In light of the rapidly changing coronavirus (COVID-19) situation, Troutman Sanders and Pepper Hamilton have postponed the effective date of their previously announced merger until July 1, 2020. The new firm – Troutman Pepper – will feature 1,100+ attorneys across 23 U.S. offices. Read more.
Reprinted with permission from the May 7, 2020 issue of The Legal Intelligencer. © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
We should all expect the number of defaults reported to lenders this quarter will be unprecedented. They will be both large and small and include technical, payment and covenant defaults as well as over advances. There has never been a period where such a rapid, broad disruption will have occurred. Given the unprecedented nature of recent events, how does a company effectively negotiate its way through?
However serious, a lending default may not be the biggest problem facing those industries that have ceased operations causing cash to stop flowing. Management teams, boards of directors and business owners, face the challenge of projecting a future in the middle of the storm; while our political leadership and the scientific community remain unable to provide guidance on when we will return to normal- and what the “new normal” will look like. What is relatively clear right now is that when we emerge from the current quarantines, the economy we enjoyed before COVID-19 will be very different. In the near term, unemployment levels may be at depression levels; GDP will have dropped significantly; the velocity of money will have slowed to a trickle; and we almost certainly will be in a recession. Will the massive stimulus and bailouts allow us to quickly return to pre-COVID economic conditions? Perhaps, but unlikely. And almost certainly the return will not be uniform across industries, or even within industry groups.
With this uncertainty, how should we move forward? As human beings, our strongest instinct is survival—for business leaders this is true as well. As long as there is some hope, the path toward survival will almost always be taken. (More on that in a minute).
So, what are the legal and financial issues business leaders must consider right now and what steps should they take? Immediately, aggressive planning must be undertaken in an attempt to preserve as many options as possible over the next few months. That planning will require input from existing management, the board of directors, equity as well as legal and business advisors to help decide short- and long-term steps as well as whether the business can or should be saved.
The most obvious first step, maintaining liquidity, will be critical. Without cash, a business cannot restart, let alone ramp back up to full operations. Once the reality of COVID-19 was recognized in the United States, industry was quickly impacted. Many took the hard steps of furloughing workers, negotiating with lenders, landlords and other creditors. Many drew down available lines of credit. Those who have not taken these steps, should exercise all available options to preserve cash. This first step of accumulating maximum liquidity is critical to provide companies with the greatest number of options as we experience a return to the new normal.
With whatever stockpile of cash a company has been able to accumulate, the next step is to forecast near-term liquidity. In terms of survival, planning for next steps and communicating with internal and external constituents, this is a critical tool. For decades, the restructuring community has utilized the 13-week cash flow forecast. This will remain a primary tool during this disruption, but in reality as we sit here today, the only real visibility management will have is probably limited to four weeks. Focus on that period. This forecast should not rely solely on historical patterns. There has been a clear break in the data and as is often said in the financial markets “historical performance does not guarantee future results.” Cash forecasts today are only useful to the point of visibility. Outside of this range, these forecasts are of little use.
The liquidity forecast must consider how your customers, vendors and employees are behaving right now. What happened before is of little use after you experience a break in the data set. What becomes important is your immediate circumstances and theirs—how do you expect them to behave in the near term? Things to consider include:
All of these factors, and more, need to be realistically reflected in your liquidity forecast.
Note: You are your customer’s vendors. If everybody is stretching their vendors to conserve liquidity, you should consider how this impacts your own collections. Many company’s first forecasts are assuming they will get relief from their vendors, but not having to give relief to their customers. While this may be appropriate in limited situations, it should not be a universal starting point.
With cash protected and your liquidity forecasted, the next task will be to determine the impact of any government stimulus money. When will this come in and what are the usage, payback and forgiveness (if any)—and how will you prioritize your decision-making against the potential for forgiveness—terms? Assessing how the government stimulus money will interact with other lending obligations must also be considered. Most businesses that historically relied on outside financing will almost certainly find themselves in both payment and covenant defaults. Any company that has been materially impacted by COVID-19 and has either net income or EBITDA lending facility covenants, will have to revisit how these calculations are going to be affected. For those companies that borrow based on asset values (ABL lending) that may now be in decline, there will be another whole set of issues. Further, cross age, concentration and sub-limit provisions will all need to be evaluated. Thus existing loan documents generally, and the covenants within them specifically, will need to be revised to reflect the new normal for the company.
To buy breathing room and make it to a place where reasonable, longer-term forecasts can be made, a forbearance agreement will likely be needed. In more normal times, forbearance agreements of anywhere from 60 days to six months could be expected. Given today’s uncertainty, it is in both the lender’s and company’s interest to keep this timeframe short. An immediate 30-60 day forbearance timeframe may make the most sense given the limited visibility. This first 30-60 day agreement, and any subsequent short term agreements, should focus on keeping all parties at a standstill. Ideally, they should not include substantive long term changes to underlying agreements. Longer term forbearance agreements can be expected to include new covenants and other substantial restrictions on the business which may not be workable or advisable. Also expect longer-term agreements to include requests for additional paid in capital from outside of the business.
The immediate forbearance negotiation will be more difficult if additional cash is required beyond whatever is currently available on existing lines of credit. It is one thing to seek forbearance on the terms and conditions of the loan, including covenants and formulas. It is entirely different, if the forbearance negotiations include a request for additional availability without good visibility. In the best of times this is a difficult ask from an existing lender; without visibility lenders will only generally consider this request if it is required to protect their immediate position. Lenders will often expect many concessions from borrowers for this request. If at all possible, management teams and sponsors should consider alternative sources of capital for the very immediate term.
The heavy lifting of restructuring the company’s obligations will occur when the longer term accommodations are requested from lenders. At some point, we will have better visibility into what the new normal will look like. At that point, longer term forbearance, concessions and contract revisions will likely be required from your lenders, and from other creditors from whom you took a payment holiday. Some of the issues needed to be considered, include:
If the result of either the preliminary, or longer-term, forecasts suggests that further restructuring or liquidation are required or advantageous within a court-supervised process, then understanding what bankruptcy can offer a distressed business will be essential to management. Bankruptcy provides a respite from creditors through the automatic stay, which prevents collection activity related to pre-bankruptcy obligations. However, to continue to operate, the debtor must still have access to capital to operate the business. One source may be pre-bankruptcy receivables that remain collectible. Another, DIP financing, which was robust before the pandemic, is less clear as to its availability in the current environment. Although reorganization in Chapter 11 may be an option, the sale of a company’s assets also must be considered inasmuch as it provides an efficient forum to dispose of assets free and clear of creditors’ claim, which often enhances the purchase price or at least makes a sale feasible.
One obvious result of the current pandemic is that many businesses will fail and those that survive will need significant professional advice to navigate the multitude of issues they now face. Immediate and aggressive planning have to be undertaken so as to preserve as many options as possible over the next few months. Attention to the fiduciary duties of officers and directors must also be considered. The short-term standstill from creditors should be used to bring together the strongest teams for companies, that includes both internal resources and external advisers. That planning will require input from both legal and business consultants to help decide whether the business can, or should, be saved. By starting early and bringing together a credible team experienced in restructuring, companies will be in the best possible position to be one of the survivors.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.