Borrower beware: Share market volatility may impact debt funding arrangements

In the current financial environment, a volatile stock market has repercussions for both financiers and borrowers, who need to carefully consider the terms of their financing arrangements. This update discusses key issues arising from the impact of external shocks on debt funding arrangements.

Substantial write-downs of a borrower's share price are generally disconnected from the underlying value of their assets because market sentiment generally does not have a significant or immediate impact on the underlying assets of a listed entity (particularly where the assets are primarily real property).

However, a significant reduction in share price of a listed borrower may result in its financier considering a renegotiation of the terms of the borrower's debt facility or calling an event of default. The borrower, for whom the certainty of continued funding in accordance with the facility documentation is paramount, would seek to avoid such renegotiation or default.

The resolution of this conflict ultimately depends on the terms of the loan and security documentation.

There are several clauses relevant to considering the rights of the financier in these circumstances:

Review events

These events entitle the financier to review the terms of the debt facility. A review event may be triggered by changes in control of a borrower, in the nature of underlying business or in the borrower's credit ratings. Alternatively, financiers may have a general right to review the facility. In the current climate, the downgrading of credit ratings of some global financial institutions as a result of their exposure to the US sub-prime market may trigger a review event in respect of their own funding. Such financiers will need to determine their right to pass on added funding costs to their borrowers and seek to renegotiate funding terms offered to their borrowers.

Borrowers generally seek to limit such review events, and to be given sufficient time to arrange for refinance, should an event be triggered. However, with the current state of the financial market, if a review event were triggered in relation to a borrower whose share or asset value was significantly written down, or the financier (as a result of its own circumstances) seeks to rely on a general right of review thereby increasing the pricing of the facility or imposing unacceptable terms, the need to refinance existing debt may cause more difficulties than accepting the revised terms.

One consequence of the current market volatility is that financiers may seek to include more review events in loan facility documents, particularly for listed entities. The breadth of the circumstances which constitute a review event may also be increased.

Breaches of Loan to Valuation Ratios (LVR)

While a write-down of a listed entity's shares may not breach LVR conditions in facility documentation, a financier may want to revalue property assets at the borrower's cost. Generally, a financier's right to request a property revaluation at the borrower's cost can only be triggered if an event of default occurs, or otherwise only once a year. If such a clause is included in the facility documentation, the reduction in the value of the listed securities does not necessarily entitle the financier to require the borrower to revalue the underlying property assets.

Financiers may still wish to obtain a valuation at their own cost. If this valuation indicates a reduced value of the underlying property, the consequences resulting from a breach of the LVR ratio or the occurrence of a review event may apply.

Security top-up

If the assets of the borrower offered as security to a financier include listed securities, a significant reduction in market prices may cause the LVR requirement to be breached, resulting in an event of default. It is also likely to trigger an obligation on the borrower to provide additional security to maintain the required LVR ratio.

As the top up security needs to be acceptable to the financier, other listed securities may no longer be acceptable or their value may be discounted by the financier due to the volatile market. It may, therefore, be more difficult for some borrowers to comply with these requirements, and makes it more likely that the borrower will need to agree to amended terms suggested by the financier to avoid the occurrence of an event of default.

Breach of financial ratios

In addition to the LVR covenant, facility documentation generally includes financial ratios which must be satisfied by the borrower, like interest cover ratios and ratios of total tangible assets to total liabilities. These may be breached as a result of a significant write-down in the value of listed securities and can trigger an event of default entitling the financier to demand repayment of the facility.

As the current financial climate can make refinancing such debt difficult, the financier is in a position to negotiate with the borrower to change the terms of the facility. In the absence of an agreement as to the terms applicable going forward, the financier may be entitled to exercise its rights to demand repayment of the facility and withhold future funding.

Events of default

Another event of default relates to the occurrence of a material adverse effect. Often difficult and expensive to establish, financiers will generally only rely on this event of default when the circumstances clearly have a material adverse effect on the borrower's ability to satisfy its obligations under the loan facility, for example, as a result of a significant reduction in its income or the value of its underlying assets.

Financiers may therefore reconsider how to define material adverse effect and include specific circumstances so as to minimise the uncertainty of whether or not the clause can be triggered. For example, short term consequences may be specifically included so as to entitle the financier to rely on such event of default.

Conditions precedent to further funding

In the case of un-drawn facilities, financiers are not required to provide funding unless their conditions precedent are satisfied. Generally, these include that all representations and warranties are correct as at the date of drawdown and that no events of default or potential events of default have occurred or will occur on the date of drawdown. If the documentation includes review events, these may also need to be absent for drawdown to occur.

The borrower may not be entitled to request the financier to provide funding (or further funding) if financial ratios have been breached as a result of market write-downs of the value of listed securities, or other events of default have been triggered, or if representations are made as to shareholder capital or other matters which are adversely impacted upon by the market write-downs.

Going forward, the conditions precedent to be satisfied for drawdown may be broadened to specifically deal with market shocks. This will make it more difficult for borrowers to drawdown funds under debt facilities. Borrowers will need to ensure that the conditions precedent, as well as the representations and warranties and events of default, will not significantly diminish the certainty of funding for a project.

Appointment of investigating accountants

Loan documents often allow a financier to appoint an investigating accountant if it believes that an event of default, or potential event of default, has occurred. Depending on the circumstances and the nature of the event of default clauses, the financier's right to appoint such an investigating accountant may be triggered by the current reduction in market prices of listed securities.

Going forward, even if no event of default or potential event of default has occurred (due to the wording of the relevant clauses), financiers may seek to amend documents to allow them such a right in circumstances where there are significant market movements.

Assignment clauses

Financiers who wish to reduce their exposure to particular borrowers may use their right to assign their interest in a facility to another financier. Borrowers who do not wish to deal with a different financier will need to consider whether they have a right to approve such assignment in accordance with the terms of the loan documents. In addition, borrowers should make sure that any assignment does not increase the cost of the facility to the borrower.

Possible changes to finance documents

In addition to the possible changes to financial documents noted above, financiers may wish to have underwriting type 'outs' in their documents, that is, they may seek to either have a right to review and/or request repayment of the facility if there are significant movements in the stock market or the value of listed securities issued by the borrower even if such movement does not trigger either an event of default or other review event.

Borrowers will need to be careful to resist any such moves as clearly such circumstances are beyond the control of a borrower and do not necessarily affect the underlying business or the value of its assets. In the context of takeover financing, such clauses are not likely to be acceptable as it will be necessary for a bidder to have certainty of funding to be able to fund the takeover.

It is often said that once documents are negotiated and signed, the parties to them tend to develop their relationship with little reference to the strict wording of the documents. Clearly, in the current climate, both financiers and their borrowers need to review existing facility documents to clearly understand their rights and obligations under them.

In addition, both borrowers and financiers will need to carefully consider any changes to documents relating to future facilities which are put forward so as to deal with market conditions such as those currently being experienced.

Peter Faludi, Special Counsel
T +61 2 9286 8159
peter.faludi@dlaphillipsfox.com