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


An agent bank appealed the special mention 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 it did not meet the regulatory definition of a special mention credit as outlined in the “Asset-Based Lending” booklet of the Comptroller’s Handbook, dated March 2014 (ABL booklet). The appeal stated the credit should be risk rated on a “liquidity basis.” The company possessed sufficient liquidity to cover projected free cash flow (FCF) shortfall over the next 12 to 18 months and had been able to cover its cash flow shortfalls over the past 12 months. Specifically, liquidity levels could support 5.5 years and three years of cash burn.

The appeal also asserted that annualizing first quarter 2015 FCF is not an appropriate proxy for future cash flow generation. The appeal argued that this method ignores the established and consistent pattern of seasonal working capital swings. The appeal also stated that the sponsor had demonstrated a track record of providing incremental capital. The appeal further stated that the contention that the company’s projections are unreliable was overstated and deviations driven by a conscious, corporate strategy were far less concerning for the company’s long-term stability.


An interagency appeals panel of three senior credit examiners concurred with the SNC examination team’s originally assigned risk rating of special mention.

The panel agreed the appeal correctly stated that the ABL booklet states asset-based loans (ABL) should be risk rated on a “liquidity basis” if they are well-structured and properly controlled and not pari passu with other debt.” The ABL booklet cites additional criteria, however, that must be met:

  • Liquidity trends are reasonable, consistent with reliable projections, and unlikely to be affected by extraordinary liquidity needs.
  • Operating performance is reasonable and does not pose a material threat to liquidity or turnaround potential, if applicable.
  • Performance reasonably tracks to a viable turnaround plan, if applicable.

Among the characteristics cited in the ABL booklet are conditions that may warrant an adverse risk rating, including

  • failure to meet earnings or liquidity projections.
  • a significant unplanned increase in cash burn or a decline in revolver availability.
  • excessive leverage.

The ABL booklet also states that trends in the borrower’s operating cycle and overall financial performance that can signify credit or collateral quality deterioration that could lead to an adverse risk rating include

  • increases in monthly cash burn and liquidity needs.
  • an unstable or rapid decline in excess availability.
  • an operating performance that deviates materially from planned performance.
  • borrower inability to provide reliable projections of liquidity and borrowing needs.

The appeals panel concluded that the company’s performance demonstrated adequate liquidity to cover the borrower’s actual cash flow shortfalls over the past 12 months. Conversely, the appeals panel questioned the appeal’s assertion that liquidity was adequate to cover projected cash flow shortfalls well beyond the next 12 to 18 months based on the adjusted cash burn calculations and the lack of long-term company projections. The appeal conceded that FCF generation had underperformed to the plan and was likely to diminish further in the near term. The lack of longer-term projections was problematic since the company’s cash flows were volatile and trending downward, and liquidity had declined due to the acquisitions and inventory build-up not previously budgeted.

It is not enough for a company generating declining levels of cash flow from negative operating trends to fund its obligations from available credit or cash for a certain number of months. The company should also have a credible plan to reverse its present negative trends. The ABL booklet is clear in stating that business and liquidity trends, operating performance in comparison to plan, and other factors enumerated previously are considered in evaluating the adequacy of a company’s liquidity.

Although liquidity was sufficient to cover the prior year cash burn of 61 months, the company’s liquidity position changed significantly and was not in line with the company’s budgeted projections. Total liquidity had declined due to the company’s decision to make an unplanned purchase of a company along with an unbudgeted inventory build.

If all inventory was added back, the resulting cash burn per month resulted in cash burn coverage of 5.9 months. This is considerably less than the prior year’s cash burn coverage of 61 months and less than the upcoming 12 to 18 month guideline as stipulated in the ABL booklet. While the addback of all inventory costs may not be realistic, this does highlight that one-time working capital costs are not the primary reason for the decline in FCF.

The appeals panel agreed that the sponsor had demonstrated it had the means to provide support for this company. Additional capital support from the sponsor had not, however, been sufficient to cover declines in liquidity as a result of negative FCF and capital outlays for acquisitions.

The appeals panel concluded that the borrower’s actions to make strategic acquisitions had significantly changed the company’s actual operations relative to plan. The company’s decision to pursue a recent significant acquisition was not included in the budget submitted to the bank shortly before the acquisition. The unpredictability of these actions, the ongoing cost to integrate these acquisitions, and the lack of accurate planning highlights the difficulty in evaluating the adequacy of the company’s liquidity to meet future operating needs.