Security Provisions and Protective Covenants - Financial Management

The security provisions and protective covenants specified by a term loan agreement are often determined by the borrower’s credit standing: the weaker the credit standing, the more restrictive the protective covenants.

Security Provisions

In general, security requirements apply more often to intermediate -term loans than to short -term loans, due to the fact that longer-term loan contracts tend to have more default risk. Security provisions are also dependent on the size of the borrowing firm. For example, term loans to small firms tend to be secured more often than term loans to large firms, although there is an increasing tendency for all bank -oriented term loans to be secured.

The sources of security for a term loan include the following:

  • An assignment of payments due under a specific contract
  • An assignment of a portion of the receivables or inventories
  • The use of a floating lien on inventories and receivables
  • A pledge of marketable securities held by the borrower
  • A mortgage on property, plant, or equipment held by the borrower
  • An assignment of the cash surrender value of a life insurance policy held by the borrower for its key executives

Affirmative Covenants

An affirmative loan covenant is a portion of a loan agreement that outlines actions the borrowing firm agrees to take during the term of the loan. Typical affirmative covenants include the following:

  • The borrower agrees to furnish periodic financial statements to the lender, including a balance sheet, income statement, and a statement of cash flows. These may be furnished monthly, quarterly, or annually and frequently are required to be audited. Pro forma cash budgets and projections of the costs needed to complete contracts on hand may also be required.
  • The borrower agrees to carry sufficient insurance to cover insurable business risk.
  • The borrower agrees to maintain a minimum amount of net working capital (current assets less current liabilities).
  • The borrower agrees to maintain management personnel who are acceptable to the financing institution.

Negative Covenants

A negative loan covenant outlines actions that the borrowing firm’s management agreesnot to take without prior written consent of the lender. Typical negative covenants include the following:

  • The borrowing firm agrees not to pledge any of its assets as security to other lenders, as well as not to factor (sell) its receivables. This type of agreement, called a negative pledgeclause, is found in nearly all unsecured loans. It is designed to keep other lenders from interfering with the immediate lender’s claims on the assets of the firm.
  • The borrower is prohibited from making mergers or consolidations without the lender’s approval. In addition, the borrower may not sell or lease a major portion of its assets without written approval of the lender.
  • The borrower is prohibited from making or guaranteeing loans to others that would impair the lender’s security.

Restrictive Covenants

Rather than requiring or prohibiting certain actions on the part of the borrower, restrictive loan covenants merely limit their scope. These are typical restrictive covenants:

  • Limitations on the amount of dividends a firm may pay
  • Limitations on the level of salaries, bonuses, and advances a firm may give to employees These restrictions, in essence, force the firm to increase its equity capital base, thereby increasing the security for the loan. Other restrictive covenants might include the following:
  • Limitations on the total amount of short- and long-term borrowing the firm may engage in during the period of the term loan
  • Limitations on the amount of funds the firm may invest in new property, plant, and equipment. (This restriction usually applies only to those investments that cannot be financed from internally generated funds.)

And, finally, a firm that has outstanding long -term debt may be restricted as to the amount of debt it can retire without also retiring a portion of the term loan.

These restrictions are quite common, but the list is not all -inclusive. For example, a standard loan agreement checklist published by a large New York City bank lists 34 commonly used covenants. In general, covenants included in a loan agreement are determined by the particular conditions surrounding the granting of the term loan, including the credit record of the borrower and the maturity and security provisions of the loan.

Default Provisions

All term loans have default provisions that permit the lender to insist that the borrower repay the entire loan immediately under certain conditions. The following are examples:

  • The borrower fails to pay interest, principal, or both as specified by the terms of the loan.
  • The borrower materially misrepresents any information on the financial statements required under the loan’s affirmative covenants.
  • The borrower fails to observe any of the affirmative, negative, or restrictive covenants specified within the loan.

A borrower who commits any of these common acts of default will not necessarily be called on to repay a loan immediately, however. Basically, a lender will use a default provision only as a last resort, seeking in the meantime to make some agreement with the borrower, such as working out an acceptable modified lending plan with which the borrower is more able to comply.Normally, a lender will call a loan due only if no reasonable alternative is available or if the borrower is facing near -certain failure.

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