2.4 Legal Risks Inherent in Funding Transactions 15the asset is leased from a financial intermediary that acts as a specialised rede-
ployer of specific assets with specialist knowledge of their alternative uses; and it
is easy for the intermediary to terminate the contract.^31 Typical examples of such
redeployers include aircraft-leasing firms and real estate firms. (c) In addition, re-
possession risk depends on the transaction. There is a high repossession risk at the
expiry of leasing contracts, unless the lessee has an option to purchase the asset
from the lessee.^32
Sixth, there are various other risks related to collateral. (a) In addition to the
repossession risk, there is a market risk. If the value of the collateral declines, the
firm may be forced to give the collateral-taker more collateral or pay. (b) There is
a similar risk when the collateral arrangement is about to expire. In that case, the
collateral-taker often makes an “extend or pay” claim. Extend or pay claims are
usual, for example, in demand guarantees. (c) The collateral-giver may itself be
exposed to counterparty risk. Depending on the legal circumstances, the collateral
may not be easily recoverable if the collateral-taker defaults.
Seventh, there are various risks related to covenants. Covenants are typically
used as credit enhancements. They act as contractual constraints that limit the ac-
tions of the firm. Too restrictive covenants can prevent the firm from taking the
best business decisions, increase the firm’s costs, increase the risk of default by
the firm; and make it more difficult to raise new funding from other sources.
Eight, several legal risks are connected with transferability. The transfer of
claims can signal a deterioration in their quality. In addition, the transfer may in-
crease agency costs or counterparty commercial risk, because the transferor may
have been a better agent or counterparty than the transferee will ever be. For ex-
ample, a share block might be bought by a competitor, or a long-term debt might
be bought by a hostile financial institution for the purpose of terminating it on
grounds of alleged default.
Ninth, there is the risk of conflicting contracts. It can be legally complicated to
raise equity, debt, or mezzanine finance, and to release capital. Without proper
drafting, the legal framework of one transaction can contain aspects that breach
the terms of another transaction and are regarded as a default.
Information. In funding transactions, the firm typically undertakes disclosure
obligations in order to reduce investors’ perceived risk.
All contract terms and other terms of funding can signal something to investors.
A contract term signals the firm’s willingness and ability to comply with it.
There also specific disclosure obligations based on contract. Breach of repre-
sentations or information covenants can amount to default and increase costs, or
trigger the acceleration of payments or the termination of the contract.
Disclosure obligations can also be based on mandatory laws. For example,
funding transactions are influenced by their accounting and tax treatment, which,
in many cases, determine the structure of the transaction. In capital markets, issu-
ers must comply with mandatory disclosure rules.
(^31) Generally, see Habib MA, Johnsen DB, The Financing and Redeployment of Specific
Assets, J Fin 54 (1999) pp 693–720.
(^32) Ibid, p 703.