COVID-19 outbreak: financial market ramifications
The COVID-19 pandemic has already left its mark on Serbia’s economy, and the belief is this is merely the tip of the iceberg for the financial sector in particular. Uncertainties abound. Bankers are concerned about borrowers’ ability to service their debts, while it might not be long before we see companies being hit with payment defaults. Additionally, there waning confidence about project finance transactions.
Specific issues in financing agreements
Companies could soon find themselves in the midst of a cash flow problem, which in turn could leave them vulnerable to payment defaults. Loan agreements typically give debtors the benefit of the doubt until payment default actually occurs. Third-party funding or an improvement in liquidity are the long-desired saviors when debts fall due. Still, when it comes to highly structured financing, the ability to inject fresh money may be limited by existing financing arrangements.
Although lenders will try to do their best to help any borrower facing short-term liquidity issues, the nature of a borrower’s capital structure could be the deal-breaker. At the first hint of a problem with liquidity, borrowers must examine ways of injecting fresh money into their group, while at the same time avoiding protracted negotiations with new lenders so as not to fall foul of default provisions under existing agreements.
Financial covenants are a means to gaining the trust of a lender. They give the lender confidence that there the risks associated with a loan agreement are secured.
Usually, a breach of a financial covenant results in a lender gaining the right to: (i) foreclose the loan; (ii) collect the collateral in exchange for the breach of a covenant agreement; or (iii) charge a higher interest rate on the loan than previously agreed upon.
Financial covenants may also be waived at the discretion of the lender. However, it entirely depends on the lender, and the borrower is usually powerless regarding the waiver decision.
Various financial covenants could be agreed and could include:
Loss of income and depreciation in asset values would certainly negatively affect financial covenant compliance. Lenders may be kept waiting for timely provision of financial information, and they are commonly backward looking outside of the leveraged market. Furthermore, in recent years breach provisions of financial covenants were never triggered except in extreme circumstances and long after the borrower has requested a fresh injection of cash. In that respect, if borrowers already foresee breaches, they may have contractual rights to cure by equity injection or be able to raise subordinated group debt to apply in partial prepayment, failing which they will need to reset covenants with lender support.
What is cross default?
Cross default is a provision in a loan agreement that puts a borrower in default if it defaults on another obligation. For instance, a cross-default clause in a loan agreement may say that a person automatically defaults on his car loan if he defaults on his mortgage. The cross-default provision exists to protect the interest of lenders, who wish to have equal rights to a borrower’s assets in case of default on one of the loans.
Why is it agreed or should be agreed?
When other creditors are exercising their rights to refinance, demand early repayment and/or take enforcement action, no lender wants to be left in the cold, so most finance transactions will include cross default provisions, and if not already included, lenders should start doing so.
If government advice on doing business during an epidemic or pandemic is not followed borrowers may finds themselves in breach of applicable laws and regulations and liable to stiff penalties. The lenders could be left waiting for interest payment dates before an event of default is triggered. Some agreements also include provisions as to there being no threatened labor disputes, which might result from periods of quarantine and isolated working, as well as confirming that there are no other events or circumstance which could be deemed an event of default or termination under any other agreement.
Lenders should set such loan and security terms that require borrowers to keep their lenders informed of material contracts and potential breaches, amendments or waivers in relation to them where those contracts are crucial to debt coverage, security packages or day-to-day business. Due to COVID-19 virus outbreak, it is likely that loss of trade, supply shortages and the domino effect from business to business will trigger breaches or termination rights in material contracts which borrowers need to keep under review and disclose to lenders.
Lenders need to reassess credit risk and consider protecting their position and restructuring options to hopefully avoid insolvency proceedings, and ultimately achieve a better return by keeping the borrower in business. On the other hand, lenders must take a judicious approach before waiving defaults in order to keep their options open and ensure they retain their rights to take action in the future without needing to await further default events.
For more information, please contact us via covid19@geciclaw.com
