In that piece, I made the following remarks:
"There is no doubt that the pandemic and the subsequent government actions have had a material detriment on many businesses across the world. In a UK context, the pandemic is accelerating and thereby placing an enormous strain on the NHS. The UK Government has therefore imposed a "lockdown" under which many businesses have been forced to close their doors to further trade, and gatherings of two or more persons have been banned altogether (unless comprised of a family unit that lives in the same house). Indeed, each individual is expected to self-isolate if he or she is experiencing symptoms, and to practice social distancing if he or she is not with strict rules as to when a person may leave his or her house. It doesn't take too much imagination to picture the scale of damage this will do to many businesses, regardless of the emergency economic stimuli packages which the UK Government has rolled-out."
As of today's date, there is informed speculation that the pandemic may have reached its peak in the UK and that some relaxation of the lockdown may be a matter of weeks away. However, it is also clear that policy-makers are very concerned about the possibility of a second spike in the reproduction rate of the Covid-19 virus, which may give rise to the necessity for a second lockdown. Accordingly, it may be many more weeks (and possibly months) before the lockdown is relaxed. It is also likely that the relaxation of the lockdown, when it comes, will be phased, with partial returns for certain parts of the economy and others remaining locked-down to a greater or lesser extent. Uncertainty therefore continues to stalk markets and it remains the case that many businesses will be under considerable strain for the foreseeable future.
Where such businesses have raised external debt capital on typical loan market terms, reduced cashflows and depreciating asset values may well give rise to one of several events of default under the terms of the loan documentation. For example:
- Most obviously, it may not be possible for a business to meet its scheduled debt service obligations in terms of loan principal repayments or interest and recurring fee payments. Should that be the case, a non-payment event of default will occur.
- Depending on the circumstances, events of default which pertain to the insolvency of the borrower may be triggered.
- In a leveraged finance context where a business generates trading cashflows from its commercial activities (for example, a cinema chain, or a pub or restaurant chain), reduced or zero trading will mean lower than anticipated and modelled levels of EBITDA and turnover. This in turn may give rise to leverage or cashflow cover financial covenant defaults, which will typically give rise to an immediate event of default (subject to equity cure rights).
- In a real estate finance context, reduced property valuations may transpire on annual portfolio valuations as a result of the lack of buyers in the applicable market giving rise to loan to value financial covenant defaults, which again will typically result in an immediate event of default (again, subject to equity cure rights).
- Material adverse change events of default may be triggered by a lender, particularly where the "mac" clause is drafted subjectively in favour of the lender so that the lender is given a discretion to make the "mac" determination based on its own analysis of the prevailing circumstances.
It is no doubt true that "mac" and other similar defaults are somewhat nebulous in nature and I have heard "mac" clauses in particular referred to as "the last refuge for the desperate banker". However, non-payment, insolvency and financial covenant breach events of default are far more definitive and create solid grounds for a lender from which to launch acceleration and enforcement proceedings.
What then can a business experiencing financial distress as a result of the pandemic do to mitigate the risks of an acceleration or enforcement event occurring?
Well, the first and most obvious step will be to open up the loan agreement and figure out what the document actually says. A well-run business with a CFO who has his or her finger on the pulse will know whether non-payment or financial covenant defaults are likely to occur and should therefore be able to anticipate difficulties in advance. The key here will be to open a dialogue with the lender as soon as an anticipated default is identified - far better to begin a conversation with your lender in advance rather than waiting for the default to occur and for the lender to get in touch with you.
Much will depend upon the circumstances of the case, but assuming an event of default has occurred or is anticipated, an early dialogue will allow you to gauge the initial reaction of the lender and also propose constructive solutions. For example, in the case of an anticipated financial covenant breach, it may be possible to explore an equity cure option whereby sufficient capital is placed on account with the lender until such time as the covenants return to compliance whereupon the equity injection is released. Many loan agreements will contain specific equity cure rights, but even where a loan agreement does not do so, a lender may be prepared to consider this as a solution rather than falling back immediately on its acceleration and enforcement rights.
Before any dialogue is opened with a lender, I would recommend that the business looks to all "self-help" remedies that may be open to it. For example, if it is open to a business to place employees into the Government's furlough scheme (see https://www.morton-fraser.com/knowledge-hub/coronavirus-furlough-leave-government-guidance-updated) or agree a rental payment holiday with its landlords, and thereby reduce its operating expenses, then it may be possible to present reductions in turnover in a less pessimistic light. Equally, to the extent that a business is able to access capital via the Government's business continuity lending schemes (see https://www.morton-fraser.com/knowledge-hub/financial-assistance-available-for-borrowers), then that may also allow a lender to come to a view about ongoing debt service capabilities.
The reality is, however, that you will at some point most likely have to ask the lender for some degree of forbearance in terms of the adverse trading conditions occasioned by the pandemic. This might include one or more of the following:
- A payment holiday during which scheduled amortisation is suspended and interest payments are switched-off so that the interest either accrues on account or is capitalised over the period of the holiday.
- Waivers of financial covenant and other defaults, perhaps in return for additional or enhanced security.
Whether the lender will be prepared to grant any such forbearance will very much depend upon the specific circumstances of the particular business. If the loan has been performing historically and there have been no previous defaults, a lender might take a favourable view. However, if there have been previous defaults unrelated to the pandemic and the business in question hasn't attempted to help itself as recommended above, then perhaps the lender may be ill-disposed to consider a forbearance request favourably. Having said that, many lenders will be cognisant of the following considerations before making what may be a precipitous decision to move to acceleration and enforcement:
- There are likely to be reputational issues for a lender to consider here. Adverse publicity may be generated if a lender is seen to be subjecting businesses to enforcement measures in the current environment. This may stay a lender's hand at least until the health scare occasioned by the pandemic has subsided. However, there is unlikely to be any such forbearance for businesses which find themselves holed below the waterline once the health scare occasioned by the pandemic subsides.
- Enforcement will usually involve placing the borrower into an insolvency process and, most typically in a UK context, into an administration process under the Insolvency Act 1986 (noting that a fixed charge receivership may also be considered in England and Wales). However, the success of such a process will most frequently depend upon the presence of a willing buyer of the business and assets out of the applicable process. Given current market conditions, finding willing buyers at an acceptable price may not be straightforward.
- For certain businesses, it may be difficult to find an insolvency practitioner willing to accept an appointment. For example, one can imagine the difficulties involved in trying to take over the operation of a care homes business in the current circumstances both from a reputational and a personal health perspective.
- The UK Government has announced that it is implementing plans to prohibit commercial landlords from taking enforcement action (including winding up and administration) against tenants. This is another move aimed at protecting businesses at a time when they are at their most vulnerable - but obviously comes at a cost to those borrowers who are landlords and who are unable to take steps to protect their own income streams.
It may therefore be the case that many lenders are willing to work in a constructive manner with borrowers in distress to allow them to survive this almost unprecedented period of market uncertainty and volatility.
In normal times, directors of a company would need to be very careful about personal liability attaching to continued trading in a financial distress scenario as a result of the wrongful trading rules under the Insolvency Act 1986. However, it has been announced by the UK Government that these rules will be suspended temporarily (with retrospective effect) in the hope that this will allow directors to continue operating the company to bring it through the pandemic in reasonable shape to continue trading or operating on the other side. The exact shape of that suspension has not been detailed and so it is not clear yet to what extent directors are truly being given a "free hand" to navigate the current difficulties. It is unlikely that that any governmental intervention in this area will release directors from all aspects of their fiduciary duties and so directors will still be required to have regard to the interests of creditors in their decision-making.