Appeal of Shared National Credit (Fourth Quarter 2014)
A participant bank appealed to the ombudsman the decision rendered by the interagency Shared National Credit (SNC) appeals panel to require cash basis nonaccrual treatment for an asset-based lending (ABL) revolving credit facility reviewed during the 2014 SNC examination.
The appeal asserted that the facility should be on accrual status, as assets supporting the revolving facility were deemed fully collectible at the time of the review. The bank disagreed that the deterioration in the borrower’s financial condition would negatively affect full repayment of the ABL facility. If the borrower filed bankruptcy, the appeal acknowledged uncertainty regarding future debt repayment of other third-party debt in the borrower’s capital structure, which may not have adequate or liquid collateral protection. The bank argued that three possible exit strategies were available to the lenders of the ABL facility in the case of a bankruptcy, all of which would enhance full repayment of the facility. The appeal stated that the facility is well collateralized with liquid assets with advance rates within OCC policy guidelines and supported by periodic field exams and appraisals.
The appeal disagreed with the decision to perform the facility’s risk rating analysis using a cash flow basis. The bank stated that the primary source of repayment for the facility is the conversion of receivables and inventory into cash with a current collateral cushion of 1.2 times. The facility is structured and monitored so that the collateral will be readily available if the loan must be liquidated. Additionally, the loan agreement provides the lenders with reasonable discretion to implement reserves or change the borrowing base structure to help ensure full repayment, in the event of further credit deterioration.
The appeal argued that borrowers accessing the availability of funds from an ABL facility for non-working capital purposes is not uncommon and should not be a factor in determining the nonaccrual designation. The bank believed that charging of interest due from the borrower to the ABL facility satisfies the criteria outlined in Examining Circular 229, “Guidelines for Capitalization of Interest on Loans.”
The ombudsman conducted a comprehensive review of the information submitted by the bank and the SNC appeals panel and relied on supervisory standards outlined in the Comptroller’s Handbook booklets “Asset-Based Lending” and “Rating Credit Risk,” the instructions and glossary sections of the Consolidated Reports of Condition and Income (call report), and Examining Circular 229, “Guidelines for Capitalization of Interest on Loans.”
The Comptroller’s Handbook booklet “Asset Based Lending” provides guidance on when it is appropriate to risk rate an ABL facility on a liquidity basis versus cash flow basis. The ombudsman concurred with the appeals panel to evaluate the ABL facility on a cash flow basis.
The company’s liquidity (measured as cash balances plus availability under the ABL facility plus the cash flow revolver) was not sufficient to cover projected cash burn through the end of 2014. In addition, the company is projected to generate negative free cash flow going forward and, based on those projections, will not be able to repay funded senior or term debt under reasonable amortization terms. Liquidity is projected to further deteriorate and a restructure appears likely in the near term. Refinance risk is high given the company’s repayment capacity, high leverage position, poor liquidity, uncertain turnaround plan, and weak industry outlook. The potential for bankruptcy filing is high.
The glossary section of the call report provides the applicable standards for nonaccrual and loan impairment. In applying these standards, the ombudsman concurred with the appeals panel that nonaccrual treatment with cash basis interest income recognition is appropriate for this facility because full repayment of principal or interest, according to the contractual terms of the original loan agreement, is not probable. This is due to the company’s ongoing deterioration in operating performance and cash flow generation, severely constrained liquidity, weak performance relative to original projections and budget, high leverage, inability to reasonably amortize debt, and declining and low excess borrowing base availability. Additionally, standard ABL control features are springing in nature and not fully in place. Fully functional controls would include effective lock box, full cash dominion, and sweep of proceeds to revolve the facility at an adequate pre-determined application rate, as well as a reasonable period of performance to evidence satisfactory functioning of the controls. As long as the facility is adequately secured, interest income should be recorded on a cash basis. Current collateral prevents more severe classification based on the most recent borrowing base certificate, field audit, and inventory appraisal.
In applying the standards from Examining Circular 229, the ombudsman determined that the borrower’s weak operating performance, highly leveraged balance sheet, and low and declining liquidity do not support the capitalization of interest.
Well-defined weaknesses exist for this ABL facility and the bank agrees with the substandard rating. Given the well-defined weaknesses and uncertainty of future ability to repay the debt according to the contractual terms, capitalization of interest is not appropriate, and the ABL revolving credit should be maintained on nonaccrual status, with any payments received recorded as income on a cash basis.