Last week Quiz Clothing reported that revenue had dropped to £17.2m or 73% in the six months to 30 September 2020. The reasons given were coronavirus store closures and suppressed demand for the brand’s “trademark” occasionwear.
This news followed media reports in August 2020 that Quiz Clothing had doubled its banking facilities. At that time, it appears that there were no financial covenants applicable to this facility. But given its latest results, had Quiz Clothing been looking to double its facilities last week, the outcome might have been different.
Also, earlier in January , Victoria Beckham’s auditors at BDO warned that reliance on shareholders to provide ongoing financial support had created a “material uncertainty that may cast doubt on the company’s ability to continue”. This followed Victoria Beckham having received a further £9.2m from shareholders in April 2020 in order to repay monies owed to HSBC after breaching its debt covenants.
Certainly, it is the case that not many UK businesses have the luxury of an apparently unlimited source of alternative funding from an associated party. A significant deterioration in UK companies’ results/financial positions, as a consequence of Covid-19, will undoubtably cause breaches of debt covenants to occur.
However, does a breach of a debt covenant inevitably mean that a bank will take action? If so, what remedies can a lender seek and is there anything that a borrower can do to plead its case?
What are debt or financial covenants?
Debt covenants are contractual obligations that banks impose on borrowers in facility agreements. The borrower agrees certain positive or negative actions.
- Positive debt covenants include:
- Achieve certain financial thresholds ratios (examples below)
- Agree to supply audited financial statements and other information
- Ensure accounting policies are applied in accordance with applicable standards
- Negative debt covenants are by comparison covenants that state what a borrower cannot do without lender consent. For example:
- Pay cash dividends over an agreed threshold
- Dispose of key assets
- Borrow more debt or grant security (known as a negative pledge).
Examples of debt financial ratio covenants
Listed below are common debt covenants which you often see in loan agreements:
- Debt / EBITDA
- Interest Coverage (EBITDA/ Interest)
- Debt / Equity
- Debt / Assets
- Total Assets
- Tangible Net Worth.
Determining a breach?
A significant deterioration in a company’s financial health may cause easily identifiable breaches of debt covenants. This could render the related debt repayable on demand before the contractual maturity date. The auditors may then need to reclassify the debt liabilities as payable within the current financial year.
However, loan agreements often also include subjective covenant clauses (e.g. ‘material adverse change’ clauses) and borrowers will need to exercise judgement in determining whether those subjective clauses are breached. Even if a breach remains uncertain, directors will still need to assess their ability to maintain compliance with debt covenants, in order to:
- minimise risk of breaching their director duties/ running wrongful trading risk (when these obligations are back in force); and
- to decide whether to renegotiate the covenant clauses with lenders.
Greater challenges in complying with debt covenants
In the current Covid- dominated economic environment, it is likely that companies will find it more difficult to comply with debt covenants. The following circumstances could cause a significant deterioration of financial performance, which may in turn lead to a breach of debt covenants:
- a decrease in customer demand
- a disruption in production or supply
- key trading partners also suffering financial difficulties and looking to restructure terms, and
- uncertainty over the continuance of Government support.
If a breach of covenant results in the debt becoming repayable before the contractual maturity date, then directors would need to consider the breach as part of a broader assessment in determining the company’s ability to continue as a going concern.
Consequences of a breach of Debt Covenants
When a debt covenant is breached, depending on the severity, the lender can do several things:
- Apply a default interest rate
- Look at renegotiating terms
- Request an increase in the amount of security held
- Demand a partial or full repayment of the loan
- Look to appoint administrators/receivers.
It’s also interesting here to examine whether the banks have learned the lessons of the past? After the last material economic crash of 2008, banks (whose economic instability had caused the issues in the first place), compounded the problem by often seeking breach waiver fees. Faced with a reduction of fees for arranging new facilities, they sought payments from existing borrowers for allowing facilities to continue, notwithstanding the borrower’s breach of existing debt covenants. However, this came with a price and borrowers felt that they were being blackmailed into paying these breach waiver fees. So far, it has not been widely reported that banks are looking to apply these. The Government also stepped in to stop them asking for excessive Personal Guarantees (PGs) from directors to back up CBIL support loans.
Actions for management and evaluation of subjective covenant clauses
As stated above, some loan agreements may include covenant clauses that are not based on financial ratios, making the determination of whether a breach occurs more subjective. To assess whether a borrower needs to renegotiate with their bank to change the borrowing covenants (and in the most serious case whether terms loans need to be reclassified as current debt), management may need to do the following.
- review government legislation preventing banks from taking enforcement action in Covid times
- review covenant clauses in loan agreements and assess whether a breach has occurred or is likely to occur
- assess whether it is necessary/possible to obtain a waiver or grace period from the lender
- evaluate the company’s ability to maintain compliance with debt covenants and consider whether a renegotiation of covenant clauses with lenders is necessary
- seek professional advice from its lawyers and financial advisers.
For assistance in reviewing your debt or financial covenants and the next commercial steps to take, get in touch with the authors of this article or your usual Fox Williams contact.