Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

Defaults

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

After nonpayment, the most important defaults are those involving covenants. These are not static events. Covenants apply to the activities of the borrower throughout the life of the loan. Failure to comply with a covenant can result in the default of the entire loan agreement, even if the borrower is current in its payment obligations. A covenant default is therefore a powerful tool in the hands of the lender, and lenders frequently use covenant defaults to impose additional restrictions on a borrower or even to accelerate repayment of the loan.

Covenant defaults usually have a cure period. The borrower is given a chance to correct the default before it becomes a reason to accelerate the loan. Covenant defaults are sometimes classified in two groups: those that have short cure periods, such as five days of less, and those that have longer cure periods, usually thirty days. The shorter cure periods are reserved for those important covenants that can’t be readily corrected, such as the delivery of an incorrect financial statement. The longer periods are reserved for the things that can be corrected with proper diligence, such as compliance with laws, removing liens from properties and delivering compliance certificates.

A special class of defaults is reserved for bankruptcy and insolvency. These generally trigger immediate default of the credit agreements.

Remedies

Once a default has occurred and the borrower has run out of time to correct it (if such a right exists) the lender has the ability to accelerate the loan and demand that all amounts due under the loan be repaid immediately. Any obligation of the lender to continue extending credit under a revolving credit facility is canceled. If the borrower fails to immediately prepay the loan, as is generally the case once a default occurs, the lender is then free to exercise the security instruments and liens it carefully acquired when the loan was made. Also at this time the defaulted loan begins to bear a higher, default interest rate.  

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Affirmative covenants are those things the borrower must affirmatively do during the term of the loan agreement. Most of these requirements are things the borrower would do in any case without being instructed by a lender, such as pay its taxes, comply with laws, and meet its financial obligations. Other covenants are matters that work to conserve the borrower’s cash flow, focus borrower on a specific line of business and generally keep its nose to the grindstone.

Negative covenants are the things the senior lender says that a borrower may not do. Most of these are things the borrower wouldn’t do anyway. The rest are designed to keep the borrower focused on running its business in the ordinary course and repaying the senior lender’s debt.

Here is a list of certain affirmative and negative covenants that are often negotiated in the credit agreement of a private equity transaction:

Affirmative Covenants:

• Ordinary Course Conduct of Business. Conduct its business in the ordinary course and use its reasonable efforts, in the ordinary course, to preserve its business and the goodwill and the business of its customers, advertisers, suppliers and others having business relations with it.

• Payment of Taxes. Pay and discharge before the same shall become delinquent, all lawful material governmental claims and all material federal and material state, local and foreign income, franchise and other taxes, assessments, charges and levies.

• Maintain Insurance. Maintain insurance with responsible and reputable insurance companies or associations in such amounts and covering such risks that are sufficient, appropriate and prudent in the conduct of the business of the kind conducted by the borrower.

• Access to Information. Let the lender have access to books and records, visit properties of the borrower, meet with management and meet with auditors.

• Books and Records. Keep proper books of record and account, in which full and correct entries shall be made in conformity with GAAP.

• Maintain Condition of Assets. Maintain its properties in good working order and condition and preserve its permits and intellectual property.

• Additional Collateral. Deliver any supplements or amendments to the collateral documents as may be necessary to reflect and fully protect the lender’s security interest in the collateral.

• Deposit Accounts. Where collateral includes cash, deposit all cash in controlled collateral accounts.

• Real Estate. Comply with all obligations under lease agreements, and deliver mortgages on any real estate acquired subsequent to the loan.

Negative Covenants:

• Indebtedness. Borrower will not create, incur, assume or otherwise become or remain directly or indirectly liable with respect to any Indebtedness except for expressly permitted items that are typically subject to caps and refunding limitations.

• Liens. Borrower will not create or suffer to exist, any lien upon or with respect to any of its properties or assets, whether now owned or hereafter acquired, or assign any right to receive income, except for items expressly permitted such as those arising in the ordinary course of business or by operation of law.

• Investments. Borrower will not make any investments in any other party except as specifically permitted or as may be necessary in connection with the borrower’s ordinary course of business.

• Sale of Assets. Borrower will not sell, convey, transfer, lease or otherwise dispose of, any of its assets or any interest therein except as specifically permitted or as may arise in the ordinary course of business (subject to caps and permitted baskets).

• Restricted Payments. Borrower will not pay any dividends on stock or redeem and stock subject to permitted exceptions.

• Prepayment and Cancellation of Debt. Borrower will not prepay or cancel any debt subject to compliance with defined restrictions such as leverage ratios.

• No Mergers. Borrower will not merge with another party or enter into any fundamental transaction that changes the identity of borrower.

• Change in Nature of Business. Borrower will not make any material change in the nature or conduct of its business, except for businesses reasonably related to the business already carried on or ancillary or complementary thereto.

• Modification of Subordinated Debt Documents. Borrower will not change or amend the terms of any subordinated debt if the effect of such amendment is to (i) increase the cash pay portion of the interest rate on such debt, (ii) change the dates upon which payments of principal or interest are due, (iii) change any default or event of default, or change any covenant with respect to such debt in any manner materially adverse to borrower, (iv) change the subordination provisions of such debt, (v) change the redemption or prepayment provisions of such debt or (vi) change or amend any other term if such change or amendment would be materially adverse to borrower.

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The buyer of a company will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The purchase agreement will specify the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The purchase agreement will often have a number of things attached to it, such as schedules of information, forms of notes, or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the purchase agreement and often constitute part of the items delivered by the parties at the closing.

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The first covenant given by seller is the promise that it will operate its business only in the “ordinary course” and “consistent with past practice” between signing the purchase agreement and closing. The covenant goes on at length about specific things that seller will and will not do during this period without the permission of buyer. The purpose of these sections is to make sure that no significant or unusual transactions are undertaken without buyer’s knowledge and consent.

Seller agrees to give the private equity firm and its representatives access to its books, records, facilities and employees between signing the purchase agreement and closing. This is often necessary to bring in lenders for the transaction and let them complete their due diligence and investigation of seller and its business. 

Seller and its affiliates, including principal shareholders of seller, typically agree not to engage in the same business for up to three to five years, sometimes longer. This non-compete restriction will include owning any equity interest in any entity that is engaged in the same business being sold and otherwise participating in, managing, controlling, operating or financing any entity that is engaged in this business. The geographic territory of the restriction is generally limited to the area in which seller conducts the business as of the closing date. Also, seller and its affiliates are not allowed to solicit or hire employees of the business to work for them or solicit customers or suppliers to the business. Seller and its affiliates also agree not to use confidential information, such as trade secrets and customer list, of seller after the closing.

These non-compete and confidentiality covenants are very important to a private equity buyer, as seller and its affiliates would otherwise have the ability to set up an effective competing business immediately after the closing. Buyer is given rights to specifically enforce these provisions against any party that breaches them. It is also important to make these covenants assignable to any person the private equity firm may later sell the business.

Often, special covenants regarding trademarks and trade names are included in the purchase agreement, as seller may need to change its name or take other actions to ensure that buyer has the exclusive right to use the purchased trademarks and goodwill. Other times, special covenants regarding the employment of seller’s management team and work force will be included in the agreement.

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