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Appeal of Shared National Credit (SNC) Appeal Panel's Rating of a Credit Facility as Substandard Nonaccrual (Fourth Quarter 2009)

Background

A bank appealed to the Ombudsman the decision by the SNC appeal panel to rate an asset-based lending (ABL) facility as Substandard Nonaccrual. The appeal specifically disagrees with the nonaccrual designation.

Discussion

Appeal

In its appeal, the bank states that it agrees with the general rule for placing a credit facility on nonaccrual; however, bank management cannot reasonably conceive of any circumstances where full collection of principal and interest would not occur on an ABL. Management asserts the structure of the facility insures ABL facilities are well collateralized, and interest and principal will be repaid in full by the loan's contractual terms.

In the worst case scenario which the bank feels has a remote probability of occurring, the company would be forced to reorganize under the protection of Chapter 11 of the Bankruptcy Code. Under this scenario, the bank asserts that it is highly likely this facility would be repaid at inception of the bankruptcy case given the loan is collateralized by the company's accounts receivable and is a minor part of the overall capital structure. Alternatively, but less likely given the small size of the facility, the lenders to this facility may agree to continue to provide the facility as part of a Debtor In Possession financing in bankruptcy.

The appeal further asserts that it is not relevant whether a company decides to drawdown an ABL facility and holds its cash or pays down the facility and has less cash and greater availability. Under either scenario, the company's liquidity is the same. Finally, the appeal states that under the structure of the facility, the company's outstanding balance cannot exceed the accounts receivable borrowing base less $50 million without triggering additional controls including full cash dominion, weekly borrowing base reporting, and a fixed charge coverage test. Should the bank's borrowing base decline either due to contraction in accounts receivable or more accounts becoming ineligible, the company would be required to make a pay down to bring the borrowing base back into compliance. The company's liquidity would permit it to make any pay down that may be necessary.

Supervisory Office

The original SNC voting team considered the facts and circumstances surrounding the credit quality of the obligor, collateral, and loan structure in deriving the nonaccrual decision. Among the primary drivers of the decision were the company's extreme leverage, inadequate capitalization, ongoing deterioration in operating performance and cash flow production, performance relative to projections, and overall enterprise value relative to senior secured and total debt. Factors relevant to the asset-based structure of the revolving credit were also considered in the analysis of the credit facility. The examiners found that the margin on the accounts receivable (AR) was very thin. This was a continuation of a declining availability trend since the initial funding of the facility. Monitoring processes and control environment are critical in assessing the credit risk mitigation afforded by an ABL structure.

To qualify as a favorable decisive factor in a continued accrual assessment of a troubled borrower, in most cases the control feature of the loan facility should be fully vested and functioning. This would include effective lock box, cash dominion, and sweep of proceeds to revolve the credit facility at an appropriate pre-determined application rate, as well as a reasonable period of performance to evidence satisfactory functioning of the controls. The downward trend of the borrowing base since funding, the very low availability margin, and the increasing past due levels identified by the last field audit raised significant concern regarding the principal and interest protection afforded by the collateral and the revolving credit structure. Without the fully implemented control environment, a higher level of risk exists until the controls are fully enforced and tested.

The SO concludes the obligor exhibits a variety of well-defined weaknesses and performance issues that indicate full collection of principal and interest is questionable. The control environment of the asset-based revolving credit facility as structured is not sufficient to provide prudent justification for continued accrual status for the facility.

Conclusion

The Ombudsman reviewed the bank's appeal and conducted a comprehensive review of the documentation supplied by the SNC appeal panel. He relied on the definition of nonaccrual as defined in the glossary of Call Report instructions and the Comptroller's Handbook for Rating Credit Risk as the standard for his analysis.

The Ombudsman stated that when determining the accrual status of a credit, consideration is given to the financial strength of the borrower as well as the underlying collateral. With regard to this facility, the combination of the company's distressed financial condition and the lack of existing collateral controls casts doubt as to full collectibility of principle and interest. The borrower is highly leveraged with ongoing deterioration in operational performance and cash flow production. The mere existence of a borrowing base to maintain a minimum loan to value ratio is not sufficient protection to eliminate risk of loss. Controls such as full cash dominion, weekly borrowing base reporting, and fixed charge coverage are not triggered until the company exceeds a defined threshold. Delaying implementation of these controls until the company shows further signs of distress diminishes their effectiveness.

Based upon his analysis, the Ombudsman found the substandard nonaccrual rating assigned by the SNC appeal panel appropriate and consistent with guidance provided in the Comptroller's Handbook for Rating Credit Risk.