The current disruption caused by COVID-19 is often and rightly described as “unprecedented”. So perhaps we should not be surprised by unprecedented practices that might emerge from it. One such practice seen in the private equity and leveraged finance sector appears to raise some ethical questions for the lawyers involved.
It concerns a market practice known as ‘EBITDAC’. EBITDA is a concept used as a proxy for a company’s revenues and valuation. It performs (or, at least once performed) a critical role in loan covenants in leveraged buyouts (LBOs); it is/was central to the lender’s ability to monitor and test the borrower’s financial performance, and these days is also often used in ‘cov lite’ deals as the benchmark against which to assess whether the borrower has the capacity to borrow more debt, make dividend payments and/or undertake other ‘restricted’ activities which might weaken the position of the lenders by making the prospect of the loan ultimately being repaid less likely. ‘EBITDA’ is an acronym for earnings before interest, tax, depreciation, and amortisation. The ‘C’ added at the end in this new and contested construct ‘EBITDAC’ stands for, as you might have guessed, Coronavirus/COVID-19.
A few days ago the Financial Times (‘Pandemic spawns new accounting term ‘EBITDAC’ to flatter books’) reported that private equity backed companies are seeking to add back projected revenue ‘lost’ during the COVID lockdown and beyond to inflate their EBITDA – this is ‘EBITDAC’ in action. In the article, market participants expressed disapproval of this practice: one describes it as a ‘fiction’, in that revenues lost due to the COVID-19 pandemic “will never come back”. If we accept the sentiments expressed in the FT article, ‘EBITDAC’ is at least morally questionable, if not a breach of applicable accounting rules.
So, what does this have to do with lawyers? It seems some lawyers may be advancing a similar argument on behalf of private equity-owned borrowers in relation to existing LBO loan agreements that would otherwise be in breach due to the effects on revenues of the pandemic.
This article from the Journal of International Banking Law ( ‘Covid-19 and the impact on financial covenants’) was posted in the online comments below the FT article. It is written by lawyers active in the leveraged finance market and was posted by one of the authors. It starts, in the bold font introduction paragraph, by saying: “A borrower may seek to argue that financial ratios should be calculated on the basis of ‘EBITDAC’, so that the effect of the Coronavirus is ignored.”
The article begins by observing that over recent years, LBO lenders have lost a series of key loan document protections already. In particular, lenders have generally ceased to enjoy the protection of financial covenant tests that apply all the time (maintenance covenants) and have instead been forced to accept ‘cov lite’. However, as the authors explain, where the covenants do apply, for example where there is a revolving facility, or further debt is drawn down, the lenders are able to “monitor a borrower’s financial condition and to pick up signs of distress at an early stage, thereby giving them a seat at the table on any restructuring discussions.” The authors then explain how ‘EBITDAC’ might be used to potentially deprive lenders of those rights.
This paragraph sets the argument in context:
“Over the past decade, well advised borrowers have succeeded in remoulding the rules for calculating earnings before interest, tax, depreciation and amortisation (EBITDA) by introducing a range of subjective elements which make it easier to game the related financial covenants.”
When the authors say borrowers have “succeeded in remoulding the rules”, presumably this success was only possible with the assistance of their lawyers, as this is stated in an article written by lawyers in a legal journal. And when the authors say that these borrowers have been “well advised”, the legal advisers advising borrowers to “game” the financial covenants are presented as doing their jobs well.
Now look at this language:
“…borrowers may now seek to argue that the effects of COVID-19 on the business constitute an “exceptional item” which can be added back into EBITDA”.
Again, with the help of their lawyers, presumably.
Then the key section:
“IFRS does not define what constitutes an exceptional item, so a borrower might seek to exploit this ambiguity to increase its flexibility in interpreting EBITDA”.
The authors are advising how borrowers might exploit ambiguity, both in the “ambiguous drafting” in loan documents and in IFRS, the applicable accounting rules.
The argument the authors put forward goes something like this: the COVID-19 pandemic is an exceptional event. Therefore, it can be argued it is also an exceptional accounting event, as IFRS, the applicable accounting rules, are ambiguous. Therefore it should be treated like other exceptional items already expressly provided for in the loan covenants as exclusions, to be disregarded for the purposes of the covenants, even though it is not expressly referred to like the other exceptional events (albeit the list of express exclusions might be stated to be “non-exhaustive”). The effect is that the borrower can replace the (presumably much reduced) EBITDA revenue position for the period affected by the exceptional event (the pandemic), with the (presumably much healthier) EBITDA number for the corresponding reporting period in the previous year.
A breached covenant may as a result no longer be breached. And the lenders may consequently lose their usual rights and entitlements that flow from a breach of financial covenant, in a scenario where the borrower’s financial condition may be rapidly deteriorating due to the COVID-19 crisis. The effect could be that potentially major losses flow through to the banks, financial institutions and funds that comprise the lenders in the LBO market.
This article appears to provide the arguments to support the seemingly dubious practice the FT article cited above was describing (and impliedly decrying). If lawyers in the market are inviting borrowers to assert ‘EBITDAC’ in their discussions with lenders, do they defeat the spirit of the financial covenants in the loan documents they are each party to by pushing a distorted version of IFRS?
Both the language used and the substance of the JIBL article appear to represent the contested ‘standard conception’ of lawyer role orientation, where lawyers see their role as providing neutral advice to their clients and, in doing so, become unaccountable for its ethical substance and implications. This may be appropriate in the context of a solicitor advising a defendant in a criminal context, but when taken to extremes, is ethically questionable in a transactional context, where it can encourage lawyers to advise their clients to exploit the letter of legal rules (particularly where there is ambiguity) whilst undermining or avoiding their spirit. We saw instances of this ‘client first and only’ approach in the global financial crisis. It led to practices such as ‘creative compliance’ (a phrase coined by Dorren McBarnet and Christopher Whelan). David Kershaw and Richard Moorhead also explored how a legal opinion issued by a large firm, which was legally accurate, may have helped facilitate what was described by the Lehman’s Bankruptcy Examiner as ‘balance sheet manipulation’. Joan Loughrey has made a compelling case for lawyer accountability as a way of mitigating the risks presented by these sorts of practices.
The lawyer’s role is, of course, morally ambiguous but the ‘client first’ approach is tempered by wider informal and formal norms of professional and legal ethics, and so should never be the only, and sometimes not even the primary, consideration. You might say that the morals of a lawyer should align with ordinary morality, in other words, the morality of most people in society. You might even argue that lawyers, as officers of the court, have higher ethical duties. In any event, under the SRA’s Principles, as well as acting in the best interests of each client, each solicitor must also act in a way that upholds the public’s trust and confidence in the solicitors profession, and with independence, honesty and integrity. Integrity denotes a higher moral standard than honesty; in SRA v Wingate Evans  EWCA Civ 366 the judge noted that integrity requires a “moral soundness, rectitude and steady adherence to an ethical code”. Where the Principles come into conflict, those which safeguard the wider public interest (such as the rule of law, and public confidence in a trustworthy solicitors’ profession and a safe and effective market for regulated legal services) take precedence over an individual client’s interests. Further, under the SRA’s Code of Conduct, a solicitor must not mislead or attempt to mislead her clients, the court or others, either by her own acts or omissions or by allowing or being complicit in the acts or omissions of others (including her client).
Taking all of this into account, lawyers should be careful to avoid acting in a way that might be interpreted as a ‘dog whistle’ to current and potential clients that they have expertise in arguing the letter over the spirit of both contractual provisions that protect lenders and accounting rules that exist to protect key market participants and stakeholders.