On March 27, 2014, the Office of the Comptroller of the Currency (OCC) issued a new handbook “Asset-Based Lending,” which provides guidance to federal bank examiners, national banks and federal savings associations1 on the safety and soundness of asset-based lending (ABL).2
The new handbook provides a detailed overview of the inherent risks and advantages of asset-based lending and discusses prudent risk management guidelines and regulatory expectations. It also includes detailed examination procedures, an internal control questionnaire, transaction examples and verification procedures designed to assist examiners in their reviews of ABL portfolios.
Key Elements in ABL Transactions
The OCC acknowledges that ABL is a specialized credit product that provides fully-collateralized credit facilities to borrowers that may not qualify for cash-flow loans due to high leverage structures, inconsistent earnings or insignificant cash flows. ABL also provides access to working capital for healthy companies interested in flexible credit structures without highly restrictive financial covenants.
ABL loans are typically structured as revolving credit facilities where advances are limited to a percentage of eligible collateral (the borrowing base) and are repaid from the conversion of collateral to cash (sales of inventory and collection of accounts receivable) over the borrower’s business cycle. Tight controls and close monitoring are critical to the soundness and profitability of ABL facilities.
While the OCC recognizes that, if properly structured, ABL loans can be profitable, fully collateralized and, in fact, low-risk, it also emphasizes that the administration and monitoring of ABL portfolios can be very time- and cost-intensive for banks and are particularly susceptible to borrower fraud. The OCC identifies credit risk, operational risk, compliance risk, strategic risk and reputation risk as the primary risks associated with ABL.3 Out of these five categories, credit risk is considered the most significant risk associated with ABL, as a typical ABL borrower may not be as financially strong as other commercial borrowers.
Proper Risk Management Systems for ABL Lenders
The handbook is very specific in outlining the OCC’s expectations regarding each bank’s risk management system. The efficacy of a bank’s risk management system is evaluated on the basis of its policies, process, personnel and control systems.
In the event of a decline in liquidity cycles, borrowing base composition and/or operating cash-flow, an acceptable ABL loan policy must address the management’s policies for remedial plans, including risk-rating changes, changes to accrual status and loss recognition. In addition, the bank’s ABL risk limits and expectations, approval procedures demonstrating sufficient senior-level supervision, underwriting standards, pricing policies and monitoring procedures must be discussed.
The OCC allocates a significant part of the handbook to the analysis that banks must undertake with respect to each ABL borrower. Thus, each ABL facility must be assessed on the basis of the facility’s liquidity, as well as the borrower’s financial condition, operating cycle, industry and management. The liquidity assessment must demonstrate that the ABL facility is properly structured, controlled and monitored. The facility must be stand-alone and self-liquidating, with minimal reliance on illiquid collateral or allowance of over-advances, and secured by a senior lien on the borrower’s assets. It must be supported by reliable projections of future liquidity and borrowing needs. In a turnaround scenario, the borrower’s actual performance must be consistent with the approved turnaround plan. The handbook also explains that if the liquidity criteria are not met, then the ABL facility must be evaluated on a cash-flow basis.
The OCC requires lenders to clearly analyze and document the borrower’s financial condition and operating cycle as part of the underwriting and approval process. Among other things, the financial analysis must address excessive leverage, erratic earnings and cash flow, and negative financial trends. The operating cycle analysis, supported by the industry analysis, must demonstrate the lender’s understanding of the particular borrower’s ability to convert working assets to cash over a specific period. The measures used in the operating cycle analysis must include inventory turnover, accounts receivable turnover and accounts payable turnover.
As could be expected, the OCC also dedicates a notable section of the handbook to the establishing and monitoring of the borrowing base, as the successful limiting of the outstanding loan balance to the quality liquid assets assures ABL lenders of the greater likelihood of the repayment of the loan. It should come as no surprise to ABL lenders that the OCC expects a typical borrowing base to be comprised of accounts receivable and inventory. While acknowledging that sometimes other assets, such as real estate, equipment or intellectual property, may be included in the definition of the borrowing base, the OCC warns against the reliance on such assets, as the inclusion of such assets in the borrowing base erodes the overall liquidity of the credit facility. For these reasons, the OCC also instructs examiners to review borrowing bases for advance rates, expecting the advance rates against illiquid assets to be lower than the advance rates against quality liquid assets.
In addition to acknowledging the common advance rates against accounts receivable (ranging from 70% to 85% and, in some instances, going up to 95% before subtracting dilution and reserves), the handbook provides the typical criteria for excluding certain receivables from the borrowing base. As part of the analysis, receivable concentrations of 10% or more in a single account must be considered and limited. The OCC specifically recommends that banks limit concentrated accounts to no more than 10% to 20% of the borrowing base. It also warns against the inclusion of delinquent accounts in the borrowing base, directing examiners to scrutinize all instances of inclusion of accounts that are past due by three times their standard terms. Additionally, affiliate receivables, re-aged receivables, government receivables, contra-accounts, receivables owed by an insolvent customer, or foreign receivables affected by legal, price and country risk should not be included in the borrowing base.
The handbook also advises that advance rates against inventory usually should be lower than those against accounts receivable. While the OCC acknowledges that an advance rate against eligible inventory may go up to 65%, it advises banks to limit the risk of lending against inventory by supporting the advance rates by expert inventory valuations and using the liquidation value rather than the market value in its formula. The handbook tells examiners that a shift from reliance on accounts receivable to reliance on inventory should be viewed as a red flag in their examination.
Establishing and implementing strong controls is a key element of an effective ABL risk management system. Among the necessary controls, OCC counts clear and tight loan agreements defining the borrowing base, the handling of cash proceeds, the monitoring and reporting requirements, as well as other collateral protections, including insurance and audits, and the perfection of lenders’ liens on the collateral. Regular reappraisals of collateral must be permitted by the applicable loan documents and will be reviewed by OCC examiners. Field audits are another mandatory feature of ABL lending. The OCC expects a field audit to be conducted prior to the booking of a new loan and at least quarterly thereafter and, in the case of a high-risk or workout relationship, as frequently as weekly and even daily.
Financial reporting requirements are considered another level of controls that must be implemented with respect to ABL loans, and they must reflect the level of credit risk posed by each borrower. Thus, interim financial statements may be required. A borrowing base certificate with supporting documentation is typically required by ABL lenders on a monthly or weekly basis.
Although ABL lenders rely less on financial covenants than on collateral controls and monitoring, some covenants may be appropriate in detecting potential problems, restricting the borrower’s ability to take on unwarranted risks, and permitting the lender to trigger events of default forcing remedial actions and limiting the lender’s loss. Financial covenants used with ABL loans typically include a minimum fixed charge coverage rate and limits on capital expenditures.
Finally, ABL lenders can use changes in pricing as another form of effective controls. Changes in pricing triggered by delinquency, covenant violations and overadvances, as well as fees charged for administrative costs, such as field audits, lockbox arrangements and appraisals, must be clearly provided for in the loan documents.
As stated above, the OCC considers the complexity of proper ABL administration an additional transaction risk associated with ABL facilities. The OCC expects ABL departments to clearly separate employees responsible for credit approval, collateral control and portfolio management. Examiners are instructed to scrutinize lending units where employees perform multiple, often conflicting, roles. Examiners are charged with evaluating the sufficiency of training and experience of back-office employees of ABL units, particularly in banks with smaller, and potentially understaffed, ABL units.
Where an ABL borrower has credit facilities with other units of the bank (such as a mortgage or an equipment loan facility), the OCC recommends that the ABL unit be given the primary responsibility for the entire relationship, as the ABL unit is often best equipped to properly monitor the risk and maximize the bank’s recovery in the event of a default. Notably, the OCC cautions against permitting ABL borrowers to obtain credit facilities with other financial institutions.
The handbook addresses debtor-in-possession (DIP) financing as a separate form of ABL lending. Provided to companies operating under Chapter 11 bankruptcy, DIP financing is often provided by the same ABL lender that financed the borrower prior to the commencement of the bankruptcy case as a form of strategic protection of the lender’s collateral values through priming liens, additional unencumbered assets and the replacement of the pre-petition debt with post-petition debt secured by post-petition assets. Structurally, DIP financing is not much different from an ABL revolver with a borrowing base. However, it requires even tighter controls, including more frequent reporting and certifications.
When entering into DIP credit facilities, an ABL lender must be supported by experienced bankruptcy counsel to make sure that the court’s order approving the DIP facility, and later the debtor’s reorganization plan, provide the lender with a priming lien status, provide for the repayment of the lender’s debt upon plan confirmation, and protect the lender’s collateral in the event of conversion to a Chapter 7 liquidation case.
Credit Risk Considerations
The handbook provides some guidance to banks and examiners with respect to the factors used in the risk-rating analysis of an ABL facility. Liquidity is considered the primary factor in this analysis. Sufficient liquidity should cover the borrower’s actual cash burn over the last 12 months and the upcoming 12 to 18 months. Cash-flow is considered a secondary source of repayment for an ABL revolver but a primary source of repayment for an ABL term loan or an overadvance. A change in the bank’s advance rates, liberalizing the borrower’s access to advances, is likely to warrant an adverse rating.
As mentioned above, the OCC handbook also contains expanded procedures for examining ABL activities and products. The procedures, covering the scope of examinations, quantity of risk and quality of risk management, are intended to assist OCC examiners in tailoring their examinations to different banks. The handbook also includes an internal control questionnaire to be used by examiners in assessing a bank’s internal controls and verification procedures. Although designed for use by examiners, banks’ credit and compliance officers should familiarize themselves with these materials for the purpose of appraising the quality of their internal ABL risk management systems.
While this article provides only an overview of the OCC handbook on ABL, banks engaging in ABL transactions should review the handbook to keep abreast of the current examination principles and, if necessary, strengthen their internal procedures designed to improve the risk management of their ABL portfolios.
Inez M. Markovich is a shareholder and the chair of the Banking and Lending practice group at Anderson Kill P.C. She concentrates her practice on the representation of banks and finance companies in all aspects of commercial lending transactions, including ABL transactions, lease finance, bankruptcy and debt restructuring, and creditors’ rights. Markovich may be reached at 267-765-8216 or firstname.lastname@example.org.
1. National banks may engage in ABL loans with no aggregate limitations, provided that the quantity and quality of ABL transactions do not pose unnecessary risk to the bank’s financial soundness. Federal savings associations (FSAs) are subject to limitations on ABL loans, as well as other commercial loans. This article does not address circumstances under which FSAs may be able to engage in ABL.↩
2. The handbook expands the ABL fundamentals addressed in the Accounts Receivable and Inventory Financing Booklet of the Comptroller’s Handbook issued in March 2000, and it replaces the ABL portion of §214 “Other Commercial Lending,” issued in October 2009, as part of the Office of Thrift Supervisions’ Examination Handbook.↩
3. The OCC has defined the following categories of risk for bank supervision purposes: credit, interest rate, liquidity, price, operational, compliance, strategic and reputation.↩