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A large bank appealed to the Ombudsman of the Office of the Comptroller of the Currency (OCC) the decision by the Shared National Credit (SNC) Appeals Panel to assign a risk rating of substandard to an asset-based lending (ABL) revolving credit facility. Specifically, the bank believed the facility exhibited a low risk of default and low risk of loss in the event of a default, which does not support a substandard rating.
In its appeal, the bank stated that it acknowledged that the low cash dominion threshold level and lack of financial covenants of the ABL facility are less robust terms than current market practice. These factors alone, however, do not support the SNC Appeals Panel’s conclusion of substandard or the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. The bank further asserted that the panel focused on company cash flows and did not take into account the key structural protections for lenders inherent in the accounts receivable and inventory financing (ARIF) structure. Therefore, the panel gave insufficient weight to the extremely low risk of default and low risk of loss in the event of a default based on the composition, value, and liquidity of the collateral.
The appeal provided the following support that the ABL facility does not meet the regulatory definition of a substandard credit: (1) the ABL is unused, and it is unlikely the company will use the line of credit before maturity; (2) a news release announced that the company intends to launch a multimillion dollar registered rights offering and pursue the refinancing of its outstanding indebtedness; and (3) the bank’s credit loss experience for its ARIF portfolio is very low.
The SNC Appeals Panel weighed the adequacy of the structure and controls of the ABL facility and the strength of the operating performance of the borrower in assigning the substandard rating. The panel stated that the facility has an inadequate cash dominion threshold, which does not allow the bank to exercise full control over cash until availability on the revolver is less than 5 percent of line availability. This creates a significant potential for over advances. The panel further supported a substandard rating based on the lack of financial covenants, a lax credit agreement, no cash flow recapture provision requiring excess cash flow to be applied to debt repayment, deteriorating liquidity with reliance on factoring, poor performance compared with budget, a fixed charge coverage ratio below 1.0, high refinancing risk, and high default risk.
The Ombudsman conducted a comprehensive review of information submitted by the bank and the SNC Appeals Panel. Two Comptroller’s Handbook booklets—“Rating Credit Risk” and “Accounts Receivable and Inventory Financing”—were the standards for the Ombudsman’s analysis.
The primary consideration in credit risk assessment is the strength of the primary repayment source. The ARIF booklet states the primary repayment source of an ABL credit is the dedicated cash flows from the conversion of working assets. Decisions on risk rating must take into account whether sources of repayment produces sufficient cash flow to service the debt as structured, collateral value, and collateral liquidity. Because greater emphasis is on collateral (than in cash flow lending), an ABL facility should be structured so that collateral is readily available if the loan must be liquidated. Any laxity in the bank’s monitoring and control of the collateral can diminish protections afforded by collateral and lower a loan’s risk rating. Inappropriate structure can also be a significant factor in assigning an adverse rating.
Per the “Rating Credit Risk” booklet, the terms “probability of default” and “loss given default” are not used in the regulatory rating definitions, but the concepts are inherent to them. Probability of default measures repayment capacity—the higher the probability of default, the weaker the primary source of repayment. When repayment capacity exhibits well-defined weaknesses, analysis shifts to the strength of the secondary sources and the potential or expected loss. Collateral and other protective structural elements have a greater bearing on the rating. Poor structure may require classification even though the likelihood of default is low. Regarding loss given default, the amount of loss is generally affected by the quality of underwriting, including establishing conditions and protections that allow the bank to control the risk in the credit relationship.
The Ombudsman analyzed the ABL facility based primarily on liquidity, structure, and quality of controls over the collateral and secondarily on the financial performance of the borrower. The Ombudsman found that the bank made valid points regarding the self-liquidating nature of the collateral; however, the bank does not have sufficient control over that liquidity. Low cash dominion threshold, absence of restrictions on asset purchases, and lack of financial covenants were critical elements that substantiated weak structure and controls. In addition, the borrower accelerated its granting of extended terms to aftermarket customers, with long-term accounts receivables increasing dramatically during the period of review. These longer-term receivables do not qualify as eligible collateral against which to borrow. Lastly, while there were no draws on the facility, the credit agreement allows the borrower to use cash and other liquidity sources to make substantial investments in other ventures without limit or any control or approval from the lender group. There are insufficient controls to prevent the company from drawing on the line or making the aforementioned investments before loan maturity.
Given the weaknesses in controls, the Ombudsman gave more weight to the borrower’s financial performance and liquidity trends. While cash flow is not the primary source of repayment for an ABL revolver, it is an important part of evaluating the overall soundness of the borrower. Based on a review of financial information, the borrower has experienced significant negative trends over the last two years including high net losses, deficient cash flow, insufficient fixed charge coverage ratio, marginal liquidity, and a reliance on factoring to support liquidity. In addition, the equity rights offering, while planned, had not been executed during the review period.
The Ombudsman concluded that these aggregate conditions represent more than merely potential weaknesses characteristic of a special mention rating. The Ombudsman found sufficient evidence demonstrating the existence of well-defined weaknesses in both the primary and secondary sources of repayment, which is sufficient to support a substandard rating. Well-defined weaknesses include marginal liquidity, inadequate controls, and weak financial performance. Although substandard assets in the aggregate have a distinct potential for loss, an individual asset’s loss potential does not have to be distinct for the asset to be rated substandard.
