Further identifying covenant management risk
A risk-based debt compliance program focuses on the real, manageable risks by excluding the dependent covenants, any not applicable boilerplate covenants, and the lender option covenants.
Independent covenants are triggered by events or actions outside the agreement, while dependent covenants are any required actions following a triggering of an independent covenant. A notice of an asset sale is an independent covenant. The subsequent covenants requiring the proceeds to be reinvested in similar assets within a certain period of time or used to prepay the debt are dependent covenants. Many notice requirements will have dependent covenants, especially in covenant-lite deals. The latter will often dependent incurrence covenants, requiring the pro forma calculation of financial ratios against fixed limits.
The dependent covenants are not relevant if their independent covenant has not been triggered. While independent covenants represent the initial risk, dependent covenants also pose a significant risk because they are often forgotten.
Always when a covenant issue arises, the compliance team must read the applicable debt agreement text to ensure that all requirements are or will be satisfied. Provided that there is such a commitment, then the dependent covenants do not need to be monitored in the quarterly compliance process.
Nearly all debt agreements will have these kinds of covenants:
- Preparing the books in accordance with GAAP
- Compliance with the Foreign Corrupt Practices Act, the Patriot Act, etc.
- ERISA events
- Becoming an “Investment Company” per the Investment Company Act of 1940
- Federal Reserve Board Regulation U on margin stock.
It is unnecessary to include the first two in the debt compliance program if they are covered by the company’s other compliance programs. If the company has no defined benefit plans, the ERISA covenants are simply not applicable. Similarly, there’s no chance that any nonfinancial company will suddenly become an investment company or start providing stock margin loans to its customers. Banks include these two because they are related to restrictions imposed by their regulators.
Lender option covenants:
Lender option covenants give the lender the right to request certain information at any time or demand additional payments based upon changed circumstances independent of the borrower. These covenants include the right to visit the borrower, inspect or audit the books, and have discussions with management. They also include additional payments due to changes in law or reserve requirements that increase the lender’s borrowing costs.
Since these covenants are initiated by the lender and are not triggered by borrower actions, they are not compliance risks that can be managed. Of course, they need to be complied with when they are initiated by the lender.
For debt compliance purposes, by excluding the above covenants, we are left with a risk-based list of relevant, controlling covenants organized by logical lender objectives. Further risk analysis can be done, excluding the unlikely covenants from the moderate to high risk covenants, provided that the covenants deemed unlikely are periodically reviewed.
From this carefully vetted list, we can confidently develop a multi-agreement quarterly questionnaire process to document the compliance, a consolidated permitted baskets analysis, and a consolidated calendar of the regularly scheduled payment and document delivery due dates.
The covenant questionnaires, organized by objective and subject provide a useful context to non-treasury/legal staff for why these covenants are important and why they need to be responsible for their compliance.
This checklist process identifies the covenants that need to be regularly monitored without cluttering the debt compliance program with covenants that are initially not or really not relevant. However, in debt compliance the only authority is the debt agreements, not the checklist. Just like a map is not the territory.
So, whenever a covenant issue is raised, it is the compliance team’s responsibility to research the applicable covenant text and make sure that the company is in compliance with all of the covenant’s requirements, including any dependent covenants.