Posted on January 11, 2011 by Susan Alker

Is the Borrower in Default? Sometimes It's Hard to Tell

This post was written by guest blogger Svetlana Attestatova, one of my colleagues in the financial industry group here at Reed Smith.  She answers a question that often comes up at this time of year, when year-end financial statements are being prepared.   

Let’s talk about borrowing money under revolving lines of credit.  Sometimes it's not entirely clear whether the borrower is in default, and there's a question as to whether they can borrow money.  Here are our facts: 

  1. The company needs to draw on its revolving line of credit, and it’s three weeks before the end of the fiscal quarter.
  2. Based on the numbers in hand, the CFO thinks the company may go into default on its financial covenants at the end of the quarter.
  3. The required “notice of borrowing” under the credit agreement requires the company to certify that there is no default at the time of the borrowing.

Can the company borrow the money?

The answer is an all too frequent “it depends.”   It would be helpful to know more.  What if the CFO learns that the company is expecting additional sales that will result in more revenue, and that revenue is expected to come in before the end of the quarter?  Once the revenue is in, the financial covenants would be met and there would be no default.  In that case, the answer is that it’s probably OK for the CFO to certify that there is no default.  If the quarter has not yet ended (assuming the financial covenants are tested only as of the last day of the fiscal quarter, as is typical for many corporate loan agreements), there is still time for the company's performance to improve, and the CFO's belief that there is no default would appear to be reasonable and in good faith.  

Now, let’s change our facts.  What if it’s three weeks after the quarter end.  The CFO has financial data for the quarter that indicates a default occurred at the quarter end, but the financial statements have not yet been completely finalized or delivered to the lenders.  The answer here is that the CFO probably can’t certify that there is no default, and the company probably can't borrow the funds.

A word of caution:  One court found the company to be in breach of its credit agreement when it certified to the lenders that there was no default even before the financial covenant test period ended (similar to our first set of facts).  This was in the "Motorola" case (The Chase Manhattan Bank v. Motorola, Inc., 184 F. Supp. 2d 384 (S.D.N.Y. 2002) (PDF)).  But, in that case the outlook for meeting the covenants was very bleak.  We'll talk about the rather unique Motorola facts in our next post.

And, of course, not every case is as clear as these sample fact patterns -- often, there are many factors that should be considered and weighed (i.e., call your lawyer).   Also, note that most financial covenants need to be tested monthly or quarterly (at the month-end or quarter-end date), rather than being tested on an ongoing basis.  A continuous requirement to comply with financial covenants would change the analysis.  

More on this next time.

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Posted on June 25, 2010 by Susan Alker

False Financial Statements -- Can You Rely on Representations from Your Borrower?

When you want to make a loan, you probably get copies of the borrower's recent financial statements, and you probably take a pretty close look at them as part of your credit process.  You might even ask for more information about certain items that you see on the financial statements.  But how often do you dig deeply behind the financial statements and conduct your own audit?  Probably never, right?

Unless you have reason to think otherwise, it's likely that you take the financial statements largely at face value and rely on representations from the borrower as to their accuracy.  Indeed, nearly every loan agreement contains a representation that the financial statements "fairly present, in all material respects, the financial position of the Borrower" as of the date of the statements and that the statements "were prepared in accordance with generally accepted accounting principles" (or words to that effect).  But what if the representation isn't true?  

In a case decided just yesterday in New York, the lenders alleged that the borrower's representations about its financial statements were false in many important respects.  At issue in the case was the question of whether the lenders should have looked behind the numbers, undertaking a review of the borrower's books and records to discover the alleged inaccuracies.  The court in this case said no.  Even though the court thought there were some "hints" that could have suggested that the financial condition of the borrower wasn't all that it appeared to be, and that the lenders might have been "put on their guard" by some of the facts, the court nonetheless found that the lenders had done enough to protect themselves by requiring the borrower to give representations and warranties as to the accuracy of the statements.  The court specifically stated that the lenders were not required to conduct their own audit or even engage in detailed questioning of the preparers, so long as they included appropriate representations in the loan agreement.  It's possible for inaccuracies in financial statements to be so obvious that the lenders really should question things further up front, but absent those kinds of facts, we wouldn't expect more to be required.

The Loan Syndications and Trading Association (LSTA) noted in a publication sent to its membership today that requiring lenders to conduct an independent examination of borrowers' financial statements could have resulted in a "material disruption" in the commercial lending market.   It's certainly nice to have avoided such an outcome.

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