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


A participant bank appealed the substandard ratings assigned to a revolving credit and term loan during the 2015 Shared National Credit (SNC) examination.


The appeal asserted that a special mention rating was more appropriate to reflect the company’s financial trends because the company had been historically profitable and projections demonstrated an ability to repay 67 percent of total debt within seven years.

The appeal stated that the borrower had maintained sufficient liquidity as demonstrated by excess margined collateral to cover the net “due to company A” position related to a fuel hedging program. No new fuel hedges would be executed by the borrower on company B’s behalf to reduce and eventually eliminate the out-of-money (OTM) position on the fuel hedging contracts.

The appeal asserted that while leverage was high, it was reduced from fiscal year-end 2014. In addition, some of the cash deposited with company A will be returned and revolver borrowings will be reduced, lowering the leverage ratio. A working capital lift from the shortening of payment terms with company B should also reduce revolver borrowings.

The appeal argued that the loan structure was strengthened with the inclusion of a mandatory annual field examination of working capital assets supporting the revolver. The minimum earnings before interest, taxes, depreciation, and amortization (EBITDA) covenant is the controlling covenant, and a reduction of the cash flow recapture provision is not a weakness in that the borrower is only permitted to make distributions for income taxes.

The appeal also asserted that despite lower levels of net income, EBITDA had remained relatively stable. The borrower had negotiated rate increases effective in 2015 which would result in additional EBITDA. The company also had control of discretionary expenses associated with sales and marketing. Operating expense increases were a result of a well-defined and measurable strategic growth plan with a realization of returns on these investments expected in upcoming periods.


An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of substandard. The borrower’s highly leveraged profile, tight liquidity, and the OTM position under the company A hedging agreement comprised well-defined weaknesses.

The appeals panel concluded that while the liability associated with the fuel hedging derivative had stabilized and the OTM position had declined from highs experienced in first quarter 2015, liquidity remained weak, and the following points support this position:

  • The borrower continued to pledge cash collateral to company A.
  • The OTM position on the fuel hedge with company A required the borrower to keep cash collateral with company A, which the bank group views as a default under the loan agreement.
  • As of this writing, the borrower did not have the ability to access additional liquidity provided by the recent increase in collateral due to the revolver limit. Presumably, the line could be increased to access this availability, but that would increase leverage that is already high and forecasted to remain high in the near term.
  • Availability under the revolver remained low despite the borrower’s receipt of funds from company A. Further, the borrower cannot use this availability for pledging purposes to company A.
  • The improvement in collateral position was due to an increase in accounts receivable and inventory, which represent a use of cash. As a result, the increasing collateral position had a negative impact on an already tight liquidity position. The bank did not factor this into its analysis.
  • The borrower had hedged expected company B diesel volume for 2015 and 2016, respectively, and the company could be adversely affected by continued soft fuel prices into 2016. While the borrower informed company B that it would not execute new fuel hedges on its behalf, the benefits of any remedies had not been realized given the OTM hedging position. There is no guarantee that the OTM position will cease or that additional cash collateral will not be required.
  • The effect of concessions from company B to help alleviate the borrower’s tight liquidity had not been realized.

The appeals panel concluded that the high leverage should be viewed in context with the other issues facing the company, as described in the preceding list. The high leverage limits the company’s flexibility in managing operations during this period of strained liquidity, especially if company A requires additional collateral should fuel prices continue to fall.

Net income has declined steadily from fiscal year 2011 to fiscal year 2014. Although earnings before interest, taxes, depreciation, and amortization, and gross profit margins have remained relatively stable, operating profit margins had declined from fiscal year 2011 to fiscal year 2014. Even after considering the discretionary expenses associated with sales and marketing, the operating margin would increase only by 7 basis points and to levels far below previous levels.

The negotiated rate increases, future minimum profitability benchmarks, realization of benefits associated with up-front costs related to the growth plan, and control of discretionary expenses are all forward looking items. These items can lead to improved operating results in future periods; however, these claims had not affected the bottom line as of the SNC examination date.

The appeals panel determined that recent changes regarding the leverage covenant, cash flow recapture, and field audits were evidence of a weakened loan structure in light of other weaknesses noted herein. From a covenant standpoint, the bank group reduced its control of the borrower by eliminating the leverage covenant. The borrower would not have met the recent year leverage covenant requirement. While the reduced cash flow recapture may be appropriate, it is less than the recapture previously required. Ultimately, the bank increased its risk by extending the maturity date and allowing increased leverage. Given the increased risk exposure, the bank group should have increased, not relaxed, controls with the recent restructure. The addition of an annual field exam requirement was an improvement to the credit. While advances under the revolver are subject to a borrowing base, however, this credit was neither structured nor had the controls associated with an asset-based lending facility.