The impact of COVID-19 and related audit statements on loan agreements
On 12 March 2020, the Netherlands imposed an ‘intelligent lockdown’ to combat COVID-19.1 The consequences of the intelligent lockdown may need to be reflected in companies’ audited financial statements. Indeed, the Dutch auditors’ organisation, NBA, expects that auditors may have to address in their statements how COVID-19 has impacted the ability of a client’s businesses to continue operating as a going concern.2 Such a statement, whether in the form of an emphasis of matter statement or audit qualification, has the potential to impact a company’s loan documents and availability of financing thereunder.
By way of background, applicable accountancy rules require a company’s board to elaborate on the expected going concern prospects of its business in the company’s financial statements. An auditor providing an audit opinion on the financial statements of a company, must, among other things, verify whether the board’s assumptions on the ability of the company’s business to continue as a going concern are appropriate, and whether there are material doubts as to the company’s ability to continue operating as a going concern. When making its assessment, an auditor will take into account circumstances existing in the period between the company’s financial year end and delivery of its audit opinion. An auditor’s statement on a company’s going concern prospects must relate to a period of at least 12 months following the company’s financial year end.
2. Executive summary
Companies whose businesses have been impacted by COVID-19 should consider how its latest or upcoming auditor’s report will interact with the terms of its loan documentation. For example, emphasis of matter statements or audit qualifications contained in the auditor’s report may trigger an event of default under the loan agreement, resulting in the loan becoming due and payable and possibly lenders taking enforcement action. Conversely, the occurrence of a (different) event of default under a loan agreement (e.g., as a result of cessation of business) may force an auditor to qualify its report. To avoid situations like these, it is important for a company to communicate closely and proactively with its auditor and lenders, and, if required, request a waiver or amendment of the relevant terms of the loan agreement with a view on preserving relationships with its lenders (and access to funding) throughout the COVID-19 crisis. How effective these solutions will be depends on the seriousness of the event(s) of default that are triggered and the willingness of lenders to maintain the financing.
3. Types of audit statements
A statement of the board on a company’s going concern prospects must relate to a period of at least 12 months following the company’s financial year end.
For companies whose financial year ended before the intelligent lockdown was imposed (e.g., on 31 December 2019), the consequences of governmental COVID-19 measures are post-balance sheet date events. In these circumstances, an auditor will express any related concerns in the “continuity” section of its report.
For companies whose financial year ends in 2020, the influence of the COVID-19 measures may not only affect the going concern statement, but also the actual financial statements (e.g., the use of a certain valuation method). Statements on the continuity of financing or the use of valuation methods may need to be included. Similar statements may have to be included in any semi-annual or quarterly financial statements that must be delivered to lenders pursuant to existing loan agreements.
An auditor will include a so-called “emphasis of matter” statement highlighting a matter which in the auditor’s opinion is of fundamental importance to the reader’s understanding of a company’s financial statements, but which does not meet the technical standards of an audit qualification. Emphasis of matter statements may be used in positive or negative audit opinions. By means of such statement, an auditor draws the reader’s attention to the board’s explanation of the expected consequences of COVID-19 and the company’s ability to continue operating as a going concern. Prior to the COVID-19 crisis, emphasis of matter statements appear to have been used only in exceptional circumstances.
If an auditor disagrees with a board’s explanation of the company’s expected ability to operate as a going concern, he or she can issue a qualified or negative audit opinion containing an explanation of the its own view on the company’s prospects.
For a useful overview and further background on how emphasis of matter statements are used in positive audit opinions, we would recommend reading Continuïteit in de controleverklaring ten tijde van COVID-19 (prof. dr. P.W.A. Eimers RA; Ondernemingsrecht 2020/XVI). This article considers the following four scenarios:
- COVID-19 is expected to have few or no expected consequences on the company’s going concern abilities. In such a scenario the auditor may include an emphasis of matter statement in the financial statements, highlighting the reason why COVID-19 is expected to have limited impact on the company’s going concern abilities.
- There is uncertainty regarding the consequences of COVID-19 on the company’s business, but such consequences do not lead to material uncertainty around the company’s going concern abilities. In such a scenario, the auditor may include a (light version of) an emphasis of matter statement in the financial statements
- There is material uncertainty regarding the company’s going concern abilities, but continuity is expected. In such a scenario, the auditor should include an emphasis of matter statement in the financial statements.
- It is clear that the company will no longer be able to exist. In this scenario, the 2019 financial statements must be established based on different valuation methods (e.g., liquidation value). In such case one would expect a qualified or negative audit opinion.
4. Implications for loan agreements
Loan agreements in the Dutch market are generally based on LMA standards or general terms and conditions of banks (in bilateral financings).
LMA based loan agreements
The LMA provides for different standard loan agreements which can be tailored to the specific commercial terms of a financing transaction. Pursuant to the leveraged finance standard facilities agreement, an event of default occurs when an auditor qualifies financial statements. What constitutes a “qualification” is not defined. Although an emphasis of matter statement in a company’s financial statement does not meet the technical standards of an audit qualification, its inclusion may still trigger an event of default, depending of the wording of the relevant provisions. In practice, companies tend to expressly carve out emphasis of matter statements from audit qualification events of default in order to avoid any debate on this topic.
LMA-based investment grade financings typically do not contain audit qualification events of default.
There are, however, other events of default that may be triggered as a result of the impact COVID-19 on a company’s business. For example, expropriation or cessation of business events of default, or material adverse change events of default.
If an event of default is triggered and is not been remedied within the relevant grace period, the outstanding loan will become due and payable, possible resulting in lenders taking enforcement measures.
Loan agreements based on general banking conditions
Dutch banks use various sets of general banking conditions in combination with bespoke loan agreements. Pursuant to the applicable general conditions, borrowers are obliged to submit audited financial statements. Some banks explicitly include in their conditions the obligation for borrowers to submit a positive audit opinion. The applicable loan agreement may contain further requirements relevant to such audit opinion and may provide further clarity on whether an emphasis of matter statement triggers an event of default.
The general banking terms do not contain a grace period in which a borrower can remedy a triggered event of default. If the relevant loan agreement does not contain further provisions on remedies, there is a risk that the loan will be immediately due and payable if there is an emphasis of matter statement which could potentially cause an event of default.
2 See prof. dr. P.W.A. Eimers RA, Continuïteit in de controleverklaring ten tijde van COVID-19, Ondernemingsrecht 2020/XVI, which refers to NBA alert 42 https://www.nba.nl/globalassets/wet--en-regelgeving/nba-alerts/alert-42/nba-alert-42-impact-coronavirus-update-6-april-2020.pdf