In our last post, we talked about the borrower making "no default" representations in borrowing notices. In this post, we would like to tell you a bit more about an important case on this topic — The Chase Manhattan Bank v. Motorola, Inc. (pdf). That case highlighted the factors and processes to be considered when deciding whether to certify to no default, and, because of some unusual circumstances, came to a different conclusion than might normally be reached.
First, a bit of background. The borrower in this case had entered into an $800 million bridge facility with a syndicate of lenders. The collateral package included the borrower’s pledge of a Memorandum of Understanding ("MOU") that it had received from its former parent company. (Several years earlier, the parent company had created this company and spun it off, but continued to maintain and operate a network for it. Under the MOU, the former parent company agreed to provide up to $300 million to the borrower to support its loan obligations.) The credit documentation executed in favor of the lenders required the former parent company to make the cash infusion required under the MOU upon the occurrence of a triggering event — i.e., an event of default under the loan, or the failure of the borrower to achieve certain financial targets. Conversely, the former parent company’s obligations could be released and terminated if things were going well — and if the borrower certified to the lenders that there was no default, that it had met certain requirements for its network systems, and that it had obtained committed funding to meet projected costs. The borrower determined that these conditions had been met and delivered this certificate 17 days before the next test of the financial targets (the non-performance of which would have triggered a requirement for the former parent company’s performance of the MOU obligations). The lenders accepted the certificate and agreed that the former parent company could be released from its obligations. Seventeen days later, as of the financial covenant test date, the borrower failed to meet its financial covenants. Indeed, the borrower’s business continued to decline, and it filed for bankruptcy a few months later.
The lenders demanded reinstatement and performance of the former parent company’s obligations, questioning the borrower’s good faith in issuing the certificate and saying that they considered the certificate to be materially inaccurate. The former parent company claimed that its obligations terminated when the lenders accepted the certificate from the borrower.
The court sided with the lenders and emphasized several facts.
Impossibility. First, the gap between the required revenues as of the financial covenant test date and the actual revenues for the borrower around the time the certificate was issued was 25 times. With a gap like that, the court found that the borrower simply could not have achieved the required revenues. In addition, the court found that the borrower could not have met the other requirements under the credit agreement to maintain its systems in line with projections (the needed equipment was substandard and unavailable, and the distribution channels were inadequate). Unlike the situation we see more often, where there may still be a reasonable possibility of meeting the covenants by quarter end, the court found that conditions existing at the time this certificate was delivered would inevitably have become events of default under the loan agreement.
Lack of Good Faith. Second, the court thought that management’s behavior was problematic. The court found that the borrower’s CFO failed to perform significant due diligence to determine whether it could make the required representations, while knowing that the actual results were substantially below targets — and to the court this showed lack of good faith.
Voluntary Certification; Not a Borrowing Notice. Third, the court noted that the borrower was not obligated to issue the certificate, but merely exercised its right to do so in order to terminate the former parent company’s obligations. Arguably, this situation is somewhat different from a borrower that has to draw on a revolving line of credit to stay in business.
The lessons learned from this case are the three "D’s": due diligence, documentation and disclosure. This case serves as a reminder that if the borrower’s performance is substantially short of targets, significant due diligence should be done – and documented – to confirm the borrower’s ability to comply with its financial covenants at the future test date. Due diligence and documentation are even more critical in the case where a borrowing notice is given after the quarter end but before the financial statements are delivered, because the covenants are tested as of the (earlier) quarter end date and the financial statements "speak" as of the quarter end. In that case, the company should consider whether it would benefit from disclosing the possibility of default to the lenders. From the lenders’ perspective, of course, lenders would rather know about a potential default than be misled into thinking all is well. From the company’s perspective, in some cases disclosure can build goodwill with the lenders, and if the lenders are likely to grant a waiver, could be considered as a viable option.