As many treasury and finance professionals will attest, organizing covenants by the legal categories of affirmative, negative, financial and nonfinancial is not very helpful. A better approach is to classify covenants by lender objective and risk. Using lender objectives is effective because nearly every covenant can be easily classified into nine logical lender objectives. Doing so facilitates the accurate comparisons needed to eliminate repetitive covenants in the same agreement and determine the controlling covenants of multiple debt agreements.
Lenders tell borrowers which covenants are most important to them by stipulating 0-3 day cure periods. The “independent covenants” that are triggered by events and actions outside the agreement should have the initial risk focus rather than the “dependent covenants” that are triggered by the agreement’s independent covenants. Finally, it is relatively easy to winnow out the common boilerplate and “lender option” covenants. The latter are actions or payment demands initiated by the lender that the borrower must allow or pay.
The foundation of an effective and efficient debt compliance program is a comprehensive and prioritized covenant checklist. Developing one is a difficult, time-consuming task because it is much more than summarizing the affirmative and negative covenants sections of a debt agreement. Depending upon credit risk, a senior credit agreement will have 80 to 100+ covenants, with 35 percent to 50 percent of them scattered throughout the agreement outside these two sections.
Classifying covenants by lender objectives
In general, lenders have two objectives. The first is to preserve the status quo at debt issuance: the existing credit conditions, security and operations. The second is to be quickly informed of any adverse changes to the status quo so they can reevaluate the credit risk, the agreement terms, and the pricing. More specifically, lenders use covenants to maintain their collateral and security interests; to preserve the borrower’s assets and business operations; and to minimize third party claims, while allowing some limited claims.
In addition, lenders also require borrowers to make payments, meet performance benchmarks, regularly report results and report material events quickly after they occur. Lenders also give themselves the option of executing certain actions or demanding additional payments.
Risk defined by lender cure periods
Lenders aggregate covenants into events of default categories that have different cure periods based upon the importance the lenders attach to their compliance. Covenant violations related to the reps and invalid security and collateral agreements are among the lenders’ most serious covenant violations. Yet, in our experience, the reps and the security and collateral covenants (and any related security and collateral agreement) rarely receive more than cursory treatment in most debt compliance programs. While companies do make every effort to provide accurate reports to their lenders, few are aware that that an inaccurate report can be an immediate event of default. Lenders will also add other events of default that do not appear elsewhere in the agreement. They are standalone covenants that must be included in the covenant checklist. Common examples are:
- Cancellation of material contracts
- Guarantors’ default
- ERISA events
- Governmental actions
- Change of control
- Revocation of licenses.
Further identifying covenant risk
A risk-based debt compliance program focuses on the real, manageable risks by excluding:
- Dependent covenants: Covenants that are any required actions following a triggering of an independent covenant.
- Boilerplate covenants: Nearly all debt agreements will have these covenants, which include preparing the books in accordance with GAAP; compliance with the Foreign Corrupt Practices Act, the Patriot Act, etc.; ERISA events; becoming an “Investment Company” per the Investment Company Act of 1940; and Federal Reserve Board Regulation U on margin stock.
- Lender option covenants: These give the lender the right to request certain information at any time or demand additional payments based upon changed circumstances independent of the borrower.
By excluding the above covenants, we are left with a risk-based list of relevant, controlling covenants organized by logical lender objectives. Further risk analysis can be done, excluding the unlikely covenants from moderate to high-risk covenants, provided that the covenants deemed unlikely are periodically reviewed.
From this carefully vetted list, we can confidently develop a multi-agreement quarterly questionnaire process to document the compliance, a consolidated permitted baskets analysis, and a consolidated calendar of the regularly scheduled payment and document delivery due dates.
The covenant questionnaires, organized by objective and subject, provide a useful context to non-treasury/legal staff for why these covenants are important and why they need to be responsible for their compliance.
This checklist process identifies the covenants that need to be regularly monitored without cluttering the debt compliance program with covenants that are not relevant. However, in debt compliance the only authority is the debt agreements, not the checklist. Just like a map is not the territory.
So, whenever a covenant issue is raised, it is the compliance team’s responsibility to research the applicable covenant text and make sure that the company is in compliance with all of the covenant’s requirements, including any dependent covenants.
Jeff Wallace and Jim Simpson are managing directors of Debt Compliance Services LLC.
A longer version of this article appears in the July/August edition of AFP Exchange.