Loan Agreement: Financial Covenants
It has already been noted that the normal legal meaning of covenant has no relevance to the use of the word in loan agreements. This group of clause are terms of the contract whereby the borrower makes certain promises as to his future performance and behaviour. By way of preliminary comment, the following discussion assumes a corporate borrower, country borrowers are less suited to covenants which will be designed differently in their case.
The most important covenants are probably the financial covenants. These are based on various accounting ratios and are designed to give a lender early warning of a default by the borrower. If one considers a failure by the borrower to make a payment as an actual default, a breach of financial covenant can be seen as an anticipatory default. Both have the same effect, however, which is that an event of default has occurred with the lender's consequent right to accelerate the facility.
Financial covenants can be based on any combination of the following non-exclusive list of ratios:
• ratio of debt to equity
• ratio of current assets to current liabilities
• minimum net assets
• minimum working capital
• interest rate cover
In addition covenants will be included as follows:
• restriction on mergers
• restriction on disposals of assets
• restriction on dividend distribution
• restriction of rapid growth
• restriction of change of business
• restriction on borrowing
• restriction on leasing of assets
• obligation to maintain assets in good condition
• obligation to insure assets
• obligation to provide copies of accounts of the company as they are produced
Clearly some of the above require qualification or quantification. For instance, a restriction on disposal of assets could hardly be absolute as a borrower would be committing technical events of default on a daily basis and this is never desirable due to the impact of the cross-default clause . Solutions include an exclusion of assets sold in the normal course of business and a 'basket' exemption of a certain proportion of net assets.
Covenants are also designed to preserve the ranking of the lender. Where a loan is secured this may not be necessary if the lender considers the security adequate, although a floating charge invariably involves a promise from the borrower not to create charges which would rank superior or equal to it (known as a "negative pledge"). It is a matter of some debate in English law whether such a promise subordinates a charge taken in contravention of it. In practice registration of the prohibitive clause is sufficient to preserve the lender's position. Clearly the position is not so straight forward when the loan is cross-jurisdictional and the assets being secured are in a range of countries.
In loan agreements it has been standard practice to incorporate a negative pledge when the loan is unsecured. The aim is to ensure that whilst the lender will not rank ahead of other creditors, he will at least rank equally with them. A number of problems are associated with this clause, however. First, there is a problem of defining the scope of the clause. It must be drafted to include all the different kinds of security which may be created. Under English law alone this includes a mortgage, charge, lien, pledge and hypothecation. The clause should list all of these and then go on to include a wrap-up phrase such as "any other encumbrance". The problem remains, however, that title financing schemes are excluded by this definition. The most obvious is the sale and leaseback whereby instead of mortgaging an asset, the owner of it sells it and leases it back which achieves a similar, but not identical, result. Alternatively instead of buying an asset and mortgaging it, a borrower might simply lease it from the institution which would have been the secured lender. It is true that restrictions on disposals and on leasing would be effective in these cases, however. Another problem is that the clause may be over-restrictive as a borrower may legitimately need to charge assets, e.g. purchase money finance, or may do so without wishing to, e.g. non-consensual security such as the repairer's lien. Once again a lender will not wish there to be technical events of default. The above can be specifically excluded and a basket exemption can be incorporated, i.e. charges of a certain proportion of the borrower's assets does not breach the covenant, and, perhaps less satisfactory, that charges are permitted if the lender receives equivalent security .
Breach of the negative pledge will be an event of default with the usual consequences but of course if the breach of it involved the charging of the borrower's assets to another creditor, the lender will be in a poor position. This has led to the extension of the clause to state that if the negative pledge is breached, equivalent security will automatically be created in favour of the lender. The effectiveness of such a provision has been the subject of considerable discussion and in an international scenario any number of legal problems can arise. In English law alone there is the matter of whether such a provision requires registration, whether any security automatically created by it would require registration (or registrations in more than one register), whether it would be void for want of all necessary registrations, whether it would be void as a preference, whether priority would be lost and whether specific performance could be obtained to perfect the charge, e.g. to execute the necessary deed in the case of a charge over land.
There is little prospect of the negative pledge having the effect of voiding the charge taken in breach of it, even if the second lender knew of the restriction. However, a second lender who took the charge knowingly in breach of the negative pledge could be sued for the tort of inducing a breach of contract by another (i.e. by the borrower of his promise to the first lender). Also a lender who came to know that a charge was about to be granted to a second lender could seek an injunction to prevent the borrower from committing the threatened breach of contract.
Finally equal ranking is also protected by a 'pari passu' clause which restricts the creation by the borrower of non-secured debts which would rank ahead of his debt to the lender. In English law the only example of this is the category of preferential creditor which is created by the Insolvency Act 1986 and which only becomes relevant on the liquidation or administrative receivership of the borrower. This is common to many country's insolvency laws and other jurisdictions contain further examples . In English law preferential creditors are limited to the employees of the debtor for unpaid wages and pension fund contributions, the so-called Crown Preference whereby government departments could claim preferential creditor status for certain unpaid taxes was abolished by the Enterprise Act 2002. A borrower cannot confer preferential creditor status on a creditor, it arises only by operation of statute. It is, however, open to a borrower to decide whether or not to borrow money to pay wages. Some lenders take the view that it is wise to exclude preferential claims from the ambit of the pari passu clause as it invites the problem of technical breaches, which are undesirable due to the widespread use of the cross-default clause. In sovereign loans, the pari passu clause has little relevance as a sovereign party cannot be made bankrupt and therefore is unlikely to be able to confer higher-ranking on any unsecured creditor.
The clause is typically phrased as:
“The payment obligations of B rank at least pari passu with all its other present and future unsecured obligations.”
In some recent cases, it has been argued that the clause means that any payment to another creditor that is not made pari passu (as opposed to not ranking pari passu) to the lender is a breach of the clause in the lender’s agreement. Such a broad interpretation of the clause would permit a creditor to prevent a borrower from making any payment to other creditors unless an equivalent payment was made to himself. In Kensington International v Republic of Congo , an injunction to restrain a payment to other creditors was not granted as it was deemed inappropriate in any case, no view was taken on the wide or narrow meaning of the clause. In Republic of Nicaragua v LNC Investments , a Brussels court did agree with a broad interpretation of the clause and granted an injunction to prevent the payment of interest on unrelated bonds issued by Nicaragua.