94 4 Debt
Some firms have been able to borrow money on easy terms that give little secu-
rity to lenders (so-called covenant-lite loans). The largest issuers of covenant-lite
loan instruments have been private-equity firms, which were able to dictate terms
to lenders before the financial crisis that began in mid-2007. The firm is obviously
less likely to default on a covenant-lite loan before actual insolvency, as there are
few or no covenants to break even as the firm’s finances deteriorate.
The firm can mitigate risk by limiting the scope of covenants to one or just a
few corporate entities. For example, it is more difficult for the firm to comply with
a covenant that covers the business of all subsidiaries and affiliated companies,
and easier to comply with a covenant that only applies to one corporate entity.
Generally, covenant risk tends to be higher when absolute terms are used (for
example, “the firm shall not dispose of any of its assets”). Qualified terms can
help to reduce the risk of default. The borrower can thus mitigate covenant risk by
adding words that dilute the covenant (for example, “the borrower shall not dis-
pose of any of its assets, where it would have a material adverse effect on the re-
payment capacity of the borrower”).
The firm should ensure that negative pledge and pari passu clauses do not pro-
hibit indebtedness and security interests that are created by reason of law in the
ordinary course of the firm’s business. For example, freight forwarders and carri-
ers may have a statutory security interest in goods that are in their possession.^32
Subordination. Subordination is a way to mitigate the risk of covenant default
under existing contracts (for subordination, see Chapter 6; for pari passu, see
Volume II). Subordination can also be used when the firm issues loan instruments
that belong to different tranches.
A subordination agreement is the opposite of a negative pledge in the sense that
instead of trying to obtain priority over other parties, the creditor voluntarily
agrees to subordinate its right. Subordination can often help to reduce the risk of
the firm breaching pari passu clauses, because the usual wording of pari passu
clauses does not cover subordinated debt (for subordination, see section 6.3).
Subordination can be contractual or based on mandatory provisions of law. The
mechanics of subordination can vary from contract to contract.^33 For example, a
(subordinated) creditor can agree: to postpone receipt of payments until the debt
payable to the senior creditor has been discharged (complete subordination);^34 to
postpone its right to be paid upon the insolvency of the debtor until the senior
creditors have been paid in full (usual form of contractual subordination);^35 that
the creditor is entitled to payments until the occurrence of a specified event, such
as an event of default under a senior finance document.^36
For example, a company may issue A notes and B notes. If the B notes mature six months
after the A notes, they will be subordinated to the A notes (as there might not be sufficient
(^32) See, for example, § 14 of the General Conditions of the Nordic Association of Freight
Forwarders (NSAB).
(^33) The Law Commission, Registration of Security Interests, paragraph 6.51.
(^34) Ibid, paragraph 6.52.
(^35) Ibid, paragraph 6.53.
(^36) Ibid, paragraph 6.52.