Covenant analysis isn’t all about the docs
I am often asked for my take on how a particular transaction might play out under a specific set of covenant terms. Most of the time, I am sent only the underlying legal documentation to conduct my analysis, and without exception this is not enough.
Analysing docs is not enough for any covenant question.
Contractual analysis done in isolation is inherently incomplete. Contracts do not exist in isolation – they are promises made by the parties to the agreement, and the identity of the parties always matters.
Take a Change of Control analysis as an example – in most agreements, regardless of governing law, a “Change of Control” means that at least a majority of shares or control is transferred to another party(sometimes there are other prongs, including a sale of all or “substantially all” of the business – and don’t even get me started on what that may or may not mean).
Imagine a joint venture transaction has just been announced. Party A, the current owner of the borrower, will enter into a JV with Party B. Party A will retain majority shareholding, leaving Party B with less than 50% of the shares.
Is this a Change of Control? Give me the docs and nothing else, and my answer will be: it depends.
It depends on whether Party B wishes to gain beneficial ownership of the voting power of the borrower. It depends on what the JV agreement says. It depends on whether Party A and/or B are willing to forego a transfer of control to save the costs of paying out a Change of Control put. It depends which country’s governing law is at play.
It depends on the parties, their motivations, and – in some IG or cusp-y deals – whether the transaction results in a ratings downgrade within a specified time period after the announcement of the transaction (this latter prong of the trigger puts the question outside of even the parties to the contract).
The fact that the analysis neither begins nor ends with the docs is why our Leveraged Finance Covenant Training course starts with a chapter on Foundations – which covers the who, what, why and how of contract negotiation and analysis.
So, the next time you need to analyse a covenant question, remember that the docs tell only part of the story.
By Sabrina Fox - FLT Founder