The COVID-19 Forbearance Challenge
In light of the exceptional circumstances of COVID-19, Speciality Finance businesses (e.g. auto finance providers, SME lenders, first and second mortgage providers, consumer finance providers, and equipment leasing providers) are facing significant challenges in implementing forbearance schemes including payment deferrals for customers. These challenges apply regardless of whether forbearance is being granted to comply with regulatory measures, including the complex regulatory requirements of the Consumer Credit Act 1974 (CCA) (if applicable), or in responding to customer requests for forbearance irrespective of government or regulatory intervention.
Structure of Specialist Lender funding arrangements
Increasingly Speciality Finance businesses take on private debt (wholesale financing or conduit/private securitisation funding arrangements) to ramp-up their portfolio before looking to the public rated securitisation markets as an alternative source of funding. In each case, funding is provided against the underlying eligible portfolio up to a specified advance rate (the borrowing base calculation).
Impact of Forbearance on Speciality Finance Funding Arrangements
Whilst forbearance schemes (including payment deferrals) implemented by Speciality Finance businesses permit their customers to make no payments (or a £1 token payment only) for a specified period without being considered to be in arrears, the issue is the impact of forbearance-affected portfolio assets on Speciality Finance businesses under finance documentation with their own funders.
Notwithstanding regulatory authority official guidance*, the default contractual position under such finance documentation tends to be that forbearance-affected portfolio assets are caught by the rescheduled, arrears and defaults definitions thereby affecting borrowing base calculations and performance and portfolio covenants and leaving such Speciality Finance businesses in a vulnerable position.
To date, many private debt funders have been reasonably pragmatic and understanding of the forbearance challenges faced by their existing Speciality Finance customers. Where Speciality Finance businesses have engaged early with their private debt funders, provided weekly financial information as required, undertaken considered analysis of the potential impact from COVID-19 and prepared realistic projections, then those private debt funders have looked to support such businesses in granting forbearance to customers on a loan by loan basis, subject to the FCA forbearance guidelines (if applicable) and in line with agreed updated servicing and collection policies.
In some instances private debt funders have consented to Speciality Finance customers treating COVID-19 related rescheduled and arrears receivables as eligible assets for the purposes of the borrowing base calculation (in circumstances where such rescheduled or arrears receivables would otherwise have fallen outside of the eligibility criteria) and have approved a freeze on arrears, but in each case only for customer receivables to which forbearance has been granted for a 3 month (or shorter) period and only where such forbearance is granted during an agreed timeframe, thereby avoiding breaches under these financing arrangements in the short-term and the resulting early amortisation or event of default triggers.
Such accommodation by private debt funders has necessitated the documenting of amendment agreements to the finance documentation. The trade-off for such accommodation has typically been prohibitions on distributions to equity providers (encouraging the building up of cash reserves) as well as, in some instances, stoppage on the origination of new business (sometimes save for originations to key workers).
As for public securitisation, a number of structural mitigants (such as overcollateralisation) have resulted in public securitisation being reasonably resilient under COVID-crisis circumstances to date however as cash flow reductions continue and cash reserves are depleting, portfolios are becoming more stressed with a number of tranches having been downgraded or put on watch.
Longer-term repercussions and the Funding Gap
As the impact of payment deferrals, rescheduling of customer debts and defaulted loans continues and with it the deterioration of cash flows, Speciality Finance businesses will be forced to continue seeking funder consents. As time evolves, consents will not just be required for borrowing base breaches and performance and portfolio covenant breaches but also for events of default such as cross default, insolvency, insolvency proceedings, audit qualification, cessation of business, expropriation and material adverse change (which, in each case, in certain private debt funding structures may apply to the wider group). Consents are also expected to be required for delays to delivery of financial information such as audited accounts and quarterly audits. Typically the obtaining of consents is more straightforward for private debt transactions which do not require the same formal noteholder consent processes as may be required under public securitisation and which can take time to obtain. It is however expected that funders may be less likely to provide consents where government schemes and regulatory guidance impose longer payment deferrals which would further impact cash flows.
Generally, private funders are not permitting the usage of cash reserves for equity distributions. In some instances new originations have been restricted and in other instances further utilisation of facilities has been restricted, reduced or paused, equity cures have been implemented and/or additional equity investment has been encouraged. Specialist Lenders should consider whether a breach of funding arrangements crystiallises an event of default or step in right in favour of existing investors - this might have an impact on board control (i.e who makes decisions going forward) and how new money to bridge any shortfall goes in (e.g could other shareholders be swamped?).
Servicers should consider the impact of forbearance on their duties and servicing standards (such as taking actions reasonably expected of a prudent lender and with a view to recovering all amounts due from customers) alongside approved servicing and collection policies. In circumstances where forbearance results in events of default being triggered under finance documentation, a servicer termination event could occur, resulting in a right for the funder to replace the group servicer with an independent standby servicer.
Additionally, as the COVID-crisis continues and as markets come under increased pressure, public rated securitisation may become subject to downgrade triggers. Typically credit rating agencies require that downgrade triggers apply to public securitisation counterparties such as account banks, paying agents, cash managers, liquidity facility providers and hedge counterparties to mitigate structural cash flow credit risk.
We expect that over the coming months alternative sources of funding will need to be considered by Speciality Finance businesses (such as government schemes for SMEs, private equity funded debt, new shareholder money or otherwise) to ensure that existing portfolios are not forced into rundown and that new opportunities can be pursued. In respect of their funding arrangements, we expect that Speciality Finance businesses will have particular focus on the following in upcoming months:
- Maintaining open and frequent dialogue with their existing funders
- Exploring equity availablity from existing and new investors and/or shareholders
- Seeking interest from new funders and considering any access to government schemes
- Reviewing finance and servicing documentation to establish potential breaches
- Reviewing investment documents to asses what impact any breach of funding or servicing may have, in particular in respect of step in (or similar) rights
- Seeking clear waivers of actual and anticipated breaches
* This is referring to guidance issued by the European Banking Authority in relation to the regulatory treatment of assets subject to COVID-19 related forbearance, including in relation to interpretation of the Capital Requirement Regulations (CRR).
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Partner, Finance - Structured Finance and Securitisation & Funds Finance
Partner, Finance and Head of Structured Finance and Securitisation
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Legal Director, Finance - Structured Finance and Securitisation