Quiz Clothes and Victoria Beckham

Last week, Quiz Clothing reported that revenue fell to £17.2m or 73% in the six months to September 30, 2020. Reasons given were coronavirus store closures and the removal of the demand for the brand’s “branded” formal wear.

This news follows media reports in August 2020 that Quiz Clothing had doubled its banking facilities. At that time, it appears that there were no financial covenants applicable to this facility. But given its latest results, if Quiz Clothing had been looking to double its installs last week, the outcome might have been different.

Additionally, earlier in January, auditors of Victoria Beckham at BDO warned that relying on shareholders to provide continued financial support had created “material uncertainty which could cast doubt on the company’s ability to Continue”. This follows Victoria Beckham receiving an additional £9.2m from shareholders in April 2020 to repay monies owed to HSBC after breaching its covenants.

Certainly few UK companies have the luxury of a seemingly unlimited source of alternative funding from an associated party. A significant deterioration in the results/financial situations of UK companies as a consequence of Covid-19 will undoubtedly lead to covenant breaches.

However, does breaching a covenant inevitably mean a bank will take action? If so, what remedies can a lender seek and is there anything a borrower can do to make their case?

What are debts or financial covenants?

Covenants are contractual obligations that banks place on borrowers in facility agreements. The borrower agrees to certain positive or negative actions.

  1. Positive debt covenants to understand:
    • Achieve certain financial threshold ratios (examples below)
    • Agree to provide audited financial statements and other information
    • Ensure that accounting policies are applied in accordance with applicable standards
  2. Negative debt covenants are by comparison covenants that state what a borrower cannot do without the consent of the lender. For instance:
    • Pay cash dividends above an agreed threshold
    • Have key assets
    • Borrow more debt or give collateral (known as negative pledge).

Examples of debt financial ratio covenants

Below are common covenants you often see in loan agreements:

Determine an infraction?

A significant deterioration in a company’s financial health can lead to easily identifiable covenant breaches. This could make the related debt payable on demand before the contractual maturity date. Auditors may then need to reclassify the debt liabilities as due in the current year.

However, loan agreements often include subjective covenant clauses (eg, “material adverse change” clauses) and borrowers will need to exercise judgment in determining whether these subjective covenants are breached. Even if a breach remains uncertain, directors will still need to assess their ability to maintain compliance with the covenants, in order to:

  • minimize the risk of failure to perform their duties as a director/incurring an undue commercial risk (when these obligations come into force again); and
  • decide whether or not to renegotiate the clauses of the covenants with the lenders.

More difficulties in complying with covenants

In the current Covid-dominated economic environment, companies are likely to find it harder to meet covenants. The following circumstances could lead to a material deterioration in financial performance, which could in turn lead to a breach of covenants:

  • decline in customer demand
  • an interruption in production or supply
  • major trading partners are also experiencing financial difficulties and are seeking to restructure terms, and
  • uncertainty about continued government support.

If a breach of a covenant causes the debt to become repayable before the contractual maturity date, then the directors will need to consider the breach as part of a broader assessment to determine the company’s ability to continue in business. as long as continuity of exploitation.

Consequences of breach of covenants

When a debt covenant is breached, depending on the severity, the lender can do several things:

  • Apply a default interest rate
  • Review renegotiation terms
  • Request an increase in the amount of collateral held
  • Demand partial or full repayment of the loan
  • Seek to appoint administrators/receivers.

It is also interesting here to examine whether the banks have learned the lessons of the past? After the last major economic crash of 2008, banks (whose economic instability had caused the problems in the first place) compounded the problem by often charging waiver fees. Faced with reduced fees for arranging new facilities, they demanded payments from existing borrowers to allow facilities to continue, despite the borrower’s violation of existing covenants. However, this comes at a price and borrowers felt they were being blackmailed into paying this breach waiver fee. So far, it has not been widely reported that banks are seeking to enforce them. The government has also stepped in to prevent them from requesting excessive personal guarantees (PG) from directors to back CBIL support loans.

Management and evaluation actions of subjective contractual clauses

As noted above, some loan agreements may include covenants that are not based on financial ratios, making the determination of default more subjective. To assess whether a borrower should renegotiate with their bank to modify borrowing covenants (and in the worst case, whether term loans should be reclassified as current debt), management may need to proceed as follows.

  • review government legislation preventing banks from taking enforcement action in times of Covid
  • review covenants in loan agreements and assess whether a breach has occurred or is likely to occur
  • assess whether it is necessary/possible to obtain a waiver or grace period from the lender;
  • assess the company’s ability to maintain covenant compliance and determine if renegotiation of covenants with lenders is necessary
  • obtain professional advice from its lawyers and financial advisors.

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