What a Lender Needs to Know: Key Loan Document Terms in a Time of Crisis
By David W. Morse, Esq.
As circumstances are moving rapidly, companies and their lenders are dealing with unprecedented times. While companies try to determine the full impact of the current economic tailspin on their businesses, lenders are looking to understand their risks and how they can respond to them.
The credit agreement sets out the rules of the road for the relationship between a company and its lenders. In the list of credit agreement provisions set out below we attempt to provide a map for the secured lender for navigating those rules, anticipating where there may be bumps or wrong turns and providing some guidance for where a lender may go in the credit agreement to determine its path when confronted with a borrower in distress.
Material Adverse Effect
In the past week there has been a lot written and even more discussed about the concepts of a “material adverse change” (“MAC”) or “material adverse effect” (“MAE”), that wind their way through almost all credit agreements. The volume of commentary being quite natural given the dramatic turn for businesses in today’s environment.
Let’s try to break it down in a functional manner—at least to the extent that the uncertainties of the law permit—to try to answer the question that inquiring minds want to know: What is a Material Adverse Effect?
Event of Default or Condition Precedent?
Before we get there--does the credit agreement include an independent event of default as a result of a “material adverse effect” to the business? Most middle-market and upper-middle market transactions will not, but some middle-market and many lower-middle market transactions will. In the middle market and in larger transactions, while there will not typically be an independent default there will be a representation by the company that no “Material Adverse Effect” has occurred since a specific date, usually the date of the last audited financial statements received by the agent or lender prior to the execution of the credit agreement. What does this mean? This means that the standard condition precedent to the making of loans that all representations be true and correct as of the date of the making of the loan will not be satisfied if the business has in fact experienced a Material Adverse Effect. Therefore, the lenders will not be obligated to make a requested loan, that is, there will be a “draw stop”.
Elements of “Material Adverse Effect”
In either case, how does a lender know if there has been a “Material Adverse Effect”—and so there is either an event of default (if there is an independent default based on it) or the lender is not obligated to make a loan? The answer starts with looking at the definition of the term in the particular credit agreement. The definitions are generally very similar. Most of the time the definition includes some version of the following:
• a material adverse effect in the business, operations, results of operations, assets, liabilities or financial condition of the borrowers and guarantors, taken as a whole,
• a material impairment of the ability of the borrowers and guarantors to perform their obligations under the loan documents or of the ability of the lenders to enforce the debt or realize on the collateral, or
• a material impairment of the enforceability or priority of liens of the lenders with respect to the collateral.
Sometimes, besides referring to a material adverse effect on the business, assets, liabilities, etc., the definition will also refer to an adverse effect on the “prospects” of the borrower, which can be helpful to the lender in considering the future performance of the borrower. More often, “prospects” will not be included, which means that the material adverse effect on the business must have actually occurred—and not be an effect that is expected to occur. Sometimes in specific provisions there may be a reference to an event that has an MAE or “could reasonably be expected to have an MAE”, but that does not usually appear in the condition precedent to borrowing. Even in those cases where there may be a reference to “prospects” in the definition, as discussed below in more detail, a lender will want to be cautious.
While the answer starts with the definition, it does not end there. The definition does not include any objective, clear criteria that a lender can point to. The definition just does not define “material”.
Since the term “material” is not defined, we have to turn to any case law that there may be in providing guidance as to how it might be understood, particularly in the context of the circumstances of the specific borrower at the time. Unfortunately, at least as to conditions precedent to the making of loans or an event of default under a credit facility, there is not much to go by. However, there are a series of cases interpreting a “Material Adverse Effect” in the context of acquisitions that it could be expected a court would look to. These are cases where the buyer tried to back out of an acquisition when one of the conditions to the buyer’s obligation to close was the absence of a material adverse effect on the target business.
When you look at these cases a couple of general themes are clear. First, it is very difficult to “prove” an MAE, a point made by the fact that at least in Delaware no court had found that there was an MAE until the 2018 decision in Akorn, Inc. v. Fresenius Kabi A.G.1; Second, to support the finding of an MAE requires an intensive and cogent factual analysis of key objective indicators of business performance: sales, margins, EBITDA, operating revenue, etc. Given these requirements, before relying on an MAE for any purpose, the lender needs to be certain it can make the case.
In looking for an MAE, the case law refers to three aspects of the adverse change to the business that will be considered:
• the duration of the change,
• the magnitude of the change, and
• the relationship of the change to the purpose of the transaction.
In a 2013 case in England, Grupo Hotelero Urvasco SA v. Carey Value Added SL2, the English High Court also said that the material change cannot include circumstances or events which were known to the lender at the time the agreement was made.
In terms of duration, the material adverse effect must be “durationally-significant.” In the leading case of In re IBP S'Holders Litig. v. Tyson Foods 3, the Court said that a “blip” in earnings does not constitute an MAE and the effect should substantially threaten the overall earnings potential of the target in a “durationally-significant manner.” In Hexion Specialty Chems., Inc. v. Huntsman Corp.4, the Court noted that for a significant decline in earnings to constitute a material adverse effect, poor earnings results must be expected to persist significantly into the future.
This means that to rely on an MAE, a lender would have to be able to convincingly show that a current downturn in a business’ performance does not have any reasonable prospects of bouncing back. In the IBP case, the Delaware Court found that a 64% drop in quarterly earnings did not constitute a material adverse effect, because a major producer of beef suffered a large quarterly decline in performance primarily due to widely known cycles in the meat industry, exacerbated by a harsh winter. After the bad quarter and the onset of spring, the company performed more in line with its recent-year results.
In terms of the magnitude of the change, here is where some of the cases came out.
In the Hexion case, the court said that when evaluating the magnitude of a decline, a company’s performance generally should be evaluated against its results during the same quarter of the prior year, in order to minimize the effect of seasonal fluctuations. The Hexion Court declined to find an MAE where the seller’s 2007 EBITDA was only 3% below its 2006 EBITDA, and where according to its management forecasts, its 2008 EBITDA would be only 7% below its 2007 EBITDA or even using the buyer’s more conservative forecasts, the seller’s 2008 EBITDA would still be only 11% below its 2007 EBITDA.
By contrast in Genesco Inc. v. Finish Line Inc.5 , the Court noted that the target, Genesco, suffered a 61% decline in earnings for the second and third quarters of 2007 compared to the comparable quarters in prior years and there was no “rebound” in subsequent months. The Court found that this was a “material adverse effect,” but because it was a result of general economic conditions and the definition of the term “Material Adverse Effect” in the acquisition agreement carved out adverse effects as a result of general economic conditions, the buyer was not excused from closing.
In Akorn, the Court cited one treatise which noted that courts have considered decreases in profits in the 40% or higher range a material adverse effect and cited another case where the judge suggested that a decline in earnings of 50% over two consecutive quarters would likely be an MAE. Under the facts of Akorn, the Delaware Court found an MAE on the basis of declines in quarters measured against performance in the same quarter of the previous year of revenue of 29%, operating income of 89% and earnings per share of 105%--and declines of EBITDA of 86% and of adjusted EBITDA of 51%.
Burden of Proof, Lender Liability Risk and Reputation Risk
Given the fact-intensive nature of the case for the occurrence of a Material Adverse Effect, and the number of variables that affect whether or not a court might find that one has occurred, it is understandable that the concept is rarely used, and often when used, only in conjunction with other events of default. In failing to make a loan or in demanding repayment based on an MAE, the shadow of lender-liability claims looms large.
The lender will need to evaluate each situation carefully to determine a strategy that will lead to the best ultimate recovery, which will include not only assembling the data to be in a position to make the case that an MAE has occurred, but also taking into consideration the risk of at least a claim against the lender by the company as a consequence of the lender failing to fund, whether or not such claim might be successful. Part of understanding this risk includes considering which party bears the burden of proving the existence of an MAE, since that party will have the more difficult position. At least in the context of acquisition agreements where the buyer has not wanted to proceed, the courts have said that absent clear language to the contrary, the burden of proof with respect to a material adverse effect rests on the party seeking to excuse its performance under the contract, which in this case would be the lender. 6
Beyond the question of whether funding or not is more or less likely to lead to a successful recovery, the lender will need to consider the potential reputational damage to taking such action in the current environment and the signal that it will send to the market.
While there is a lot of discussion about the occurrence of a “Material Adverse Effect” or “Material Adverse Change”, there is also a representation in most credit agreements that the company is “solvent”. Since a condition to a borrowing under a revolving credit facility typically requires that all representations be true, if a borrower cannot make the representation that it is “solvent,” it may not be able to borrow.
Most often the concept of “solvent” is defined in the credit agreement to match the definitions in fraudulent transfer laws (now known as “voidable transfer” law) and corporate dividend laws. In some ways, like a “Material Adverse Effect,” understanding the definition of “Solvent” means considering the fraudulent transfer statutes and the case law applying them.
Just as a starting place, and to simplify, generally there are three types of “insolvency” in the applicable statutes:
• A balance-sheet test based on whether the sum of the borrower’s liabilities exceeds the sum of its assets at a “fair valuation”;
• A cash-flow test based on whether the borrower has incurred debts that are beyond the its ability to pay as such debts mature; and
• A capitalization test based on whether the borrower is engaged in a business or a transaction for which it has unreasonably small capital.
There is extensive case law interpreting and applying these concepts that would need to be considered as part of examining whether a borrower has ceased to be “solvent” as such term is defined in the credit agreement, but as events unfold, this may be another area for the lender to more closely exam, particularly in consultation with counsel familiar with how these tests are applied by the courts.
Conditions Precedent to Borrowing: The Borrowing Base
Many companies have been making substantial draws under their credit facilities to have cash on hand—often to avoid the risk of failing to meet the conditions precedent at some point in the future. The question becomes how should a lender react to this request? In some ways this is both a general question of approach by any institution, and a specific question of what makes sense for that institution for that borrower.
In most credit agreements the lender has agreed that it will make loans up to the amount of the availability under the borrowing base. In these times, a complete understanding of the elements of the borrowing base becomes critical. While the borrower may provide a borrowing base certificate as of a point in time, usually monthly, sometimes weekly, the information in the certificate does not necessarily dictate the actual amount that a borrower can borrow at such moment. Availability is actually measured each day. The loans available on any day depend not only on the amount of the eligible assets multiplied by the applicable advance rates relative to outstanding loans and any other extensions of credit, but also on any reserves or ineligible assets as of such day. The right of a lender to establish reserves or determine ineligibles is generally subject to a reasonable, good faith standard and there may be specific notice requirements in the credit agreement related to them, but under the circumstances a careful review of these elements of the borrowing base is warranted.
Frequency of Reporting
While often a company in the negotiation of the credit agreement looks to reduce the frequency of when it must deliver a borrowing base certificate to provide the information that the agent needs to know for the core elements of the borrowing base, there can in fact be circumstances where it is advantageous for the borrower to report more frequently. The timing of a particularly large sale, or increases in inventory, could actually help the borrower’s liquidity. A very granular review of these circumstances may provide an avenue for additional availability for the borrower in the short term.
Additional Field Exams and Appraisals
A real question in light of current events is whether the values attributed to receivables, inventory, equipment or other assets will hold up given the market disruptions. This is one of the lessons of 2008 and of the downturn in the energy industry over the last few years. How is an asset valued when there is little or no market for it? Or when customers are tight on cash, what is going to happen to dilution? The question for the lender becomes whether this is a time to get a new appraisal or a new field exam, recognizing the practical difficulties of doing so (rollforwards and desktops may be the order of the day).
While it is common for credit agreements to include a limitation on the number of field exams and appraisals that the borrower is responsible to pay for, there is also a common practice of allowing for the agent to conduct field exams or appraisals at its own cost in addition. Is this a time to do so?
Financial Covenants: The EBITDA Problem
Asset-based lending, as the original “covenant-lite”, typically does not include extensive financial covenants in the credit agreement. Most commonly, the credit agreement will include only a fixed charge coverage ratio that is not tested until excess availability falls below a specified amount. Nonetheless, as liquidity is impacted, and particularly if there is going to be a significant draw under the facility, that ratio may be tested sooner rather than later.
There are at least three issues here for lenders.
First, the real challenge in the current state of loan documentation is the ability of the lender to actually calculate the fixed charge coverage ratio, given that some of the addbacks are based on speculative judgments by the company, including in particular the addbacks for “restructuring charges” or “cost savings and synergies.” In today’s environment, lenders may want to begin now to get an understanding from the borrower of how it is calculating its EBITDA particularly around those elements that are less certain and more speculative, so that the lender has a point of reference for understanding the real position of the company and more importantly perhaps, its risk.
Second, the lender may want to examine the addbacks and anticipate how losses and other events triggered by current events may be incorporated into addbacks already provided for in the definition of the term “EBITDA”. Are the charges driven by the current crisis within the scope of an addback for “unusual, non-recurring or extraordinary charge”?
Third, lenders may also anticipate that there will be requests from borrowers for amendments to the definition of EBITDA to allow for addbacks to minimize the impact of the current economic crisis in the covenant calculations as the consequences work through the financial statements to be delivered in the months and quarters to come.
Qualified Audited Financial Statements
For a borrower that a lender is particularly concerned about it may be worthwhile to inquire as to the status of the audit of its annual financial statements given the current economic situation, recognizing that there may ongoing discussions in any event about the timing of the delivery of the audited financials given the current state of matters. Most credit agreements will require that a company deliver audited financial statements with an “unqualified opinion” from the accountants, so that the opinions or reports provided by accountants do not include any qualification, explanation, supplemental comment, or other comment concerning the ability of the borrower to continue as a going concern or concerning the scope of the audit.
Given the risks of disruption in the supply chain or customers pulling back from purchases or even the borrower’s inability to perform its obligations under a material contract, understanding the provisions of the credit agreement that relate to material contracts of a borrower may be appropriate. There is a wide range of approaches to addressing material contracts in credit agreements. Some credit agreements may only require a notice of any default under a material contract while others may include an event of default based on a default under the material contract. As the economic downturn continues, with respect to retailers, the lender may want to watch for the measures that credit card processors and issuers may take to address chargebacks and other exposure that they may have to retailers, like requiring collateral or other credit support or setting off against amounts otherwise payable to the retailer.
Credit Agreements typically have an affirmative covenant pursuant to which a borrower is required to notify the agent or lender of specified events that may be relevant to the lenders’ risk of repayment of the debt. For example, the borrower may be required to notify the lender or agent of:
• a material adverse change to its business,
• a default under a material contract,
• any event of default or event, condition or circumstance that, with the giving of notice, the passage of time, or both, would be an event of default,
• any dispute, litigation, or investigation,
• any material change in accounting policies or financial reporting practices of a borrower or guarantor.
A lender may want to look at these events that the borrower is required to provide it notice of and consider checking with the borrower as to whether the borrower should be sending notices for any of the events listed in the credit agreement.
Other Debt/Cross Defaults
Most companies have borrowed from multiple sources—some have accessed the capital markets, some have loans from private debt funds, in addition to their asset-based credit facilities. The current crisis will clearly impact the ability of a company to refinance debt that has an upcoming maturity, even one for this purpose within the next 12 months (and with the resulting impact on its treatment in the financial statements).
This is clearly a time to review the capital structure of a borrower, and look not only at maturity dates but also the character of the other debt on the balance sheet of your borrower, to determine how the attributes of that other debt may impact on what your borrower will need to do as its financial performance may deteriorate. Ultimately, debt with significant financial covenants may give rise to a default under such debt in the coming months, with the resulting consequences for the asset-based lender, including a cross-default under the asset-based credit facility. Needless to say, intercreditor agreements will be significant.
On the other side, lenders may want to be thinking about ways for companies to get additional credit. This means an examination of the terms of incremental facilities (or “accordions”) in the credit agreement and the terms and conditions around permitted indebtedness and permitted liens. Lenders may look at amendments to the credit agreement that would be required to allow additional secured debt to be provided by some or all of the existing lender group, recognizing that getting approvals from members of the lender group may be challenging.
Agents in syndicated credit facilities when confronted with a request for loans beyond the borrowing base will need to check provisions of the credit agreement that allow the agent some discretion to make either “protective advances” or “overadvances”, or both, as part of its determination as to how to respond to such requests. The determination of whether or not an advance satisfies the requirements so as to constitute a “protective advance” will need to be evaluated on a case by case basis tied to the purpose of the particular advance.
Suspension/Cessation of Business
Some credit agreements, particularly in the lower middle market, may include as an event of default based on the cessation or suspension of business by the borrower. While businesses outside of those industries most immediately and dramatically impacted by the pandemic may not have suspended or ceased their business, a lender may want to check to see if there is such a provision in its list of events of default, in case matters take a turn in that direction for a particular business.
As reflected by those companies that have already taken down all of their availability, the company will want to build up its cash position to address concerns about future liquidity. The loan proceeds and other cash will be held in cash or cash equivalents in deposit accounts and investment accounts, which often falls within the definition of an “investment” under a credit agreement. Most credit agreements are generally relaxed in allowing such “investments” except in the case of an asset-based facility after a cash dominion event has occurred. When excess availability under the borrowing base has fallen below the agreed upon threshold so as to trigger a “cash dominion event”, most cash is to be swept to the lender or agent for application to the debt.
In years past, there were sometimes limitations on the right of a borrower to “hoard” cash by triggering a mandatory payment if such cash or cash equivalents exceeded certain agreed upon amounts or just an absolute prohibition on having such “investments” in excess of a specified amount. These “anti-hoarding” provisions have become less common and certainly were and are rare in larger transactions. But, a review of the negative covenant on permitted investments in the credit agreement may be worth a look and a lender may want to consider whether it should pursue an opportunity to incorporate the concept into its credit agreement as part of an amendment or waiver.
Given the way that interest rates have been going, most credit agreements over the last few years have been including a zero percent floor on the LIBOR level that is the basis for the calculation of the interest rates. However, there may be older credit agreements where that floor was not included or has not been added through subsequent amendments. As the opportunity to revisit terms of arrangements may arise pursuant to request for waivers or other amendments, this is another provision in the credit agreement to be checked.
1 C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018)
2  EWHC 1039 (Comm) (26 April 2013)
3 789 A.2d 14 (Del. Ch. 2001)
4 965 A.2d 715, 738 (Del. Ch. 2008)
5 2007 WL 4698244, at *19 (Tenn. Ch. Dec. 27, 2007)
6 See Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008)