and MAC Clauses in Commercial Lending Structuring Effective Credit - - PowerPoint PPT Presentation

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Presenting a live 90-minute webinar with interactive Q&A

Financial Covenants, EBITDA, Events of Default and MAC Clauses in Commercial Lending

Structuring Effective Credit Agreement Provisions to Maximize Borrower Protection and Lender Remedies

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific THURSDAY, NOVEMBER 12, 2015

Benjamin D. LaFrombois, Partner, Hinshaw & Culbertson, Appleton, Wis. Upneet S. Teji, Attorney, Greensfelder Hemker & Gale, Chicago

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FINANCIAL COVENANTS, EBITDA, EVENTS OF DEFAULT AND MAC CLAUSES IN COMMERCIAL LENDING

Structuring Effective Credit Agreement Provisions to Maximize Borrower Protection and Lender Remedies

Why Financial Covenants?

Purpose

• To monitor the strength of a business
• To evaluate the ability to repay debt
• Early warnings of financial issues and potential payment default

What do they measure?

• Cash flow
• Leverage
• Liquidity
• Net Worth

*Covenant-Lite Loans

6

When are Financial Covenants Relevant?

Underwriting process

• Loan application

Commitment/term sheet stage

• Covenant figures
• Covenant definitions

Loan document negotiation stage

• Negotiation of covenant definitions
• Grace periods
• Cure rights
• Flexibility, reporting obligations and reasonableness
• Expenses

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Where to find Financial Covenants

Affirmative Covenants

• Reporting requirements
• Tax returns
• Income statements/balance sheets (audited)
• Rent rolls
• Maintenance Covenants

Negative Covenants

• Incurrence-based Covenants
• Maintenance Covenants

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Types of Financial Covenants

Maintenance Covenants

• Periodically tested
• Breach is generally an immediate default
• Equity cure rights
• Simple or Complex

Incurrence-based Covenants

• Triggered by specific events
• Examples:
• Incurring additional debt
• Entering into acquisitions
• Paying dividends
• Selling assets

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Maintenance Covenants

Focus on Balance Sheet (measured as of a given date)

• Net worth covenant (tangible)
• Debt to capital ratio
• Balance of accounts

Focus on Cash Flow (measured for a given period)

• Leverage ratio
• Interest coverage ratio
• Debt service coverage ratio
• Fixed charge coverage ratio
• Free cash flow

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Covenant Periods

Measurements as of a particular date:

• “Total Debt as of the last day of each fiscal

quarter”

• “Net Worth as of last day of each fiscal year”

Measurements for a specified period:

• “Interest Expense for the twelve month period

ending on the last day of each fiscal year”

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Financial Covenant Definitions

Definition:

“Net Worth” means, as of any date of determination, (i) the total of all assets appearing on the most recently delivered balance sheet of the Borrower, after deducting all proper reserves (including reserves for depreciation, obsolescence and amortization) less (b) the total liabilities of the Borrower appearing on the most recently delivered balance sheet of the Borrower, in each case, calculated in accordance with Generally Accepted Accounting Principles which excludes accounts receivables, work-in-progress, accounts payable and certain accrued liabilities as determined by Lender.

Covenant:

Borrower shall not permit Net Worth of the Borrower as of the last day of any fiscal quarter of to be less than the sum of $[________________] plus [___%] of positive Net Income for each fiscal year ending after December 31, 2015.

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Financial Covenant Definitions

DSCR:

Borrower shall maintain as of March 31, June 30, September 30 and December 31 of each year, commencing December 31, 2015, a ratio of (i) Income Available for Debt Service to (ii) Debt Service Requirements of not less than 1.25 to 1.0, calculated for the immediately preceding twelve-month period.

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EBITDA

EBITDA means:

Earnings before interest, taxes, depreciation and amortization.

EBITDA is:

• Reflective of operating cash flow available for debt

service

• Not "actual" cash flow
• Useful for cash flow evaluation in connection with

cash flow lending and business valuation

• Useful in comparing businesses that are impacted

by factors such as interest and tax

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EBITDA means…

“EBITDA” means, for any period, Net Income for such period plus (excluding any extraordinary gains and/or losses), to the extent deducted in determining such Net Income, Interest Expense, income tax expense, depreciation, amortization, and [***ADD- BACKS: any one-time, non-recurring charges/fees/transaction costs, or other expenses that do not have to be paid (such as management fees***], transaction fees (including legal and

• ther costs and expenses) incurred in connection with

[acquisition/financing] or such other one-time, non-recurring non-cash charges and expenses approved by Bank, in its reasonable discretion, on a case-by-case basis.

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EBITDA Add-Backs

• Included in EBITDA definition

– Interest, Tax, Depreciation and Amortization

• Negotiation Points

– Non-recurring loss items – Management fees to related parties – Internal, one-time restructuring charges – Anticipated cost savings (in connection with an acquisition) – Equipment lease payments – Future fees and expenses in connection with acquisitions and future debt

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EBITDA Add-Back Considerations

1. Specific one-time charges: penalties and settlements 2. Current Transaction Expenses: “all non-recurring expenses, fees, costs and charges incurred within [6] months of Closing in connection with the Loan Agreement”. 3. Future Transactions Expenses: “all non-recurring expenses, fees, costs and charges incurred in connection with any Permitted Acquisition, any Permitted Issuance of debt, any Permitted Disposition or any proposed

• r actual amendment, modification or refinancing of any indebtedness”.

4. Non-Cash/Accounting Items: goodwill write-offs; non-cash equity compensation expense. 5. Management Fees: “the amount of management, consulting and advisory fees paid to [Guarantor/Manager] (or any accruals related to such fees) during the measurement period.” 6. Limitation on Add-Backs: “provided that such amount shall not exceed [% of EBITDA or amount] for such measurement period]”.

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EBITDA in Financial Covenants

• Use of EBITDA in Cash flow vs. Asset-based lending
• Leverage Ratio:

– Debt to EBITDA (Maximum)

• Interest Coverage Ratio:

– EBITDA to Interest Expense (Minimum)

• Fixed Charge Coverage Ratio:

– EBITDA to specific "Fixed Charges" (Minimum) – Fixed Charges may include senior debt charges, interest expenses, dividends/distributions, and capital expenditures

• Measurement Periods:

– monthly/quarterly/semi-annually/annually

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EBITDA in Pricing

Applicable Margin/Pricing Grids Example:

"Debt" to EBITDA Ratio Applicable Margin for Revolving Credit Loan (in basis points) Applicable Margin for Term Loan (in basis points) Greater than 2.00x 400 425 Less than 2.00x but greater than or equal to 1.50x 375 400 Less than 1.50x but greater than or equal to 1.00x 325 350 Less than 1.00x 300 325

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Increasing EBITDA

• “Increasing” EBITDA

–Acquisitions (pro forma financials)

• Equity Cure Rights

–Limitations

• Opportunities to exercise cure rights

(consecutive and/or non-consecutive)

• Limits on size of cure amounts

(individual and/or aggregate)

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Equity Cure Rights

In the event that the Borrower fails to comply with the requirements of any financial covenant set forth in Sections [ ] until the tenth day after delivery of the related Compliance Certificate, [PARENT/SPONSOR] shall have the right to issue Permitted Cure Securities for cash or otherwise receive cash contributions to the capital of [PARENT/SPONSOR], and, in each case, to contribute any such cash to the capital of the Borrower, and apply the amount of the proceeds thereof to increase EBITDA with respect to such applicable quarter (the "Cure Right"); provided that (a) such proceeds are actually received by the Borrower no later than [ten] days after the date on which financial statements are required to be delivered with respect to such fiscal quarter hereunder, [(b) such proceeds do not exceed the aggregate amount necessary to cure (by addition to EBITDA) (the "Cure Amount") such Event of Default under Sections [ ] for such period,] (c) the Cure Right shall not be exercised more than [three/four/five/six] times during the term of the Loans, (d) in each period of four fiscal quarters, there shall be at least [two/three] [consecutive] fiscal quarters during which the Cure Right is not exercised and (f) such proceeds shall be applied to prepay the Loans in accordance Mandatory Prepayment

• Requirements. If, after giving effect to the foregoing pro forma adjustment, the Borrower is in

compliance with the financial covenants set forth in Sections [ ], the Borrower shall be deemed to have satisfied the requirements of such Sections as of the relevant date of determination with the same effect as though there had been no failure to comply on such date, and the applicable breach or default

• f such Sections [ ] that had occurred shall be deemed cured for purposes of this Agreement. The

parties hereby acknowledge that this Section may not be relied on for purposes of calculating any financial ratios other than as applicable to Sections [ ] and shall not result in any adjustment to any amounts other than the amount of the EBITDA referred to in the immediately preceding sentence.

21

Mandatory Prepayments and Baskets

• Mandatory Prepayment Requirements

– Excess Cash Flow

• Covenant Baskets

– “Builders” Baskets

22

Events of Default

The wink and a nod at financial covenant violations is a thing of the past.

23

• A. Types of Default:

The occurrence of any one or more of the following events shall constitute an "Event of Default"

• Nonpayment
• Breach of Representation
• Financial Information
• Judicial Actions
• Noncompliance
• Judgments
• Bankruptcy

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• A. Types of Default:

The occurrence of any one or more of the following events shall constitute an "Event of Default"

• Inability to Pay
• Cash Management Liabilities and Hedge Liabilities
• Lien Priority
• Cross Default
• Breach of Guaranty, Security Agreement or Pledge

Agreement

25

• A. Types of Default:

The occurrence of any one or more of the following events shall constitute an "Event of Default"

• Change of Control
• Invalidity
• Licenses
• Pension Plans
• Reportable Compliance Event

26

• B. Lenders Rights and Remedies

After Default

• Rights and Remedies
• Agent's Discretion
• Setoff
• Rights and Remedies not Exclusive
• Allocation of Payments After Event of Death

27

• B. Lenders Rights and Remedies After

Default

Drafting Issues:

• Must remedies be exercised in a commercially

reasonable manner?

28

• B. Lenders Rights and Remedies After

Default

Immediate Default Remedies:

• Immediate Termination of Financing
• Focus on notice requirement, if any, and cure periods
• Is good faith required? (immaterial versus material

may be a factor) Lender may follow literal terms of the loan agreement even if it permits immediate termination of financing.

29

• B. Lenders Rights and Remedies After

Default

Be wary of Set Off remedy. Seek to limit in remedies section.

30

• C. Waiver
• Waiver of Notice
• Delay
• Jury Waiver

31

• C. Waiver
• Does it matter if the Default is Material or

Immaterial?

• Do the documents allow for waiver of default? What

is the evidence of the intent to waive?

• Have the lender's actions caused the debtor to take a

position in reliance of such actions?

• If there is a waiver, to which potential default could it

apply?

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• C. Waiver

If a lender declares a default "at will" or "when insecure" in order to accelerate payment of the loans, must a lender act in "good faith"? UCC 1.208 says it does not apply to true demand instruments. Good faith is not a factor when contract terms are clear. The Court will not decide whether one party ought to have exercised privileges as expressly reserved in the documents.

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• D. Cross Default and Cross Acceleration

ADMINISTRATIVE ERRORS: Example: Notwithstanding the foregoing, any such event shall not constitute an event of default under this agreement if such default or other condition is resulted solely and inadvertently from a purely technical or administrative failure and is probably cured upon notice, provided, however, that this clause shall not apply to any default or other condition that (a) arises out of any inability of the Company to perform its

• bligations because of any general or specific financial liquidity problem or (b)

currently prospectively materially impairs (i) the ability of the company to make timely payment of any amount due or to become due under this agreement or (ii) the enforceability of any of the company's obligations under this agreement.

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• D. Cross Default and Cross Acceleration

ILLEGALITY: Typically seen where there is a unique regulatory scheme that could, in theory, cause interruption of payment or a failure to satisfy other

• provisions. Typically this exception would have a "grace" period where

performance would resume within a stated period. Note of caution: Less than careful drafting may result in a situation where there are unintended cross-defaults triggered in other documents, but the primary agreement which contains the illegality exception would not be in

• default. This situation could prevent the lender from seeking remedy on the

primary agreement where other ancillary agreements would not provide the remedy desired by the lender.

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• D. Cross Default and Cross Acceleration

CONTESTED OBLIGATIONS: A cross default or a cross

acceleration provision may provide for an exception where the borrower is contesting the obligation in question or the

• ccurrences that created the default. This provision is very rare

and arises with highly rated borrowers with adequate bargaining

• power. The terms of the exception are typically in terms of

contesting the duty to pay the accelerated payment obligation. Certainly, a good faith or reasonableness requirement would be included with such an exception.

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• D. Cross Default and Cross Acceleration

CONCLUSION: A fact often ignored in the negotiation of credit agreements is that the cross defaults contained in standard forms (such as ISDA Agreement) which often contain different or less stringent terms than the ones that might be negotiated in loan agreements. It is important for the lawyer to analyze these provisions, to consider the provisions of other agreements that may be in existence. Absent the ability to review all other agreements that may be impacted by the financing documents, then one should consider limiting cross default language or acceleration to specific

• agreements. Narrowing the application of the cross default provision would

be a starting point, but still less than what should be done.

37

Material Adverse Change/Effect

38

Material Adverse Change (Material Adverse Effect)

• Clause:

– Material change in assets, liabilities, revenue, expenses, business, operations, condition, prospects, etc. – Qualitative vs. Quantitative test – How structured? (ex. condition, representation/warranty)

• Significance: lender’s risk has materially changed from when

the loan was underwritten but no particular default covenant (other than the MAC/MAE) is triggered

• Can be difficult to prove

39

Case Law

• Hexion Specialty Chemicals, Inc. v. Huntsman

Corp., 965 A.2d 715 (Del. Ch. 2008)

• In re IBP, Inc. Shareholders Litigation, 789 A.2d

14 (Del. Ch. 2008)

40

Interaction with Excuse Doctrines

• Impracticability/ Impossibility
• Frustration of Purpose
• Force Majeure

41

Impracticability/Impossibility)

• Supervening

Where, after a contract is made, a party's performance is made impracticable without his fault by the

• ccurrence of an event the non-occurrence of which

was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary. REST 2d CONTR § 261

42

Impracticability

• Existing

Where, at the time a contract is made, a party's performance under it is impracticable without his fault because of a fact of which he has no reason to know and the non-existence of which is a basic assumption

• n which the contract is made, no duty to render that

performance arises, unless the language or circumstances indicate the contrary. REST 2d CONTR § 266(1)

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UCC Impracticability

Except so far as a seller may have assumed a greater obligation and subject to the preceding section on substituted performance: (a) Delay in delivery or non-delivery in whole or in part by a seller who complies with paragraphs (b) and (c) is not a breach of his duty under a contract for sale if performance as agreed has been made impracticable by the

• ccurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was

made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid. (b) Where the causes mentioned in paragraph (a) affect only a part of the seller's capacity to perform, he must allocate production and deliveries among his customers but may at his option include regular customers not then under contract as well as his own requirements for further manufacture. He may so allocate in any manner which is fair and reasonable. (c) The seller must notify the buyer seasonably that there will be delay or non-delivery and, when allocation is required under paragraph (b), of the estimated quota thus made available for the buyer.

• Unif. Commercial Code § 2-615

44

Frustration of Purpose

• Supervening

Where, after a contract is made, a party's principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or the circumstances indicate the contrary. REST 2d CONTR § 265

45

Frustration of Purpose

• Existing

Where, at the time a contract is made, a party's principal purpose is substantially frustrated without his fault by a fact of which he has no reason to know and the non-existence of which is a basic assumption on which the contract is made, no duty of that party to render performance arises, unless the language or circumstances indicate the contrary. REST 2d CONTR § 266 (2)

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Force Majeure

• Sample clause:

Force Majeure. Neither party to this Agreement is in breach hereunder by reason of its delay in the performance of or failure to perform, in whole or in part, any of its obligations hereunder, if such delay or failure resulted from

• ccurrences beyond its reasonable control and without its fault or negligence,

including but not limited to, earthquakes, floods, fire, power failures, communications failures, epidemics, strikes, lockouts, war, terrorist activity or government regulations which go into effect after the effective date of this Agreement, and the economic impracticability of _________(Party) to _____________(perform).

• Abatement

– What if force majeure abates? – What if MAC/MAE abates?

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Thank you!

Benjamin D. LaFrombois blafrombois@hinshawlaw.com Upneet S. Teji uteji@greensfelder.com