The rapid spread of COVID-19 has created massive stress on liquidity levels and credit availability across many industry sectors and markets including the debt capital markets.
We have summarised below some of the key steps that debt capital markets issuers (Issuers) in financially stressed sectors can take to navigate the current market turmoil.
Identify potential cashflow shortages early
Issuers should be on the front foot in identifying any potential cashflow shortage over the next 12-18 months that could impact working capital, cash reserves or liquidity positions. If a cashflow shortfall is identified, Issuers need to consider the impact on financial ratios and ultimately solvency and how they will manage debt obligations during this period (noting that the solvency test under Australian law is a cashflow test not a balance sheet test). In particular, Issuers should:
- identify any upcoming payment obligations (e.g. principal amortisation, interest and fee payments) to determine whether those payments can be met when due and payable and any applicable default interest provisions to determine when liability for default interest will arise (e.g. following a payment default or whilst an event of default is continuing);
- assess whether they are liable under reimbursement, indemnity or increased costs provisions for any fees, costs, losses or liabilities as a result of market disruptions or debt providers reactions to market disruptions and, in the case of note trustees, security trustees or other agents) investigating and addressing events of default; and
- check if their insurance coverage, including for business interruption or property impairment, covers losses arising out of a party's inability to meet its obligations due to a specific event. Certain specialised insurance products such as force majeure insurance, trade disruption insurance, political risk insurance or performance bonds, may offer an avenue of relief.
Conduct a solvency analysis
Issuers should undertake a careful analysis of their solvency and consider the position of each group company and its directors (having regard to directors’ duties and recent law changes to provide additional “safe haven” protection for directors).
In this regard, Australian Issuers may take additional comfort from a range of insolvency relief measures that have recently been introduced by the Australian government (see our article covering these measures here). Similar measures have been introduced in other major jurisdictions including the United Kingdom and Germany.
Review funding sources including speed to market
Issuers concerned with their liquidity position should review their ability to access alternative funding sources across the full capital stack ranging from senior to subordinated debt, hybrid securities and equity.
Where Issuers are fortunate enough to retain investor support for their existing programmes, they should ensure that their programme documents are up to date, so new notes can be issued quickly when market conditions are favourable. In particular, Issuers should consider whether express COVID-19 disclosure should accompany disclosure of standard risk factors for new issuances.
Issuers should also review any conditionality in dealer commitments or mandates (such as MAC clauses or market disruption clauses) that are more at risk of being triggered in the context of the current market conditions, and commence commercial discussions early to assess arranger/dealer appetite for supporting a new issuance.
Identify contractual stress points in existing programme documents
Issuers should conduct a detailed review of their existing note programme documents to identify any potential “stress” points which may be tested by the recent market conditions. Examples of some of the key stress points are summarised below.
- Issuers should carefully review financial ratio covenants and related default provisions to understand whether those provisions have been or could be breached in future and the consequences of a breach occurring. If ratios are likely to be breached, early engagement with debt providers to plot a course through the period of financial stress should be considered.
- Issuers should carefully review their solvency covenants and related default provisions to understand whether those provisions have been or could be breached in future and the consequences of a breach occurring. If there are potential solvency issues for an Issuer, directors need to consider what relief from debt obligations is required and what ability exists to access additional funding (including from shareholders).
- Guarantor coverage tests which reference EBITDA should also be reviewed. If such tests are breached, there could be a requirement for additional obligors to accede to the financing arrangements. Minimum share price or rating provisions in respect of guarantors might also trigger obligations to replace guarantors or provide alternative credit support.
- Material adverse effect (MAE) or material adverse change (MAC) clauses in debt documents need to be carefully reviewed and analysed. Such clauses are often broadly drafted to expressly refer to circumstances or events that materially impact an Issuer’s financial condition, its business, operations and prospects, and, in some cases, the prevailing economic and market conditions. Although Australian courts have interpreted such clauses narrowly to date, making creditors wary of reliance upon them, an Issuer should identify any MAE/MAC provisions in their note programme terms and consider whether notice should be given of any circumstance that could constitute a MAC/MAE. Whether the current circumstances and market conditions will trigger a MAC or MAE depends on several different factors, including the drafting of the relevant provision in question (which courts have considered to be extremely important), the specific impact on the Issuer and whether it is temporary only or longer term, the industry the Issuer operates in and the market conditions in which the note programme documents were signed. If new programme documents are being negotiated or entered into, there may be a need to address specifically the current circumstances and market conditions in any MAE or MAC clause.
- Where the revenue of their business has been adversely affected, Issuers should be aware of the impact of any covenant restrictions on their business operations, including their ability to pay dividends or distributions, make future acquisitions or incur new debt.
Given financial covenants are usually backward-looking, Issuers who have successfully navigated recent March testing dates may have to brace themselves for more a difficult compliance process in respect of future testing dates.
Specific considerations for securitisation transactions
Originators under term securitisation or warehouse programmes should also review other key provisions in their programme documents including stop origination/funding events, portfolio parameters, eligibility criteria, amortisation events and triggers for replacing key transaction parties.
Servicing and origination procedures should also be reviewed to determine whether these can handle an increase in mortgage hardship following the sharp rise in unemployment as a result of COVID-19. The treatment of arrears in Australian residential mortgage-backed (RMBS) structures should also be considered in light of a recent announcement by the Australian Prudential Regulation Authority that where borrowers are accessing payment holidays on their mortgages as a result of COVID-19, banks need not treat the period of the repayment holiday as a period of arrears.
Smaller lenders who access funding via the Australian securitisation market should also be actively exploring their eligibility to benefit from the A$15 billion structured finance support fund (SFSF), recently established by the Australian Government. The SFSF will be used to fund direct investment by the Australian Office of Financial Management in asset-backed securities issued by nonbank lenders and small banks, and will provide welcome support for primary market issuance in this sector (see our article covering the SFSF announcements here).
Events of Default (EoDs)
Issuers should analyse the potential for EODs to be triggered and the consequences of this under their note programme documents. Some of the more obvious EODs relate to failures to pay or observe other obligations and Issuer insolvency. Although EODs triggered by business restrictions or temporary suspensions are rare in note programmes, it is not entirely unheard of to come across them. Issuers should also be alert to any breaches/EODs under any of their other debt documents that may trigger a cross-default under their note programme.
Representations and warranties
Any ongoing representations and warranties made by an Issuer (for example, under subscription agreements) should be checked to ensure they can still be made in the context of the current circumstances and market conditions.
Information undertakings and reporting obligations
Issuers should check and consider their obligations to report material breaches, potential EODs or actual EODs, including where financial covenants have been breached but contractual cures are available. The deadlines by which Issuers are obliged to deliver financial statements and other related reports or certificates (including compliance certificates) should also be considered to ensure that financial statements can be delivered on time. Issuers should also consider whether there is a possibility that audited accounts could be qualified and engage early with their auditors to manage this risk.
Issuers should check if they are subject to any requirements to report a change in rating under their note programme documents. They may also wish to assess the impact of the current circumstances and market conditions on their ability to comply with their rating requirements (if applicable) and the consequential impact on the note programme structure.
Listed Issuers should already be taking advice on their continuous disclosure obligations in relation to the impact of COVID-19 on their business (see our article covering these obligations here). Unlisted Issuers should also review any COVID-19 related disclosure obligations that may apply to them as a result of their involvement in an issue of notes that are listed on local or offshore exchanges.
Investor relations strategy
Issuers should prepare a communication strategy for investors and manage the communication appropriately, ensuring a consistent approach where a wider coordination of local relationships is necessary. In a COVID-19 environment, we expect that all roadshows or similar market soundings will be conducted electronically.
Monitor local regulatory actions and restrictions
Issuers should monitor and understand new regulations to determine whether they provide opportunities for Issuers to access relief or create additional risks for their note programmes. The SFSF facility referenced above is a good example of government relief that has been welcomed by the Australian securitisation industry.
Be proactive – go early with restructuring proposals
If an Issuer anticipates a breach of a financial covenant, it should assess whether it can access permitted adjustments to the financial covenants in light of current market conditions (e.g., EBITDA adjustments for abnormal or extraordinary items). Alternatively, it may wish to consider if any contractual remedies are available such as forbearance, waivers or grace periods and how those can be accessed or exercised. The possibility of a breach should be considered ahead of time and raised with debt providers early in order to have the requisite waiver in place prior to a breach occurring to avoid the risk of triggering cross-defaults under other financing arrangements.
Issuers should also consider potential restructuring options. These will vary considerably depending upon an Issuer’s capital structure and its circumstances, including the extent to which the Issuer requires short-term relief or long-term solutions.
For example, if an Issuer believes that it has sufficient liquidity, but its outstanding notes are trading at a discount to par, cash tender offers or privately negotiated repurchases can be explored to buy back debt and capture the discount – this needs to be done after careful consideration of contractual and disclosure issues, applicable securities and corporate laws and tax and accounting issues. Alternatively, where liquidity needs to be preserved, debt-for-debt transactions, whether by formal exchange offer or privately negotiated exchanges, can be structured to both extend debt maturities and capture discount opportunities in return (for example) for the new notes being placed in a higher priority position than the original bonds (e.g., exchanging an unsecured note for a secured note). Issuers may consider either a stand-alone consent solicitation in exchange for payment of a consent fee or a consent solicitation combined with an exchange offer.
Other restructuring options include modifying or seeking relief from financial covenants or debt payment terms, or seeking greater flexibility to incur additional debt.
These restructuring options will require time to implement and careful planning. For example, amendments to entrenched rights require noteholder consent, often a 75% or 90% majority, or even unanimous consent, and the process of obtaining consent can be cumbersome and time consuming. Clearing systems requirements and notice requirements will also affect the timeline as will the investor engagement process.