Negative Covenants in Lending Transactions
By Paul Wolpert
In corporate loan agreements, negative covenants are restrictions and prohibitions that are designed to preserve the credit of the borrower as it was when the lender initially made its underwriting decision. In order to achieve this, negative covenants allow the lender to:
- Impose operational restrictions designed to maintain the character and cash flow of the borrower’s business
- Restrict activities that would alter the creditworthiness and risk profile with respect to the borrower
- Ensure the borrower’s continuing ability to repay the loans
Negative covenants, which typically apply to the borrower and each of its consolidated subsidiaries, generally begin with a broad prohibition before enumerating specific exceptions. The scope of these prohibitions and exceptions will depend on the size and type of the relevant loan, the borrower’s creditworthiness and relative negotiating power, whether the loan will be syndicated, and the lender’s risk appetite.
The majority of the exceptions to negative covenants are designed, in light of the broad nature of the prohibitive provisions, to permit the borrower to continue operating in the ordinary course of business. Other exceptions recognize that, over the course of the term of the loan, the borrower may need to take certain otherwise prohibited actions, such as incurring additional debt or selling assets, in reaction to changing market realities. When these contingencies are built into the loan agreement, they are typically narrowly tailored or otherwise limited (either by dollar amount or by reference to a financial ratio). With respect to bilateral loans to small-cap borrowers, however, lenders often prefer to include only limited exceptions to the negative covenants, opting instead to require the borrower to request a consent or amendment each time they wish to engage in a prohibited activity.
Below is an overview of certain negative covenants commonly found in loan agreements.
For lenders, additional debt means, among other things, (1) additional payments of principal and interest that reduce the amount of cash flow available to service the lender’s loan and (2) additional leverage, which potentially dilutes the lender (particularly to the extent it is unsecured or under-secured) in relation to the assets underlying the credit.
In order to address these impacts, the debt covenant prohibits the borrower from incurring additional indebtedness during the term of the loan. Indebtedness is typically defined broadly and includes, among other things, any indebtedness for borrowed money as well as any guarantees, capital lease obligations, and obligations with respect to deferred purchase price (including accounts payable and earnouts). In addition, debt covenants often prohibit the issuance of equity securities that look and act like debt – such as any preferred stock that pays dividends and “matures” (i.e. is subject to mandatory redemption) during the term of the loan.
The broad prohibition in the debt covenant is typically subject to a number of exceptions including, but not limited to:
- Trade payables in the ordinary course of business and certain other ordinary course obligations (such as obligations under surety bonds and performance guarantees)
- For borrowers with subsidiaries, intercompany debt – This allows the borrower to use intercompany loans for internal cash management purposes. However, this exception typically only applies to subsidiaries that have provided a guarantee of the loan, ensuring that the cash remains within the credit group (and therefore subject to a direct claim by the lender). Intercompany debt is often required to be subordinated.
- Purchase money debt incurred in connection with the purchase of a capital asset useful in the borrower’s business – This exception may be subject to a dollar limit.
- Debt existing on the closing date and listed on a schedule to the loan agreement
- Other debt up to a specified dollar amount (which is typically derived as a percentage of EBITDA) – This is often called a “general basket” and is more common in mid- and higher-cap transactions.
For an unsecured lender, the existence of a lien means that another creditor has a claim to the borrower’s assets that is senior to that of the lender. For a secured lender, other liens may affect the priority of the lender within the capital structure and grant other creditors a competing claim to the assets of the borrower.
The lien covenant addresses these issues by prohibiting the borrower from incurring, or suffering to exist, any liens during the term of the loan, except for permitted liens. The definition of permitted liens typically includes, among other things:
- Certain liens arising by operation of law and certain other types of liens commonly incurred in the ordinary course of business (such as under insurance arrangements)
- Liens existing on the closing date and listed on a schedule to the loan agreement
- Liens securing purchase money debt, but only to the extent of the asset that was the subject of the purchase
- In mid- and higher-cap transactions, liens securing otherwise permitted indebtedness up to a general basket amount (which may be determined either as a dollar amount or by reference to a financial ratio)
Asset Sale Covenant
From the perspective of a lender, asset sales (1) alter the asset base that was the basis of the lender’s initial underwriting decision and (2) convert income-generating assets into cash, thus reducing the borrower’s ability to continue generating cash flow to service the loan in future periods. In order to address these potential impacts, the asset sale covenant prohibits the borrower from selling assets during the term of the loan. The definition of asset sale is typically broad and includes any sales, transfers, conveyances, and other dispositions, whether or not for value.
The asset sale covenant typically includes exceptions allowing for, among other things:
- Sales of inventory in the ordinary course of business and dispositions of accounts receivable in connection with a collection or compromise thereof
- Sales of obsolete or worn-out assets
- Transfers of assets within the credit group
- In mid- and higher-cap transactions, sales of assets for cash at fair market value, up to a general basket amount (which may be determined either as a dollar amount or by reference to a financial ratio or other financial metric).
The loan agreement may also include provisions requiring the net cash proceeds from certain permitted asset sales to be used to either (1) reinvest in assets useful in the borrower’s business or (2) pay down the loan.
For lenders, investments (including loans) in other persons or entities mean (1) that cash is flowing outside the credit group, where the lender will not have a direct claim on it and (2) that excess cash that could have been used to pay down the loan is being used for another, perhaps speculative, purpose. To address this, the investment covenant prohibits the borrower from making any investments, including loans, advances, equity purchases, note purchases, and asset acquisitions. Exceptions to this prohibition often include, among other things:
- Investments in “cash equivalents,” such as government bonds and other low-risk, liquid investments
- Investments within the credit group
- Investments in assets useful in the borrower’s business, often subject to a cap
- Loans to employees, often subject to a cap
- Investments existing on the closing date and listed on a schedule to the loan agreement
- In mid- and higher-cap transactions, investments up to a general basket amount
Restricted Payments Covenant
Restricted payments are amounts paid to equity holders, including distributions and equity redemptions or repurchases of the borrower’s equity interests. For lenders, restricted payments mean (1) that cash, which could be used to pay down or otherwise service the loan, is flowing out of the credit group and (2) that payments are being made with respect to junior obligations – i.e. obligations that rank behind the lender in the capital structure – before the loan has been paid off. To address these issues, the restricted payments covenant prohibits the borrower from making any restricted payments while the loan is outstanding. Some lenders will allow the borrower to make restricted payments under a basket, which may be a fixed amount or which may build over time based on an earnings-based metric. Some lenders may allow for the payment of cash distributions subject to pro forma compliance with financial covenants, including a coverage ratio (with distributions deducted from the EBITDA side of the ratio).
Other Negative Covenants
Loan agreements often include a number of other covenants including, without limitation, the following:
- Financial covenants designed to measure the borrower’s cash flow, leverage, liquidity and/or net worth, in order to ensure that the borrower will continue to be able to service the lender’s debt
- A covenant prohibiting the borrower from merging or consolidating with another entity, and from liquidating or undergoing a change of control
- A covenant prohibiting transactions with affiliates unless they are on arms-length terms, no less favorable to the borrower than terms that could have been obtained from an unaffiliated third party – This covenant prevents “value leakage” in the form of sweetheart deals with affiliate entities or persons.
- A covenant limiting the borrower’s ability to make capital expenditures, which reduce cash flow available to service the loan, often subject to a specified annual cap
- A covenant restricting the borrower from changing its line of business from what was being conducted at the time the loan closed, when the lender made its credit decision.