TOOL L2
General Points
- These Covenants are intended to prevent other stakeholders obtaining direct control
- Apart from Pari Passu they should be taken on a group basis where commercially possible
- Checking compliance is difficult. The right to insist on independent compliance helps mitigate this.
- Many of these clauses are relevant for ISDA documentation but usually only on a counterparty basis. Special amendments are needed for group application
- Note that issues of debt priority, debt and guarantee levels can also be addressed via financial covenants
| Risks | Covenant | Key Issues | Concerns |
| Debt Priority | Pari Passu | – With whom are we Pari Passu? (Often only with other unsecured creditors) – Exactly how is the clause defined? – The stronger equally rateable clause is sometimes used. | – Only deals with distribution of assets in a liquidation, it does not require equal treatment before that time. – Does not, on its own, prevent: 1. Additional secured debt or the issuance of guarantees (Use negative pledge / restrictive covenants) 2. Agreeing tighter conditions with other creditors including set-off 3. Selling assets (Use a non-disposal of assets clause) 4. Accelerating repayment to other creditors (Use non-acceleration or cross acceleration clauses) 5. Other stakeholders taking recovery action before us (use cross-default clause) 6. Structural subordination if the borrower is Holding Company (See Possible Mitigants for Holding/Operating Companies) – See items under negative pledge |
| Debt Priority | Negative Pledge | – Which assets, contracts and cash flows are covered by the clause? – Are there significant exceptions? – Are future assets, contracts and cash flows covered? What happens on acquired secured debt? – What types of security are permitted? | – Negative Pledges often fail to prevent 1. Issuance of guarantees (Either include in the clause or use a restrictive covenant) 2. Set-offs or liens in the normal course of business 3. Transactional security through control of cash flows or trade finance documents 4. Title retention in supplier contracts 5. Leasing / Hire purchase financing (Use a restrictive covenant) 6. Special finance transactions such as repos, factoring, asset securitisation, sales and lease backs (Use a restrictive covenant) 7. Acquisition of assets which are already subject to secured debt 8. Rights of officials in insolvency proceedings – See also set off / netting below |
| Debt Priority | Prevention and / or acquisition of set off rights | – Is the relevant jurisdiction set off / netting friendly? | – These rights can be different in loan documentation and ISDA dcumentation with the same counterparty – Take care with these rights for derivative and cash management banks |
| Other creditors acting before we do | Cross Default | – Who and what do we cross default to? – Does our clause contain a cross acceleration provision as well? – Is there a threshold amount? | – This is a very powerful clause which must be used carefully to avoid a “domino effect” which might be harmful to the banks own position. – Do we have cross default between our own facilities (funded and non funded)? – Is the threshold set at a realistic level so that we still get protection but without defaults occurring frequently on non-material amounts? – Do other stakeholders rely on a non-discretionary pre-payment clause rather than cross default? |
| Disposal of key cash generating assets | Non Disposal of Assets | – Does the clause apply only to assets of the borrower or to other credit bases as well? (e.g. subsidiaries) – Is the clause an absolute restriction on disposals or are there exceptions? | – Client will wish to retain maximum flexibility. – The clause should not prevent the client from managing his business. – For Holding companies, the definition of assets must include shareholdings in subsidiary companies. |
| Dilution | No / limited additional debt / guarantees | – Link to levels and definitions of financial covenants | – Definition of debt – Our primary concern is with financial guarantees. Customer will wish to exclude commercial guarantees in the normal course of business. |
| Change of ownership / Control | No change of ownership / Control | – Is the clause an absolute restriction or merely a need to advise the bank? – Does it refer to shareholders and / or investments in subsidiaries? | – Often difficult to negotiate with a publicly quoted or widely held client. In that case a “Change of Control” clause may be more appropriate. |
| Unforeseen events | Material Adverse Change | – How is the clause defined – Is it clear what is “material” or “adverse”? | – This clause is a good “catch all” but is rarely called because of the potential for argument about definitions and the impact of the change in question. – The best use of MAC is to prevent draw down under a committed facility. – If the bank is concerned about a specific risk then a more specific clause must be used to provide protection. – Take care when using with other financial covenants which are not breached. |
