Covenants

When Anglizismus covenants ( Latin conventio , "contract agreement") is in German usage to certain clauses or (side) agreements in loan agreements and bond terms .

General

These are contractually binding assurances by the borrower or bond debtor during the term of a loan or a bond .

The word is derived from the French term covenant ( old French for "contract", Latin from convenire "to meet, to come together") and is used for all conceivable secondary contractual obligations of the borrower or bond debtor. This contractual practice (see syndication , syndicated loan) - insofar as it is in accordance with German law - has been adopted in German loan agreements and loan terms. These are ancillary provisions that relate to specific behavioral obligations and stipulate them contractually.

Systematization

The large number of assurances can be systematized into financial indicators (these are the financial covenants in the narrower sense), non-financial covenants and corporate (financial) covenants . Covenants can also be defined as a credit event .

Financial metrics

The financial indicators include all business indicators that can be developed from the annual financial statements of the borrowing company, such as the balance sheet clauses. Financial indicators can, however, also be linked to the borrower's income statement or have other financial indicators as their content. Since the variables are variable, minimum figures (for example for the equity ratio) or fluctuation ranges are specified with the specific indication of the lower and upper limit (" headroom "). Typical financial ratios of this type are:

• Equity ratio
• Leverage
• Return on investment
• minimal cash flow
• Asset coverage
• Interest rate
• Debt service coverage ratio

The key financial figures also include interest rate clauses , which make the change in the lending rate dependent on the change in the creditworthiness of a borrower (so-called margin grids or margin ratchets ). If the creditworthiness of the borrower deteriorates due to a rating , for example , the margin automatically increases and vice versa.

Non-financial covenants

Non-financial covenants are various clauses such as the pari passu clause , negative declaration , cross-default clause and the collective action clause , because with their help the creditors want to prevent changes in the formal credit risk in the event of a corporate crisis of the debtor . They are intended to prohibit subsequent collateral orders to other creditors, unless the lender is treated equally:

• The pari-passu-clause assures the creditors of absolute equality of their claims, in which the company policy is realized that no kind of claims are given an implicit priority. As a result, the creditors of later loans and bonds are not disadvantaged and take the same rank.
• This principle of formal equality is through the negative pledge expanded ( "negative pledge") to the collateral level by the clause assuring the unsecured creditors secure their claims, the debtor should make other creditors collateral.
• In the case of the cross-default clause , the creditors have a special right of termination if the debtor pays off their bond but falls behind with another payment obligation. As a result, all creditors should be affected by the debtor's payment difficulties at the same time.
• The Collective Action Clause makes a change to individual bond and credit terms dependent on the approval of the majority of the creditors and is binding for all bond creditors in the event of a majority approval. As a result, minorities can be outvoted and are, for example, forced to agree to debt relief .

This also includes the material adverse change clauses , which use individually listed examples to define a significant deterioration in the economic and / or legal situation of the borrower and, if they occur, trigger additional collateral obligations or even a loan termination . When granting loans to group subsidiaries , banks in Germany often make use of the tax group declaration in order to oblige the parent company to compensate for losses at the borrowing subsidiary for the entire financial year . So-called assignment clauses are contained in the loan agreements so that loans can be transferred to other lenders in the future, for example in the context of loan trading . Positive declarations ensure that the borrower has to provide certain loan collateral if the conditions or events described in the loan agreement have occurred. In addition, the borrower undertakes to provide the lender with precisely defined information on certain dates (e.g. quarterly reports , confirmations of compliance with at least the financial covenants).

Corporate financial covenants

These include e.g. B. the prohibition of the disposal of essential assets ("disposals"), restrictions on internal corporate restructuring as well as restrictions on the dividend policy of the company. In this context, the term "affirmative covenants" appears frequently, which is used inconsistently and which often combines non-financial covenants and corporate financial covenants. In any case, affirmative covenants stipulate certain actions or the failure to act by the borrower. Examples are:

• Constancy in the shareholder relationships ( English ownership clause );
• Restriction of dividend payments or withdrawals ( English dividend / withdrawal restrictions );
• Negative clauses that prohibit the provision of collateral to other creditors without the lender being placed on an equal footing with these creditors;
• Restrictions on major capital items such as investments ( English disposals );
• ordinary course of business ( English ordinary conduct of business );
• Compliance with all laws and regulations ( English representations and warranties ).

Legal consequences

A deviation from the agreed financial covenants usually triggers a pre-scheduled healing period ( English remedy / grace period ) from. This healing period is intended to enable the borrower to subsequently meet the specified key figures or assurances. If this does not succeed, however, a higher credit margin or even an extraordinary right of termination is triggered by the breach of contract ( English covenant breach ). Alternatively, deviations from the agreed regulations can justify a claim to the provision of loan collateral (so-called right of subsequent collateralisation ). The borrower is then obliged to provide initial or additional loan collateral. If he does not comply with this request, the right to terminate according to no. 13 para. 3 in connection with no. 19 para. 3 AGB-Banken or no. 26 para. 2b AGB-Sparkassen triggered.

When agreeing (financial) covenants, there is a risk under German law that the clause and thus the entire credit agreement may be ineffective. Through very close and comprehensive agreements, borrowers can get into disadvantageous situations, as there is a risk that lenders intervene in the management of the borrower like a gag. If banks intervene in the management of their borrowers by completely taking over the management of the debtor company in the financial area and largely disempowering the company, for example through credit gagging, they are liable to other creditors for their damage. In the case of restructuring loans in particular, credit institutions walk the fine line between improperly influencing corporate management and the necessary strict monitoring of their increased credit risk .

Monitoring needs

The agreement of covenants results in the bank's supervisory obligations in the credit process to review the borrower's economic situation regularly - usually at least quarterly. The results are to be taken into account in the rating of the credit exposure. Financial covenants in particular are not an end in themselves. They lead to an instrumentalization of the risk assessment and are thus objectively comprehensible for external bodies ( banking supervisors or auditors ). They thus form part of the risk management at banks, as required by the minimum requirements for the lending business .

When agreeing covenants, the costs for the monitoring effort from the disclosure of economic circumstances during the year must be related to the risk relief. Covenants are generally to be used for all loans, including those that are supposedly initially risk-free. It is not foreseeable whether the creditworthiness will deteriorate during the credit period (so-called rating migration ); It is usually difficult to implement improvements if more detailed covenants have not been agreed. Then only the less specific and therefore non-binding terms and conditions can help.

purpose

Overall, covenants are intended to cement the status quo in the economic / legal circumstances of the debtor at the start of the loan agreement or the issue of the bond during the term. This status forms the basis of the business, on the basis of which the granting of credit was at all justifiable for the bank. If something changes here to the detriment of the bank, the covenants form a kind of early warning system to which the contractually stipulated options (margin increase, additional collateral, loan termination) can be used to respond appropriately.

Meaning and impact

The rating agency Moody's , according to 45% of European companies had included in 2008 with a low credit risk ( "investment grade") and 75% of companies with a high risk of default ( "non-investment grade") credit agreements covenants. Accordingly, the proportion of borrowers with covenants with a higher degree of risk increases, although it makes sense to agree covenants at times with favorable ratings. Obviously, covenants in credit agreements tend to be stricter than in bonds. In the event of a covenant breach, there is a risk of a loan being canceled , which in turn can trigger a wave of cancellations from other creditors (via the cross-default clause ). In order to be able to fulfill financial covenants at all times, debtors must take entrepreneurial measures that ultimately also contribute to their own restructuring.

Abbreviations

Usual abbreviations e.g. B. Summaries of new issues of bonds are:

• NP: Negative declaration (negative pledge clause)
• PP: pari passu clause
• XD: cross default clause
• CoC: Change of Control Clause

See also

Dynamic covenants:

• Debt service coverage ratio
• Interest coverage ratio

Static covenants:

• Lending Limit
• Lending period

Loan Term:

• Payment requirement

• On Bill

literature

• Christian Lützenrath, Marcus Schröer: Financial Covenants - Clear Targets for Borrowers , in: Kredit & Rating Praxis, year 2001, issue 5, page 19ff
• Wolfgang Servatius: Influence of creditors through covenants, hybrid financing instruments in the field of tension between external and self-financing , Mohr Siebeck 2008
• Maik W. Fettes: On the use of covenants with corporations , Duncker & Humblot 2014
• Markus Walchshofer: The Significance of Covenants of SME Bonds from the Perspective of Institutional Investors , in SME Bonds - A Guide for Practice , Springer Gabler, 2012, pp. 55–66.

Individual evidence

1. ↑ Alexander Szodruch, State Insolvency and Private Creditors , 2008, p. 168 f.
2. ↑ - Christian Lützenrath / Marcus Schröer, "Clear targets for borrowers", 2001 ( Memento of the original from February 7, 2016 in the Internet Archive ) Info: The archive link was automatically inserted and not yet checked. Please check the original and archive link according to the instructions and then remove this notice. 
3. ↑ BGH NJW 1989, 1800 (so-called TBB judgment)
4. ↑ Folker Bittmann, Insolvenzstrafrecht: Handbuch für die Praxis , 2004, p. 662
5. ↑ Convergence Directive on Basel II; here paragraph 518 ( memento of the original from October 17, 2006 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked. Please check the original and archive link according to the instructions and then remove this notice. 
6. ^ Basel II The Internal Ratings-Based Approach; here point 516 ( memento of the original from October 18, 2006 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked. Please check the original and archive link according to the instructions and then remove this notice. 
7. ↑ Frank M. Hülsberg, Due Diligence in Company Acquisitions , 2010, p. 48
8. ↑ Joshua D. Rauh / Amir Sufi, The Composition and Priority of Corporate Debt: Evidence from Fallen Angels , September 2007, p. 23  ( Page no longer available , search in web archives )  Info: The link was automatically marked as defective. Please check the link according to the instructions and then remove this notice. (PDF; 215 kB)  
9. ↑ Handelsblatt dated December 8, 2008, when the bank cancels the loan