Managing Loan Defaults in the COVID-19 Environment
Lenders and Borrowers are experiencing default situations as a result of the COVID-19 pandemic and related economic fallout. Lenders will want to stick with the fundamentals in managing these defaults.
Lenders are facing complexity and uncertainty on the business front. The economy of the country, and the world, is in an unprecedented state, with uncertainty ahead. This means Lenders are navigating through challenging underwriting scenarios. Also on the business side, there are reputational and relationship issues, since the Lenders will want to maintain good relationships with borrowers, sponsors and other customers.
In this challenging business scenario, there are also legal risks. While there can be legal uncertainties in any default situation, the COVID-19 environment has added legal uncertainties because there are relevant issues that have not been extensively tested in the courts. As further discussed below, there are questions regarding the sorts of adverse changes that qualify as a “material adverse change” default, questions about when a situation crosses the line from something concerning to the Lender to an actual default that can trigger the exercise of remedies, and question about whether a default is material enough to justify a Lender's actions if it is COVID-19 related and considered temporary.
On the lender liability front, Lenders should consider the risk that a Borrower will make claims that by not honoring draw requests and/or by exercising remedies, the Lender acted improperly and damaged or destroyed the Borrower’s business. The Lender will be judged in hindsight, and there is potential for backlash if judges and juries see a Borrower as the victim of not only COVID-19 itself, but quarantines, lockdowns and other governmental actions.
Adding to this potential sentiment are the statements from federal regulators that banks should work with Borrowers in the COVID-19 environment. On March 13, 2020, both the OCC and the FDIC issued statements encouraging banks to work constructively with borrowers affected by COVID-19. The FDIC specifically advised that banks “may modify or restructure a borrower’s debt obligations due to temporary hardships resulting from COVID19 related issues” and that “prudent efforts to modify the terms on existing loans for affected customers of FDIC-supervised banks will not be subject to examiner criticism.” On Sunday, March 22, 2020, the OCC and FDIC, joined by other regulators, issued a joint statement continuing this stance and including guidance regarding COVID-19 related loan modifications. Click here for the text of the release. These accommodative stances from the regulators may increase the likelihood of a finding of lender liability for Lenders who exercise remedies in the near term.
In what is quickly becoming a common scenario, a Borrower may make a draw request when both the Lender and the Borrower know that the COVID-19 environment has been materially detrimental to the Borrower’s business. The Bank may believe the Borrower's business will face significant distress, or may believe that the Borrower will be in default of financial covenants when the Borrower reports for the current quarter. The Borrower may have even acknowledged that default is certain. When the Borrower makes a draw request, the Lender faces the question whether to fund the draw.
Given the business and legal uncertainties, Lenders will have to assess their options case by case and balance potential business and legal risks in determining their next steps. There will likely be situations in which funding a draw request is simply not advisable, and the best course of action is to cease funding and commence collection action. In most cases, the Lender will want to utilize the tools discussed below to manage the business and legal risks.
In order to take advantage of the protections some of these tools offer, it may be necessary to fund the draw. The draw request typically must be honored in a matter of days or hours under the contracts with the Borrower. It is also possible that the draw is needed to fund payroll or other vital expenses that must be paid in order to preserve the Borrower's business and maximize the Lender's recovery. In other cases, particularly if cash needs are not at a critical point, it may be possible to talk to the Borrower and work out an agreement that funding will occur only if certain conditions are met.
1. Identifying Defaults
The COVID-19 environment puts unusual pressure on the determination of whether a default exists. Change has been rapid and dramatic, and a Borrower may be in dire straits without having yet breached any loan covenants. This is causing Lenders to focus on some important questions. Has a Material Adverse Change or Material Adverse Effect (a “MAC”) default occurred? If the business is sufficiently impaired that there is certain to be a default when the Borrower reports for the current quarter, can the Lender take action based on the anticipatory default? Also, if a default has occurred, is there a risk that a court will later, with the benefit of hindsight, determine that the default was a blip caused by COVID-19 and not material enough to justify the Lender exercising remedies? Historically, Lenders have avoided relying solely on a MAC default in exercising remedies, and have avoided taking action before a default has fully materialized or while the materiality of the default is uncertain. Lenders have historically wanted to avoid the risk of taking enforcement actions based on defaults that were subject to interpretation, and, usually, when a Lender has wanted to take an enforcement action, there have been other defaults the Lender can rely on. In the COVID-19 environment, there may not yet be reported covenant defaults or other defaults that the Lender can identify with certainty.
a. MAC as an Event of Default
MAC clauses present a special interpretive problem. Because the court's job is to enforce the intended agreement of the parties to a contract, courts will start by carefully reading the language of the MAC clause itself. However, MAC clauses are typically so broadly – even nebulously – worded that they may provide little specific guidance as to whether a particular circumstance is included or excluded. The court will therefore determine for itself what might constitute a "material" condition, how to measure “adversity,” and, ultimately, how to distinguish between an unfortunate, but temporary, reversal and an actual event of default.
For example, some MAC clauses state broadly that there can be a MAC if the Borrower's “prospects” are adversely affected. Others may contain more Borrower-friendly language, requiring an actual adverse impact, with a focus on a company's or a group of companies' business, financial condition and/or ability to perform the loan documents. Consequently, while MAC clauses are written to provide Lenders with flexibility in dealing with distressed Borrowers, if the parties dispute the meaning or effect of a MAC provision, extended litigation could ensue before a court decides whether a MAC has occurred that justifies a Lender's exercise of remedies. For example, in the Lyondell chapter 11 cases in New York, eight years of litigation resulted in a $7.2 million judgment against the Lender for improperly refusing to approve a pre-bankruptcy draw by the debtor.
Perhaps because Lenders are typically reluctant to rely solely on a MAC default, there have been few cases discussing MAC clauses in the loan default context. Nonetheless, a few consistent themes emerge from the case law.
Of particular interest is that courts have said that a MAC does not exist unless an event has caused a persistent and continual decline specific to a borrower's business. The influential Delaware Chancery Court has held that the “persistence” of economic distress should likely be measured in years, not weeks or months.
Depending on the language of the documents, a Lender could argue that the “persistence” concept does not apply. Some loan documents contain language that encompasses adverse effects on a Borrower's “prospects,” and that forward-looking language may mean that the Lender does not have to wait for the Borrower to develop persistent economic distress. On the other hand, the Borrower could argue that the Lender should have looked at longer term prospects, after the COVID-19 environment ends and there is economic recovery.
MAC language often states that there is a MAC if there is harm to the Borrower's ability to comply with its loan documents.& If the Borrower appears unable to comply with the documents, notwithstanding the potential for recovery, a court could find that the cases requiring a longer-lasting economic impact do not apply.
While this discussion suggests that the economic effects of the COVID-19 pandemic, by themselves, may not justify declaring a default under a MAC clause, each analysis will be specific to its own facts and depend upon the exact language of the MAC clause at issue.
b. Anticipatory Default
Where a situation, like the COVID-19 pandemic, threatens severe economic distress to Borrowers in the future, Lenders might look to the concept of "anticipatory default," drawing an analogy to the doctrine of "anticipatory breach" from contract law and under the Uniform Commercial Code.
As with MAC clauses, case law on anticipatory default is thin in the Borrower-Lender context, but it appears mainly to involve suits by Borrowers against Lenders for failures to advance. The concentration on the Lender's action makes sense in the context of the doctrine, which focuses on voluntary actions by a party to a contract: generally, either an express statement by the party that it will take some action that would give rise to a claim for damages in favor of the other party, or a voluntary act that suggests that the party is unable or unwilling to comply with the agreement. Lenders may have difficulty establishing that economic distress prompted by the COVID-19 pandemic or a government's actions in response to it – such as closing businesses or barring certain activities – prompted voluntary actions by a Borrower constituting anticipatory defaults.
There is an important ancillary issue regarding anticipatory defaults if the documents have an equity cure provision. Depending on the language of the provision, it is likely that the document states clearly that there is no default until the reporting period has come to an end and the equity owners have failed to meet the requirements of the equity cure during a specified additional period.; So even if the Borrower has confirmed it will miss a financial covenant at quarter end, unless the Borrower or its equity owners also state that they are not going to exercise the cure right, there may not be an anticipatory breach.
2. Loan Documents and Liens
An important step in any default scenario is to assess the loan documents and liens. Any sort of defect could be significant in a collection effort, and often the defects can be addressed during a workout. Also, the Borrower may be willing to provide guaranties, collateral or other protections that were not included in the deal previously.
This is also a time to assess intercreditor arrangements. There may be agreements that require notices of default or require the Lender to give notice prior to exercising remedies. If the Lender wants to stop payments on subordinated debt, it may be necessary to give notices.
3. Notices of Default and Reservation of Rights
The Reservation of Rights Letter will be an especially important tool in the COVID-19 environment. Despite the many advantages of a Forbearance Agreement discussed below, there inevitably will be delays while forbearance terms are negotiated and gain credit approval and documents are drafted and negotiated, especially when the economy is severely impacted and large numbers of Borrowers are facing distress at the same time. Although not signed by the Borrower, a Reservation of Rights Letter can help mitigate the Lender's risk.
The Reservation of Rights Letter will establish that the Lender considers existing defaults to be material, is not waiving defaults or agreeing to forbear, and if the Lender is continuing to fund, it is doing so as an accommodation to the Borrower and is not obligated to continue funding. Depending on the context, it may be important that the letter follow any notice requirements under the loan documents.
The letter can also serve the purpose of encouraging desired action by the Borrower. For example, if the Borrower has proposed to provide updated projections or cash flows by a certain date, this fact can be confirmed in the letter, which may provide added motivation for the Borrower to comply. If the Borrower does not meet the requirements, the letter can be part of the paper trail showing the Lender's efforts and the Borrower's failure to follow through.
There may also be important items in the documents to be addressed in the notice, such as a requirement that the Lender give a notice to stop subordinated debt payments or dividends.
4. Forbearance Agreements
A Forbearance Agreement is at its core an agreement by the Lender for the benefit of the Borrower that the Lender will forbear from exercising remedies for a period of time. These agreements also have key advantages to the Lender and can be especially valuable in reducing the legal risk to a Lender in the COVID-19 environment. Often a Lender thinks about entering into Forbearance Agreements when the Lender and Borrower have agreed on a workout plan, but these agreements can provide distinct advantages earlier in the process. The Forbearance Agreement can set out the parameters under which the parties will operate while working to develop a workout plan and can put the Lender in a better position if the workout plan does not materialize and the Lender pursues remedies.
If a Lender is willing to waive defaults, the parties may choose to enter into an amendment rather than a Forbearance Agreement. This option may be particularly attractive if the Borrower wants to achieve the release of clean audited financial statements or does not want to be in default as it interacts with vendors or potential buyers. Although the discussion below focusses on the advantages of Forbearance Agreements, the same or similar terms and protections can be included in amendments if the Lender waives defaults.
a. Acknowledgement of Defaults
In a Forbearance Agreement, the Borrower will acknowledge defaults. In a COVID-19 environment in which the Lender is relying on a MAC default or on defaults arising from deterioration that both has occurred and is anticipated, the Forbearance Agreement is an opportunity to obtain the Borrower's agreement that the defaults exist and are material. Also, if there is an equity cure opportunity in the documents, as a condition to the forbearance, the Lender may require the equity owners to either commit to cure the default or acknowledge that they don't intend to do so and that the Lender may take future action without regard to any equity cure period.
b. Addressing Document and Lien Issues
If there are defects in the Lender's documentation or liens, the Forbearance Agreement may be able to fix the defects, or if not, the Lender can require the desired actions as a condition to the forbearance. These required conditions can include (i) shoring up collateral that was part of the original transaction; (ii) adding additional guaranties or collateral, and (iii) correcting any errors in perfection (e.g., ensuring all UCC-1 financing statements are correctly filed; ensuring all mortgages are properly recorded; obtaining deposit account control agreements where necessary). Even if the documents are in good order, there is value in requiring the Borrower to acknowledge the amount owing and agree that the documents are in full force and effect and the liens are valid, perfected and continuing.
c. Defining the Borrower's Obligations
The Forbearance Agreement will define the Borrower's obligations, as agreed between the Borrower and Lender. This may include such items as complying with an agreed budget, giving regular financial or cash flow updates, hiring a workout consultant, obtaining additional equity, refinancing, and selling assets. In some cases, it may be helpful to include interim deadlines, such as a date for providing a loan commitment or a letter of intent for a sale. In the COVID-19 environment, with the rapid pace of change, it may be valuable to identify expectations for the near term in case of additional negative impact of the COVID-19 pandemic.
d. Defining the Lender's Rights and Obligations
The dramatic impact of the COVID-19 pandemic means that many of the covenants in existing loan documents no longer reflect the reality of the Borrower's business. This creates ambiguity regarding the ongoing terms of the deal. The Forbearance Agreement can both memorialize the basis on which the parties are moving forward and recite that the Borrower agreed to the forbearance terms in the COVID-19 environment and that the Borrower acknowledges that the Lender has not agreed to make additional accommodations.
One key benefit of a forbearance arrangement is that it has a specified end date. The Borrower will have agreed that the Lender has no obligation beyond that date. The document can also include provisions for the potential need to end the forbearance early, such as if the Borrower does not meet interim milestones toward compliance with the Forbearance Agreement or if the Borrower incurs greater losses than expected. The agreement can also be tied closely to the Borrower's budget, limiting the Lender's obligation to lend and limiting the Borrower's right to obtain advances in order to monitor and enforce the approved budget.
e. Facilitate any Future Effort to Realize on Assets
Forbearance Agreements often include the Borrower's agreement to cooperate in a future collection action. These provisions can vary greatly since the Forbearance Agreement could be used in a variety of scenarios, from when the parties expect a speedy return to loan compliance, to when the parties are nearly ready for a deed in lieu of foreclosure or voluntary surrender of assets.
To facilitate an eventual collection action, the Forbearance Agreement can include waivers of rights, an agreement to streamlined foreclosure periods, including an agreement to appointment of a receiver, and could even contain specific parameters for transfer of collateral to the Lender. The document could also provide for the Borrower's cooperation in a recovery effort. Lenders often find that the owners are better able operate the business leading up to a sale, better able to collect accounts, and have better connections for selling the collateral or the company.
While a provision prohibiting the Borrower from filing a bankruptcy case is not enforceable, prohibitions against the commencement of a state-law insolvency proceeding (e.g., an assignment for the benefit of creditors) can be enforceable. Moreover, some bankruptcy courts will enforce a Borrower's waiver of the protections of the automatic stay of creditor actions in a bankruptcy case, particularly if the Lender can show that it provided new consideration (e.g., forbearing from enforcing remedies) in exchange for the waiver.
f. Release of the Lender
A key provision in a Forbearance Agreement is a Borrower's acknowledgement that the Lender acted appropriately and a release by the Borrower of all claims against the Lender. The intent of this provision is to create a clean slate and limit the Lender's risk of being sued by the Borrower over the handling of the workout or any other matter. While the release is important in any deal, it may be especially valuable to have a release of claims given the lack of clarity as to what actions by a Lender might give rise to a claim in the COVID-19 environment.
5. Tips for Negotiating with the Borrower
Sometimes claims against a Lender arise from the activities that occur after default and prior to a collection action. Below are some tips for minimizing the risks during the negotiation stage.
a. Consider entering into a pre-negotiation agreement. Under a pre-negotiation agreement, the Borrower agrees that defaults are not waived, that term sheets and discussions are not binding, that the individuals acting on behalf of the Lender do not have authority to bind the Lender and credit approval is necessary for any deal.
b. Be thoughtful about which representatives of the Lender will talk to the Borrower during this period. Try to avoid sending inconsistent messages or including Lender representatives who are not familiar with strategies for limiting the Lender's risk of claims.
c. Manage Borrower expectations. Do not lead the Borrower to expect additional advances, extensions of time or other accommodations, particularly if the Borrower may take actions in reliance on the expectation.
d. Consider memorializing conversations in writing. A follow-up email or other summary of the status may help avoid misunderstandings or disagreements about what was said during negotiations.
e. Choose words carefully in emails and file notes. All such material will likely be made public if there is a dispute. In particular, avoid using language that could be construed by a Borrower (or a judge or jury) as a promise to sacrifice the Lender's interests to those of the Borrower (e.g., "we will work with you"; "we are your partners"; "we will get through this problem together").
f. Do not control the Borrower's business. In particular, the Borrower should be the one to prepare any workout budget, and importantly, the Lender should not be involved in determining which creditors will be paid.
There are significant challenges in applying the old default and forbearance tools to the new COVID-19 pandemic. The impact of COVID-19 is unprecedented, and the future is uncertain. The rapid pace of change and the sheer number of Borrowers experiencing difficulty simultaneously will strain resources and inevitably result in challenges for Lenders managing loan defaults, at least for an interim period. In this context, Lenders will want to stay grounded in the traditional ways of managing loan defaults in order to maximize recoveries and limit risks.
For more information reach out to your Quarles & Brady contact or
- Kim Wynn: 414-277-5377 / Kim.Wynn@quarles.com
- Anthony Marino: 414- 277-5365 / Anthony.Marino@quarles.com
- Christopher Combest: 312-715-5091 / Christopher.Combest@quarles.com