The knock-on effect of the coronavirus pandemic on the wider economy will see the demise of many businesses. Borrowers will be poring over the terms of their credit agreements for months to come, trying to avoid triggering a default and/or attempting to remedy an unavoidable default, and lenders will be considering what actions they can take to protect their interests and recover the loan (albeit with the recent
Bank of England guidance in mind).
In the wake of the current crisis, the terms of those credit agreements negotiated many months, or years, ago may not offer sufficient flexibility to borrowers experiencing an unforeseen and unprecedented downturn in business, as we have seen over recent weeks. Where borrowers anticipate a breach of their covenants under the credit agreement as drafted, or where they require the terms to be relaxed or changed (whether on a temporary or permanent basis) in order to continue to operate, they will need to approach their lenders for the relevant amendments and waivers.
Recently,
Elis and
The Restaurant Group obtained waivers on their half-year covenant tests and
Fnac Darty, which added a €500 million French state-guaranteed term loan to ease liquidity, has obtained a commitment from its lenders to suspend the testing of its financial covenants for the rest of the year. We expect that swathes more borrowers - and their sponsors - will be vying for amendments and waivers from their lending syndicate.
This article seeks to examine how borrowers and sponsors have successfully negotiated some key changes to the events of default and grace period provisions in recent years - changes that may well give them significant flexibility in the coming months, such as:
- EBITDA-based “growers”, rather than fixed monetary amounts, in certain event of default de minimis limits;
- Cross-payment and cross-acceleration provisions instead of full cross default clauses;
- Longer grace periods and/or grace periods following a payment default which are not always contingent upon an administrative or technical error;
- Grace periods will not start ticking until the agent has notified the borrower of a default; and
- Automatic annulment of acceleration taken in reliance on cross-default/cross-acceleration provisions if the underlying default is remedied, cured or waived within a certain period of time.
We also consider the wider implications of a default on borrowers as well as lenders. Further, we set out some key considerations for a borrower seeking an amendment and waiver under the credit agreement.
The data referred to in this article has been drawn from our representative loan terms, or RLT, database and refers to deals reviewed by Reorg Debt Explained during the period from Jan. 1, 2017 to present (the relevant period) which are governed by the laws of England and Wales or the laws of another European jurisdiction. For any follow-up queries, contact us on
questions@reorg.com
Defaults and Events of Default
The Basics
- A breach of one of the provisions in a credit agreement by a member of the borrower group will trigger a “default”, which may limit some of the borrower group’s flexibility under their covenants.
- Most credit agreements will allow a short period of time (often referred to as a “grace period”) for borrowers to put the default right; the length of the grace period will vary depending on the type of default.
- If the borrower is unable to remedy the default by the end of any applicable grace period, an “event of default” will occur.
- While an event of default is continuing the borrower will be restricted from taking certain action under the credit agreement and, although generally a last resort, lenders will be able to accelerate all (or some) of the facilities.
Categories of Events of Default
Most credit agreements will include, as a minimum, the following categories of events of default. However, there may be significant differences in the detail between documents, particularly in relation to grace periods, thresholds and other qualifications, as discussed further below.
- Non-payment: This should encompass non-payment of any amount due under the credit agreement, including principal, interest, fees, indemnity amounts, costs and expenses due to lenders etc.
- Breach of financial covenant: With a traditional maintenance covenant package, breach of a financial covenant would usually result in an event of default under all facilities but the position is different for cov-lite loans, where only revolving lenders benefit from the financial covenant and term lenders’ rights only arise if the revolver is accelerated. The breach of a springing financial covenant will be explored further later in the Navigating Uncertainty series.
- Misrepresentation: This event of default will bite if the borrower is no longer in a position to make any ongoing representations required under the credit agreement; in current market circumstances most likely to be relevant when making a drawdown or rollover under a revolving facility.
- Breach of other obligations: This is a “sweeper” event of default intended to catch non-compliance with any provision in the credit agreement for which there is no dedicated event of default.
- Cross-default: Designed to result in a default under another financing triggering an event of default under the relevant facilities, so that all lenders to the group are put in the same position and entitled to a seat at the table for any renegotiation or potential restructuring. For borrowers, the consequence is that their looser financing documents effectively get the benefit of more restrictive provisions under other facilities, and this event of default is frequently watered down as discussed below.
- Insolvency related events: While the onset of formal insolvency proceedings will almost universally cause an event of default, there can be significant variation in other insolvency-related provisions, with many borrowers seeking to eliminate statutory “deemed” insolvency triggers and informal processes such as negotiations with creditors.
- Cessation of business: Perhaps seen historically as a boilerplate event of default not likely to be at the front of the default queue, this event of default has come to the fore during the coronavirus pandemic, with borrowers increasingly concerned about whether extensive shutdown will be caught.
- Credit support-related events of default: Covering impairment of guarantees and/or security supporting the facilities.
- Material adverse change: Often seen as a last resort event of default, but perhaps more relevant in the current turmoil and to be explored further in this Navigating Uncertainty series. This event of default is traditionally widely drafted to catch events which are not specifically covered by a covenant or representation but which materially impact the market or the borrower group. Despite lenders’ historic reluctance to rely on MACs, sponsors increasingly resist their inclusion.
- Others: Audit qualification, breach of intercreditor by other creditor groups, change of control (rare in European law documents) and other deal-specific matters. To the greatest extent possible, sponsors will try to resist events over which they have no control giving rise to an event of default.
De Minimis Limits/Thresholds
- In order to ensure they have as much leeway as possible, and to limit the circumstances in which lenders can enforce their rights and demand repayment, the borrower will have negotiated a series of de minimis limits. In practice, this means that if the value/impact of the relevant event/action is below the threshold, no default will arise. Note that multiple de minimis limits may apply - one in the operative covenant / representation and one in the related event of default.
- Traditionally, a de minimis limit would be a fixed monetary amount. However, approximately 18% of deals in the relevant period included a “grower”, usually based on the greater of a percentage of EBITDA and a fixed amount, in the de minimis for at least one event of default.
- While the change of a fixed amount de minimis in an event of default to an EBITDA-based de minimis is consistent with movement seen in other areas of the credit agreement in the relevant period, such as covenant baskets, it has been subject to greater resistance from lenders as, arguably, a greater degree of certainty is required when determining whether or not a borrower is, or may be, in default. When business is performing well, the inclusion of “growers” may well give borrowers additional flexibility to avoid a default but this may not necessarily be the case in a downturn and careful attention will need to be paid to the construction clause and calculation flexibility provisions to see what scope the borrower has to manipulate EBITDA and the baskets.
- As mentioned above, cross-default provisions allow lenders to “piggy back” off a default under other financing arrangements. Usually these will only be triggered if an actual, not potential, event of default has occurred under the relevant document. In addition to excluding amounts of debt under a certain threshold, which should be an aggregate rather than an individual (i.e. per facility) threshold, the borrower will typically have sought to limit the types of underlying financing arrangements that can give rise to a cross-default (by excluding intercompany debt and/or subordinated debt, for example) to ensure its key financing cannot be recalled in the event of a default under a minor (or immaterial) financing arrangement. Increasingly, borrowers are negotiating the inclusion of cross-payment and cross-acceleration provisions instead of full cross-default clauses - this is a narrower formulation meaning that an event of default will only occur if there is a non-payment event of default under under the other financing arrangement or if that debt is actually accelerated.
Materiality Qualifications
- Where a monetary/other de minimis is not appropriate, borrowers may have successfully sought to water down certain events of default by a materiality qualification. Given the potential consequences, there are reputational risks for lenders in calling an event of default so anything which muddies the waters in this regard increases the decision-making burden.
- One way that this may be expressed is by saying that an event of default will only apply if it will have (or is reasonably likely to have) a material adverse effect. The thinking here is that some events/actions may actually have a minor impact on the underlying business and the lenders’ risk profile so they should not trigger a default unless they would have, or are reasonably likely to have, a material adverse effect on the borrower, the collateral package, the lenders’ rights to be repaid and/or any other rights of the lenders under the credit agreement.
- As we will explore in a later article, both the “material adverse effect” definition itself, and the events of default that the concept dilutes, will have been heavily negotiated and the burden of proof will be on the lenders if they are seeking to call a default based on an event/action having a material adverse effect.
- Alternatively an action may only trigger an event of default if it is, using misrepresentation as an example, incorrect or misleading in any “material” respect and materiality may be a subjective test, determined by the lenders as a whole (preferable from the syndicate’s perspective) or an objective test.
Grace Periods
- Grace periods effectively give borrowers a chance to remedy certain defaults before they crystallize into an event of default (i.e. the borrower gets an opportunity to undo or correct the underlying breach so it is no longer in default). The most serious defaults, such as insolvency and audit qualification, will not benefit from a grace period and will be immediate events of default.
- Traditionally, grace periods have ranged from a few days (two-three business days/five days is typical in the case of payment defaults) to longer periods of time (20 business days/30 days is typical for a breach of other obligations) but this is often subject to much negotiation.
- Recently, we have seen borrowers and sponsors successfully pushing out grace periods to match those in the high-yield bond market and this extra time may prove invaluable to them in the current market. For example, just over 10% of deals in the relevant period had a 60-day grace period for breach of “other obligations” and two-thirds of these were 2019/2020 deals showing how the trend for including these concepts has changed.
- Another area where we have seen the parameters change over the recent period is in relation to payment defaults. Failure by the borrower to pay principal, interest, fees and other amounts when due is the key event of default in all credit agreements and typically a grace period would only be available if the failure to pay was caused by an administrative or technical error however, this condition was absent in 12% of deals in the relevant period. While the majority position in European leveraged loans remains that there is no grace period for non-payment of interest, in just under 10% of deals in the relevant period borrowers have a 30-day grace period following a default in the payment of interest or any other non-principal/premium payment default; however, nearly all of these deals had some (or all) of the events of default set out in a New York-law governed schedule to an English law governed credit agreement and it is not unusual in a New York law credit agreement for there to be a grace period for the non-payment of interest.
- With the exception of payment defaults, which would be evident immediately, and financial covenant breaches, which would be evident upon delivery of the relevant compliance certificate, it may take time before the parties realize that a default has occurred. As such, grace periods have typically started ticking upon the earlier of (i) the agent giving notice to the borrower that they are in default and (ii) the borrower becoming aware of the failure to comply with the credit agreement (whereupon the information undertakings would usually require the borrower to notify the agent of the default and the steps, if any, being taken to remedy it).
- Recent, seemingly minor, changes to the event of default provisions in some deals have reversed the burden of notification by shifting it entirely onto the agent (usually acting on the instructions of the requisite number of lenders), which may have a negative impact on the rights of the lenders. In the deals in question, which represent approximately 6% of the deals reviewed in the relevant period, the grace period will not start ticking until the agent has notified the borrower of certain defaults including, but not limited to, cross-default/cross-acceleration, “final judgment” and “other obligations”. Should the agent fail to notify the borrower of the default, the default will not constitute an event of default and the lenders will not be able to accelerate the facilities and/or take any enforcement action. Pending receipt of the default notification, the borrower would essentially have an unlimited period in which to remedy the default and they would be able to continue to operate under the credit agreement with no immediate threat of acceleration, prevented only from taking those limited actions subject to a “no default” condition.
- As one of a number of strategies seen in the market resulting from sponsors’ increased focus on infiltration of syndicates by funds who also hold a short position, some recent deals go even further and preclude the agent from giving a notice of default if the action which caused the default took place before a certain cut off date (for example, if the relevant action took place more than two years prior to the date on which the agent intended to give notice of the default). While this may give borrowers comfort that historic defaults, defaults which may have been deemed unworthy of notification by the agent (and, if required, some or all of the lenders) at the time, cannot be used against them it is a further limitation on the lenders’ rights.
Ability to Cure
- Different to grace periods, a cure period gives the borrower an opportunity to take certain action to cure an event of default that has actually occurred. If the event of default is cured during the relevant cure period, then the lenders will no longer be able to take any enforcement action.
- Cure provisions are most commonly seen in relation to a breach of financial covenants and, in such context, are usually referred to as “equity cures”. In addition, a credit agreement may include a “deemed cure” which is a provision that deems an event of default caused by a breach of the financial covenant(s) to be remedied if the borrower is back in compliance on the next testing date, even if the sponsor/borrower has not taken any positive action to cure the breach, provided that the lenders have not taken any enforcement action by such date. We will be exploring financial covenant cure rights and deemed cures in greater detail at a later date.
- Recent developments in this area have seen borrowers/sponsors successfully incorporating “auto-cures” into a handful of credit agreements. As discussed in our recent article on this topic, which can be found HERE, auto cures also allow financial covenant breaches to be cured without an injection of equity or shareholder debt but, unlike deemed cures, the borrower does not need to wait until the next quarter date to cure the breach. Instead, a borrower can re-calculate the covenant at any time based on newly available financial information (such as monthly management accounts) and delivery of such information to the lenders, together with the relevant calculations showing that the borrower is back in compliance with the financial covenant(s), will suffice as evidence that the breach has been cured. Auto-cures are considered by many to be very aggressive, sponsor friendly, provisions which prematurely cut short the time period for taking enforcement action that would otherwise be available to the lenders following an event of default. In addition, the provision affords the borrower a significant degree of flexibility as there is generally no express requirement as to how the recalculation is to be done or what factors, including the source of funds, are to be taken into account.
Other Considerations
- The parties may have agreed that certain events (such as a change of control or sale of all/substantially all assets) will trigger a mandatory prepayment obligation rather than an event of default - this is primarily to avoid triggering cross-defaults under other financing arrangements or commercial contracts. In this situation, an event of default would not arise unless the borrower failed to make the required prepayment.
- It will be crucial to determine which entities may be caught by the event of default (and/or which entities are subject to the underlying provisions) - borrowers, obligors, significant subsidiaries, restricted subsidiaries / unrestricted subsidiaries, all subsidiaries etc.
- For borrowers seeking to enter into negotiations with creditors, they should be sure to confirm that such negotiations would not be caught by the scope of the insolvency/ bankruptcy, insolvency proceedings and creditors’ process events of default. While some events of default will only be triggered by the commencement of insolvency/bankruptcy proceedings, others may be triggered by “balance sheet” insolvency and where the borrower group spans multiple jurisdictions, consideration will need to be given to the equivalent concepts under local law.
- As there has been a significant increase over the relevant period in the number of deals with split governing law provisions, parties need to be aware that they may have multiple default provisions to review. In nearly a quarter of deals in the relevant period, the body of the credit agreement is governed by the laws of England and Wales but other sections, usually set out as schedules to the credit agreement, are governed by New York law; it is likely that both contain event-of-default provisions. Usually, the provisions will have been aligned but occasionally there are duplicative or conflicting clauses, with mismatched in the thresholds, grace periods and other terms (whether by accident or design) which could result in an accidental breach - borrowers must ensure they comply with the most restrictive provisions to avoid a multi-jurisdictional debate. As mentioned in the context of payment defaults above, the inclusion of New York law governed events of default has also had an impact on the specific terms found in the events of default provisions in European deals.
Acceleration
- English law credit agreements, unlike their New York law counterparts, do not generally provide for automatic acceleration.
- After the occurrence of an event of default, the agent may (if directed by the requisite number of lenders) give notice to the borrower that it is accelerating the facilities whereupon the commitments will be immediately canceled, the facilities (together with accrued interest and all other outstanding amounts) will become immediately due and payable or payable on demand and the security agent may be directed to exercise its rights to enforce the security and guarantees.
- Majority lender consent is usually required to accelerate the facilities and this is customarily set at 66.67% in credit agreements governed by the laws of England and Wales and 50% in credit agreements governed by the laws of New York. However, we are increasingly seeing the 50% threshold creep into English law credit agreements, especially where the deal includes New York law and/or high-yield bond concepts. In a handful of deals from the relevant period, we saw majority lender consent being set at 50% for everything other than acceleration which would still require consent of 66.67% of the lenders.
- Agents and lenders must ensure that they comply with precise terms of the acceleration clause, and give the appropriate notifications, to avoid any risk that the acceleration is not effective.
- In cov-lite deals, which contain a springing leverage financial covenant for the benefit of the revolving credit facility lenders, a breach of the financial covenant will usually entitle a majority of the revolving credit facility lenders to accelerate the revolver. Upon such acceleration, a majority of the term lenders under the same credit agreement would usually be entitled to accelerate their facilities by virtue of a specific event of default provision or, if absent, by relying on the cross-default/cross-acceleration event of default although, if the latter, any relevant thresholds may apply.
- Following the trend seen throughout credit agreements in recent years, we have also seen the inclusion of some high-yield bond style terms in the acceleration provisions. 7% of deals in the relevant period included an automatic annulment of any acceleration taken in reliance on the cross-default/cross-acceleration event of default if the underlying default is remedied, cured, waived or discharged within a certain period of time. Traditionally, unwinding the instruction to accelerate would require the same level of lender consent as the initial acceleration decision.
Further Consequences of Event of Default for Borrowers and Lenders
Consequences of an Event of Default for Borrowers
- Well before the decision is taken to accelerate, the occurrence of an event of default will have other consequences for the borrower.
- The most immediate practical effect will likely be the triggering of a drawstop event for any further borrowing under revolving facilities which will increase liquidity pressure. Even if there is no specific condition precedent to drawdown requiring the borrower to confirm that no event of default is continuing or would result from the proposed loan, on the date of the utilization request and on the proposed utilization date, the borrower would nearly always be required to represent that no event of default is continuing on the same dates. Fortunately for the borrower in the current market, an event of default will not usually prevent a loan under the revolving credit facility from being rolled over unless a notice of acceleration has been given (or a declared default has occurred).
- Interest payments may increase if the borrower has been paying a reduced rate of interest in reliance on the margin ratchet provisions. Traditionally, the margin would be reset to its highest level upon the occurrence of an event of default. However, there has been a substantial erosion in this position over the relevant period and in most credit agreements the margin ratchet reversion will only be triggered by a limited set of events of default (which tend to include non-payment and insolvency/bankruptcy as a minimum). In addition, default interest may be payable on overdue amounts.
- The borrower will not be able to take any action under a covenant / undertaking which is subject to a “no event of default” condition. Whilst lenders will have sought to minimize the extent to which cash may leave the group following a default in the credit agreement, there has been successful push back from borrowers and sponsors here so certain actions may still be able to be taken after a default and, more concerning, after the occurrence of certain events of default. Of paramount concern for the sponsor will be the extent to which an event of default precludes the borrower from making a distribution under its general restricted/permitted payment basket(s), paying their annual monitoring fee and making certain other permitted payments, for example those needed to service debt elsewhere in the capital structure. Also key in the context of the coronavirus pandemic, if liquidity is an issue and additional funding is required, an event of default may prevent the borrower from incurring incremental debt under the credit agreement.
- Potentially limiting the options available to a borrower in uncertain times, an event of default is likely to suspend any rights the borrower group has to buy back debt under the credit agreement.
- Management may be obliged to attend meetings with the lenders and/or they may be required to provide the lenders with additional information and access to the premises and financial records.
Consequences of Event of Default for Lenders
Should a loan go into default, lenders would need to consider carefully any implications for making a provision or for their capital buffer.
Waivers and Amendments
- If a borrower thinks that it is headed for a default under the credit agreement, counsel would nearly always advise the management team to approach the lenders for a pre-emptive amendment of the provision that will be breached and/or a waiver of the default that may result.
- Given that a consent fee is usually payable in connection with an amendment and waiver request, not to mention legal and other professional fees, a borrower and its sponsor should consider the scope of the amendments and waivers that may be needed in the short to medium term (if not longer) in light of the most recently available projections for the business. Multiple amendment and waiver requests should be avoided at all costs.
- The level of consent needed for each amendment and/or waiver being sought will need to be carefully analyzed as it will be far harder to obtain consent from all lenders and a supermajority of lenders (although this depends in part on the threshold for this level of consent) than it will be to obtain consent from a majority of lenders. Borrowers/sponsors will need to consider whether they have any ability, legally and practically, to “yank” non-consenting lenders by forcing them to transfer their commitment to another lender or by prepaying their entire holding. In the current climate, it may be difficult to find other lenders willing to buy out a non-consenting lender and if the business is underperforming it may not have the funds necessary to take out a non-consenting lender by way of prepayment.
- All parties would need to be familiar with any “snooze and lose” provisions which can result in a lender’s commitments being ignored (or, worst case, caught by the non-consenting lender provisions) if they do not respond to the consent request within the prescribed time period.
- As part of the consent process, lenders may have the opportunity to renegotiate certain borrower-friendly provisions and borrowers and sponsors would need to be alive to the fact that lenders may seek to make additional gains, over and above the consent fee, in this way.
- Lenders also need to be conscious of their confidentiality obligations to borrowers and, where possible, should seek to have them expressly waived so that the syndicate can discuss waiver/amendment requests. Borrowers who think it may serve them better to keep their lenders apart in an effort to reduce push-back and renegotiation should bear in mind that this is not necessarily conducive to a speedy result and, should their circumstances deteriorate and additional or emergency lender support be needed, it may even have a negative effect on restructuring discussions.
Conclusion
Fundamentally, a credit agreement sets out a commercial arrangement between the borrower and the lenders where both have something to gain. The borrower gains access to funds to enable it to operate and grow the business whilst the lenders stand to make a profit from the fees and interest charged. However,
relationships are key in the leveraged finance market and these will play a vital role in any default scenario, especially if the borrower is looking to garner support for a waiver and/or amendment in an attempt to avoid the lenders having grounds for acceleration and thus an improved negotiating position. Traditional, often institutional, lenders are not only interested in ongoing relationships with large companies but also with private equity houses who will have lucrative mandates to award in the future. As such, they will be looking to support a struggling business wherever possible. Investors with purely commercial interests however, such as hedge funds and distressed debt funds, are likely to be less supportive and may simply be looking to get out as soon as they can, suffering as little damage as they can. These competing interests highlight why borrowers and sponsors are so focused on the transfer restrictions in a credit agreement - they are the only way to ensure that some control can be retained over the composition of the lending syndicate.
Of course, the impact of a default under the credit agreement on the credit agreement itself is only one aspect for a borrower to consider. They will also need to consider the wider implications that a default, event of default and/or acceleration may have on its business, including under any material financial and commercial agreements that are necessary to continue operating.
See also in the Navigating Uncertainty Series: Top 10 Areas for Consideration in Leverage Finance Docs Amid Coronavirus Outbreak
Springing Financial Covenants, RCF Drawdowns, Flexibilities May Allow Borrower to Duck Testing
Increased Restrictions on Loan Transfers Hampers Liquidity - Part I and Part II
Loan Buybacks: Docs Might Provide Borrowers Pathway to Leverage and Cost Reduction Even In Default
Loan Buybacks: Sponsors Explore Options to Purchase Debt Amid Market Turmoil
Multiple Avenues for Priming Debt Exist in Docs and Could Be Increased Through Calculation Flexibilities