Regulatory Relief

I had a lovely conversation with an old friend yesterday. Knowing that he’s running a business that will be hurt – perhaps devastatingly – by the present shutdown of large parts of the US economy, I had called to offer moral support. We spoke for quite a while about our families and the travails he’s facing in his business. In the course of our conversation, he reminded me that the business that I had helped run survived the 2007-2008 Great Recession relatively unscathed only because we had had the great good fortune of having gone into that storm with a so-called covenant-lite (i.e., no covenant) bank facility.

That absence of ratio-based financial covenants allowed our company to sail on – in spite of calamitous losses that could’ve triggered a forced sale of assets at fire sale prices to repay our debts if the banks had had the right to force such an action.


We know that the banks would have pulled the trigger provided by defaulted ratio covenants if they had had such a trigger because of how they behaved when we asked them for an eminently sensible amendment to the terms of our deal in the midst of the crisis. The bankers’ behavior that made that conclusion clear was described in my extended post Scenes from a Life in Business:

 While, when the Great Recession hit, we didn’t know that we wouldn’t go broke even without the banks taking hostile steps, having to fight the banks could only make matters worse. We had to radically restructure our business model if we were to survive long enough to have the chance to thrive again.

The most tempting target for cost cutting was a subsidiary that (as a direct result of the Great Recession) was losing enormous amounts of money. It had three huge fixed-price contracts with suppliers – each of which worked, and was friendly, with the other two, rather like a bank group – at prices that, if left untouched, would guarantee losses for years to come. So bad were the numbers in that subsidiary – which was not vital to the parent company’s over-all strategic positioning – that they might actually sink the mother ship.

One plausible solution for us was to abrogate the subsidiary’s unfortunate contracts with its suppliers by having it – the subsidiary – declare bankruptcy. Our company’s over-all financial position would be dramatically improved by such a move, because it would immediately stop the subsidiary’s losses that we were funding. The biggest impediment to this approach, from our perspective, was that while the parent company’s (i.e., our) bank deal didn’t have any financial covenants, it did have a provision that the loans would be in default (which would enable bank enforcement action) if any of our subsidiaries went bankrupt.

I called the banker at our lead bank – one of the biggest in the country – and explained to him that our operating results would be immeasurably improved if we were to let go of the subsidiary, but that we couldn’t do so because of the provision I’ve just described (so we were looking to them to waive that provision in our mutual interest). We couldn’t be expected to hand the banks a loaded gun (in the form of a default).

The banker was a friend of mine – somebody I had known for nearly a decade. We had had meals with spouses and on several occasions he and I had gone skiing together. He told me he would run our request for a change to the deal, enabling us to put the subsidiary into bankruptcy, up the flagpole. It couldn’t have been a very big flagpole – he was a senior guy.

When my friend called back he explained that they would let us out of the provision – for an eight figure amendment fee. He explained that they knew that the change was in our interest – and in theirs, as creditors – but they needed to get the ridiculously huge fee (a more customary amount might have been in the low six figures – enough to pay for the paperwork) because our loans were trading at something like seventy cents on the dollar in the secondary market, and they needed to get back the money that they would be notionally losing by setting aside loan loss provisions based on the secondary trading values.

I told him that that was ridiculous – they were trying to charge us a fortune for prospectively doing something that it was in their interest that we do – and besides, the loans of virtually every company in our industry and related industries were underwater, and would recover as soon as the panic went out of the market. By charging such a fee – or maybe forcing us to go on operating the subsidiary at a loss – they would in fact be putting another nail in our coffin and further endangering their loans to us.

My friend agreed, but said he had his marching orders. I told him to tell his bosses to get lost – they were being way too greedy, and we would find another way out of our problem.

The CFO and I then flipped the script. We bluffed our way out of the problem (by renegotiating our subsidiary’s contracts with its suppliers)…


The ironic effect of the fact that we had a covenant-lite bank facility during the Great Recession is that the banks’ powerlessness to force our company to liquidate – or even to extort a huge fee from us – ultimately worked to everybody’s benefit. The market recovered and we ended up repaying our loans in full; meanwhile our employees’ – and our – jobs were saved. Even our equity values came back, and then some. If we had had to sell at the bottom of that fierce recession – when there were no buyers (which we know, because we tried to sell a prized asset to improve our liquidity position and no buyers showed up) everybody would have lost, the banks included.    

The now-retired banker who tried to hit us for an eight figure fee (which, needless to say, was the last thing we needed to pay in the context of our fight to survive) is still a friend – indeed, he’s an at least occasional reader of these posts, so he may well be reading this with a smile. I never blamed him for trying to extort a huge fee from us. He was “just following orders” to be sure, but the more fundamental reason for my forgiving attitude – even at the time – is that I knew that his institution’s hand was being forced by the banking community’s regulators. Which brings me to the point of today’s post:

Just as the bank that then employed my friend was in effect forced to deal as harshly as possible with companies that were severely underperforming (as our company was at the time, along with essentially all of its direct competitors) by its regulators, so today’s banks may be forced to take action against the innumerable companies that will experience covenant defaults as a result of the present coronavirus-related shutdown of large segments of the US economy.

In ordinary circumstances, loan covenants perform an important function. If a company is doing much worse than it had led the banks to expect it would, the bankers need to know that and to be able to take actions designed to protect their capital. (In my career, I spent seventeen years as a banker, then another seventeen as an entrepreneur and an executive of a rapidly growing company that borrowed – and repaid – hundreds of millions of dollars, so I have lived with – and fully understand – the logic of both sides of loan transactions).

The regulators, for their parts, want to know when banks have a lot of troubled loans; they react to rising default rates (both covenant and payment defaults) with understandable alarm – and twist the arms of banks with a lot of troubled loans to force solutions on the troubled borrowers and/or raise very expensive new capital. Again, in ordinary circumstances, these regulatory attitudes make sense because the regulators know that the US Government – i.e., the taxpayer – effectively backstops the banks. They want to nip troubles in the bud by pushing banks to be vigilant.   

These, however, are not ordinary circumstances.

Over the next few months, innumerable small and midsize businesses – and some large ones – will undoubtedly be defaulting on some or all of their financial ratio covenants; some might also have payment defaults, which are much more serious. The Coronavirus-related hard stop in business activity in many sectors of the economy is no ordinary business-cycle recession – it’s not even analogous to the severe Great Recession of 2007-2008. For many companies, it’s a full stop.

This – hopefully brief – cessation in business activity, followed at best by a gradual recovery, does not reflect poorly on the judgements or characters of managements of the defaulting companies – as, arguably, defaults often do.  It is a true example of force majeure. As such, at the discretion of the banks (which should know a survivable company from one that is doomed), most financial performance-related covenants should be suspended for six or nine months – and the operating results of that period ignored for purposes of future financial ratio covenant calculations – without any regulatory penalty.

Would such regulatory lenience mean that the banks’ portfolios just became a bit more risky? Yes. But guess what: they already have. And such regulatory lenience would give the companies that have good prospects of fully recovering the opportunity to do so, and thereby reduce the immediate prospect of millions of unnecessary job losses.

Sometimes, common sense is more valuable than regulatory firmness; this is one of those times.

I’m confident that my friend’s company will survive – and eventually thrive again; But it – along with the rest of the economy – will recover much more quickly with the kind of regulatory flexibility that I’m arguing for herein.

M.H. Johnston   

2 comments to Regulatory Relief

  • DP  says:

    100% correct Mark and a compelling narrative. Send it to the Treasury Secretary. The banks will not act on their own or singly.

  • RC  says:

    Mark – Great to read another one of your life lessons, and excellent business story. And even better that not a single element relates to politics, left, right, Republican, or Democrat. Very refreshing… Thank you.

    Stay healthy, stay safe.

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