When the covenants fall – the risk of recovery in covenant based lending

In case of insufficient real security, so called covenants are used in company financing to compensate the risk of the bank in the lending. The use of covenants has been demonstrated to be more common in lending to SME-companies than to large companies, but the choice of covenants are effected by many factors i.e. the purpose of the loan and the capital structure of the borrower. To make lending possible when the security mass is deficient, covenants may provide a sufficient risk management mechanism, even though the banks’ first choice is real security.  Corporate financing is increasingly based on cash flow thinking. Attention is paid to the borrower’s actual solvency and to the banks’ possibilities to assure protection against the risks that are included in the borrower’s business. The purpose of the covenants is to assure the borrower’s solvency, provide the bank with information of decreased solvency in sufficient time for the bank to be able to effectively intervene and finally to secure repayment, if the credit risk is realized.

Covenants are principally divided into three categories; restrictive covenants, financial covenants and information covenants. The restrictive covenants are traditionally oriented to preserve the borrower’s assets and the structure of ownership, when the information covenants aim to secure the banks’ access to the information needed to monitor that the borrowers is not in default. The financial covenants are a warning mechanism regarding the borrower’s financial position and are generally linked to financial ratios. For the covenants to be effective, they are linked to sanctions that generally provide the bank a right to terminate the facility agreement in case the borrower violates the covenants.

In the ongoing financial crisis, the financial covenants will fall above all when the business prerequisites are restricted and the business income decreases. Suppose that the borrower’s financial position and liquidity is greatly degraded and the bank utilizes its termination right, with the result that the credit becomes payable in full. The repayment may risk putting the borrower in insolvency and pushing it towards bankruptcy. What protection do the bank have in this situation against the risk that the payment, which itself is based on an earlier negotiated contract, is recovered in the case the borrower is declared bankrupt? The answer is – actually no particular protection at all.

The Act on the Recovery of Assets to Bankruptcy Estates (758/1991) regulate the basis for recovery, which may be applicable for instance on payments from the debtor to a lender within the last three months before the claimed due date, i.e. the day when the petition in bankruptcy was brought before the court. The recovery time is considerably longer if the receiver has a close relationship to the debtor. The law is compulsory for the benefit of the creditors’ collective. As well as the general basis for recovery in 5 §, as recovery of payment of debt in 10 § could be applicable in a situation when the credit is due for payment as a result of the borrower’s covenant breach.

Recovery of assets in accordance with 5 § is contingent on three prerequisites. In the case of the repayment of a loan this would require that (a) the loan payment has favored a creditor in an undue manner, (b) the debtor was insolvent when the payment was made or became insolvent as a result of the payment, and (c) the creditor was aware or should have been aware of the debtor’s insolvency or the payments significance for the debtor’s financial position and the circumstances that made the act undue. The prerequisites for recovery of debt payments are that the payment has been made with unconventional payment methods, prematurely or that the payed amount is considerable in relation to the assets of the estate. Notwithstanding the aforementioned, payments are not recoverable if they are considered conventional in the light of circumstances at the time of payment.

The financial covenants trigger the bank’s right to accelerate the loan, allowing the bank to manage its risks and demand immediate repayment of the outstanding debt when the debtor’s financial prospects deteriorate. The bank would undoubtedly benefit and improve its position at the expense of other creditors if the debtor simultaneously became insolvent. It is, however, probable – depending on the bank’s role as a creditor (e.g. principal lender) – that repayment of the entire amount would increase the risk for the debtor’s insolvency. As the bank continuously oversees the financial situation of the lender during the loan period as a result of the information covenants, it is also likely that a bank would be considered aware of the significance of the repayment for the debtor’s financial position, its possible insolvency, and that the payment may favor the bank in an undue manner.

The covenants and the basis for termination have been agreed upon, together with the payment schedule and other terms, prior to the facility being made available to the borrower. Is it possible that an agreed basis for termination yet can be considered as a premature payment, and consequently fall into the sphere of recovery? There are no actual case law on the subject, but at least the draft legislation states that a payment based on the debtor’s payment request may constitute an early repayment in accordance with 10 §, if the terms of payment deviate from the parties’ previous practice. Thus it can not be excluded that a repayment based on a default clause would constitute an early repayment according to the the Act on the Recovery of Assets to Bankruptcy Estates. The bank should also be able to assess whether the amount of the payment is considerable relative to the assets of the bankrupt’s estate. In particular if the bank is the borrower’s principal lender, the borrower is usually obliged to manage its payment operations through the bank, which provides the bank with good insight into the borrower’s assets.

The risk of recovery result in covenant based lending having a very different starting point when insolvency is approaching, than lending on real security. The bank can safely convert a pledge into money even though the borrower is threatened by insolvency or bankruptcy. The money received will benefit the creditor without the risk of recovery, provided that the pledge was conditioned in connection with the lending. Can covenants still be a satisfactory risk management mechanism and what other options does the bank have to handle the risk of recovery?

To avoid having to act within a potentially recovery period, the covenants need to cover relevant parameters (e.g. cash liquidity) and need to be set on a level to be triggered early enough, before the borrower is close to actual insolvency. Moreover, a sufficiently frequent follow-up is needed to ensure discovery of deviations on time. However, too strict covenants do not serve the relationship as a whole and it has also been found to increase the borrower’s costs, primarily by increased interest rates in refinancing, but also by costs for restructuring to be able to manage the repayment. Finding the optimal level can be tricky, particularly in the beginning of a new client relationship when the bank do not know the borrower’s business or the business is in a starting phase. Furthermore, in a sudden and acute liquidity crisis, like the Corona pandemic has caused in some business areas, the covenants may fall at very short notice. In these situations, there is a great risk that the bank does not have time to react, in spite of well balanced trigger levels, partly because of delayed access to updated information and partly because the liquidity crisis surprised the borrower, who did not have time to adapt its business to maintain the ability to pay. The alarm did not go off before the damage was made.

If the bank already is in a situation where an acceleration of the credit risk to force the borrower towards bankruptcy, is it generally wiser not to let the credit fall due to payment, especially if the borrower under normal circumstances has a profitable business. The parties should instead seek other options to manage the risks and the repayment. If the borrower still has a sufficient cash flow, the bank may consider a quicker repayment of the credit. The parties may also renegotiate the payment schedule and the interest rates, making it possible to eventually restore the ability to pay, but at the same time compensate the bank for its increased risk. It might be worth to expand the real security if it is possible to do so, provided that the borrower is not already declared insolvent or can be assumed to be insolvent at this time. Security not conditioned in connection with the lending, run the risk of recovery in a bankruptcy. However, the objective should be to avoid bankruptcy or at least postpone it, i.e. through easing the payment schedule, so that security arrangements can be made before a recovery period begins.

Sources

• HE 102:1990
• Beneish, Messod D. & Press, Eric, Costs of Technical Violation of Accounting-Based Debt Covenants, The Accounting Review, vol. 68 No. 2/1993
• Bradley, Michael & Roberts, Michael R, The Structure and Pricing of Corporate Debt Covenants (University of Pennsylvania 2004)
• Malitz, Ileen, On financial contracting: the determinants of bond covenants, Financial Management, no. 2/1986
• Villa, Seppo, Velkojan asema osakeyhtiössä, Talentum, Helsinki 2003
• Välimäki, Olli, Kovenantit, 2014