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Appeal of Shared National Credit (SNC) (Third Quarter 2015)


A agent bank appealed the substandard rating assigned to a revolving credit during the 2015 Shared National Credit (SNC) examination.


The appeal asserted that a pass rating for this reserve-based loan (RBL) was appropriate because, consistent with the “Oil and Gas Exploration and Production Lending” booklet of the Comptroller’s Handbook, dated March 2016. RBLs are a form of asset-based lending rather than enterprise value cash flow lending.

The appeal asserted that the booklet states, “As with other types of loans, oil and gas (O&G) loans adequately protected by the current sound worth and debt service capacity of the borrower, guarantor, or underlying collateral generally should not be classified for supervisory purposes. When risk rating O&G facilities, it is important to keep in mind that O&G lending is a borrowing-base, collateral-focused type of commercial lending.”

The appeal asserted the collateral had a present worth of the cash flows discounted at 9 percent (PW9) exceeding the full first lien commitment by 2.2 times (45 percent loan-to-value) and very little was funded under this RBL. The engineered loan value (ELV) covered the first lien RBL by 1.16 times, resulting in a fully conforming borrowing base. Due to the nature of these assets, the appeal stated that additional value above what is set as the ELV would be achieved in a liquidation process.

The appeal asserted that the borrower had sufficient liquidity to fund projected negative free cash flow (FCF) for 2015 and 2016, after considering the second lien note.

The appeal also asserted that the borrower’s recent debt offering illustrated its ability to access capital markets to bolster liquidity, if necessary. The second lien was upsized based on strong investor demand. The company also successfully completed two additional recent capital markets transactions that reduced the principal balance of notes, which reduced the annual interest expense.


An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of substandard.

Regulatory agencies recognize that unique attributes of O&G RBL result in risk inherent to the O&G industry requiring additional risk management practices and programs for O&G lending, including some controls that are similar to asset-based loans (ABL). For an ABL, however, the primary source of repayment is the conversion of working capital assets to cash, whereas for an RBL, the primary source of repayment is cash flow generated from the sale of O&G over the life of the reserves.

The appeals panel concluded that the controls in place for a traditional ABL are more stringent than those typically found in an RBL. ABL controls include a first lien on account receivables and inventory, which is not shared with any other lending group, dominion of cash through a lock box arrangement or a springing covenant, regular field audits, and periodic collateral valuations.

The appeals panel concluded that the primary source of repayment for an RBL is the cash flow generated from the future sale of encumbered oil or natural gas once it has been extracted. RBLs often share the cash flow repayment “pari passu” with other debt, both secured and unsecured. In many cases, the other debt (term notes and bonds) requires no principal repayment until maturity. While the structures of RBLs may vary, the facilities generally do not self-liquidate. Disbursements of proceeds, while generally not restricted, are primarily used for capital expenditures pertaining to the exploration, acquisition, development, and maintenance of oil and gas reserve interests. Oil and gas reserve interests tend to be longer term, depleting assets as opposed to accounts receivable and inventory.

The regulatory agencies believe an RBL is subject to additional risks than a traditional ABL and should be evaluated and risk rated through cash flow analysis, although consideration is given to each facility’s structure, controls, and collateral. The primary determinant for the regulatory risk rating is the ability of the borrower to service all debt from operating cash flow, the primary source of repayment.

The appeals panel concluded that the company’s financial performance had been negatively affected by the decline in oil and gas prices and the heavy debt burden associated with acquisition activity in recent years. As of December 31, 2014, earnings before interest, taxes, depreciation, and amortization (EBITDA) produced a fixed charge coverage ratio below 1.0. Cash flow performance through March 31, 2015, using trailing projections, produced negative FCF. Leverage was high due to declining EBITDA and increasing debt. Despite the borrower’s ability to raise equity and obtain second lien financing to reduce the revolving credit balance, projected negative FCF for fiscal year end (FYE) 2015 and 2016 was projected to increase total debt to EBITDA by FYE 2016. A fully funded revolving credit would not payback within the half-life of the reserves.