COVENANT-LITE LOANS - Paul, Weiss

CONSEQUENCES OF NON-COMPLIANCEFailure to comply with financial maintenance covenants canhave serious and adverse consequences for a borrower. Inalmost all loan agreements with financial maintenance covenants, failure to comply with any one of them will result in animmediate event of default under the loan documents.One exception to this rule is if the loan agreement has an equitycure right. This right gives the borrower’s parent company aright to contribute equity to the borrower in an amount that,when added to EBITDA, would cause the borrower to be incompliance with the failed financial maintenance covenant.Equity cure rights, while not uncommon, are not a panacea fora borrower that is failing a financial maintenance covenant. Theequity owners might be unable or unwilling to use the right,especially if the amount needed to cure is large or the borroweris expected to fail the financial maintenance covenant again onfuture test dates. In addition, the use of equity cure rights maybe limited by the terms of the loan agreement. Although theserights are highly negotiated and vary from deal to deal, thereare often limits on the number of times and the number ofconsecutive times they can be used. There may also be limitson the size of the equity cure amount, either individually or inthe aggregate.Generally, loan agreements treat all events of default more orless equally. Upon an event of default, lenders have the right,among others, to demand immediate repayment by acceleratingthe debt and to exercise collateral remedies. In practice, however,market participants do not treat all defaults with the same levelof gravity.The most serious are payment and bankruptcy defaults.The next most serious are financial maintenance covenantdefaults because they are a warning that a payment default orbankruptcy might be pending for the borrower.The consequences for a borrower of a financial maintenancecovenant default are numerous and varied and will depend onseveral factors, including the specific terms of the borrower’sloan agreement and the composition of the lender group. Theconsequences of a financial maintenance covenant defaultcan include: Loss of liquidity. In a loan agreement with a revolvingcredit facility, it is usually a condition precedent that nodefault or event of default exists at the time a new loanis made. Even if the revolving credit is governed by aseparate loan agreement that does not contain the failedfinancial maintenance covenant, the revolving creditagreement is likely to contain a cross-default provision tothe loan agreement with the failed financial maintenancecovenant, thereby preventing the borrower from satisfyingthe condition precedent. Reputationaldamage. If the borrower is a publiccompany or has public debt outstanding, it may havean obligation to disclose any breach of a financialmaintenance covenant. Depending on the nature of theborrower’s business, this disclosure can cause customersto leave and go to competitors who are perceived to bemore financially sound. It can also cause suppliers totighten credit terms, potentially further straining theborrower’s liquidity. Increased interest costs. Many leveraged loanagreements require (or may allow lenders to require) theborrower to pay a default interest rate on its loans. Thisrate is often a 2% per annum increase over the nondefault rate. The borrower may also have to start using ahigher index for determining its interest rate (such as baserate instead of LIBOR). Both of these consequences canpotentially further strain the borrower’s liquidity. Cross default. A financial maintenance covenant defaultin one loan agreement may result in a cross default insome or all of a borrower’s other indebtedness. This canlead to greater pressure for protective bankruptcy filingsto fend off aggressive creditors. Distraction to management. Management may needto spend significant time negotiating an amendment,restructuring or workout of the loan terms in order towaive a financial maintenance covenant default. This candistract management from running the business or fixingthe problems responsible for the underperformance. Acceleration. The lenders may choose to acceleratetheir debt and demand repayment, which is very likely tolead to a bankruptcy filing.In addition, if a borrower cannot meet its financial maintenance covenants or, possibly, if prior to a default a borrowercannot show its auditors projected compliance, the auditorsmay issue a “going concern” qualification in its annual auditbecause of all the consequences that can result from an eventof default. In most leveraged loan agreements, this alone maycause an event of default because of a requirement for theborrower to deliver an unqualified audit. As a result, depending on the timing of when a borrower is no longer able toshow projected compliance with its financial maintenancecovenants, a borrower may have a default tied to its financialmaintenance covenants long before it actually fails a test.a Practice Note explaining events of default in loan agreements, Forincluding the rights and remedies of lenders, search Loan Agreement:Copyright 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.Events of Default on our website.Practical Law The Journal September 2011 39

(continued from page 37)CASH FLOW DEALSA typical cov-lite cash flow loan has the following structure: One loan agreement that includes both a funded termloan or series of term loans and a relatively smallerrevolving credit facility. However, there is a trend towardslenders refusing to provide revolving credit facilities incash flow financings (see below Elements of Post-CreditCrunch Cov-lite Loans). All of the credit facilities share the same covenants(other than financial maintenance covenants),mandatory prepayments and events of default. All of the credit facilities are secured by the samecollateral, which the facilities share ratably.Generally, these deals either have no financial maintenancecovenants or financial maintenance covenants that only applyto the revolving credit facility (see Box, Purpose of FinancialCovenants). In the latter case, remedies upon a breach of thefinancial maintenance covenants (usually a single covenant,such as a maximum leverage ratio) will be within the controlof the revolving credit lenders only. The revolving creditlenders (usually by majority vote of the class), to the exclusionof the term loan lenders, will have the power to: Amend the terms of the financial covenants. Declare an event of default relating to a breachof the financial covenants. Direct the exercise of remedies (including terminationof commitments to lend, acceleration of debt andforeclosure of collateral) resulting from an accelerationbased on breach of the financial covenants.Only if the revolving credit lenders do not agree to a waiver ofthe breach within a specified time period (usually between 45and 90 days) can the term loan lenders declare a default andbegin exercising their remedies for the breach of the financialmaintenance covenant.It is also typical in these cov-lite loan transactions for thefinancial maintenance covenants to be “springing” in nature.This means they will only apply to the revolving credit facilityif certain thresholds are met. For example, the thresholdcan be that no revolving credit loans are outstanding or therevolving credit outstandings are below a certain dollaramount or percentage of the total revolving commitments. Asa result, the borrower can avoid being required to meet anyfinancial maintenance covenant if, at the time the covenantwould otherwise be measured, it reduces its revolving creditusage below the threshold trigger.In contrast, in deals with full financial maintenance covenants,breach of one of these covenants is normally an immediateevent of default regardless of the amounts outstanding at thetime. If an event of default occurs, all of the lenders (term andrevolving lenders voting as a single class) by majority vote canexercise available rights and remedies.40 September 2011 practicallaw.comASSET-BASED LENDINGCov-lite loans can also be structured using an asset-basedlending (ABL) component for the revolving credit portion.Typically, this involves an ABL revolving credit facility with aseparate cash flow term loan (or multiple term loans).In these transactions, the ABL revolving credit facility isdocumented separately from the term loan, and will havea different covenant package and prepayment events. Theability of the borrower to use the ABL facility is limited by aborrowing base formula often tied to a percentage of accountsreceivable and a percentage of inventory meeting certaineligibility criteria in the ABL documents. The ABL documentsgenerally have a springing financial maintenance covenant forminimum fixed charge coverage. Unlike a cash flow cov-liteloan transaction where springing covenants are tied to theusage of the revolving credit facility, the trigger in an ABL covlite transaction is tied to the amount of remaining availabilityunder the borrowing base formula.In an ABL cov-lite transaction, the term loan is documentedin a separate agreement that would not have any financialmaintenance covenants. To prevent the term loan lendersfrom getting the benefit of the ABL financial maintenancecovenant, the term loan agreement usually has a crossacceleration to the ABL facility rather than a cross default.This means the term loan lenders only have an event ofdefault in their transaction related to the ABL facility if theABL facility has an event of default and the ABL lendersaccelerate their debt as a result.more information on ABL transactions, search Asset-based Lending: ForOverview on our website.COMMON COV-LITE FEATURESThe absence of a financial maintenance covenant for the benefit of the term loan lenders is the core feature of a cov-lite loan.Cov-lite loans also often have other borrower-favorable termsthat make them more like high-yield bonds than traditionalloan transactions with full covenant packages. In particular,cov-lite loans have looser negative covenants. Many cov-liteloans allow the borrower to take one or more of the followingactions, subject to certain restrictions: Incur additional debt. Rather than having a hard dollarcap on the amount of other debt a borrower can incur,many cov-lite loans allow an unlimited amount of debt ifthe borrower meets an incurrence test after giving effectto the incurrence of the new debt. Often the incurrencetest is a maximum leverage ratio or a minimuminterest coverage ratio. Incur additional secured debt. Even if a borrowercan incur additional debt, additional liens on the collateralmay not be permitted by the security arrangementsentered into with the initial lenders. However, somecov-lite loans allow the borrower to grant additionalCopyright 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.

Cov-lite loans often have other borrower-favorableterms that make them more like high-yield bonds thantraditional loan transactions with full covenant packages.liens to secure newly-incurred debt (thereby diluting thesecurity of the initial lenders), if the borrower meets anincurrence test. Often this test is a maximum leverageratio that applies to secured debt or first lien debt. Pay dividends. Rather than prohibit dividends or cap themat a fixed amount annually or over the life of the deal, orboth, many cov-lite loans allow unlimited dividends (muchlike a typical high-yield bond deal), subject to a limit basedon a percentage of net income or EBITDA at any given time. Make acquisitions. Rather than cap acquisitions at afixed amount, per acquisition, annually or over the life ofthe deal (or some combination of caps), many pre-creditcrunch cov-lite loans allow unlimited acquisitions, subjectto the borrower showing pro forma compliance withan incurrence test. Often, in transactions with both arevolving credit facility and a cov-lite term loan governedby the same document, this incurrence test is proforma compliance with the level set out in the financialmaintenance covenant applicable to the revolving creditfacility at that time, regardless of whether the covenantis required to be complied with at that time. Other testsmay be a maximum leverage or senior leverage test at alevel set out in the acquisition covenant. Repay junior debt. A common negative covenant inleveraged loans is limitations on repaying junior debt.Junior debt can be second lien, unsecured or subordinateddebt. Likely, the junior debt is more expensive than theleveraged debt for the borrower so it is beneficial for theborrower to pay down the junior debt. Many cov-liteloans allow borrowers to repay junior debt subject tocompliance with an incurrence test.ELEMENTS OF POST-CREDITCRUNCH COV-LITE LOANSGenerally, post-credit crunch cov-lite loans have many of thecommon features and provisions described above. For example,recent cov-lite loans do not have any financial maintenancecovenants for the benefit of the term loans and include looserincurrence-based negative covenants.However, one trend that was emerging before the creditcrunch and has continued since is the reluctance of lenders toprovide revolving credit facilities in cash flow financings. Thismeans that a leveraged borrower’s debt structure will includean ABL facility for the revolving portion that funds ongoingliquidity needs. Therefore, the cov-lite cash flow term loan isdocumented in a separate loan agreement and does not benefit from any financial maintenance covenants in the revolvingfacility agreement, even after a standstill period.PROS AND CONS FOR BORROWERSCov-lite loans present the following benefits for borrowers: Reduced risk of default. Freedom from having tomeet financial maintenance covenants allows a borrowerto keep its credit facility in place even if the businessunderperforms relative to expectations as long as interestand other obligations are met. This removes the risksto a borrower of having extended and possibly costlyworkout negotiations with its lenders to waive or avoida financial maintenance covenant default, which canresult in higher interest rates, payment of fees and lossof negative covenant flexibility. It also lowers the risk ofother negative consequences of breaching the financialmaintenance covenants (see Box, Purpose of FinancialCovenants: Consequences of Non-compliance). Greater flexibility. The looser incurrence stylenegative covenants that are often included in cov-lite loansenable the borrower to engage in other transactions (suchas acquisitions) without having to worry about seekinglender consent, paying consent fees or being unable toobtain the necessary consent. Reduced risk of losing ownership or control. Whena borrower defaults, or might default, it may find thatthere are divergent goals among its lenders. Traditionallenders such as banks, insurance companies and certain newcategories of lenders, such as CLOs and prime rate funds,may have a goal of repayment in full or having a loan withmarket terms that will trade at par on the secondary loanmarket. Other lenders, such as hedge funds and distressedinvestor funds, may view the ownership of the troubledborrower’s debt as a path to owning or taking control ofthe borrower. The more difficult it is for the borrower todefault, the harder it is for the distressed investor to tryand obtain control of the borrower.For a borrower, there does not appear to be many disadvantagesin having a cov-lite loan. A borrower may have to pay a slightlyhigher interest rate for a cov-lite loan, although this is notuniversally true. A borrower that pays more for a cov-lite loanmay end up overpaying if it performs as expected or betterand does not use the additional flexibility of the incurrencestyle covenants. However, the incremental cost, if there is one,Copyright 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.Practical Law The Journal September 2011 41

is small and the benefits generally seem to greatly outweighthe costs.Another risk, especially in a transaction with a combinedrevolving credit and term loan in one document, is that becauseonly 50% of the much smaller revolving credit facility (ratherthan 50% of the entire debt amount (term loan plus revolvingfacility)) is needed to block an amendment or declare a default,an activist lender can potentially gain greater influenceand control over the process with a smaller investment. Aborrower may have consent rights over assignments to lenders,but it may be hard to keep out the activist lender because thatright has to be exercised reasonably.Other arguments against a cov-lite loan from the borrower’sperspective are theoretical. Some have argued that a borrowerand its management benefit from the focus and discipline of having to meet financial maintenance covenants quarterly, and as aresult, they may do a better job of maximizing profit. Anotherargument is that incurrence style negative covenants can allowa borrower to engage in transactions that would otherwise berestricted by a fully-covenanted deal, which may involve takingon too much debt or overpaying for an acquisition.through tighter covenants or new events of default. Thelenders also have the option to refuse to provide relief and tryto exercise remedies or precipitate a bankruptcy. In a cov-litedeal, these options are significantly reduced.a Practice Note describing the process of amending a syndicated Forloan agreement, search Loan Agreement: Amendments on our website.The benefits for lenders in a cov-lite loan are more limited.As discussed, the lenders may receive a higher yield than ina fully-covenanted loan. However, other benefits seem tobe highly theoretical. One argument is that the lenders mayultimately recover more if an underperforming borrower isgiven time to improve its performance without the pressure offinancial maintenance covenants and the costs and distractionsof a workout.PROS AND CONS FOR LENDERSFrom a lender’s perspective, cov-lite loans may dilute manykey lender protections, such as: Early warning of payment default. The earlywarning provided by the periodic financial maintenancecovenant can alert lenders in advance of a possiblepayment default or bankruptcy. Avoiding unfavorable transactions. The lack ofcontrol otherwise provided by tighter negative covenantscan allow the borrower to enter into transactions that arenot beneficial to the lenders. Security interest in collateral. The ability of theborrower to incur additional secured debt may dilute thelenders’ collateral coverage for their loans. Priority over junior creditors. If the borrower ispermitted to repay higher-cost junior debt prior to adefault on the lower-cost credit facilities, the seniorlenders would then have to work out loans with anunderperforming or over-leveraged borrower without thecushion of the junior debt (whose repayment depleted theborrower’s available cash).In a fully-covenanted transaction, if the borrower cannot meetits financial maintenance covenants or wishes to engage in atransaction that the negative covenants prohibit, the borrowerand the lenders can negotiate a waiver or amendment. In thesenegotiations, the lenders, acting as a group, have the optionto provide relief in return for concessions by the borrowerthat either compensate the lenders for increased risk (suchas increased interest and fees) or further protect the lenders42 September 2011 practicallaw.comCopyright 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.Use of PLC websites and services is subject to the Terms of Use (http://us.practicallaw.com/2-383-6690) and Privacy Policy(http://us.practicallaw.com/8-383-6692). For further information visit practicallaw.com or call (646) 562-3405.

be many years before new cov-lite loans returned. However, starting in 2010, cov-lite loans began reappearing in the syn-dicated loan market. Borrowers can obtain cov-lite loans because of market dynamics. At the top of the last credit cycle, there was an oversupply of capital, and lenders competed for deals from private equity sponsors and .