Covenants in a facility agreement are designed to protect a lender's investment during the term of the loan. They aim to ensure that the financial condition, business and assets of the borrower remain within the limits which formed the basis of the lender's original credit assessment on the granting of the loan. Financial covenants usually monitor interest and cashflow cover, leverage ratios and net worth. In order to monitor compliance with financial covenants, lenders will require the borrower to provide financial information on a regular basis against which the financial covenants can be tested.
Financial covenants in facility agreements have been the focus of much attention recently, as borrowers struggle to meet them in the light of significant deterioration in market conditions since the covenants were first agreed. They have become a point for renegotiation as borrowers seek to avoid being in default and lenders seek some leverage in renegotiating the costs of the loan.
As financial covenants are intended to be an early warning to the lender that the borrower's business may not be performing as well as was originally anticipated, they are often the first event of default to be triggered.
There are various options available to a lender upon the failure by a borrower to meet a financial covenant which triggers an event of default:
- accelerate repayment of the loan in full and, if payment is not made, exercise its rights under the securities granted in its favour;
- refuse to make further advances or to rollover existing revolving loans;
- exercise its "further assurance" rights - demand the borrower takes further action to perfect and protect any security and exercise greater control over the borrower's assets or cash.
Prior to financial covenant event of default - borrower's rights
There are three key periods for the purposes of any covenant test date (most likely to be the end of the borrower's financial year) when analysing whether an event of default has occurred or may occur as a result of a breach of a financial covenant.
First, the period before the test date. Neither the borrower nor the lender can be certain that the financial covenant will not be satisfied, even if it appears likely that this will be the case. If the lender is hesitant, the borrower should ensure that the lender continues to fulfil its obligations under the facility agreement on the basis that there has been no breach of the facility agreement at that time. However a lender may not be willing to wait until evidence is clearly available and may instead seek to argue that there has been a material adverse change which constitutes an event of default under the facilities agreement. This would be a fairly aggressive step, particularly given the usual uncertainty of determining that a material adverse change has occurred.
Secondly, there is the period from the test date until the financial statements relating to the testing period and the related compliance certificate have to be delivered to the lender in accordance with the facilities agreement. The lender may seek to argue that a potential event of default exists, but without the necessary financial information being available, the borrower can dispute this. The alternative course for the lender would be to ask the borrower to confirm that it is not aware of any breach, in which case the borrower would need to carefully consider its response in light of the information available to it.
Finally, there is the period after the delivery of the financial statements relating to the testing period and the related compliance certificate. It is only in this period that both the borrower and the lender can measure the financial covenants against the financial information provided and ascertain whether a breach has occurred.
As soon as a financial covenant breach has occurred, the borrower should consider whether it has the right under the facility agreement to cure a breach for loss of cash flow or EBITDA by obtaining funds from its shareholders (if they are wiling to invest funds)by way of additional equity or subordinated loans into the borrower.
The terms setting out the availability and effect of an equity cure should be carefully reviewed for any restrictions they place on when and how often the cure may be exercised and what it can achieve. The equity cure may be used to add to EBITDA or cash flow (which works well for the borrower) or to prepay the debt (which is better for the lender). A borrower should consider the equity cure as soon as possible to give its shareholders as much time as possible to consider whether they want to invest more into the borrower.
If feasible - in practical as well as legal terms - this could be useful to a borrower to reduce the principal amount of debt and so improve the gearing as well as reducing the regular payments required to service the debt.
If the borrower's position deteriorates to such an extent that it no longer has a reasonable prospect of avoiding formal insolvency or it becomes unable to pay its debts as they fall due, the borrower ought to take immediate advice as statutory duties will become relevant. These will be particularly important for the directors to bear in mind as they may find that they incur personal liability if the borrower continues to operate while it is insolvent.