The Revival of Covenants in the Credit Crisis
During times of credit shortage, lenders want to make the most of the financing they provide. Banks attempt not only to reduce the risk of lending but also to become their borrowers’ strategic financial service providers. This points to the spread and the increasing sophistication of covenants in credit agreements.
Poland was hit by the financial crisis in mid-September 2008 with the sudden devaluation of its domestic currency, Polish zloty (PLN). The crisis brought an immediate drying out of market liquidity and substantially increased corporate credit risk. Such an environment has raised the importance, as well as the frequency, of covenants included in credit agreements concluded between banks and companies. Within the space of several months, covenants spread from structured, large-scale financing agreements to small, plain vanilla loans. They also became more specific and detailed.
As professor Joel Bassis put it: “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”.1
Credit risk management during the time of the agreement typically turns out to involve a frequent review of the credit, the condition of the borrower and status of the possible collateral. The lender should therefore ensure the right to perform these reviews by the respective provisions of the credit agreement. Moreover, the lender usually adds additional, associated requirements – covenants – concerning:
A covenant therefore becomes one of the conditions of credit being granted. The agreement may require the borrower, for example, to present to the bank the newest financial statements as soon as possible, or it may prohibit the borrower to undertake certain new obligations. In case the borrower defaults under these conditions, the credit may be declared immediately due, and the borrower may be obliged to sell certain assets or to present new assets as additional collateral.
Legally, the Polish Banking Act established the right of a bank to monitor its borrower’s behaviour. Article 74 of the Act obliges the borrower to present – during the life of the loan agreement, at the bank’s request – “such information and documents as are necessary to assess its financial and economic standing and to enable monitoring of the loan use and repayment”. Granting a loan is always conditional. In particular, the bank shall condition loan extension upon a borrower’s creditworthiness, which “shall be understood as the capacity to repay the loan taken, together with interest, at the dates specified in the agreement” (Article 70 paragraph 1). In order to enable the bank to execute this condition, Article 70 paragraph 3 requires the borrower to “facilitate measures taken by the bank to assess the financial and economic situation and to monitor loan use and repayment”. Finally: “where the terms of the loan have not been observed by the borrower or the borrower has lost its creditworthiness, the bank may reduce the amount of loan granted or give notice of termination of the loan agreement” (Article 75 paragraph 1).
However, the Banking Act is not the only regulation that requires the bank to monitor the condition of the borrower, the status and value of collateral and the punctuality of credit servicing. The key supplementary regulation is the Ordinance of the Minister of Finance concerning the creation of reserves covering banking activity risks. The Ordinance assumes, inter alia, that the inspection of the financial-economic situation of the borrower considers such financial ratios as: return on equity (ROE), financial liquidity, debt-equity ratio, etc. Moreover, banks are obliged to appraise their borrowers qualitatively with respect to: managing quality, market dependence, dependence on government donations, bids, dependence on few large suppliers or buyers and the extent of dependence from other group members, if any. The appraisal usually occurs at the end of each quarter and, in some specific cases, annually.
Traditionally, covenants address three areas:
Financial performance covenants are based on the assessment of a borrower’s economic condition (members of its group, guarantors, etc). They use the indicators of liquidity, profitability, market indicators, capital management and debt coverage, and refer to general risk, the sector in which the borrower is active, company management, etc. These covenants often define acceptable limits of capital (acceptable minimum) or the level of financing (maximum value of debt).
Information covenants usually refer to such key points as the availability of updated financial information and insurance agreements, as well as documents referring to ownership, transfer of share or to proceedings.
Covenants referring to the protection of assets are usually divided between so-called ‘positive’ (requiring the borrower to undertake certain action) or ‘negative’ ones (prohibiting some borrower actions or requiring it to protect the company, its assets or the lender’s situation and claims under the credit agreement against deteriorating changes). Positive covenants frequently require the borrower to inform the lender of the occurrence of certain critical events, e.g. on any actual or possible default of the borrower versus other lenders. They require the borrower or their assets to be properly insured, to hold the relevant authorisations and necessary licenses, etc. Negative covenants include: negative pledge, pari passu (equal) treatment (i.e. no discrimination) of lenders, the borrower’s undertaking regarding disposals and acquisitions, lending, issuing shares, distribution of dividends, and choice of auditors.
Covenants are typically used under one of two strategies:
Both strategies can be used by the same institution in different cases. Sometimes, the exit strategy is applied after the hardening strategy has been unsuccessful.
However, considering differences in the banking credits marketplace, the quicker exit option is most frequently and commonly applied by lenders that concentrate their offer on small- to medium-sized enterprises (SMEs) and have developed scoring engines to define the initial credit limit on the basis of limited, standardised, primarily publicly available information on potential borrowers. This mechanism enables these banks to offer credits on a mass scale (to thousands of SMEs at once). However, in the case of such rapid lending expansion (not uncommon before the credit crisis), these banks often have too many credit relationships to renegotiate or to restructure them quickly. Therefore, their main strategy in almost any default is the exit option. As these banks are usually neither the main nor the only lenders for many of the borrowers, they try to receive repayment or at least additional collateral as early as possible, i.e. before other lenders would claim the same. Here, loyalty is definitely not implicit in the credit policy, as it is not expected from borrowers.
The hardening option, assuming renegotiation, and often restructuring, is typical for strategic lenders, cannot be easily repaid on demand. Therefore, these banks usually demand additional collateral to be presented, and pari passu treatment i.e. no repayments of other loans before their debt would be repaid.
These corporate banks which – due to their market position and strategy – consider themselves the strategic lenders, logically imply the element of loyalty in their policies. They do not want to be credit shops only, but they consider financing as an investment in the borrower’s business and primarily into broader relationship with the borrower. Therefore, these lenders are determined to finance selected companies with credit margins lower than their standard expectations. They are motivated to attract the loyalty of their customers. This loyalty is measured by the share of all operations (turnover) of the client that are effected via the bank that finances the activity of the company. There are two systems that come together here:
Due to such conditions, the lending bank is not only able to closely monitor the situation of its borrower, but also receives the expected return from the capital invested in the financing relationship. This dimension of covenants is particularly important during the financial crisis, especially as banks effectively use it to increase their non-credit income, related to extended financing. These covenants force banking experts to cooperate actively with their clients to fulfill the discussed provisions of the agreement. The fact that a client does not fulfill the turnover covenant (specifying the number of payment transactions or a volume of operations) cannot be substituted with anything else (not by requesting collateral, or by increase of the price of the credit) as it poses key doubts regarding borrower’s business performance. Even if the bank relinquished additional, associated income, it should definitely not neglect the monitoring of its client’s turnover, thereby especially insisting on fulfillment of cash management related covenants.
Although 2010 will be a difficult time of recovery for the Polish economy, the banking market is gradually unfreezing in terms of credit policies, risk appetites, lending conditions and, finally, interbank competition. In this environment, three questions arise regarding the future scope, importance and purposes of covenants in corporate credit agreements:
If this last scenario emerges, that would mean that the financial crisis helped the banks to set up their strategic direction and that the local corporate banking market is ready for a gradual consolidation, with around five or six banks forming the stable nucleus of strategic lenders, with the remaining dozens of banks playing the role of exchangeable, less stable, credit shops.
1 Bessis, Joel, “Risk Management in Banking”, J Wiley & Sons, 2nd ed., 2002, page 514.
2 David Adams, “Corporate Finance: Banking and Capital Markets”, Jordan Publishing Ltd., 1998, page 82.