Economic climate and banking transactions

Answer

It’s not normally a good sign when the economic climate is at the centre of media attention. Indeed, this observation holds true in modern times. Inflation is running rampant and in November 2022 was up at around 10.7%, according to the Office for National Statistics. In November 2022, the Bank of England responded by raising interest rates by 0.75 percentage points to 3% – the biggest rise since 1989. Following this, in December 2022, interest rates were further raised by 0.5 percentage points to 3.5%. This is unlikely to be the last time we see rates rise over the next two years and the Bank of England has warned that the UK is facing a long recession – a sentiment echoed by the Chancellor of the Exchequer. It’s not just the UK grappling with a recession; indeed, it’s possible that the international community is looking at a global recession in 2023.

With this economic outlook in mind, the implications on banking transactions are numerous. A recession is obviously bad news for UK businesses. Company insolvencies in quarter 2 of 2022 were at their highest rate since 2009 – the aftermath of the 2008 financial crisis. If UK businesses are struggling financially, many will seek to rely on the provision of debt finance (ie, banking facilities) to see them through this economic turbulence.

The primary concern of any lender in a banking transaction is that the funds they lend are serviced (repaid) in full. This concern invariably intensifies in times of economic turbulence as lenders fear borrowers may become insolvent. The increased demand for banking facilities means lenders are placed in a position of stronger negotiating power and can insist on favourable provisions designed to protect their position and maximise their chances of recovering monies owed.

In short, banking transactions and the documents involved in these transactions such as facility agreements (ie, the main contractual document that sets out the respective obligations of lender and borrower) and debentures (ie, a security document typically charging much of the borrower’s assets that supports a facility agreement) become more ‘lender-friendly’. This article will examine some of the ways in which these documents become more ‘lender-friendly’, affording lenders greater protection, during a recession.

Financial covenants

Financial covenants are provisions within a facility agreement that detail the parameters, in the form of financial restrictions or targets, that the borrower must operate within – breaching a financial covenant will usually trigger an event of default (see below).

The lender will be conscious not to impose financial covenants on the borrower that are so onerous that a breach is inevitable – that would serve neither parties’ interests. However, in an economic climate where the risk of a borrower’s insolvency is ever-present, the lender may insist on more stringent financial restrictions and loftier financial targets on the borrower. In addition, financial covenants can impose obligations on the borrower to report various financial details to the lender enabling the lender to closely monitor the borrower’s financial performance. Financial covenants can, therefore, alert the lender to deterioration in the borrower’s financial position and, in response, the lender can take early action to protect their position.

An example

A common covenant in a facility agreement is an interest cover covenant. The covenant tests the borrower’s profit versus its interest liability under the loan over the preceding 12-month period. Put simply, if the ratio of the borrower’s profit to the amount of interest payable under the loan falls below a pre-determined level, this covenant will be breached. Borrowers’ interest liabilities under facility agreements are usually floating rates (ie, linked to central bank rates). Naturally, the borrower’s profit can reduce during economic downturn, but as central banks increase interest rates, both components of the test are stressed, increasing the likelihood of a struggling borrower being tripped.

Simultaneously, however, it’s clear the benefit this covenant provides to lenders that wish to closely monitor the financial health of their borrowers and their ability to service the interest payable on their loans.

Events of default

For a lender to take early action to protect their position, an event of default must occur.

In a committed facility, one which isn’t repayable merely upon the lender’s demand, the lender makes funds available to the borrower and the borrower will have to pay the lender back these monies (and some) in the future. Lenders don’t have a right per se to request the immediate repayment of the facility. If, however, an event of default occurs, the lender can obtain a right to request immediate repayment of the monies owed under the facility and/or enforce security – otherwise known as acceleration of the facility.

Ultimately, a lender doesn’t want to wait until the borrower’s insolvency before calling an event of default – they’ll want to be ahead of the curve, and this is why well-drafted and carefully monitored financial covenants are fundamental for a lender. Financial covenants can test the financial health of the company and breach of a financial covenant doesn’t necessarily mean the borrower is insolvent. A breach can, however, indicate that the borrower is heading that way.

It's important to note that events of default aren’t intended to be punitive towards the borrower. Naturally, any missed payments from the borrower to the lender, breaching the terms of the facility agreement, will constitute an event of default. However, a wide variety of events may also constitute an event of default. These provisions reflect circumstances which, in the lender’s view, put the likelihood of the borrower fulfilling their obligations under the facility agreement in such jeopardy that the lender needs to take affirmative action in the form of acceleration to mitigate the risk of non-payment.

It follows, therefore, that in tough economic times lenders are less likely to concede on grace periods affording the borrower time to remedy an event of default. Grace periods could defeat the purpose of the event of default provisions outlined above. If an event of default has occurred, regardless of whether the borrower is subsequently able to remedy the default, the lender’s overarching concern that the borrower’s financial position is such that they may not be able to service the facility in the future will remain.

It’s inevitably in both parties’ interests that the events of default provisions are drafted clearly and in a manner that enables them to assess whether an event of default has actually occurred. The consequences of a wrongful acceleration of the facility could be disastrous for both parties. 

Consequences of interest rate rises 

As interest rates have been historically low for such a long period of time, borrowers are now particularly vulnerable to interest rate rises. Many borrowers have not ‘hedged’ their interest rate liability. Interest rate ‘hedging’ is where the borrower contracts with a third party to periodically pay a fixed sum to this third party. In exchange, the third party pays the borrower a sum that varies depending on the borrower’s interest liability under the floating rate imposed in the facility agreement. In essence, for a fixed sum, the borrower essentially achieves fixed interest liability under the facility – it’s the third party that, in exchange for a premium, takes the risk of adverse interest rate fluctuations.

Having been in a low interest rate environment, many borrowers haven’t thought it necessary to pay the premium associated with hedging products to protect themselves against interest rate rises. This is undesirable for both the lender and borrower under a pre-existing facility agreement. Going forward, lenders may insist that as a condition of the facility, borrowers acquire hedging protection to ensure they’re protected against further interest rate rises. 

The security package

The borrower will provide security to the lender. Security provides the lender with rights against specific assets offered by the borrower to the lender. A mortgage is a form of a security that most people are familiar with but, in the context of a security package supporting a banking facility provided to a commercial borrower, many forms of security can be offered including mortgages, fixed charges, floating charges, pledges and liens. The type of security will usually need to be considered against the class of asset and ability of the borrower to use its assets and continue its business. For example, a mortgage transfers legal title of the asset to the lender – this might not be appropriate for a borrower’s stock.

Lenders will want to ensure they have the best possible security package supporting the facility agreement. This will often mean that they take as much security over the borrower’s assets as possible (often, over all the business’s assets). Security provides the lender with rights such as seizure and sale against the borrower’s assets in addition to their contractual rights under the facility agreement. The lender’s contractual rights will not be much use, of course, if the borrower becomes insolvent or is teetering on the verge of insolvency. Lenders without security are known as unsecured creditors and unsecured creditors tend to fare poorly in recovery of monies owed once the insolvency process commences.

The importance for a lender of negotiating a comprehensive security package supporting the facility agreement cannot be understated. Borrowers expect to be required to give security and the provisions under the security agreement may therefore be subject to less intense negotiation in comparison to the events of default or financial covenant provisions. As well as a debenture, a lender may require a personal guarantee from a director of the borrower or a guarantee from the borrower’s parent company.

In tough economic conditions, the lender will be acutely aware of the possibility that the security provided may need to be relied upon and this elevates the security provisions to the forefront of a lender’s considerations. As part of the due diligence process, the borrower will likely provide the lender with exhaustive details of the properties they own, their bank accounts, their shares, stock, equipment and much more. The lender will consider which security is appropriate in the circumstances for each asset class and the security documents will be drafted to reflect this.

In the background, lenders may instruct lawyers to review existing security portfolios to satisfy themselves that, in the event the security needs to be relied upon, the existing security is enforceable should the need arise.

To enforce or not to enforce

Enforcing security is to some extent, the nuclear option. It can spell the end of the commercial relationship between the lender and the borrower as well as having consequences for both parties. Although a lender may be entitled to enforce its security, the reputational impact of taking this step against a borrower (that is, after all, their customer) may outweigh the value of the outstanding debt.

As mentioned, the lender’s primary concern is to ensure that the monies they’ve provided to the borrower are serviced in full – enforcing security immediately may not always be the best way of addressing this concern. The value of the secured asset(s) may not cover the outstanding loan. Where lenders acquire a right to enforce security as a result of the borrower’s event of default, they may therefore opt against exercising this right.

Instead of exercising a right to enforce, the lender may waive the breach or insist that the borrower comes back to the negotiating table and the facility agreement be renegotiated and restructured. In this situation, the lender is clearly in a strong negotiating position. If the lender has reviewed its security portfolio under the facility agreement and spotted any gaps, this can be its opportunity to ensure that these gaps are plugged. The lender may insist that the borrower provide an equity injection into the facility, reducing the overall sums owed by the borrower to the lender under the facility. Going forward, the lender can insist on enhanced amortisation under the facility – essentially reducing the time afforded to the borrower to repay sums owed by way of more frequent repayment instalments and/or requiring greater sums payable in respect of each instalment.

The question as to whether to enforce or not to enforce will be finely poised and dependent on the relationship between the parties, the severity of the event of default and a myriad of other commercial considerations.

Conclusion

At the best of times, negotiating documentation for a banking transaction is time-consuming and complicated with borrower and lender having different priorities and concerns – and we’re certainly not in the best of times at present. Each facility agreement will look different, and some borrowers will be able to resist the tightening of provisions in the lender’s favour. In general, however, with the risk of borrower insolvencies increasing during a recession, it’s envisioned that documents involved in banking transactions will become more ‘lender-friendly’ as lenders seek to mitigate the financial risk to themselves of a borrower becoming insolvent during the life of a facility.

Thomas Wilkinson is a trainee solicitor at Shoosmiths.