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Covenants are obligations for borrowers and options for lenders. Covenant breaches trigger prompt repayment of outstanding debt, making it mandatory for the borrower to renegotiate with the lender for continuing operations. The borrower needs a waiver to continue operations. A breach in a covenant is, for instance, a ratio falling below a threshold value, such as a Debt-Cover Ratio (DCR). Covenants are options for lenders since they have the right to grant waivers or to ignore breaches of covenants.

The rationale of covenants is twofold. Covenants help to protect the lender from any significant deterioration in the risk profile of the transaction without prior agreement. They allow lenders to impose a restructuring of the transaction in such instances. Covenants also make it costlier for the borrower to default, because he loses the value of continuing operations even though this value is superior to the debt value. Covenants are incentives against moral hazard, as collaterals are, since they restrict borrowers from taking additional risks or actions that would increase the lenders risk.

Under active credit risk management, lenders use covenants as a pre-emptive device before losses occur. As such, covenants differ from guarantees and collaterals that are similar to insurance policies. The next section lists and defines some standard covenants. Covenants become essential whenever the credit standing of the borrower and/or the collateral do not provide adequate protection. In such cases, they make deals feasible, even though these would not be by classical standards.

Covenant Types

Covenants are either financial or qualitative. Financial covenants refer to minimum values of ratios or key parameters. For instance, the DCR should not decrease beyond a certain value. Others are qualitative in nature. For instance, the lender might have no right to diversify while a transaction is still alive. If there is a breach, the lender has the right to accelerate repayment of the loan. The borrower needs to interact with the lender and renegotiate some aspects of the transaction in order to get a waiver, allowing continuing operations without loan repayment. The goal of the covenant is not to exercise the loan repayment obligation, but to make the borrower dependent on the lender if his credit standing deteriorates or if the risk profile of the transaction changes.

Covenants effectiveness depends on: how tight or loose they are for the borrower; the banks attitude towards risk; or its willingness to exercise the right to impose some restructuring (of debt for example) on the borrower. Often, covenants appear less powerful risk mitigants than collaterals or guarantees because they always remain subject to intangible factors. This explains why rating agencies sometimes consider that certain covenants have no credit mitigating value. However, the usage of covenants is widespread.

Covenants usually fall within four categories: affirmative covenants, restrictive clauses, negative covenants and default provisions. All follow simple rationales. Affirmative covenants are obligations imposed on the borrower, such as communicating information to lenders. Quantitative financial clauses, such as a minimum financial ratio, are a special class of affirmative covenants. The restrictive covenants aim to protect the bank by prohibiting the borrower from taking actions that could adversely affect the likelihood of repayment, such as diversifying into areas other than the core business that could alter his risk profile. By agreeing to loan covenants that limit his actions, the borrower commits not to make choices that might reduce the wealth from the lender. The adverse effect of such covenants is that they may deprive the borrower of valuable investment options and strategies. Negative covenants specifically prohibit certain actions, such as not posting the same collateral as a guarantee for multiple lenders. Default or credit event covenants trigger a default dependent on specific clauses. Default event rules stipulate what happens under default.

Affirmative Covenants

These are obligations imposed on the borrower to provide periodical information. A commonly used covenant in this group is the requirement of communicating periodical financial statements. Keeping track of the borrowers financial condition enables preventive timely actions. In project finance, structured finance and other complex transactions, the obligation extends to comprehensive and detailed monitoring of transactions. In securitizations, investors have periodic reports on the portfolio serving as collateral for the structured notes or any other relevant information.

Financial Covenants

Financial covenants are obligations to comply with certain values of financial ratios. Typically, the DCR of a project should be higher than a certain value, such as 1.4. Other ratios extend to debt-equity structure, payout ratios of dividends and similar. The underlying rationale is self-explanatory. The protection potential of such covenants is highly dependent on how tight they are. A DCR of 1.4 provides more protection than a DCR of 1.2.

Restrictive Clauses

Restrictive clauses limit the borrowers actions. Since borrowers tend to divert liquidity and net worth to shareholders rather than keeping it within the firm to protect creditors, a common restrictive clause limits the dividends to shareholders. It is also common for the bank to restrict salaries, bonuses and advances to employees of the firm. Other covenants limit specific types of investments or diversification away from the core business of the borrower because such developments alter the firms risk profile, possibly to the creditors detriment.

Negative Covenants

While restrictive covenants limit certain actions, negative covenants prohibit them. A common negative covenant is the negative pledge clause, usually found in unsecured loans. Under the clause, the borrower cannot pledge any of his assets as security to other lenders because the value of the collateral substantially diminishes if it is subject to claims from others. The fewer the assets of the firm pledged for other loans, the greater the share available to the bank in the event of bankruptcy. There may also be prohibitions regarding mergers, consolidations and sales of assets, diversification out of the core business of the borrower. It is also common for the bank to prohibit borrowers from making loans to others or guaranteeing debts to others. Such actions protect the lenders claim.

Default and Credit Event Provisions

These are event-triggered clauses rather than obligations limiting ex ante the risk of such events. Such clauses make the entire debt immediately due and payable under certain conditions. Ordinarily, even though the bank has covenants for governing the borrowers behaviour, violation does not automatically allow the bank to call the loan as long as scheduled payments occur.

The pari passu covenant stipulates that the default on any debt triggers default events on all other debts. Effective violation of such a covenant automatically makes full payment due immediately, or accelerates all loan repayments. This pre-emptive clause allows lenders to take corrective timely actions that would become impossible once the deterioration materializes in missed payments. Because corrective actions take place earlier, they avoid further deteriorations of the borrower, that make recoveries lower. The acceleration clause does not trigger an effective repayment as long as the lenders and borrowers find a common interest in pursuing operations. Rather, it makes it an obligation for the borrower to obtain a waiver, once there is a covenant breach, thereby necessitating renegotiation of the debt terms and restructuring. The lenders look for additional security provisions before allowing the borrower to continue. Typically, this might include raising more equity by the sponsors of a project, getting more information, imposing new restrictions, and so on. Restructuring a loan becomes an obligation under such covenant clauses, if the lenders require it. Restructuring can also take place without any contractual obligations, simply when the lender perceives a deterioration and initiates a negotiation on corrective actions with the borrower.

All credit event provisions apply to events differing from default. Common definitions of default events, that are not very different, include the absence of payment for a minimum period after the date payment is due (for example 3 months) or filing for bankruptcy, which is the ultimate stage of default. Credit events designate a broader range of events, all of them possibly triggering acceleration clauses:

• Failure to make timely payments.

• Inaccuracy in representations and warranties.

• Impairment of collateral, invalidity of a guarantee and/or security agreement.

• Failure to pay other indebtedness when due or to perform under related agreements.

• Change of management or ownership.

• Expropriation of assets.

These credit events become, with acceleration clauses, similar to default events. In some cases, the loan agreement provides the borrower with a grace period to correct his default. If the borrower fails to do so, the bank may terminate the lending relationship. Though banks rarely exercise the right to accelerate loan repayment, having this right substantially strengthens a lenders position. Common related clauses include:

• Cross-default—gives the bank the right to declare an event of default when the borrower defaults with a third party (another lender). It implies that a default with any specific lender is equivalent to a default event for all other lenders. Hence, a default with lender X triggers a default with lender Y as well, even though Y did not suffer from any payment deficiency.

• Cross-acceleration—means that the acceleration of repayments also applies to all lenders equally.

Cross-acceleration and cross-default ensure the equal treatment of all lenders when the borrower defaults on any one of his obligations. It also precludes some lenders from initiating claims earlier than others.

Other Parameters of the Loan Agreement

Loan agreements have many provisions other than amount and price that must be negotiated between the bank and the borrower. Some of the more important parameters of the loan agreement are:

• The time schedule for withdrawing funds from the bank.

• The time schedule for paying back the interest and principal.

• A compensating balance requirement: an obligation by the borrower to maintain deposits at the lending bank.

• A prepayment penalty for repaying a loan before it matures.

Standard covenants are commonly used. The emergence of new structures gave birth to entirely new term sheets making the SPV entirely ruled by covenants. With new vehicles, the role of covenants changes. Instead of being simple enhancements to transactions, they have the role of governance of the structure. In practice, term sheets and public information disclosure fully detail the covenant ruling structures, SPVs, Collateralized Debt Obligation (CDO) structures and liquidity lines.