As financial markets and various industries begin to feel the effects of coronavirus-related shutdowns, our bank clients need to consider the potential impact of financially distressed customers on derivatives contracts and loan documentation. We would like to highlight the following key concepts that banks should be focusing on the coming days:
- Payment Deferrals and other Loan Modifications
Many banks are proactively offering principal and interest deferrals to distressed customers, typically for 90 days. Additional loan modifications may include elimination of financial covenants or changes in revolving loan availability. For banks that offer interest rate swaps, banks have a number of options, including:(i) deferring principal and interest but not regular swap payments; (ii) deferring principal, interest and regular swap payments; (iii) deferring principal and interest only and capitalizing deferred swap payments under a separate promissory note; and (iv) amending the swap transaction to reflect the new economics of the deal after deferring principal and interest payments. Each of these options is beneficial to borrowers, but will have a different impact on the efficacy of the hedge, on amortization, and on the overall economic outcome for the bank.
While loan modifications are in process, this is also a good opportunity to update outdated LIBOR fallback language and consider whether a floor on LIBOR/SOFR is appropriate.
Our team is available to assist with customized amendments and high-volume modification requests, and to help our bank clients understand the economic and legal ramifications of each of these options.
- General Termination and Default Preparedness
Despite the offer of payment deferrals and loan modifications, some customers will unfortunately not be able to meet their contractual obligations under derivatives transactions and credit facilities. As a result, banks should prepare to address an increase in loan and swap defaults. While most banks have full-time special asset groups, many regional and community banks are not well-equipped to handle a higher volume of loan defaults, or any volume of swap defaults. For bank clients that offer interest rate swaps, it is critically important that swap counsel be engaged to prepare for early termination of interest rate swaps and to be sure that swap counsel is working together with local bank counsel to make certain that loan default proceedings do not adversely impact a bank’s rights under any interest rate swaps, which have significantly different termination procedures and dynamic termination payment calculation methodologies.
- Force Majeure
A force majeure clause allows a contract party to suspend performance if it cannot perform due to circumstances beyond the control of the parties. While the 2002 ISDA Master Agreement contains a force majeure clause, not all derivatives transactions are governed by a 2002 ISDA Master Agreement and may not include force majeure terms. Similarly, loan documentation may or may not include these terms. If a bank determines that the relevant transaction includes force majeure terms, the bank and its counsel will then need to evaluate whether or not a coronavirus-related failure to perform qualifies as a force majeure event. This is a very fact-specific analysis which may include multiple financing agreements and multiple potential defaults within each agreement. Banks will need to understand how multiple document sets (and potentially divergent force majeure terms) will interact and impact the bank’s default and termination rights and remedies.
- Material Adverse Effect / Material Adverse Change/ Insecurity
Many loan agreements contain material adverse effect (MAE), material adverse change (MAC), and/or insecurity clauses which may result in a default in the event that a customer’s business suffers a material adverse change in its business or if the bank deems itself to be insecure. The exact wording of these clauses varies significantly, so great care must be taken to review the loan agreement and the customer’s business to determine whether or not the bank is justified in declaring a default as a result of a MAE/MAC/Insecurity.
Questions on how to prepare for potential impacts on derivatives and/or loan transactions during the COVID-19 crisis? Please contact Alec Fraser or Cheryl Isaac with any additional questions.
For more in-depth analysis of the legal and policy ramifications of the COVID-19 pandemic, please visit Michael Best’s COVID-19 Resource Center. There you can find a number of client alerts on other relevant COVID-19 topics, including recently enacted legislation and its impact on a variety of industries and individual businesses.