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Covenants in loan agreements—an analysis of practices within the Swedish high-yield bond sector

Fors, Fredrik LU (2013) JURM02 20132
Department of Law
Abstract
A high-yield bond is a financing option for a non-investment grade corporation, enabling it to raise funds on the capital market. In light of harsher conditions for senior financing, the development of a liquid high-yield market for bonds may prove a necessary way forward to ensure global competitiveness for Swedish small and medium-sized enterprises (“SMEs”) that typically relies heavily on bilateral- and syndicated bank loans.

The reasons behind issuing a bond instead of turning to senior financing alternatives or stock issuances vary, but usually it is a combination of factors concerning price, control and flexibility. As the owner of notes in a bond, i.e., a long-term, tradable debt, you are eligible to annual remuneration: every... (More)
A high-yield bond is a financing option for a non-investment grade corporation, enabling it to raise funds on the capital market. In light of harsher conditions for senior financing, the development of a liquid high-yield market for bonds may prove a necessary way forward to ensure global competitiveness for Swedish small and medium-sized enterprises (“SMEs”) that typically relies heavily on bilateral- and syndicated bank loans.

The reasons behind issuing a bond instead of turning to senior financing alternatives or stock issuances vary, but usually it is a combination of factors concerning price, control and flexibility. As the owner of notes in a bond, i.e., a long-term, tradable debt, you are eligible to annual remuneration: every year until the bond maturity date, you collect interest. Upon the bond’s maturity, you will collect the value of your investment, known as the principal. Due to the lack of controlling rights accompanied with holding debt securities such as bonds, compared to owning shares, investors wish to employ a method for mitigating their risks towards the issuer. Predominantly, this need is accommodated through the usage of covenants.

Complex covenant packages are often influential in dictating the terms and conditions of the facilities agreements governing bonds. For many investors, which covenants to employ may be hard to determine. This factor, combined with the need to tailor covenant packages to suit each specific loan agreement, has led to contrasting covenant practices within the Swedish high-yield bond sector. This is evidently supported by this study, and is in part believed to be a result of the fact that the standardized loan agreements that have evolved in the Swedish high-yield bond sector have yet to encompass covenants to any extent. Therefore, this study sets out to map the covenant practices on the Swedish market, including how covenants are drafted in each separate case, thus ascertaining their value for the investor. This objective is accomplished by comparing theoretical purposes behind covenants in loan agreements—derivative of doctrine within financial law—with the actual wording of the clauses employed in agreements within the scope of an empirical survey that has been carried out. In this process, some legal pitfalls were identified, possibly leading to diverging results when comparing the purposes behind employing a covenant with the implication in practice.

The main diverging aspects between purpose and practice were found in negative pledge-covenants—due to their apparent lack of effect towards third parties under Swedish law—and within no-disposal clauses’ and no-merger clauses’ function due to the usage of the vague term material adverse effect as an outer limit for the covenants’ applicability. Certain issues related to basket sizes and specific carve-outs were also recognized.

For the most part, the majority of covenants investigated did however seem to provide lenders with the level of protection that was pursued. This means that the theory and practice of most covenants corresponded. Hence, it is concluded that the purpose behind covenants as the carrier of effective enforcement rights against the borrower is fulfilled, even though some possible limitations of a few covenant clauses’ legal effect were in fact identified. This conclusion was held by adapting a pragmatic and rational view of covenant practices—not neglecting the power that is vested in the noteholders to accelerate premature payment of the notes (should an event of default under the facility agreement occur)—rather than strictly scrutinizing covenants’ effects under the law. (Less)
Abstract (Swedish)
En högriskobligation, eller företagsobligation med hög risk, är ett sätt för ett litet- eller medelstort företag med låg kreditvärdighet att anskaffa pengar på kapitalmarknaden. I takt med att hårdare krav ställs på seniora långivare så växer betydelsen av en välutvecklad marknad för högriskobligationer i Sverige. Detta är nödvändigt för att bibehålla en global konkurrenskraft hos svenska små- och medelstora företag som ofta är starkt beroende av bilaterala- och syndikerade banklån.

Anledningarna till att ett företag väljer att ge ut obligationer i stället för att uppta seniora banklån eller att ge ut aktier varierar, men är vanligtvis beroende av faktorer såsom pris, kontroll och flexibilitet. En obligation är ett långvarigt,... (More)
En högriskobligation, eller företagsobligation med hög risk, är ett sätt för ett litet- eller medelstort företag med låg kreditvärdighet att anskaffa pengar på kapitalmarknaden. I takt med att hårdare krav ställs på seniora långivare så växer betydelsen av en välutvecklad marknad för högriskobligationer i Sverige. Detta är nödvändigt för att bibehålla en global konkurrenskraft hos svenska små- och medelstora företag som ofta är starkt beroende av bilaterala- och syndikerade banklån.

Anledningarna till att ett företag väljer att ge ut obligationer i stället för att uppta seniora banklån eller att ge ut aktier varierar, men är vanligtvis beroende av faktorer såsom pris, kontroll och flexibilitet. En obligation är ett långvarigt, omsättningsbart lån. Ägaren av obligationen är berättigad till årlig ersättning i form av ränta som periodvis betalas fram till obligationens förfallodag. På förfallodagen betalas även obligationens principalsumma ut. Eftersom obligationsinnehavaren likt andra kreditgivare saknar det inflytande över bolaget som innehas av aktieägare så måste andra metoder användas för att reglera riskerna förknippade med kreditgivningen. Detta görs primärt genom användandet av covenanter i låneavtalen.

Komplicerade covenantpaket har ofta en stark inverkan på hur obligationernas avtalsvillkor ser ut i sin helhet. För många investerare är frågan vilka covenanter som ska användas svår att avgöra. Denna faktor, i kombination med behovet att kunna skräddarsy vilka covenanter som ska användas till varje specifikt låneavtal, har lett till en kontrasterande användning av covenanter på den svenska marknaden för högriskobligationer. Detta styrks av denna studie, och antas delvis bero på det faktum att det standardavtal som har utvecklats för den svenska högriskobligationsmarknaden inte innefattar covenanter. Det är i bakgrund av detta som denna studie avser att kartlägga hur covenanter används på den svenska marknaden, innefattande deras ordalydelse i varje enskilt fall. Därigenom finns en förhoppning att kunna utröna det praktiska värdet av dem för obligationsinnehavare. Detta mål uppnås genom att jämföra det teoretiska syftet som finns bakom olika covenanter, enligt relevant doktrin inom finansiell rätt, med covenanters ordalydelse såsom de är utformade i de låneavtal som är del av den empiriska undersökning som uppsatsen bygger på. Denna process ledde till att flera legala fallgropar har kunnat identifieras, som tänkbart kan leda till skillnader i resultat vid en jämförelse av covenanters bakomliggande syfte och det syfte de får i praktiken.

De primärt åtskiljande faktorerna mellan det bakomliggande syftet och den antagna praktiska implikationen fanns vid användandet av negative pledge-covenanter – på grund av deras till synes avsaknad av effekt gentemot tredje män i svensk rätt – och i covenanter som avser att begränsa låntagarens förfoganderätt över bolagets egendom, samt i covenanter som avser att begränsa sammanslagning eller uppdelning av det. I det senare fallet argumenteras det att anledningen till detta är användandet av terminologin material adverse effect som en yttre gräns för covenanternas tillämplighet. Vissa möjligt åtskiljande faktorer mellan syfte och praktik identifierades även vid användandet av vissa basketbelopp samt carve-outs.

Sammantaget konkluderas det dock att majoriteten av covenanterna i studien ger investerare det skydd som är avsett. Detta innebär att syftet bakom covenanter korresponderar med den praktiska innebörden de antas få vid sin tillämpning. Således dras slutsatsen att covenanternas roll som ett effektivt påtryckningsmedel gentemot låntagaren uppnås, trots att vissa begränsningar i ett fåtal covenanters legala värde de facto kunde urskiljas. I stället för att strikt analysera varje covenants legala tillämplighet har denna slutsats dragits genom att anta ett pragmatiskt och rationellt synsätt av hur covenanter används – utan att försumma den befogenhet som obligationsinnehavarna besitter när det kommer till att accelerera betalning av obligationerna i förtid för det fall att ett covenantbrott i enlighet med avtalsvillkoren inträffar. (Less)
Please use this url to cite or link to this publication:
author
Fors, Fredrik LU
supervisor
organization
course
JURM02 20132
year
type
H3 - Professional qualifications (4 Years - )
subject
keywords
Avtalsrätt, associationsrätt, förmögenhetsrätt.
language
English
id
4228819
date added to LUP
2014-01-16 07:44:41
date last changed
2014-01-16 07:44:41
@misc{4228819,
  abstract     = {A high-yield bond is a financing option for a non-investment grade corporation, enabling it to raise funds on the capital market. In light of harsher conditions for senior financing, the development of a liquid high-yield market for bonds may prove a necessary way forward to ensure global competitiveness for Swedish small and medium-sized enterprises (“SMEs”) that typically relies heavily on bilateral- and syndicated bank loans. 

The reasons behind issuing a bond instead of turning to senior financing alternatives or stock issuances vary, but usually it is a combination of factors concerning price, control and flexibility. As the owner of notes in a bond, i.e., a long-term, tradable debt, you are eligible to annual remuneration: every year until the bond maturity date, you collect interest. Upon the bond’s maturity, you will collect the value of your investment, known as the principal. Due to the lack of controlling rights accompanied with holding debt securities such as bonds, compared to owning shares, investors wish to employ a method for mitigating their risks towards the issuer. Predominantly, this need is accommodated through the usage of covenants. 

Complex covenant packages are often influential in dictating the terms and conditions of the facilities agreements governing bonds. For many investors, which covenants to employ may be hard to determine. This factor, combined with the need to tailor covenant packages to suit each specific loan agreement, has led to contrasting covenant practices within the Swedish high-yield bond sector. This is evidently supported by this study, and is in part believed to be a result of the fact that the standardized loan agreements that have evolved in the Swedish high-yield bond sector have yet to encompass covenants to any extent. Therefore, this study sets out to map the covenant practices on the Swedish market, including how covenants are drafted in each separate case, thus ascertaining their value for the investor. This objective is accomplished by comparing theoretical purposes behind covenants in loan agreements—derivative of doctrine within financial law—with the actual wording of the clauses employed in agreements within the scope of an empirical survey that has been carried out. In this process, some legal pitfalls were identified, possibly leading to diverging results when comparing the purposes behind employing a covenant with the implication in practice. 

The main diverging aspects between purpose and practice were found in negative pledge-covenants—due to their apparent lack of effect towards third parties under Swedish law—and within no-disposal clauses’ and no-merger clauses’ function due to the usage of the vague term material adverse effect as an outer limit for the covenants’ applicability. Certain issues related to basket sizes and specific carve-outs were also recognized. 

For the most part, the majority of covenants investigated did however seem to provide lenders with the level of protection that was pursued. This means that the theory and practice of most covenants corresponded. Hence, it is concluded that the purpose behind covenants as the carrier of effective enforcement rights against the borrower is fulfilled, even though some possible limitations of a few covenant clauses’ legal effect were in fact identified. This conclusion was held by adapting a pragmatic and rational view of covenant practices—not neglecting the power that is vested in the noteholders to accelerate premature payment of the notes (should an event of default under the facility agreement occur)—rather than strictly scrutinizing covenants’ effects under the law.},
  author       = {Fors, Fredrik},
  keyword      = {Avtalsrätt,associationsrätt,förmögenhetsrätt.},
  language     = {eng},
  note         = {Student Paper},
  title        = {Covenants in loan agreements—an analysis of practices within the Swedish high-yield bond sector},
  year         = {2013},
}