TOOL L9
What risks are we trying to mitigate?
A ring fencing structure attempts to protect the debt service capacity of a legal counterparty (LCP) by ensuring that the:
- cash flow
- assets
- liabilities (on and off balance sheet)
- contracts
cannot be significantly influenced or controlled by related parties. In particular, we are often looking to prevent the flow of cash out of our LCP to a parent or other related party.
[See footnote for other definitions of ring fencing ]
The Perfect Ring Fence?
A perfect ring fence can only be achieved when the bank is controlling every cash flow in and out of the company. This is rarely possible, and usually only with the appointment of a monitoring agent in recovery situations.
If there are commercial trading transactions or strong business dependencies between the parties, such as purchases of raw materials, a ring fencing structure will not be fully effective. In such circumstances you should watch out for the Parent forcing the subsidiary to take delivery of and pay for inventory it does not need or for the Parent refusing to deliver raw materials unless a certain price is paid.
Collateral
In structures where the bank is secured by charges on all assets, cashflows and contracts of the LCP, then the bank’s position is stronger, but there are still escape routes, such as:
- Transfer Pricing
- Intercompany Guarantees & Loans
Covenants will be required to mitigate partially these escape routes (see below).
Some protection can be achieved through the use of a “lock box” mechanism whereby third party accounts receivable are deposited directly into an account controlled by, and in the name of, the security trustee or collateral agent (the bank).
Ring Fencing Covenants
A stand alone covenant package (without collateral) is weaker protection than a structure with collateral. The following covenants should be included.
Non-Financial Covenants
| No distributions | – No dividends – No fees, management / administration charges, royalties – No / restricted interest on loans from related parties – No repayment of loans from related parties |
| Intercompany Transactions to be at arm’s length | – Trade transactions at market pricing – Restriction on trade payables days – Guaranteed continued supply at market conditions from related parties to our LCP – Trade receivables days to be in line with market practice – No sale of assets, except in the normal course of business at fair market value – If interest on loans from related parties is not restricted, then such interest should be at market rate |
| Restrictions on assets / contracts | – No loans to, or commercial contracts with, related parties including directors and shareholders – No sale or transfer of assets, contracts and intercompany advances – Exclude our LCP from group cash management schemes |
| Restrict investments | – No new equity investments – No creation of new entities – No future acquisitions of related parties |
| Restriction on liabilities | – No share buy backs – Intercompany loans received to be subordinated – No guarantees to be issued |
| Cross default | We would want power to call default if it is possible that other lenders to related parties could involve our LCP in legal action |
Unconsolidated Financial Covenants
Financial covenants on the unconsolidated accounts of the LCP force related parties indirectly to inject cash, profit or assets to avoid default. Stepping covenants in line with projections further improves control. Suggested covenants are:
| Covenant | Purpose |
| Debt Service Capacity Ratio | Ensures enough cash flows into the LCP to meet debt obligations |
| Debt / EBITDA Interest Cover Ratio | Limit (directly or indirectly) transfer pricing and / or debt levels |
| Minimum Net Worth Solvency | Protect the capital structure provided related party assets are excluded from definitions |
Footnote
Defintions:
- Protective covenants designed to restrict the shifting of assets and liabilities between parent and subsidiary. (Standard & Poor’s “Project & Infrastructure Finance Review” October 2002)
- Techniques used to insulate the credit risk of an issuer from the risks of affiliate issuers within a corporate structure. (Report to Nevada State Government 2003)
