Protective Covenants as Deterrents to Default in the Repayment of Debt by Companies - Coursework Example

An Assessment of the Validity of Protective Covenants as Deterrents to Default in the Repayment of Debt by Companies Smullen and Hand (2005) define senior Debt as debt that has precedence over other debts for repayment if the loans made to a company are called in for repayment. Often companies borrow different amounts from different sources; one lender may stipulate that their loan should rank as the senior. Subordinated debt on the other hand is regarded as debt that is below senior debt in the payment of interest and in the right of payment during liquidation. It might either be secured or unsecured. Because of the high risk involved it usually carries a higher rate of return than senior debt. (Mckean, 2005; Law, 2005; Moles and Terry 1997). For example, Junk Bonds whether secured or unsecured are always subordinate to debts to banks and Subordinated debt that ranks behind other issues of the same class is referred to as junior debt. (Law, 2005). Mezzanine finance, a typical example of subordinated debt is funding that possesses both equity and debt characteristics and it is usually provided by specialists’ financial institutions. This funding like other forms of subordinated debt carries a very high risk of default and as a result earns a higher rate of return than pure debt although less than equity. Mezzanine finance can be secured or unsecured. (Smullen and Hand, 2005). Due to its mixed nature of both equity and debt characteristics, investors have the opportunity to earn interest alongside their equity stake in the company. (Terry and Brian, 2000). Mezzanine financing is also attractive to banks since it offers interest higher than that paid for senior debt especially in environments where competition makes it difficult for them to provide funding at the normal lending rate thus encouraging banks to embark on mezzanine financing as a means of earning higher returns. (Terry and Brian, 2000). The borrowing base of potential takeovers in the UK has increased as a result of increase willingness by UK lenders or investors to provide mezzanine finance. For example, bids for the Gateway and Magnet companies in the UK involved very large amounts of subordinated debt and as such reflect the importance of mezzanine finance to borrowers in large acquisitions, were financing required is beyond the limits set by equity and senior debt providers in their own lending criteria. (Terry and Brian, 2000). Terry and Brian (2000) assert that because inclusion of mezzanine debt allows a lower equity share as a percentage of the total funds provided than straight equity investment, equity investors prefer such inclusion in deal structures since it will improve returns to the equity shareholders. Including mezzanine in a deal reduces the investment required from equity investors by a percentage, which is higher than a reduction in their ultimate shareholding and therefore increases the overall return on investment. Mezzanine finance has also been used as a strategy for leveraged buy-outs, corporate takeovers and other acquisitions. The first instance of using mezzanine finance in such a way was in the United States of America. (Terry and Brian, 2000). The first instance in the United Kingdom was for the buy-out of Evans Halshaw. (Terry and Brian, 2000). Because of the separation of ownership from control and also as a result of information asymmetry between debt holders and the management of the company, it is has become a common practice that the loan agreement or indenture contains ratio covenants and other covenants so as to prevent the debt holders from losing their money in the event of insolvency or bankruptcy liquidation. In the preceding paragraph, we take a closer look at some of the covenants and assess their validity in actually providing protection to lenders or debt holders. Covenants and Events of Default Terry and Brian (2000) define Covenants as promises by the borrower to do or not to do certain things during the term of the debt facility. Events of Default are defined events which, if they occur, give the bank the right to demand immediate repayment irrespective of the unexpired term of the facility. These covenants are usually part of the loan contract and such covenants limit the actions the company may take. (Ross et al, 1999). A breach of a covenant will always be documented to be an event of default. (Terry and Brian, 2000) Terry and Brian (2000), identify the following covenants: (a) Negative Pledge Ä negative pledge is a promise by the borrower to the lender that she will not place her assets as collateral security for other debts unless the bank is given a pro-rata share of that security. In case of a holding company, the asset referred to above will be consolidated asset. However, Mortgages on new assets, that have been financed by new loans are usually excluded from the agreement on the basis that such "purchase money mortgages" do not dilute the recourse of existing lenders to existing assets. (Terry and Brian, 2000). (b) Restriction on Asset Sales Under this covenant, the borrower undertakes not to sell a material part of its (consolidated) assets either without the knowledge of the lenders or below the market price of the assets. The "Material" is defined preferably as assets having a book value or market value (whichever is the higher) of X amount or greater. (Terry and Brian, 2000). By so doing, transfers of assets (which result in reduction of value) between groups of companies such as sale and leaseback agreements, which, in substance, are exercises to raise new debt secured on existing assets (Terry and Brian, 2000). Bottom of Form   (c) Cross Default Cross default considers the failure to perform another lender’s agreement as an event of default. It gives the Bank the protection of other lenders' events of default and covenants and, depending on the wording, ensures that the bank can demand repayment either if another party is put in a position where it can do so (irrespective of any waiver given by that other party), or if another party actually declares an event of default (i.e. the cross default triggers only if no waiver is given by the other party). (Terry and Brian, 2000) (d) Pari Passu Clause This is reinforcement to the negative pledge, which prevents the company from receiving any debt that will rank as senior debt before above the bank’s debt. The company also undertakes to treat all debt holders equally. (e) Continuing Ownership this covenant or event of default protects debt holder against change in control or ownership of the business It gives the debt holder the right to renegotiate or demand repayment should such circumstances (change of control, ownership or merger) occur. This covenant is necessary when lending to a subsidiary or state corporation in which circumstances, there is a strong parent or State but no collateral security from the parent or State. The covenant also ensures that the bank is consulted in the event of any of the afore-mentioned changes. Ratio Covenants Ratio covenants are designed such that a term loaned is converted into an “on demand loan” should there be a material deterioration in the financial condition of the company. (i.e. to the extent that safety of repayment is threatened). (Terry and Brian, 2000) Some of the ratio covenants commonly used include: (a) Debt Service Ratio Company undertakes that profits after tax and after adjusting for all material non-cash items will exceed a specified percentage (e.g. 150%) of term debt due within one year and/or will exceed a specified percentage, depending on the business, of Total Debt(e.g. 20%). This triggers if cash flow looks like becoming inadequate to make principal repayments when due. (Terry and Brian, 2000). Defining cash flow to equate to Retained Operating Cash Flow proves a most valuable trigger since the scope for creative accounting is reduced. The complexity of the accounting adjustments, however, often mean that borrowers will prefer to accept restrictions on tangible net worth (TNW), gearing and interest cover. (Terry and Brian, 2000). (b) Minimum Tangible Net Worth (MTNW) The borrower undertakes to maintain a minimum level of Tangible Net Worth. "Tangible Net Worth" should exclude intangible assets (except for copyrights, brand names, etc. which, in some instances, may be included in TNW) and any increases arising solely from revaluations of assets (this limits the scope for accounting creativity). (c) Maximum Gearing This helps to prevent against a build up of unbearable levels of debt by restricting increases to a proportion of increases in the equity cushion, tangible net worth. (d) Minimum Liquidity In order for the bank or other debt holder to take control before liquidity crises set in, this covenant obliges the company to maintain a certain level of working capital either expressed as a ratio or as a monetary amount by which Current Assets should exceed Current Liabilities. (Terry and Brian, 2000) (e) Interest Cover  A company undertakes that the aggregate of Pre-tax Profits plus Interest Paid for any given period will not fall below e.g. 1.25 times interest paid. The covenant triggers immediately on the occurrence of losses and low levels of profitability, which may put interest payments in danger. (f) Dividend Cover Company undertakes that the aggregate of Retained Profits plus Dividends Paid for any given period will not fall below e.g. 2 times dividends paid. This should prevent excessive dividend payments either to public shareholders or by a subsidiary to a parent. (Terry and Brian, 2000). The above covenants only serve as a deterrent to loose or risk-oriented financial management. They cannot make a bad loan into a good one. (Terry and Brian, 2000). Since information asymmetry exists between the management and the debt holders as well as between shareholders and debt holders it is possible for management to structure deals in such a way that will reflect the terms the loan agreement. For example, managers can apply conservative accounting methods such as applying a low depreciation rate to overstate earnings and achieve compliance with a covenant that requires a minimum after-tax profit. Since debt holders are not part of the management, it is difficult for them to actually observe and understand what is going on in the company. Terry and Brain (2000) recommend monitoring as a means of 1. ensuring that no breaches of covenants or events of default have occurred or seem likely to occur in the future; 2. Identifying any material deterioration in the financial health of the borrower, even though this may not result in an immediate covenant breach. Even with monitoring, the covenants can still be bridged without the knowledge of the lenders given the degree of information asymmetry that might still exist. External Auditing has often been employed as a means of bridging the gap between the information managers have and that which the debt holders or lenders have concerning the business. However, even with external audits, there is still a great degree of asymmetry. Consider for example, the Enron Corporations recent fraud case, in which the Auditor failed to provide the lenders or debt holders as well as shareholders with enough information about the actual situation of their investments in the Enron Corporation. (Reinstein and McMillan, 2004) There might also be conflicts of interest in the covenants between the different debt holders including, senior debt holders, subordinated debt holders as well as junior debt holders. Each class of debt holder may want their covenants to be superior over the other. Covenants can therefore provide some form of protection against default to a lesser extent but to a greater extent, the use of covenants cannot fully guarantee the repayment of the debt. Managers can still connive with auditors and so-called monitors to structure deals in such a way that portray their image as complying with the covenant meanwhile they are not as such. Therefore, for debt holders to be very sure that their investments will be guaranteed, it is necessary that they become much more involved in the direct control and management of the business. BIBLIOGRAPHY Law E. J. (2006). A Dictionary of Business and Management. Oxford University Press Oxford Reference Online. Oxford University Press. 6 April 2007   http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t18.e6203 McKean E. E. (2005). The New Oxford American Dictionary, second edition. Ed. Erin. Oxford Oxford Reference Online. Oxford University Press. 6 April 2007   http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t183.e76122 Moles P. Terry N. (1997) The Handbook of International Financial Terms. Oxford University Press Oxford Reference Online. Oxford University Press. 6 April 2007   http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t181.e7456 Reinstein A., McMillan J. (2004) The Enron debacle: more than a perfect storm. Critical Perspectives on Accounting. Vol. 15, pp 955-970. Ross S. A., Westerfield R. W., Jaffe J. (1999). Corporate Finance. Fifth Edition. McGraw-Hill International Editions Finance Series. Smullen J., Hand N.(2005)  A Dictionary of Finance and Banking. Oxford University Press Oxford Reference Online. Oxford University Press.  6 April 2007. http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t20.e2319 Terry, Brian J. (2000). The International Handbook of Corporate Finance. Chicago: New York AMACOM Books. ISBN 9780814405420 Read More