Financial Covenants and Cure Rights

In finance documents, financial covenants or ratios (and the negotiation of cure rights for breaches) require careful thought during the initial documentation process for a transaction. 

There is significant value in negotiating a cure regime at the outset of a transaction.

Financial covenants are designed to act as an early warning system for a lender.  A breach of a financial covenant alerts the lender to financial underperformance that the borrower may be experiencing before a payment default occurs.

The types of financial covenants applicable to a lending transaction will depend on the type of asset being financed.  In a property finance context, an interest cover ratio, debt service cover ratio, loan to value ratio or (for a property development financing) a loan to development cost ratio will be relevant.  In financing a mining project, lenders will usually require a loan life cover ratio, project life cover ratio, debt service cover ratio and a reserve tail ratio.  In the corporate finance space a lender may require a debt service cover ratio, leverage ratio, gearing ratio, minimum liquidity or a current ratio.

Even though financial covenants are an ‘early warning system’, the effect on a borrower of breaching them can be significant.  A breach will typically trigger an ‘event of default’ under the facilities giving the lender the ability to prevent further draws, demand early repayment of the whole of the debt or enforce any security.  Triggering of an ‘event of default will also have the following adverse consequences for a borrower:

• the lender can rely on a breach to bring the borrower back to the negotiation table to discuss restructure of the facilities, including a change to repayment profiles or pricing; and
• from an accounting perspective, enlivening a lender’s right to demand early repayment will change the classification of the company’s debt from a non-current to a current liability.   From an audit perspective, there may also be legitimate questions as to whether the borrower is able to continue as a going concern.  For those borrowers who are ASX listed this will have significant market disclosure implications.

However, if a borrower has negotiated cure rights during the documentation phase of the transaction, it may have a lifeline in the form of a cure right.

This right allows a borrower to recognise a covenant breach and remedy it before an event of default under the finance documents occurs. 

A breach of a financial covenant can usually be remedied by following an agreed process by which a borrower is able to raise additional equity which can then be applied or taken into account for the purposes of recalculating the breached financial covenant.  Negotiations of that ‘equity cure right’ typically focus on:

• how the equity amounts can be applied by the borrower (e.g. to reduce borrowings or to increase the applicable revenue/profit/cashflow);
• how the ‘equity’ can be sourced and from whom (e.g. share capital or subordinated debt);
• the timing and frequency of the exercise of the cure rights; and
• the effect of the cure right.

Following completion of the cure, the affected financial covenants are then recalculated for the relevant period as if the equity amount had been available to the borrower during that period.  If as a result of the additional equity, the financial covenants are in compliance, the borrower will be deemed to have satisfied the financial covenant in respect of the relevant period the subject of the prior breach and importantly, if properly drafted, no ‘event of default’ will have occurred and the significant consequences outlined above will have been avoided.

Should you require any advice regarding how to negotiate appropriate cure rights for your transaction, please don’t hesitate to contact us on +61 8 9327 0800.