Summary
It is not unusual for a lender’s form of credit agreement for middle-market secured leveraged loan facilities with banks and other institutional lenders to contain common flaws that may result in technical covenant defaults being unexpectedly triggered. This can occur when a borrower takes an action which, although expressly permitted under a carveout for a particular negative covenant (or an action that is not otherwise expressly restricted by the credit agreement which is contemplated to be taken by the parties), can nevertheless cause a technical default because the carveouts to other negative covenants covering the action do not expressly permit such action (or such action is not otherwise excluded from the application of a particular covenant). As discussed further below, such conflicts often exist between the “Asset Sales” covenant and other negative covenants, and borrowers and their counsel should be aware of these potential conflicts and how to avoid such technical defaults.
Restrictive or Negative Covenants
Credit Agreements for middle-market secured leveraged loan facilities typically include (in addition to other customary provisions) representations and warranties, affirmative covenants (which require the borrower and/or its subsidiaries to take certain actions, such as to deliver financial statements), financial covenants (which generally includes certain financial tests), and “restrictive” or “negative” covenants which prohibit the borrower and its subsidiaries (and other members of the “restricted group”, which generally includes a parent guarantor of the borrower and its subsidiaries) from taking certain actions (subject to certain specified exclusions and carveouts), including, among other things:
(i) an “Asset Sales” covenant, which typically restricts the sale, lease, assignment, conveyance, transfer or other disposition of, or grant of an exclusive license on, the assets of the borrower and its subsidiaries (and the other members of the restricted group);
(ii) a “Debt” covenant, which typically restricts the incurrence of debt, and other items defined to be included as indebtedness for purposes of such covenant (such as capital leases and guarantees of indebtedness of others);
(iii) a “Liens” covenant, which typically restricts the incurrence of liens on the assets of the borrower and its subsidiaries (and the other members of the restricted group) and the granting of other security interests;
(iv) a “Restricted Payments” covenant, which typically restricts the payment or making of dividends or other distributions on account of the equity of, or the purchase or other acquisition for value of the equity of, or the prepayment of subordinated debt of, in each case, directly or indirectly, or the borrower and its subsidiaries (and the other members of the restricted group); and
(v) an “Investments” covenant, which typically restricts the making of investments, including guarantees of indebtedness of, and the making of loans and advances to, other persons.
Each of the restrictive or negative covenants acts independently of each other but, in many standard lender “forms”, compliance with one covenant may in fact violate another covenant if there is not an exclusion or carveout to such other covenant that permits the specified action taken in compliance with the covenant in the first instance. Alternatively, such exclusion or carveout to permit the action may be found in the defined terms used in such covenant rather than having such exclusions or carveouts expressly set forth in such covenant.
Asset Sales Covenant
One of the most common issues found in “form” credit agreements is the failure to include “customary” carveouts to the “Asset Sales” covenant that are designed to avoid a default resulting from taking actions expressly permitted under other negative covenants that the parties have agreed to permit, or actions that the parties understand will be taken by the borrower, its subsidiaries or the other members of the restricted group in connection with the conduct of their business. For example, the form “Asset Sales” covenant frequently prohibits the disposition of any and all assets but fails to permit the use of cash and cash equivalents not otherwise restricted under the credit agreement. In such an instance, the use of cash to make payroll, pay interest or principal on the loans that are made pursuant to the applicable credit agreement, and other cash payments that are otherwise contemplated to be made from time to time even if not in the ordinary course of business (such as making permitted capital expenditures or paying legal expenses in connection with lawsuits that may be brought from time to time), would not be permitted by the Asset Sales covenant. If such issues are present, absent modification of the credit agreement, a borrower will unwittingly default from the normal and expected operations of its business. Although a lender may not seek to enforce such default, particularly if the loan is otherwise performing, there is no benefit to providing a lender with the opportunity to call a default merely from the business being run as intended or contemplated. Moreover, the technical default likely hinders an officer of the borrower from delivering a clean covenant compliance certificate (which certificate is required quarterly in nearly all credit agreements) that certifies as to the absence of any defaults or events of default, which could result in other negative consequences under the credit agreement.
Accordingly, where these issues are present, a borrower should request that either the “Asset Sales” covenant itself, or the defined terms used in the “Asset Sales” covenant, expressly exclude the following items: (1) liens or other security interests permitted by the “Liens” covenant, (2) “Restricted Payments” permitted by the “Restricted Payments” covenant, (3) “Investments” permitted by the “Investments” covenants, and (4) any disposition of cash or cash equivalents.
Also, where a credit agreement includes an “Asset Sale Sweep” (i.e., a mandatory prepayment from the net cash proceeds from “Asset Sales”), care must be taken to ensure that the actions excluded from the application of the “Asset Sales” covenant are likewise excluded from the “Asset Sales Sweep”.
The carveouts described above to avoid technical defaults between covenants should be in addition to the customary covenant exclusions necessary to avoid a default from the normal operations of a business, such as (i) dispositions of inventory sold in the ordinary course of business, (ii) dispositions of obsolete or worn out property or property in the ordinary course of business, (iii) dispositions of accounts receivable resulting from the compromise or settlement thereof in the ordinary course of business, (iv) the theft, loss, destruction, condemnation or taking for public use of assets, and (v) licenses, sublicenses, leases or subleases granted in the ordinary course of business that do not materially interfere with the business of the borrower, its subsidiaries or the other members of the restricted group. Because many loan covenants overlap, these customary exclusions may need to apply to more than one covenant to avoid unexpected defaults.
Lender’s Counsel’s Responses
While the suggestions made herein are the most straightforward way to address potential technical defaults, some lenders and their counsel push back on or otherwise try to limit the aforementioned carveouts. Indeed, it is not unusual for a lender’s counsel to respond that their form of credit agreement has been used extensively and no one has previously made such comments. Nevertheless, in our experience, lender’s counsel has typically been amenable to making appropriate changes, whether the carveouts suggested herein or narrower, more specific carveouts that avoid a technical default, so long as specific examples are provided of how such technical defaults could occur.
For further assistance, please contact:
Robert Matz (212) 907-7389
Email: rmatz@golenbock.com
Michael Weinstein (212) 907-7347
Email: rweinstein@golenbock.com
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