Reshaping Business and Relationships: Managing Financial Creditors

Events of default under debt documents are numerous and varied. Failure to make any payment of principal or interest and breach(es) of any financial covenants on acovenant test date are the most obvious. In addition, there are many more specific events which can give rise to an event of default. These include cross defaults, legal action by creditors, cash flow or balance sheet insolvency, and any material adverse change in the condition of the business or its finances.

Whatever the event of default, the lender's legal rights are almost always the same. Lenders will always have the right to: (a) cancel any undrawn or unused commitments under the loan; (b) place any committed facilities on demand; and (c) demand immediate repayment of outstanding loans. The process for making demand is very quick. The lender will issue a "demand letter" demanding immediate repayment of all principal and interest and if that demand is not satisfied within a matter of hours, the lender will be entitled to enforce any guarantees and security.

It is extremely unlikely that a lender would issue a "demand letter" and enforce guarantees or security without first having discussions with a borrower about the business, its finances and its future prospects. However, it is important to note that the existence of an event of default will shift the balance of power in the lender's favour and businesses should be mindful of what this may mean in practice.

Following an event of default lenders will often assess their overall debt exposure to that borrower. This usually involves close scrutiny of all other banking facilities, including undrawn term loans, revolving credit facilities, overdrafts, invoice, trade and asset financing facilities and access to BACS and other essential payments systems. An event of default will usually entitle a lender to draw stop, cancel, terminate or otherwise withdraw other loan facilities and services which can have very serious consequences for liquidity and solvency. Lenders will be concerned about their exposure to any business that is showing signs of distress and limiting access to further debt is one way of mitigating this concern.

Most lenders include provisions in their loan agreements which allow them to sell their loans. Sometimes these rights are exercisable before an event of default but it will almost always be exercisable after an event of default. A borrower may find that instead of dealing with a long standing and trusted relationship manager, it may end up dealing with a new lender which may not be a traditional bank lender and may be less inclined to support a business through a period of distress. Hedge funds, credit funds, distressed investors and all manner of parties exist who specialise in buying up so called "distressed debt". Often distressed investors buy debt at a significant discount to its face or par value which means they have a different commercial and profit dynamic to so called "par" lenders.

Many distressed lenders have been viewed with suspicion and scepticism by borrowers over concerns about their short term horizons and their "loan to own" strategies (a "loan to own" is a strategy to exercise management control and participate in the ownership of a business using debt and security rights). This suspicion is undoubtedly justified in many cases but for fundamentally good business with good management teams, a specialist distressed lender can also bring opportunities. They have access to new money and can move quickly to repair balance sheets, shore up liquidity and recapitalise a borrower's businesses. They are more nimble and fleet of foot than some traditional bank lenders. However, in return for access to their funding, they may also expect participation in the management and ownership of the business. [MdR1] 

For many owner managed businesses, personal guarantees will often be taken by lenders to guarantee repayment of business loans. With COVID-19 support loans, lenders were not entitled to take personal guarantees for loans under the Bounce Back Loan Scheme (BBLS) but they were permitted under the Coronavirus Business Interruption Loan Scheme (CBILS) and the Coronavirus Large Business Interruption Loan Scheme (CLBILS) (in both cases, only for loans above £250,000).

Other than personal guarantees under the CBILS and CLBILS, which are shortfall guarantees limited to 20% of the outstanding loan balance, personal guarantees are usually "joint and several". This means that each individual guarantor has legal liability for the entire amount borrowed, rather than a proportionate share or shortfall on recoveries. These guarantees also usually include an "indemnity" meaning that the guarantor remains liable in the same way as the principal debtor, or any other guarantors, even if the loan or guarantee cannot be enforced against the other parties to it for any reason.

Other than under the CBILS and CLBILS, it is common that a personal guarantee will become enforceable immediately on the occurrence of an event of default on the part of the principal debtor. It is not necessary for a lender to make a claim against a principal debtor before enforcing the guarantee. However, it would be unusual for a lender to enforce a guarantee without first, or simultaneously, making a demand on the principal debtor unless there is a defect or problem with the underlying loan or security.

For all borrowers, it is worth checking and understanding the terms of any guarantees where there is a risk of an event of default by the borrower. Most importantly, if there is any waiver or standstill in relation to an event of default under the loan agreement, this should also extend to any rights to call or demand under any guarantees.   

Most loan agreements will also provide a lender with rights of set-off, netting, and consolidation of accounts. The point of caution here for borrowers is that if an event of default gives rise to a risk that other borrowing facilities may cancelled, which may cause a liquidity crunch for the business, it may also result in access to any credit balances being blocked.

Set-off and consolidation rights are usually exercisable at any time after an event of default and without notice, so, again, if there are risks that this may happen, borrowers may wish to consider carefully how and where their cash reserves are held during periods of business stress and uncertainty.

Many loan agreements include restrictions on business activities by way of undertakings. Examples may include restrictions on incurring financial indebtedness, making loans or transferring assets to other group companies and the disposal of assets (other than in the ordinary course of business). These kinds of activities may be particularly relevant for a business in difficulty looking to increase its cash base. Other restrictions typically include the payment of dividends, the repayment of other debts or the acquisition of capital assets.

It is common that these restrictions will be subject to "permissions" so that in normal times, these activities can be carried out up to certain agreed financial limits but, following an event of default, these permissions are often switched off. Unless a specific lender consent or a waiver is obtained, doing any of these things may constitute a breach of the debt documents.

For larger loans and businesses, and as a condition to temporarily waiving events of default or granting continued access to loan and credit facilities, lenders may insist on carrying out an independent business review or similar exercise (also referred to as an IBR).

An IBR involves the lenders' financial advisers spending time assessing the borrower's business to enable lenders to make a more informed assessment of its financial condition and future prospects. The precise nature and scope of an IBR will depend on the business under review but cash flows and liquidity will almost certainly be a key area of focus. This is also an opportunity for lenders and their advisers to assess the capital structure and the value of the business which will give them some idea of how much they are likely to recover in the event of a sale or insolvency or whether a restructuring process is viable.

An IBR is also often supported by a security review. This process is carried out by the lenders' legal advisers and will involve a detailed assessment of the capital structure of the business and the existence, validity and enforceability of any guarantees and security.

The issue here for businesses is that these exercises are carried out by the lenders' advisers but are paid for by the borrower. Before agreeing to meet these costs, borrowers should understand exactly what is involved and ensure any costs are fixed in advance.

Given the legal and commercial implications of an event of default, whether caused by a payment default, a financial covenant breach or otherwise, there are a number of things businesses and management teams can, and should, do.

For any company director or owner/manager, the key concern is to anticipate and pro-actively manage these issues. It is worth looking ahead to try and pre-empt cash flow interruptions and events of default so that they can be addressed before they become problems.

In the current environment, it is well worth reviewing and understanding the terms of any debt documents (including loans, guarantees, security and any intercreditor agreements). This should include a review not just of the financial covenants, but of all events of default, undertakings, representations and permissions affecting the business. Specific matters which may trigger events of default may include any cessation of business due to lock down, defaults under leases and other material contracts, actions by creditors to enforce the payment of debts, negotiations with creditors and landlords, any event of cash flow or balance sheet insolvency and material changes to the business or its financial condition.

There are also usually notification obligations on borrowers to formally notify lenders if there are events of default under facilities agreements. However, it is essential to take legal advice before doing so. Even a future or potential event of default can itself be a "default" under most financing agreements.

Any discussion with lenders in the first instance should be around obtaining a waiver or standstill to provide breathing space and time for options and solutions to be formulated. As noted above, an event of default of any kind however small can give rise to serious consequences with lending banks. It is common to seek waivers but it is always better to obtain a prospective waiver before an event of default has been triggered. Where a waiver is not possible, a standstill should be obtained to ensure lenders do not take any action under any outstanding events of default at least for an agreed period of time whilst solutions are formulated for the business.

As a point of caution, where there is a risk that an event of default may arise and be outstanding on a company's accounting reference date, this may in due course impact on the signing off by auditors of the company's audited accounts. The impact of an event of default is that all committed borrowings become "current" and will need to be recorded as such on the accounting reference date. Lenders are well used to dealing with this issue and it is not uncommon for them to grant a prospective waiver or to agree an amendment to a covenant test date to avoid this happening.

Businesses with large borrowings or complicated capital structures should be aware that the identity of their lenders may change over time. This introduces uncertainty. As a rule of thumb, the more lenders involved in a company's capital structure, the more time consuming and difficult it will be to obtain consents, waivers and decisions.

Depending on the structure of the facility, there are typically different levels of consent required. Decisions may require anything between 66.6%, 75%, 90% or 100% (in value) of lender approvals. Where there are multiple lenders, two things are relevant for borrowers: first, the higher the value threshold for any lender decisions, the more difficult it is to obtain; and second; it is not uncommon for minority lenders to dissent when asked to vote on decisions if for no other reason than to encourage equity sponsors or other lenders to buy them out.

Borrowers and management teams should understand these dynamics and the voting requirements under any facility or intercreditor documentation. These issues typically take time to deal with and in situations where a business has cash and solvency issues, time is often of the essence.

By far the biggest threat which should concern any borrower is a lender's ability to enforce security following an event of default. This can happen with very little notice and sometimes in a matter of hours after a lender has issued a notice of default and a demand for repayment. The problem for borrowers is that in an enforcement scenario, they will lose control of their business and assets and it is also usually value destructive.

Businesses should consider their options well ahead of any event of default to understand their full range of options including under the new moratorium regime in the Corporate Governance and Insolvency Act 2020 and under any other statutory rescue process including the new restructuring plan or a scheme of arrangement.

If there is a risk that lenders may try and enforce debt and security it is essential that those risks are properly assessed from a legal perspective. Just as lenders will review their guarantee and security rights to look for flaws and defects which may affect their negotiating position, so should borrowers. A security review will help in two ways: first, it will identify any defects or shortcomings in any existing guarantee and security structure which may help significantly in any negotiations with lenders; and second, it may also help to identify if there are any other assets which may be offered as security in exchange for new loans or waivers of events of default.

Where new money is required to support the business, management and shareholders should be aware that new money (whether from new or existing lenders) will normally rank super senior, and this can have significant intercreditor implications for other secured lenders. These issues take time to resolve through negotiation. Also, if new money is being contributed by management or shareholders legal protections are required to ensure that existing lenders will not enforce for an agreed period of time or that any management-provided new money will itself rank super senior in the event of an enforcement of security or insolvency.

Given the ability for lenders to draw stop or cancel existing facilities and lending commitments, borrowers should also consider whether it is appropriate and prudent to draw down those facilities before an event of default arises to ensure maximum liquidity is preserved. 

There may also be good reasons for directors to temporarily withhold repayments of debt and interest. Preserving cash may be the key not only to saving the business and avoiding insolvency, but also to ensuring that all creditor's interests are protected, which is an important legal obligation imposed upon company directors when a business is in distress. Liquidity and cash will be key to survival whilst negotiations are ongoing with lenders, landlords, suppliers and creditors.

Just as financial covenants tests look back in time, when negotiating with lenders around waivers, access to debt, or plans to raise new finance through disposals, it is essential to look ahead with a worked up restructuring plan. Solutions and options are the key to dealing with stakeholders. The most important thing for any lender is that they can have confidence in whatever solutions are being presented. This confidence can come from the quality of management but also from the quality of advisers. A cash flow forecast or a revised business plan or a funding proposal can carry much more weight when it is stress tested and endorsed by reputable and experienced advisers.

There are often several different stakeholders whose rights and interests are "in play" in times of distress. Dealing with all of these stakeholders and understanding their rights and aligning their interests is time consuming and often complex. These stakeholders may include not just lenders and banks but also landlords, suppliers, shareholders, credit insurers, regulators, pension scheme trustees and many others. It is not uncommon for stakeholders to take time to assess their own legal rights and interests before alighting on a mutually agreed plan. Again, it is far better to engage earlier rather than later with stakeholders. The biggest enemies to a successful restructuring are time and money. It often takes time to negotiate a consensual arrangement and all the while it is likely that liquidity will become increasingly depleted. The key to managing stakeholders is to start early and to start with a solution.

For any directors, management team, owner / manager or equity sponsor, rescuing a business and preserving jobs and value are usually the most important drivers in times of trouble. There are now a much greater range of options available for achieving this.

A business is usually rescued by the actions and decisions of external stakeholders as much as it is by management and employees. The time required to align stakeholder interests and expectations is usually longer than the liquidity runway available. External stakeholders can cause instability and uncertainty but this can be managed with good advice and good communication.