Biggart Baillie Solicitors

Into the Breach - Covenants in Loan Agreements

Thursday, March 05, 2009

by Grant Docherty and Rachel Gervaise

For borrowers, the arrival of their financial year-end brings with it the need to provide financial information to lenders, against which the lender will test financial covenants in loan agreements. 

31st March is one of the most common year ends for UK companies and many companies may be facing the prospect of failing to meet the financial covenant tests or having to provide accounts which show a deteriorated performance against prior years. This article considers the possible consequences of breach of loan covenants.

Article

For borrowers, the arrival of their financial year-end brings with it the need to provide financial information to lenders, against which the lender will test financial covenants in loan agreements.  31st March is one of the most common year ends for UK companies and many companies may be facing the prospect of failing to meet the financial covenant tests or having to provide accounts which show a deteriorated performance against prior years.

Many loan agreements contain financial and other covenants which require the borrower to provide the lender with certain audited or unaudited financial information against which the lender will test the financial strength of the borrower.  These covenants are used by the lender to ensure that over the life of the loan the borrower remains financially sound and continues to meet the lending criteria the lender used in providing the facility when it was first negotiated. The breach of any of the covenants in the loan agreement would normally be an event of default entitling the lender to accelerate the loan, to enforce any security it may have and to cancel any commitment to lend any undrawn part of the loan. These are serious consequences for any borrower.

As the year-end approaches, it is advisable to be prepared by reviewing loan documentation and considering provisions that may be relevant if the borrowers financial position is not as strong as it may have been in the past.

Back To Top 

Financial Covenants

• It is not uncommon to set a loan to value ratio, so that the amount of outstanding debt must not exceed a specified proportion of the value of assets or other collateral. Such provisions are common in property financing arrangements. The key for the borrower with such a covenant will be the valuation against which the ratio is to be tested. An initial valuation by surveyors made at the time the loan was arranged will have satisfied the initial lending criteria. This valuation may not have been updated, even although the borrower may be aware that property values have fallen.

It is often the case that the lender is entitled to require an up to date valuation to be prepared by a suitable expert such as a surveyor. The lender may not need to wait for a year-end in order to require the valuation to be prepared, and this is usually at the expense of the borrower. 

• Interest cover, cashflow cover and earnings to debt ratios are also common whereby income or adjusted income must exceed by a specified amount the interest or total debt service costs or must be a specified percentage of total borrowings. This tests the liquidity of the borrower. Assets may exceed liabilities, but if the borrower does not have sufficient cash flow it will be unable to service the interest payments and any capital repayments. The borrower may be aware that the test will not be met in advance of the date on which the figures will be calculated. The lender cannot normally call a default under this provision until the date for applying the financial test has arrived and the figures provided which demonstrate the breach.
  

Back To Top  

Non-Financial covenants and other events of default

• Providing copies of the audited accounts within a specified period of the year-end is an almost universal requirement.  Failure to do this is normally an event of default, so that knowing financial information is poor and not providing it to the bank will only delay the inevitable. However, the borrower may also face the problem of not being able to have the audited accounts signed off in time if the auditors are concerned with the possibility of a default under the borrowing facility. The qualification of the audit report can itself be an event of default.
  
  
• Many loan agreements contain an event of default where there has been a material adverse change in the position of the borrower or a material adverse event has occurred. The ability and circumstances in which a lender may call an event of default using such a provision is very much based on the exact drafting of the provision, which is often heavily negotiated. The provision may have to be tested objectively – has the event occurred – or may be in the subjective opinion of the lender that an event has occurred which affects the borrowers ability to repay. A lender may call an event of default under this provision before the borrower has furnished any relevant accounts to apply other financial covenant tests, where it anticipates a breach.
  
  However this would be a very aggressive, and somewhat risky approach for a lender to take. Breach of a clear fiscal test is easier to establish and unless the assets are at risk, or the lender is looking to prevent drawdown of a facility, the lender may chose to wait for financial information before assessing the position.
  
  
• The occurrence of any insolvency events or the borrower not being able to pay its debts are usually events of default. Whilst the occurrence of an insolvency event such as the beginning of insolvency proceedings by petition for the appointment of a liquidator or notice of the appointment of an administrator will result in immediate action by a lender, the lender is often also able to call an event of default based on the borrower being unable to pay its debts as they fall due, applying the Insolvency Act test of insolvency.
  
  The lender may consider that the financial information discloses that the borrower is insolvent. It is unlikely that a company will be able to have its audited accounts signed off by the auditors on an unqualified basis if it is unable to pay its debts as they fall due, and directors who consider that there is any real possibility that the company is insolvent must take great care to ensure that they do not engage in wrongful or fraudulent trading for which they could be personally liable.
  
  
• Cross default provisions are often included whereby the default of the borrower under any other financing agreement will be an event of default under the lenders agreement. This prevents the borrower failing to pay one lender to keep another from defaulting its facilities. Robbing Peter to pay Paul rarely works - the default of one will usually default the other.

Back To Top  

Whereas many lenders will expect to find a borrower’s financial positions is not as good as in previous years they may not immediately seek to trigger default clauses. There is usually no time limit on the lender exercising their rights, or any implied waiver of the right to call a default if they do not, but the position of the borrower is considerably weakened when negotiating facilities with its lender when a default has occurred. 

The lender may allow the facility to continue notwithstanding the event of default, but ask for supplemental information to monitor more closely the borrowers position. From the lenders perspective , it is concerned with the ongoing financial viability of the borrower. If the lender triggers the default and sells assets using the powers in security documentation the lender may not, in the current weak economic environment, recover as much as if it allowed the borrower to continue to trade and service the debt as best it can, until economic recovery starts.

As soon as a borrower is aware that it may be at risk of breaching covenants in its loan agreements it should be considering taking advice on the terms of its financing documents and reviewing what steps it can take to mitigate the position. It may be possible for small to medium sized businesses to access government funding from one of the government's initiatives to provide working capital, loan guarantees or additional equity investment, made available to assist financially viable businesses. Taking up any of these facilities will require negotiation with existing lenders

The Government is also encouraging all banks to continue to lend, which it sees as an obligation on banks as a result of the bail out they have received by way of government funding.

It may therefore be the case that defaulting borrowers have less to fear than they imagine. The key will be ensuring good monitoring of the business’ financial position, having a clear understanding of the rights and obligations under lending agreements, and good communication with lenders.

Back To Top 

If you have any queries in relation to the above, please contact Grant Docherty (gdocherty@biggartbaillie.co.uk or 0131 226 5541) or Rachel Gervaise (rgervaise@biggartbaillie.co.uk or 0141 228 8000).