Covenants on Loans and Bonds issue - Key points

When companies want to raise debt from banks or debt from the public (Bonds), they are usually required to meet some financial criteria and to meet other restrictive conditions, aimed to ensuring the ability to repay the debt to the lender.

We will review the key points in related to covenants:

Financial criteria (covenants) are the terms set out in a loan contract that a borrower company signs, and their purpose is to protect the lender. Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. The purpose of the conditions is to ensure that there is no adverse change in the borrower's condition and in his ability to repay the loan.

In addition, Debentures include various contractual terms and financial criteria. In these terms and conditions, the lender stipulates that the borrower company must meet the minimum requirements of a certain financial ratios. The client must meet some ratios between various items in the company's balance sheet, such as the ratio of debt to equity or the ratio of shareholders' equity to the total balance sheet, liquidity ratios, a certain level of collateral and the like.

Failure to comply with the conditions may result in the lender's demand to immediately repay all the company's obligation to it and even to forfeit guarantees. In some cases, lenders limit the amount of the dividend to the maximum rate of the company's total profits, and set the contractual stipulations determine the order of priority in case of insolvency.

Generally, there are two types of covenants included in loan agreements: affirmative covenants and negative covenants.

Affirmative Covenants

An affirmative or positive covenant is a clause in a loan contract that requires a borrower to perform specific actions. Examples of affirmative covenants include requirements to maintain adequate levels of insurance, requirements to furnish audited financial statements to the lender, compliance with applicable laws, and maintenance of proper accounting books and credit rating, if applicable.

A violation of an affirmative covenant ordinarily results in outright default. Certain loan contracts may contain clauses that provide a borrower with a grace period to remedy the violation. If not corrected, creditors are entitled to announce default and demand immediate repayment of principal and any accrued interest.

Negative Covenants

Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a borrower must maintain as of the date of the financial statements. For instance, most loan agreements require a ratio of total debt to a certain measure of earnings not to exceed a maximum amount, which ensures that a company does not burden itself with more debt than it can afford to service.

Below are some Examples for common covenants (Bank Loans & Debentures):

· Maintaining shareholders' equity-to-balance sheet ratio.

· Maintaining an amount of certain equity.

· Restriction on bank leverage amounts.

· Excess cash flows from repayments of loans at other banks.

· Restriction on dividend as a source of credit repayment.

· Certain amount of EBITDA numbers.

· Customer debt in relation to total bank credit.

· Merger restrictions - A restrictive or negative condition that prevents the issuer from merging with another entity.

· Certain Sale of Assets - A clause that restricts the issuer's ability to sell some or all its assets in a manner that would harm the bondholders.

· Restriction on activities - a negative condition that may place restrictions on the issuer's business activities.

· Negative pledge - The company undertakes that it will not pledge any of its assets if it has a detrimental effect on current bondholders.

· Restrictive covenant - a clause, which is essentially similar to a negative condition, which constitutes an obligation of the issuer to refrain from any activity that may be considered harmful to the bondholders.

· Change of control - The condition that allows the bondholders to sell the securities back to the issuer when taking over the company, a merger or reorganization to prevent takeover, as a result of which the company's assets are significantly reduced.

· Negative covenant - a restrictive clause that aims to prevent an issuer from granting benefits to shareholders at the expense of the bondholders.

· Cross default - The condition whereby a bond becomes insolvent, and then will be put into immediate repayment, if another security of the issuer is insolvent.

· Limit of indebtedness - The condition is restrictive or negative, which limits the amount of debt that the issuer can take.

· Limitation on subsidiary debt - the condition is restrictive or negative, which limits the level of debt that the issuer's subsidiaries can raise.

· Restricted payments - The condition is restrictive or negative, which limits the issuer's ability to provide cash, assets or securities to shareholders, pay off deferred debt, repurchase shares or distribute dividends.

· Rating trigger - a clause that allows bondholders to return the bonds to the issuer in the event that the rating falls below a certain pre-determined level.

· Collective action clause - a clause that gives a special majority (supermajority) of bondholders the option to make significant changes to the terms of the bond.

Source:

1. Covenant By ADAM HAYES - https://bit.ly/3qv2HtW

2. Wikipedia - https://bit.ly/3bR8CWk