Coping with Debt Covenants

In May of 2020, we published an article on Managing Financial Covenants for Health Care Borrowers in a Pandemic (here). Managing financial covenants has only gotten harder for health care borrowers in the past two years. Costs have increased, governmental relief has largely ended and many health systems find themselves perilously close (or worse) to their minimum financial covenants.

All of which is to say that even more than during the early days of the COVID-19 pandemic, many health care borrowers are facing covenant defaults, most commonly as to their Debt Service Coverage Ratio (“DSCR”) and/or Days Cash on Hand (“DCOH”). For some borrowers, the question is no longer whether they will trip a covenant, but rather which, when, how badly and what to do about it.

This article provides practical tips for monitoring debt covenants, heading off a default, and, if necessary, managing a covenant default. For all of these strategies, the earlier you take action, the better. For this reason, among others, it is imperative that borrowers understand and closely monitor their covenant compliance on an ongoing basis.

Step One: Just the Facts (Know Your Covenants)

Health system finance teams should have a clear and concise summary of all of their financial covenants, as well as a clear understanding of how each is calculated. Borrowers should maintain models of relevant financial covenants, including their most recent and projected numbers, to see how much margin of error remains and to allow borrowers to experiment with some of the following variables:

1. Where? Where are the covenants? Many borrowers have financial covenants in a master trust indenture, but other documents may modify those covenants and add new ones. These other documents may include bank credit agreements, supplemental master indentures, continuing covenant agreements and leases, among others. The financing documents for all outstanding indebtedness (and any other sources of financial covenants) should be carefully reviewed so that borrowers are certain they have a comprehensive list of their financial covenants on hand.
2. Who? Debt covenants may be calculated on an obligated group basis, a system basis or the borrower may have the option to choose between an obligated group or system basis. Leases or other contracts may impose covenants on specific entities within a system. Know the options for whose financial results must be counted.
3. When? How often are the financial covenants tested (quarterly, annually, semi-annually?), and when are they required to be provided? Is a single covenant failure sufficient to give rise to an event of default, or must there be a failure to meet a covenant for multiple measurement periods before an event of default arises?
4.  What? What, exactly, is being tested? The two most common financial covenants are detailed below, though borrowers may be subject to other or additional financial covenants.
   

   Debt Service Coverage Ratio
   DSCR tests generally have a numerator of “Income Available for Debt Service” and a denominator related to either the prior year’s debt service or maximum annual debt service (“MADS”).

   Days’ Cash on Hand
   DCOH tests are generally tested by dividing a borrower’s unrestricted cash and investments at a given point by the borrower’s operating expenses at the same point and then multiplying that number by 365.

5. Why? Debt-related financial covenants exist to reassure debt holders that a borrower has sufficient financial resources to repay its debt and to give debt holders the chance to force repayment of debt before a borrower becomes insolvent. When facing covenant violations, borrowers should remind investors (so long as it is true) that a covenant violation is not a payment violation and provide assurances as to the borrower’s ability to repay the debt.

Step Two: Preventing Covenant Violations

You’ve found all your covenants, you’ve projected out your results and it looks like a covenant violation is on the horizon. What can be done to stop it?

Once again, time is perhaps the most important variable – the more time a borrower has before a default, the more options they have to avoid or effectively manage it.

1. Improve operations. Increasing revenues and/or decreasing expenses is the most effective long-term strategy, and you don’t have to wait for covenant violation to do so! Hall Render attorneys, advisors and other consultants have myriad strategies for improving the bottom line, all of which are beyond the scope of this article.
2. Change the way the covenants are tested. Many debt documents contain options, such as testing financial covenants on a system versus obligated group basis, or choices as to the assumed interest rate or amortization schedule for balloon indebtedness or variable rate indebtedness. Some documents provide alternative required covenants depending on the measurement period utilized. Play around with these choices to see which way produces the best results.
3.  Change the numbers being tested.
   1. Can entities with poor financial performance be removed from the obligated group? Can entities with good financial performance be added to the obligated group? Often tests for adding and removing obligated group members are based on the prior year’s financial results, so it is important to move quickly if this is a helpful strategy.
   2. If the DSCR has a denominator tied to MADS and debt service is not level, can debt be restructured (even temporarily) to bring down the MADS?
   3. If the DSCR has a denominator tied to the current year’s actual debt service, can the debt service be lowered, by refunding debt, by escrowing funds for the defeasance of debt or by modifying debt such that it becomes short-term rather than long-term debt?
   4. To the extent borrowers can realize gains, avoid realizing losses or can categorize losses as extraordinary, they may also be able to improve their DSCR.
4. Find an exception. Some debt documents have exceptions for covenant violations or events of default if the violation or default was caused due to “force majeure,” which cover acts of God and natural disasters, but also often pandemics and strikes. For borrowers that can show that but for expenses related to a natural disaster, the COVID-19 pandemic or a strike, they would have met their financial covenants. These exceptions may provide covenant relief. There may be other provisions lurking in debt documents that may provide some relief, even if never noticed or used before.
5. Eliminate onerous debt. Borrowers should explore creative options to eliminate debt with onerous covenants, or to reduce debt generally, and thereby improve their DSCR. For borrowers who have identified a problem early, they may be able to refund debt with particularly stringent financial covenants with debt with less restrictive financial covenants. However, in the current interest rate environment, this refunding will often come with an increase in interest rate. Beyond traditional refinancing strategies, borrowers with capital leases may be able to restructure those capital leases to operating leases either with the current lessor or by substituting a new lessor. Some borrowers may consider implementing operating lease sale-leaseback transactions with a nonprofit foundation and use the proceeds to reduce debt, thereby replacing debt with operating lease payments and so improving their DSCR.
6. Utilize the Fungibility of Funds. Many health care borrowers issued debt for new projects in the past couple of years, taking advantage of historically low rates. If a borrower is facing financial hardship but has unused bond funds in a project fund, they may be able to use those funds for other, higher-priority projects, subject to the tax rules relating to tax-advantaged debt (such as funds must be spent at locations included in the TEFRA notice and cannot cause the weighted average maturity of the bonds to exceed 120% of the weighted average useful life of the financed projects). Reallocating proceeds in this way may increase income available for debt service and thus improve the DSCR. Thereafter, borrowers may identify an alternative funding strategy for the project intended to be financed with tax-exempt proceeds, or it may be downsized or abandoned if it no longer makes strategic sense in its original form.

Step Three: Managing Covenant Violations

Sometimes, exploring all the variables and applying all the creative solutions is not enough to stop a covenant violation. The questions then become whether the violation is a “Soft Default” or a “Hard Default” and who is on the other side of the negotiating table. Generally, waivers of default for publicly-traded debt are hard to obtain, given the difficulty in reaching a majority of holders, as well as the need for issuer and trustee involvement. Defaults on bank-held or privately paced debt may be more easily negotiated (as the holder is readily identified).

1. Soft Default/Consultant Call-In. Many debt documents have a phased-in default process, where a DSCR or DCOH may be high enough not to be declared an “Event of Default” but where the borrower is, or may be, required to engage an independent consultant to make recommendations for operational improvements in order to increase the DSCR or DCOH in subsequent fiscal years. For bank-held debt, a bank may waive a consultant call-in if it believes the borrower is making necessary changes on its own, or it may have the right to appoint, or veto the borrower’s selection of, a consultant. For publicly held debt, the borrower will generally be able to select a consultant, though they will generally be required to be independent and a professional management consultant. Generally, the report prepared by such consultant must be provided to the master trustee and may be required to be provided, or made available, to bondholders as well.
2. Hard Default. Most debt documents have financial covenants that, if not met, will constitute an event of default. Generally, a DSCR below 1:1 (though sometimes it must be below 1:1 for multiple consecutive years) will trigger an Event of Default, unless waived by bondholders. An Event of Default may mean:
   1. Acceleration. Bondholders or trustees, if directed by bondholders, may be able to accelerate payment of the debt under which an Event of Default has occurred. Often a certain percentage of debt holders (25-50%) must request acceleration of debt. A borrower facing acceleration needs to be in close communication with its debt holders as to its ability to repay the debt and may wish to explore options to give holders greater comfort on that point (such as the establishment of a reserve fund) to help avoid acceleration.
   2. Cross-Default. Generally, an Event of Default on one piece of debt issued under a master indenture is an Event of Default on all other debt issued under a master indenture. In contrast, an Event of Default under a bank credit agreement may be isolated to that document and not result in a default under other debt documents. Borrowers facing an Event of Default need to be aware of any cross-defaults to avoid a cascading problem.
   3. Credit Market Freeze. Borrowers who are in an Event of Default will generally not be able to access public markets in order to issue new debt (even if to refund the debt giving rise to the Event of Default). Borrowers may still be able to obtain bank loans, but often on onerous terms, with high-interest rates, burdensome reporting requirements and substantial operational restrictions.
3. Waivers, Amendments and Forbearance. For bank-placed debt, borrowers may be able to get a bank to agree to waive an Event of Default or to forbear enforcement of remedies, though often for a fee, and in exchange for additional, more restrictive covenants. In other instances, a lender may agree to amend the underlying documents to modify the covenant that was violated, often to lower the requirements for a period of time and then to ramp them up in future years, again generally for a fee and often accompanied by other new or more stringent covenants. As discussed above, obtaining waivers, amendments or forbearance agreements from the holders of publicly traded debt is often not feasible, but it may be worth exploring with the bond trustee(s) how many persons or entities hold a borrower’s publicly traded debt.

 Practical Takeaways/How We Can Help

• Debt Covenant Review. Hall Render can perform a low-cost review of the scope and scale of a borrower’s financial covenants as well as the implications of various defaults.
• Developing Creative Ideas to Improve Covenants. Hall Render can help borrowers consider the options included in their debt documents and work with borrowers to find creative ideas for restructuring a debt portfolio to optimize financial covenant performance.
• Disclosure Strategies. Hall Render can help borrowers communicate with their lenders and with public markets regarding their current financial situation, ensuring that holders of privately placed debt do not receive more information than holders of publicly traded debt and developing strategies for proactively communicating a likely default.
• Consultant Call-Ins. Hall Render and Hall Render Advisory Services can help identify and engage qualified consultants if a consultant call-in is required.
• Rebuild and Restore. Hall Render can assist clients in considering strategies to repair and restore their financial situation including restructuring of existing debt, monetizing and/or restructuring real estate portfolios and more.

For more information about coping with debt covenants, please contact:

• Your primary Hall Render contact.

Hall Render blog posts and articles are intended for informational purposes only. For ethical reasons, Hall Render attorneys cannot give legal advice outside of an attorney-client relationship.