause (a) of the definition thereof.”
Marriot International Inc.3
“…The Company additionally represents and warrants (which representations and warranties shall survive the execution and delivery hereof) to the Administrative Agent and the Lenders that: …No Material Adverse Change has occurred since December 31, 2019; provided, that the impacts of COVID-19 on the business, condition (financial or otherwise), operations or properties of the Company or any of its Subsidiaries will be disregarded; …” (Note: This proviso applied to the material adverse effect representation in the amendment agreement only. The material adverse change definition in the loan documents was not modified in this amendment.)
Keurig Dr. Pepper Inc.4
“’Material Adverse Change’ means any material adverse change in the business, business operations, property or financial condition of the Borrower and its Subsidiaries taken as a whole; provided that the impacts of COVID-19 on the business, business operations, property or financial condition of the Borrower or any of its Subsidiaries that occurred and were disclosed in the Borrower’s Prospectus Supplement filed on April 9, 2020 or the transcripts of investor calls posted to the Lenders on April 10, 2020 will be disregarded.”
United Fire Group Inc.5
“’Material Adverse Effect’ …provided, however, that current financial and market conditions engendered by the COVID-19 pandemic shall not be given effect in determining whether a Material Adverse Effect has occurred with respect to the Borrower and its Subsidiaries unless such conditions result in a meaningful decline after the Closing Date specific to the Borrower’s business.”
This representation typically pertains to defaults under the loan documents as well as defaults or termination events under other material agreements. This representation could be relevant where a company’s performance under third-party contracts (including supply and commercial contracts) is materially adversely affected by the COVID-19 outbreak.
Depending on the facts and circumstances of a particular borrower, the representations relating to litigation and judgments may need to be reviewed. In particular, careful review should be made for businesses that are subject to litigation as a result of the failure to perform under material contracts (for instance, litigation relating to assertion that COVID-19 constitutes a force majeure event under the relevant contract).
Borrowers may also need to bring down their solvency representation in connection with a new borrowing. Borrowers and lenders will need to check the credit agreement to confirm whether such representation needs to be brought down to each borrowing date or is limited to just the closing date. Solvency representations may vary among credit agreements but in general they require a borrower to certify:
The impact of the pandemic and the resulting economic downturn, coupled with the borrower’s need to draw under a facility, may trigger ongoing reporting requirements under a credit agreement. Reporting and notification obligations to lenders vary between credit agreements but typically include, among other things:
Borrowers and lenders will need to monitor compliance with these ongoing obligations to provide notices under their debt documents and any deadlines by which the borrower is required to deliver any required information and notices. Even where a grace period applies, a notice may still be required.
It is anticipated that lenders will receive requests for extensions of deadlines (or waivers for missed deadlines) due to the impact on operations caused by ongoing lockdown restrictions in many locations and by the subsequent general downturn. For instance, many borrowers may be unable to meet deadlines for obligations to deliver annual audited financial statements and accompanying auditor reports because their auditors have been unable to complete audit procedures (in particular those that require site visits) on their clients’ financial statements on a timely basis.
Lenders will need to consider the length of an extension and how to address any knock-on impact on calculations of financial covenants and negative covenants in credit agreements that may occur as a result of any delay in delivery of financial information. The basis for any calculations and/or requirements for interim or supplemental reporting obligations may be included as terms or conditions in any such waiver. For example, in the FS Energy & Power Fund amendment,6 the lenders granted a waiver as a result of a failure of the borrower and its subsidiaries to deliver audited consolidated financial statements for the year ended December 31, 2019 (among waivers of other specified defaults).
Lenders may also seek to impose additional interim reporting obligations during any applicable waiver period, for instance, to monitor the borrower’s liquidity.
Lenders and borrowers will need to assess the impact of the COVID-19 pandemic and its aftermath on borrowers’ ability to comply with their financial covenants, which usually are either a leverage ratio test or an interest or fixed charge coverage test, measured at the end of each fiscal quarter. In covenant-lite deals, many borrowers may need to test springing financial covenants as of the end of any applicable fiscal quarter in the event that the springing trigger occurred by such dates due to revolver drawings above the applicable threshold made prior to quarter end. Each of these tests typically measure EBITDA over a last-four fiscal-quarter period, so, as a result, the negative impact of the COVID-19 pandemic on a borrower’s ability to comply with financial maintenance covenants could last well into 2021.
To the extent that a borrower engages in discussions with its lenders for covenant relief (which may take several different forms, including a covenant suspension for a period of time or re-setting the covenant to provide additional cushion), lenders will need to consider what credit enhancements they should seek in return as a condition and whether such changes should apply only during a certain period. Based on several recent filings, borrowers have obtained covenant relief in exchange for a myriad of concessions, including:
There is an increasing number of examples and formulations of such trade-offs. A cursory cross-section of examples include:
The approach to amending documentation may depend on the required lender consent for such amendments. Borrowers and pro rata and/or revolving lenders that are parties to covenant-lite credit agreements may be reluctant to make changes that may require consent of term lenders that could extend the negotiation process and expense. Borrowers may instead seek alternative sources of funding or cash preservation methods.
The difficulty imposed by COVID-19 has also cast a light on the definitions underlying financial covenants, as borrowers and their counsel analyze these provisions to find some leeway to meet the ratios while lenders conversely may look for ways to tighten these add-backs. Lenders and borrowers will need to scrutinize these financial definitions (such as consolidated net income and consolidated EBITDA and similar terms) in loan documents. Such definitions are highly negotiated and will vary widely between different credit agreements; however, parties may need to consider the impact of certain add-backs, pro forma calculations, and borrower-friendly drafting on financial covenant compliance and access to ratio baskets or EBITDA-based growers resulting from decreased net income or EBITDA as a result of COVID-19. For example, an additional add-back to EBITDA may increase the incremental debt available to the borrower, which lenders should be careful of. The areas to focus on include:
While changes to EBITDA calculations will be heavily negotiated and fine-tuned, lenders may consider tightening calculations by capping add-backs for synergies, restructuring, and decreased revenues; limiting add-backs to amounts actually realized; tightening broad language; and/or requiring certifications or third-party opinions with respect to such add-backs. One-off COVID-19 add-backs limited to specific actions, periods, and/or amounts may also be included. Below are examples of how these are handled in selected publicly filed amendments. These demonstrate borrower-friendly add-backs but with caps to protect lenders.
Columbia Sportswear Company10
“’EBITDA’ means, as of the end of a quarter, Borrower’s consolidated net income after taxes for the twelve months ending with such quarter plus …. (ii) plus, for purposes of determining Borrower’s compliance with the financial covenants set forth in Article VIII (and not for determining Applicable Rate), and solely to the extent deducted in the calculation of Borrower’s net income, Restructuring Expenses, less (iii) ...”
“‘Restructuring Expenses’ means all costs, expenses, losses and charges arising out of or related to COVID-19, including, without limitation, costs, expenses and losses relating to restructures, scaling of operations, modification of cost structures, any cost, expenses and charges for terminations, severance, furloughs, catastrophic paid leave, store closings, lease cancellations, and contract modifications and terminations, in an aggregate amount not to exceed $50,000,000, in each case to the extent paid prior to the Closing Date or within twelve (12) months after the Closing Date and approved by Administrative Agent in its reasonable discretion.”
Ruth’s Hospitality Group, Inc.11
“’Consolidated EBITDA’ in Section 1.1 of the Credit Agreement is hereby amended in its entirety to read as follows: … (ix) nonrecurring costs and expenses in connection with permanent restaurant closures and lease terminations in an aggregate amount not to exceed $10,000,000 during such period…”
Blonder Tongue Laboratories, Inc.12
“’Permitted EBITDA Add-Back Amount’ means… plus (vi) one-time restructuring charges (including severance payments) incurred by Borrower that are associated with the implementation of cost reduction programs from June 30, 2019 through Fiscal Year 2020, so long as incurred on or prior to March 31, 2021 and in an aggregate amount not exceeding $600,000,...”
Lenders should be aware that adjustments to financial definitions will likely have implications beyond financial covenant compliance, including step-downs for asset sale and excess cash flow mandatory prepayment provisions and ratio-based covenant baskets (such as additional debt and lien incurrences, investments, restricted payments, and restricted debt payments) which may grow as EBITDA increases. Therefore, even where there is a wholesale financial covenant suspension, treatment of EBITDA calculations for periods during the suspension period may need to be considered as well, since calculations for such quarters could impact adjusted calculations that include such prior quarters which are made following the suspension period. For example:
The foregoing amendment provisions will be enough to keep many companies going through the worst of this period, until they can resume close-to-normal operations. However, this temporary relief will inevitably not be enough for all borrowers. A breach of any covenant (after the expiry of any applicable grace periods), including financial and notification covenants, or the failure of any representation to be correct in all material respects when made, could trigger an event of default under the relevant loan documents. Lenders and their counsel should anticipate borrower requests for waivers of such events of default.
The following customary events of default may be particularly relevant in the context of the COVID-19 crisis:
Applicable grace periods would need to be considered for all events of default. In some cases, the event of default may have no grace period. Lenders and borrowers should also be aware that the notification requirements may be triggered when the grace period commences rather than at its expiry.
Preservation of Cash and Assets
As discussed in various sections above, lenders should anticipate borrower requests under their existing loan documents for payment and covenant holidays, deferral of amortization payments or mandatory prepayment of excess cash flow or asset sale proceeds, and/or requests for conversion of cash interest payments into capitalized payment-in-kind payments, as additional ways of preserving or creating liquidity. Borrowers and lenders under asset-based lending (ABL) facilities may also need to consider the impact of potential defaults or late payments by customers (or borrower inability to pay suppliers) and suspensions or disruptions to its supply chain on its borrowing base and reserves. Borrowers may request waivers of or suspensions of certain eligibility criteria. For example, the FS Energy & Power Fund amended credit agreement16 provides relief regarding the delivery of assets to be included in the collateral pool and the calculation of the borrowing base. Similarly, the amendment to the credit agreement17 of Hersha Hospitality Trust relaxes the borrowing base conditions as they relate to COVID-19.
Availability Under Existing Baskets
In addition to drawing funds under a revolving facility, companies may want to seek alternative sources of funding to enhance their liquidity position. Credit agreements of non-investment grade borrowers will generally have restrictive covenants that will, among other things, limit a borrower’s and certain of its subsidiaries’ ability to incur debt and liens, make investments, and transfer or otherwise dispose of assets. These covenant packages can vary widely and are highly negotiated. However, over the past few years, the baskets negotiated in a substantial number of transactions have loosened significantly.
Even with a material degradation of a borrower’s business, using availability under some common baskets, a borrower and its subsidiaries (including subsidiaries that are not guarantors) may be able to incur indebtedness, grant liens on their assets (which may include assets that are not required to be part of the existing lenders’ collateral package), make investments in, and transfer assets to, non-guarantor subsidiaries, and prepay certain types of junior debt or buy back loans on the secondary market.
Many companies may seek to utilize debt basket capacity for receivables financing and securitization financing and/or seek to utilize supply chain financing as ways of providing additional liquidity to shore up any temporary shortfalls in revenue caused by the COVID-19 crisis that cannot be covered by other permitted debt or equity financing.
Borrowers may also seek to raise incremental (or incremental equivalent) debt and/or upsize their incremental capacity permitted by their existing loan documents. For incurrences under incremental debt baskets, borrowers will need to consider whether pricing or other features of the incremental debt would trigger most favored nation (MFN) protections for lenders under the original debt and/or whether it falls within any exceptions to such provisions. In order to avoid triggering MFN provisions, borrowers may be able to structure new debt outside such provisions, such as by incurring such debt using general debt and liens baskets (if there is available capacity to do so) and/or by non-loan parties.
CARES Act Loans and Other Stimulus-Based Proceeds
Borrowers that are eligible for loans or other relief proceeds under the Coronavirus Aid Relief and Economic Security Act (CARES Act)18 (such as Paycheck Protection Program loans (PPP Loans) or the Main Street Lending Program) or other stimulus-based loans or relief funds (Relief Proceeds) may need to consider whether such Relief Proceeds are permitted under or otherwise conflict with its existing loan documents.
Lenders should anticipate requests from such eligible borrowers in order to waive or amend loan document restrictions to permit incurrence of or waive terms that might otherwise apply to Relief Proceeds. Issues to consider in any such waiver or amendment include:
Other exceptional amendments for COVID-19 relief may need to be made to permit disposals related to relief efforts, such as a carve-out in Crocs’ facility amendment permitting the company to donate up to $10 million in inventory to the healthcare industry in response to the COVID-19 pandemic.19
To the extent its credit agreement permits equity cure rights, a borrower and its owners may consider pre-emptive injections of equity to ensure covenant compliance and designate the same proceeds as cure amounts to equity cure a covenant breach. The long-term adjustment impacts by equity cures may be limited, however, as such cures are typically limited to a maximum during the life of the facility (usually four or five times) and in some cases cannot be used in consecutive quarters.
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. This may in certain cases trigger a pricing MFN provision under existing credit agreements. Given that pricing in this distressed market may be higher than when the borrower entered into the existing facility, this may prove to be a costly option. However, that may be acceptable to borrowers if such a facility can be documented on a relatively fast timetable without requiring a marketing element and provide liquidity until less expensive options can be accessed. Disney25 (LIBOR applicable margin ranging from 0.875% to 1.5%), Cigna26 (LIBOR applicable margin ranging from 1.125% to 1.625%), and Honeywell27 (LIBOR applicable margin ranging from 0.750% to 1%), among others, have recently entered into such 364-day term facilities. Other facilities entered into during the COVID-19 crisis include Textron,28 United Fire & Casualty Company,29 Tyson Foods,30 and Becton, Dickinson and Company.31
Several non-investment grade borrowers have accessed syndicated markets for additional liquidity and had to offer investors favorable call protection and pay a significant premium compared to prior financings. For example:
The sharp decline in the market prices of loans in the secondary markets may cause borrowers to consider debt repurchases. Prior to the 2008 financial crisis, most credit agreements did not contemplate or permit borrowers or their affiliates to purchase the borrower’s loans. However, it is now common to allow such buybacks (usually limited to term loans).
Although the terms of a particular credit agreement may vary, loan documents generally provide that a borrower may carry out a buyback through open market purchases or voluntary discounted prepayments (known as Dutch Auction procedures) so long as no event of default exists and no proceeds from the borrower’s revolving credit facility are used to make such purchases. Any loans bought back are then cancelled.
Affiliates of the borrower are also generally permitted to purchase loans of such borrower subject to a cap (generally 25-30% of the loans), and such affiliates will have limitations on their access to information and lender only meetings, voting rights, and certain rights in bankruptcy proceedings. The limitations often do not apply to debt fund affiliates (i.e., debt funds that are affiliated with the sponsor). However, credit agreements will often limit the aggregate voting rights of such debt fund affiliates to 49.9% of the vote.
It should be noted however that loan buybacks do raise a number of issues.
As amendments, waivers, credit agreements, and other related loan documents are signed, borrowers and lenders will need to be prepared for logistical difficulties and delays due to closures and disruptions, such as:
Michael Chernick is a partner in the Finance practice of Shearman & Sterling LLP. Michael has over 25 years of experience in the U.S. leveraged finance market, representing leading investment and commercial banks, alternative capital providers, and other financial institutions in bank financing and debt capital markets transactions. He has extensive experience in public and private leveraged and investment grade acquisition finance (including bridge financings), refinancings and recapitalizations, second-lien, and asset-based lending. Michael also advises on securities, capital markets, bank finance, and corporate transactions representing corporations and financial institutions in bank financings, public and private offerings, and high-yield debt offerings. Brittany Roger is an associate in the Finance practice of Shearman & Sterling LLP. She focuses on a variety of financing transactions, including leveraged and investment-grade committed financings, syndicated bank loans, and asset-based finance.
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