Covenants in loan contracts as a measure and aid to reduce risk

Abstract

This article provides a detailed overview of the interpretation of covenants as a means to minimize risk. Due to the fact that companies have to take risks again and again, covenants to control them are of great importance. It is important that these are simple and quantifiable so that they can be understood by all parties involved. If covenants are based on a realistic plan, the risk can certainly be minimized. The parties involved must analyze and accept them.

A distinction is made between the most varied types of risk. In order to work economically, the company must identify and analyze these risks and assess their level. To do this, companies invest enormous amounts of financial resources and call on a risk manager to help them go through a risk management process.

If the risk is minimized through covenants, a comprehensive and prioritized covenant checklist forms the basis. However, their development is difficult and time-consuming. From a financial and legal point of view, covenants are contract promises that specify which activities may and may not be carried out. They are based on a universal legal form and can be of a financial or operational nature. Covenants can cover many different problem areas. The aim is to make contracts more trustworthy and realistic through covenants.

If a company violates a covenant, this can lead to technical failures. A distinction is made between affirmative covenants that allow something and negative covenants that restrict something. The former are clauses in credit agreements that oblige the borrower to take specific measures, such as keeping appropriate accounting and creditworthiness records. Negative covenants prevent the borrower from taking certain measures that worsen the loan portfolio. Financial ratios are an example of this. Borrowers avoid taking additional risks to avoid the cost of covenant breaches.

1. Introduction

In today's economic world everything is bound to a contract. Whether a company buys assets to produce goods or sells these products to its customers. The parties design a contract to protect their values. Of course, every party will ensure that their interests are treated first and that certain clauses are integrated that protect them of losing value.

The importance of creating and negotiating these contracts correctly so that no contractual abuse can happen is depicted by the awarding of the Nobel Prize in Economics 2016 to Bengt Holmström and Oliver Hart for their theoretical contributions to the contraction theory which improved the meaning of contracts for economy and society.

In this article the contracting of loan agreements is in the main focus. This work examines if covenants are an effective measure and aid to reduce risks in loan agreements[1]. A covenant therefore represents an additional clause in a contract which binds the borrower to fulfil or refrain certain actions. This short definition will be explained further in the following chapter.

Furthermore, this assignment deals with financial covenants which allow the lender to monitor and to control the financial and economic performance of the company. This work will therefore present some typically employed financial indicators for monitoring the loan and will deliver explanatory approaches how financial covenants are a solution to agency problems and information asymmetries.

The last section will deal with the appropriate designing of loan contracts under the usage of financial covenants. Examining how covenants can be designed too tight and restrictive and in when this is could be happening. Also, the authors will depict what happens after a violation of the covenant.

2. Covenants

2.1 Definition of covenants

Covenants mean in the broadest sense additive contractual agreements which only take effect in certain conditions. In a more strictly sense covenants are mostly used in international loan contracts and can therefore be determined as an additional contractual loan agreement between a lender and a borrower[2]. The borrower commits himself to fulfil the additional agreed on conditions during the loan period while the lender gets the power to intervene in the financial situation of the borrower[3]. The arranged covenant can therefore restrict the possible actions of the borrower but also force him to fulfil certain actions[4].

Furthermore, the borrower can be bound to accomplish specified key financial indicators during the credit period. The disregard of the agreed covenants allows the lender to change the conditions of the loan or even to cancel the loan contract before its fulfilment[5]. Also, he has the possibility to renegotiate the contract, implement collaterals or increase the value of the backed collaterals. But the possibilities always depend on the contractual design of the covenants. A covenant thus enables the lender to influence the loan contract when a deterioration occurs, thus these actions might be taken already before an acute threat happens like an insolvency[6]. This shows that the creditors get by means of the loan covenants a higher negotiating power and have a positive but also restrictive influence on business health and recovery[7].

The aims of covenants for the lenders are to protect themselves against a risk increase and raise the probability that the loan is repaid. Also, the repaid credit amount can get higher[8].

Moreover, loan covenants can be used to protect the lenders against information asymmetries and give them a monitoring device. This is also a benefit for the borrower, which can improve the effectiveness and efficiency of its company because he is bound to certain accounting and performance measures[9].

2.2 Certain types of covenants

Covenants can be distinguished in affirmative (general) covenants and financial covenants (see ill. 2.1). One speaks of affirmative covenants if the borrower has obligated to do certain actions (positive covenants) or to refrain from certain actions (negative covenants)[10]. Positive affirmative loan covenants can be therefore important financial informations which the borrower must transmit regularly in reportings to the creditor. Accordingly, possible financial informations can be consolidated accounting statements or a review of the economic situation of the past financial year. Likewise, monthly or quarterly transmitted financial reports which include an income statement, a statement about the economic and financial development of the company and a confirmation about the compliance of the granted financial covenants might be agreed on. Also, the loan can include covenants which require long and middle term planning calculations (planning balance sheet, planning income statement as well as an investment planning report)[11].

Ill. 1: Classification of types of covenants according to Brauweiler[12]

Examples for negative covenants are agreements which avoid the additionally collateralizing from assets to other lenders. With this sort of covenants the first lender can complete the loan without negotiating an extra asset security because further loans also cannot include asset securities. This so called 'Negative Pledge' prevents, in case of an insolvency, that further collateralized credits are treated first which would mean that the first lender would have a higher risk than the second one[13].

Furthermore, negative covenants can limit the economic and financial scope of the enterprise. Therefore, the borrower must obtain a permission of the lender to execute certain actions. These can be permissions for investments over a certain amount, the further admission of loan capital, the pledge or sale of assets if it does not relate to the additional purpose of the company and the changing of important contracts or the contracting of new ones[14].

Financial covenants are the most important group of covenants and are mostly meant when talking about covenants. They are agreements between a lender and a borrower which include financial key figures that the debtor has to achieve. That means by overshooting or undershooting these figures the borrower breaks the covenant and triggers previously agreed actions which e.g. might give the lender the power of a company owner[15]. These actions can be a change of the loan conditions or an acceleration of the debt because of the new risk situation. It could also be a restriction in the amount of possible actions or management decisions like investments which could, in the eyes of the lender, endanger the repayment obligations[16]. In practice most lenders often trigger renegotiation talks to increase their bargaining power. With this newly won power they reduce the credit line, require additional collaterals or increase, as mentioned before, the interest rates of the loan. But in the same way they look for performance improvements which can mean the replacement of current chief executive officers[17].

Therefore, financial covenants deal with the capital structure, the income situation and the liquidity of the company, but also include conditions to the financial situation. As one can see financial covenants are part of the creditor protection and work also as a risk reporting system and as an early risk detection system because of the agreed financial key figures[18].

2.3 Current situation and financial covenant use

Covenants are often used in international loan contracts and their importance has also increased through the financial crisis in 2008 and subsequent years. However, in Germany most loan contracts include standardised clauses inside of the standardized general terms and conditions of contracts[19]. But at the very latest since the Basel Capital Accord II also domestic banks established covenants in their loan contracts[20]. Especially for German companies bank loans are an attractive way of financing as the following illustration shows. It is the second largest method used for financing. Only equity based mezzanine finance methods are used more.

Ill. 2: Sources of financing from medium-sized companies in Germany from 2008 until 2014[21]

As examined before a bank loan is an often-used financial method for German companies. Therefore, typical financial covenants indicators which are use are the company profit (EBITDA) and a calculated dynamic debt ratio (borrowed capital / cashflow). For example, other common indicators are the interest coverage ratio (EBITDA/interest expense), the debt service ratio (debt service covering Cashflow/ repayment and interest), the net debt ratio (net debt/EBITDA) and a limit for investments[22].

Also possible are static financial indicators like the static debt ratio, the working capital ratio, the three liquidity ratios and the equity or debt ratio. But the usage of static indicators has decreased in practice[23]. The difference between static and dynamic debt ratios is that dynamic debt ratios consider income and finance potentials. But static debt ratios make a statement about the creditworthiness of the company because they compare equity and borrowed capital. So that financial institutions know with which amount external parties participate in the company. On the contrary shows the dynamical debt ratio how long, measured in years, the enterprise will need to repay their loans with their liquid funds. Therefore, gives the dynamical debt ratio a better statement about the debt capacity for the lender as the static one[24]. Another important information for the lender is the profit situation of the borrower which means that the lender is able to see that the operational income of the borrower is high enough to repay the loan in the agreed period. The interest coverage ratio or the debt service ratio therefore shows how many of the operational income has to be invested to repay the interest. For example, is the indicator lower than one, the lender has a warning sign that the borrower is not able to repay the loan. Also, a meaningful indicator is the liquidity of the company. In which amount cover the current assets the current liabilities or the liquidity funds the short term borrowed capital. The debt service ratio is therefore an indicator for the financial solvency and for the default risk. One example of how a covenant could work illustrates the case of Key Energy Services Inc. (KES) in September 1998. The company which offers its clients a wide array of onshore energy production services and solutions had a loan agreement about $550 million with the PNC Bank. The loan agreement contained, besides other indicators, a maximum debt ratio (debt/EBITDA) which was measured by the quarterly reported debt ratio of KES from the past. As the company's stock lost more than 50%, KES reported a net loss and broke the covenant. The consequence was an increase in the interest rate, the loosening up of some covenants and the adding of new covenants and limits. In this case the firm could recover through the correctly led intervention of the creditor[25].

3. Covenants in loan contracts

3.1 Design of loan contracts

The typical transaction of a loan can be divided in four phases. It starts with the loan application which simply means that the possible borrower makes an application for a credit to the financial institution. These applications often have a standardized form. Based on the loan application the lender makes a credit assessment[26]. With this audit the creditor checks if the debtor can pay the interest and the loan amount back and estimates the risk for the possibility that the loan is not payed back completely, not in time or never. Furthermore, this assessment considers the legal, personal and economic circumstances of the company[27]. Within this audit, the bank prepares already financial covenants which are refined in the phase of the credit commitment. If the borrower is creditable the last negotiations will begin about the components of the loan. The formal design of the agreed terms is the loan contract which includes typical the loan type, the loan amount, the loan period, the interest calculation, the loan collaterals and the termination options. Finally, the creditor will always restrict the credit commitment and will maintain the right to renegotiate the conditions of the loan if certain agreements were not fulfilled. This loan monitoring is a continuous process of the lender and should reveal the economic development of the company and the appropriate usage of the loan funds[28].

3.2 Reducing risks in loans with financial covenants

When talking about loans the risk which is important for the credit institute is the risk or uncertainty that the credit is not played back. This risk is priced by the interest of the loan. One important part of the interest rate builds the credit spread which represents the costs for contracting and controlling of the credit and the costs for the default risk[29].

Keeping this in mind the main reason for a covenant from the bank´s point of view is not to price the risk but to control it, to have a warning sign if the default risk is rising and therefore the possibility to renegotiate the conditions of the loan. The main reason for a financial covenant is therefore to monitor the business performance of the borrower and to intervene if a covenant violation or break is in sight. Thus, are financial covenants an aid to reduce agency problems[30].

Jensen and Meckling set the basis of the principle-agent-theory, explaining that there exists information asymmetries between the principle (company owner) and the agent (management) inside of a company structure. This agency problems can be transferred to all contractual relations and lead to the debt holder-shareholder conflict[31]. This simply means that there also exist information gaps between a lender and the entrepreneur about how future profits are used correctly[32]. The entrepreneur could for example misuse the borrowed capital by paying all the money derived by the loan to the owner in form of dividends. The consequence would be that the shareholder value is rising but the real company value would decrease through the missing liquidity so that the creditor would get an empty shell of the company[33].

Covenants are therefore an aid to reduce this information asymmetries by giving the lender more power to exercise control rights and secure loan values. Regarding this they can use the ex-ante mechanism of covenants which are the transmitting of financial information from the borrower to the lender through contracted positive affirmative covenants. Also, they can use the function of negative affirmative covenants as a measure to restrict certain actions a priori. Moreover, they can use the ex-post mechanism of financial covenants to mitigate moral hazard problems giving the lender the right to influence corporate decisions or to renegotiate the loan conditions when certain financial indicators are going to be violated[34]. The aim of the lender is to remove agency problems using covenants to reduce the default risk and ensure a risk adequate pricing[35].

3.3 Covenant violation and tightness

As explained in the chapter before, covenants are helpful for credit institutions to have a better risk control and monitoring. But what happens if the borrower violates the covenant. If a so called 'breach of covenants' happens the lender can take certain measures to mitigate the risk of default[36].

Ill. 3: Breach of Covenants[37]

The right of cancellation is not often used in practice but therefore a renegotiation of the loan conditions especially a new evaluation of the interest rate to adapt the risk to the new circumstances is regularly considered[38]. Furthermore, the cancellation is mostly agreed to only very important covenants. If the cancellation is not used the borrower can apply a waiver from the bank. This covenant waiver is usually in conjunction with so called waiver fees which the borrower must pay otherwise the loan is cancelled. Further measures are also that current credits from other banks are suspended or that the borrower requires an increase of the equity. Also, often additional negotiations for gaining additional collaterals and to take influence on the company's performance will take place between borrower and lender[39].

Moreover, the intensity and therefore the tightness of the contracted covenants is of some importance. If any covenant is set too tight it can be too restrictive for the borrower, and if set to lax principal-agency problems would occur[40].

However, covenant tightness depends on the former duration of the relationship and on the extend of information asymmetries between the lender and the borrower. With an increase in the duration of the loan relationship the tightness of covenants decreases because forecasts getting more uncertain and the future improvement is in focus. Under consideration of the information asymmetry theory the lending duration plays a more important role for small unrated borrowers with no access to the stock market on covenant tightness. Therefore, covenants are also formulated tight if the company is big, rated and has access to the stock market. Thus, information asymmetries occur and covenants are set more tightly to strengthen the bargaining position of the lender and limit the misuse of the loan[41].

On the other side, the quantity of employed financial covenants can have an impact on the relationship. If the relationship intensity is low the covenant intensity is low, too. The reasons for this are mainly performance monitoring incentives of the lender which are realized through financial covenants. This means that monitoring incentives and the related benefits of them are increasing with the relationship intensity until the relationship enters an exclusive state so that the borrower uses a lot of services from the lender[42].

Conclusion

As described in this thesis covenants and especially financial covenants are appropriate aids and measures to reduce risks in loan contracts for the lender. Thereby they work as a risk monitoring and controlling tool and reduce the default risk through showing signs that the future repayment of the credit might be in danger, if this is the case. This means that financial covenants function as an early risk reporting and detection system. Those in the contract defined and agreed upon indicators, e.g. typically used is the net debt ratio (net debt/EBITDA), deliver warning signs if the company has problems with its operative performance and more importantly with the repayment of the loan. This can lead or has led to a violation of the covenant, also called a breach of covenants. The lender has than the possibility to intervene through the agreed covenants. Possible actions could be the cancellation of the loan (not used often) but also waiver fees which arise because the lender avoids taking certain actions as requested by the borrower. Furthermore, the creditor can limit investments, restrict the strategical scope and renegotiate the conditions of the loan (often resulting in a raise of the interest rate due to an increased risk premium) from the borrower depending on the arrangement.

The other part of the contract relates to the borrower who must obey to and fulfil the financial covenants. The problem here is that the financial covenants can be to tight, to intensive and thereby restrictive for the debtor.

This underlines the fact that companies think that after a breach of covenant their financial and strategic scope is restricted. Additional work has to be accomplished, as the company must create monthly reports, e.g. about the financial situation or the compliance of the covenants. This means an increase in the costs for external consultants which also lead the negotiations with the credit institution. Anyway, financial covenants are nowadays included in most of standard loan contracts. In practice there is no clear opinion on the borrower´s side if the credit costs are really lower by the use of covenants. This is derived by the possible negative effects of further renegotiation processes and the possibility of the violation of the covenant which in turn means higher credit and additional negotiation costs[43].

REFERENCES

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[1] Cf. H.-Ch. Brauweiler (2016).

[2] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[3] Cf. R. Prilmeier (2017), p. 560.

[4] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[5] Cf. A. Robin / Q. Wu / H. Zhang (2017), p. 157.

[6] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[7] Cf. R. Prilmeier (2017), p. 560.

[8] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[9] Cf. R. Prilmeier (2017), p. 560f.

[10] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[11] Cf. S. Graml (2014), p. 42.

[12] H.-Ch. Brauweiler (2016), p. 6.

[13] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[14] Cf. S. Graml (2014), p. 43.

[15] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 1f.; G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 243.

[16] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 1f.; G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 243; R. Prilmeier (2017), p. 560.

[17] Cf. R. Prilmeier (2017), p. 560.

[18] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 1f.

[19] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 2; G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 242.

[20] Cf. W. Servatius (2013), p. 1f.; B. Zirkler; J. Hofmann; S. Schmolz: (2014); H.-Ch. Brauweiler (2014)

[21] Cf. in the internet: Statista (2014).

[22] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 243.

[23] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 2.

[24] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 2; S. Graml (2014), p. 46f.; K. Olfert (2013), p. 487.

[25] Cf. R. Prilmeier (2017), p. 560.

[26] Cf. K. Olfert (2013), p. 324; H.-Ch. Brauweiler (2015).

[27] Cf. G. Wöhe / J. Bilstein / D. Ernst / J. Häcker (2013), p. 221f.

[28] Cf. K. Olfert (2013), p. 326-332.

[29] Cf. M. Situm (2016), p. 85-90.

[30] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 2-5.

[31] Cf. ibidem, p. 2.

[32] Cf. R. Prilmeier (2017), p. 560f.

[33] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 2.

[34] Cf. J. Wang (2017), p. 332.

[35] Cf. H. Zülch / M. Holzamer / J. Böhm / K. W. Kretzmann (2014), p. 4f.

[36] Cf. W. Servatius (2013), p. 2.

[37] Source: own presentation, content related to: S. Graml (2014), p.51.

[38] Cf. W. Servatius (2013), p.2.

[39] Cf. S. Graml (2014), p.51f.

[40] Cf. H. Zülch/M. Holzamer/J. Böhm/K. W. Kretzmann (2014), p.3.

[41] Cf. R. Prilmeier (2017), p.563-578.

[42] Cf. R. Prilmeier (2017), p. 578.

[43] Cf. H. Zülch/M. Holzamer/J. Böhm/K. W. Kretzmann (2014), p.4f.