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A participant bank appealed the substandard rating assigned to a revolving credit during the 2015 Shared National Credit (SNC) examination.
The appeal asserted that the facility should be rated pass because based on the regulatory definition, a substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged. Substandard assets must have a well-defined weakness that jeopardize the liquidation of the debt. The appeal asserted that the company demonstrates sufficient operating cash flow (OCF), both historically and pro forma, to cover fixed charges, sufficient liquidity to repay the debt, and that the credit is adequately protected by collateral. Thus, full repayment of the facility is available from primary or secondary sources of repayment.
An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of substandard.
The appeals panel noted that the regulatory definition of substandard includes assets that have a high probability of payment default, or other well-defined weaknesses. Substandard assets are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. 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.
The appeals panel noted that the company began operations in 2014, and therefore the analysis of projected cash flow (CF) was given greater weight than historical fixed charge coverage (FCC) calculations per covenant definitions. The company projections demonstrated insufficient OCF to cover fixed charges in 2015 or 2016. At origination, CF deficits were expected given the company’s start-up and substantial capital expenditure (capex) requirements. The company was highly leveraged, however, and the sharp decline in oil and gas prices had resulted in higher CF deficit projections, weaknesses in liquidity, increased leverage, and decreased likelihood of debt amortization in a reasonable time frame. The FCC ratio discussed in the appeal was calculated by annualizing the first quarter 2015 covenant earnings before interest, taxes, depreciation, depletion, amortization, and exploration expenses. Based on the March 22, 2015 budget discussed in the appeal, the FCC ratio was below 1.0 times under both full and 50 percent capex projections. Projections show a weak FCC ratio for fiscal year-end 2015 and 2016 (under full capex). The FCC ratio also did not include any principal payments on outstanding debt.
Regarding the company’s liquidity and leverage, the appeals panel noted that the company issued second lien debt and recently drew on a line to reduce the borrowing base outstanding, improve liquidity, fund interest payments and preferred stock dividends, and cover increased CF shortfalls given the sharp decline in oil prices. Revolver usage was higher than expected per the company’s March forecast, largely due to unplanned working capital adjustments in the second quarter of 2015, following adjustments in the first quarter of 2015 that were also not in the original plan. If the company reduces capex to cover FCC deficits as noted previously, the ability to provide for meaningful principal amortization of the total debt will be further delayed.