The effect of COVID-19 on borrowers and their finance arrangements

The spread of COVID-19 around the globe has dominated news headlines with over 130,000 reported cases in around 127 countries and territories at last count. The social and economic impact of the virus has been incredibly damaging and the situation is likely to get worse before it gets better.

Unsurprisingly, businesses across all industries are starting to feel the impact. They are turning to their advisers to help plan for the uncertainty of the weeks and months ahead. As part of this planning, we are asking our borrower clients to look carefully at their finance arrangements with banks and other lenders and to start discussions early with their funding partners to hopefully avoid, waive or cure any potential breaches.

We understand from a number of institutional lenders that they are already getting in touch with their customers to check in with them. If you haven’t already heard from your lenders, please contact them as early as possible to discuss any (potential) issues. Lenders should be amenable to accommodating the detrimental effects of COVID-19 on businesses as it is in neither party’s best interest to default a loan. A large number of lenders are already working with their customers to manage any potential breaches of loan agreements and a variety of measures are being proposed including waiving breaches, repayment “holidays”, interest capitalisation and short-term new lines of credit including overdrafts.

How might COVID-19 affect your finance arrangements?

Our borrower clients are asking how the outbreak of COVID-19 might affect their loan agreements with lenders and the potential breaches that may occur. These could include:

1. Financial covenants – Financial covenants are an early warning system for lenders to test the financial health of their borrowers. Unsurprisingly, COVID-19 has had a dramatic impact on many businesses across the country with many companies suffering a steep decline in revenue. Depending on the extent of the income deterioration and the calculation period for each relevant test date, this could breach financial covenants. This is particularly the case for those tested on a look-forward basis, including cashflow cover, interest cover and debt service cover. The calculation period will be important as the longer this period is, the better chance there is that any one-off anomalies will hopefully be smoothed out if the remainder of the calculation period shows good financial health. If, however, a breach is likely to occur, borrowers should check to see if there are any cure rights included in the loan documentation. Additionally, borrowers should check any insurance cover that they have in place and whether it includes any income protection e.g. loss of rent cover. If borrowers are able to claim any proceeds under their insurance policy for loss of income, these proceeds should be capable of counting towards financial covenant calculations in their loan agreements. Another type of financial covenant that may be breached are value-based covenants. Given that valuers (along with many other businesses) will now be operating largely from home, a lender’s ability to obtain a valuation may be affected given the difficulty in getting valuers to look at sites/assets. As a result, some lenders are considering whether to defer scheduled valuations to avoid tripping value-based covenant tests in a very uncertain market.

2. Interest and principal payments – A failure to make a payment of interest or principal on its due date will in most cases be an event of default (though there may be a grace period of a few business days included which may not be of much use here). There are typically no force majeure circumstances expressly included in loan agreements to help borrowers avoid these payments other than technical issues with payment systems. In normal circumstances, lenders will have picked up on cashflow issues early on through financial covenant testing. However, where there has been a radical and rapid decline in income, it may be that the event of default is triggered before a breach of a financial covenant occurs. Lenders may give borrowers an increased grace period for payments to be made or grant a repayment “holiday”, or even open new lines of credit e.g. overdrafts to fund interest and principal payments. Lenders may also be willing to capitalise interest rather than collecting payments at least in the short term.

3. Cessation of business – Another event of default that is included in most LMA loan agreements and many bank standard form loan agreements is when a borrower (or a member of its group) suspends or ceases to carry on (or threatens to suspend or carry on) all or a material part of its business. Given that as a result of COVID-19 many businesses are requiring their employees to self-isolate and, in some cases, close whole offices, it is arguable that this event of default may be triggered if it’s considered to be a material part of the business. The LMA standard event of default wording doesn’t specify how long a business would need to be suspended for, so even if it is for a short period of time the event of default could still be triggered. Along with speaking to your lenders, it would also be worth checking any business interruption insurance that you may have available.

4. Negotiation with creditors – A further event of default that is often included as part of the wider insolvency-related events of default, is if the borrower or any pre-defined “transaction obligor”, by reason of actual or anticipated financial difficulties, commences negotiations with any creditor (other than a finance party under that specific loan agreement) with a view to rescheduling any indebtedness. This event of default could be triggered in any number of ways where a debt obligation is created e.g. if borrowers seek rent reductions or payment holidays with their landlords or by approaching other lenders for new lines of credit to assist with cashflow. We would therefore advise borrowers to first check their financing arrangements before making such approaches.

5. Material adverse change – The majority of loan agreements will include an event of default if the lender believes any event or circumstance occurs that has or is reasonably likely to have a material adverse effect. What constitutes a “material adverse effect” is a hotly negotiated point between borrowers and lenders. Lenders will typically try to ensure it is a broad as possible to cover off any number of events or circumstances that could affect the “business, operations, property, condition or prospects of the borrower” or “the ability of the borrower to perform its obligations under the finance documents”. Depending on how these provisions are negotiated, it is quite likely that a business that is struggling will be in danger of triggering this event of default. From a reputational standpoint, lenders are hesitant to rely on this event of default to call in loans. However, historically, in times of financial downturns or crashes, lenders have been seen to rely on this event of default even when no other breaches have been triggered.

6. Senior management – Many loan facility agreements will include a requirement on borrowers to notify their lenders if any of the specifically defined “senior management” ceases to perform their duties as a result of ill health and to find and appoint an adequate replacement as soon as reasonably practicable. Failure to do so would trigger an event of default.

7. Property developments – If a borrower is in the midst of a property development and utilising debt funding, there are a number of development-specific provisions in a loan agreement which may be breached. This includes not hitting certain milestone/practical completion deadlines, funding of any cost overruns and temporary abandonment of the development project. If any of these provisions are breached this will usually trigger an event of default under most development loan agreements. Typically, abandonment of a development is an automatic event of default if it is for a continuous period of 28 days or more. What constitutes abandonment is a grey area but given the likelihood of workers on a development site having to stay at home in the near future, it is arguable this would constitute abandonment of a development and hence an event of default.

8. Cross-defaults – It is also worth remembering that where a borrower has multiple funding arrangements with different lenders that each loan agreement is likely to include a cross default provision. This means that a breach of one particular loan will trigger a breach of all of the borrower’s other loans even if the borrower has not directly breached any of the other provisions within those loans.

What should you do?

If you think your finance arrangements may be breached in any of the above circumstances, it is advisable to speak to your legal advisers and your lenders as early as possible to discuss your options. These options include waivers of breaches, deferring valuation dates, agreeing repayment holidays or reductions, interest capitalisation and whether new lines of credit can be included to assist with struggling cashflow. Most institutional lenders are set up to help their customers following the changes put in place since the 2008 financial crash and should not be looking to default their customers in these trying times. Some lenders are even starting to pass on the reduction in the Bank of England interest rate on to their borrowers. Most loan agreement contain restrictions prohibiting a borrower from obtaining financing from other lenders, so it is worth looking at these provisions carefully to see if any short-term loans to assist with cashflow are permitted. If they are not, speak to your lender to get these restrictions waived.

The Spring 2020 Budget may be of some help with the launch of a new, temporary Coronavirus Business Interruption Loan Scheme. The scheme, which will be delivered by the British Business Bank, aims to support businesses to access bank lending and overdrafts. The government will provide lenders with a guarantee of 80% on each loan (subject to a per-lender cap on claims) to give lenders further confidence in continuing to provide finance to small and medium-sized enterprises. The government will not charge businesses or banks for this guarantee, and the scheme will support loans of up to £1.2 million in value. Further details of the Budget announcements are included here.

You may also currently be in the process of entering into a new finance arrangement and COVID-19 is likely to impact on how quickly the transaction will be able to complete. Delays may be unavoidable so do check with your lender(s) (and any other relevant parties) on their COVID-19 policies. Additionally, if loan documents are still in the process of being negotiated, it may be prudent to amend the documents now to cater for the impacts of COVID-19 rather than trying to seek waivers post-completion.

As the Coronavirus situation is rapidly evolving, our advice may change in light of government announcements and on-going developments; please consult our Coronavirus COVID-19 hub for our latest thinking.