With the spread of the COVID-19 virus and the various state of emergency declarations made by provincial governments and cities across Western Canada, there is likely to be disruption to many businesses from the resulting economic slowdown.
During this period of uncertainty it is important to understand best practices for both borrowers and lenders in respect to defaults under credit agreements and commitment letters (“credit agreements”) and forbearance agreements.
A default under a credit agreement can result from a breach of a financial covenant (i.e. a debt to EBITDA ratio covenant) and may or may not have a cure period associated with it. Most credit agreements will have reporting requirements for certain covenants that occur yearly, quarterly, or in some cases, monthly (which require that any breaches be reported within so many days of the end of the relevant reporting period).
If a business is in breach of a financial covenant under a credit agreement there are a number of options available to the lender to address such breach:
- The lender may agree to waive the default. In that case there is no default under the credit agreement as the lender has waived compliance by the borrower with the covenant that has been breached. The borrower and the lender would normally document a waiver of a default in writing so it is clear that a default will not lead to a lender exercising its remedies under its credit agreement or its security in the future.
- A lender may also provide the borrower with an extension of the period of time to meet the covenant or may delay the time for a borrower to report under the covenant until the next reporting period. Either of those solutions would also avoid a current default under the applicable credit agreement.
- If a lender is not prepared to provide an extension or a waiver of a default then it may instead be prudent to provide a reservation of rights letter to the borrower. This involves the lender advising the borrower that it is reserving its rights to take steps in respect of any defaults at some point in time in the future. It allows the lender to document the default and obtain some additional time to consider its next steps, without prejudicing its rights at some point in time in the future to take steps regarding that specific default.
In circumstances where a borrower is in financial distress and has defaulted under the terms of the credit agreement, the lender may propose to enter into a form of forbearance agreement. A forbearance agreement usually acknowledges that a lender has the right to enforce upon its security at that time but will forbear for a period of time from doing so based upon a number of important considerations.
As part of a forbearance agreement a lender may issue a demand letter and a notice of intention to enforce security pursuant to section 244 of the Bankruptcy and Insolvency Act (Canada) (BIA). This allows the 10 day notice period required under section 244 of the BIA prior to enforcing security to be waived or expire during the term of the forbearance agreement. If a forbearance terminating event occurs the lender would then be in a position to immediately enforce its security.
The purpose of a forbearance agreement is to allow a borrower an opportunity to restructure by potentially obtaining re-financing, selling redundant assets or obtaining an equity injection. It also provides the lender with additional time to gather information on the financial distress being experienced by the borrower and what its financial needs will be going forward. The forbearance agreement allows the lender or borrower to engage additional consultants or advisers to assist in identifying some of the challenges facing the business as well as some potential solutions to the financial distress.
A forbearance agreement can have a variety of terms including, but not limited to, the following:
- additional financial reporting on a monthly or weekly basis;
- preparation of a cash flow projection for an extended period that will be updated on a rolling basis with actual results from the borrower’s operations;
- confirmation that priority payables (including certain taxes employee wages) have been paid and continue to be paid by the borrower;
- agreement not to seek creditor protection or if creditor protections are obtained, the lender will be an unaffected creditor in any restructuring proceeding;
- requirement that the borrower engage and work with a financial adviser to provide additional information regarding its assets and operations. The financial adviser will normally have the ability to report directly to the lender on the outcome of its analysis regarding the current financial circumstances of the borrower;
- lender may also look to obtain additional security (from the borrower or a guarantor) or identify and correct any deficiencies in its security over the borrower’s assets;
- lender may require during the forbearance term that the borrower commence a solicitation, investment and/or sale process for the re-financing or sale of some or all of its assets. This process can be beneficial for both the borrower and the lender to test the market for the sale and/or ability of the borrower to refinance its operations as a going concern; or
- provide for a form of consent receivership order or consent judgments to be executed by the borrower or any guarantors that may be relied upon by the lender if a forbearance terminating event occurs.
All of these provisions will assist the lender in being able to appreciate the current financial situation of a borrower, assess the value of its security as well as understand some of the challenges the borrower will face in the short-term, including any potential additional cash requirements that may be necessary for the borrower to continue to operate its business.
For borrowers, entering into a forbearance agreement with the lender will provide additional time in order to try and stabilize its business operations, seek alternative solutions to try and remedy any sources of financial distress or facilitate a transaction to sell some or all of its assets outside of a formal restructuring proceeding.
We foresee many difficult and challenging circumstances arising from the spread of the COVID-19 virus on both borrowers and lenders. In this article we have attempted to outline some of the options available to both borrowers and lenders when a default occurs under a credit agreement try and mitigate the impacts of these uncertain economic conditions.
Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.