Why are banks funding the dash for cash?
In recent weeks, there has been much talk about the dash for cash, meaning companies running to draw down existing credit lines, either preemptively to park cash in their bank account or out of necessity. As revenue drys up, this seems to be a smart move for companies. Yet, given all the market uncertainty, why are banks funding the dash for cash?
There are a few—in many cases overlapping—answers to this question. Likely, at least with respect to some companies, banks are willing to take a bet on companies’ recovery. Also, banks have an interest in helping companies bridge their liquidity gaps. If a company defaults and later becomes insolvent, the bank’s balance sheet would likely have to absorb some of the losses. So better for the bank to avoid a default and provide cash—at least for now.
From a legal perspective, banks will often be obligated to fund the dash for cash. The applicable legal principle says, “pacta sunt servanda” (“agreements must be kept”). What makes things worse for the banks is that the leveraged finance market had been so hot over the last couple of years that documentation standards shifted in favor of companies sponsored by private equity houses. That means that in many cases banks are now locked into agreements that were designed for a different world. In these agreements, there are neither loopholes the banks could use to escape their obligations nor contractual clauses they could use to force a company to come to the table and renegotiate the existing agreement.
Let’s take it step by step. When I refer to a company drawing an existing credit line, I mean that a company requests a bank to fund a revolving credit facility (usually referred to as “RCF” or “Revolver”). An RCF is an overdraft facility or, put differently, the credit card of a company, i.e. a line of credit that was previously negotiated and agreed and that can be borrowed, repaid and re-borrowed at any time, at the company’s discretion.
To see money in its account, a company has to request funding of its RCF with a simple letter. In that letter, the company has to confirm that it has not defaulted on any of its outstanding debt and make certain relatively low bar representations to the bank. Such representations include, for example, that the company is validly incorporated, the governing law of the RCF loan is the law that was agreed upon, and the center of main interests of the company has not changed. Note, that generally it can be quite tricky for a company to make representations if these relate to subjects such as threatened insolvency, legal proceedings, compliance with regulations, or sanctions. Yet, the representations to be made at the utilization date of an RCF are typically quite high level and differ from the stricter and more comprehensive representations made when the RCF is signed.
Can a bank refuse to fund an RCF when it receives a funding request? The short answer is, yes, but only under extreme circumstances. Nowadays, RCF contracts are usually covenant-light (“cov-light”) and do not require a company to meet any financial covenants, e.g. a certain leverage ratio or a similar threshold, at the time of funding.
Only about half of the RCF contracts that I have seen contain a so-called “Material Adverse Change clause” (“MAC clause”), which would allow a bank to refuse to fund arguing that the impact of the Covid-19 crisis has led to a “material adverse change” in the company’s financial condition, results of operation, business affairs or prospects. Yet, the interpretation of a MAC clause is never clear-cut and, especially in times like these, when it is harder to distinguish between companies that are fundamentally sound and companies whose ability to survive is in question, an argument based on a MAC clause can be very wonky. It would take a lot to stand up to a repeat customer from a private equity house and refuse funding on the grounds of a MAC clause.
Finally, once the RCF is drawn, can a bank protect itself and make sure the company does not incur any additional debt? The reality is that market standard documentation affords little protection to banks. Before documentation became cov-lit, companies had to comply with financial covenants as long as any indebtedness was outstanding or at least as long as any portion of the RCF was drawn. Today, the financial maintenance covenant usually kicks in only if more than 35-40% of the RCF is drawn. For example, the financial covenant of the German issuer CBR Fashion requires that the group’s super senior net debt coverage ratio does not exceed 0.46x as at the end of each quarter if more than 35% of its RCF are drawn. That means as long as less than 35% of the RCF are drawn, as currently the case—CBR Fashion has drawn only €10 million of its €30 million RCF, CBR Fashion can incur additional debt without having to increase its revenue.
To conclude, the bottom line is that the Covid-19 crisis took a lot of people by surprise. Ideally, contractual commitments would be adapted to the new situation. Yet, contracts in the leveraged finance market often lack a mechanism that would allow for such adjustment or afford basic protections to banks. This is because documentation standards had become extremely favorable to companies sponsored by private equity during the lead to the crisis. The consequences for banks are that they are now not only exposed to the risk that previously extended credit may go sour but also that they may have to provide more credit to already struggling companies under conditions designed for the old world while the new, post C-19 world is already upon us.
Maria C. Schweinberger