Can we do it? Understanding restrictions contained within Loan Agreements

All commercial borrowers are acutely aware of the requirement to pay interest on a loan they borrow and to repay a loan at the end of its term. However, some borrowers (if they are not properly advised) may not know that a loan agreement can also contain certain restrictions on many activities which a company may wish to engage in.

It is important to both:

• understand the significance of the restrictions to prevent accidental events of default from occurring (which may lead to the lender demanding immediate repayment of the loan), and to
• negotiate loan agreements suitable for your company’s needs.

We present some of the main operational areas which tend to be restricted in commercial loan agreements, and the extent to which particular restrictions may be softened.

Two starting considerations

A first point to consider is the complexity of your loan agreement. The probability that it will contain substantial restrictions increases as its complexity and length increase. In particular, if it is based on a Loan Market Association (LMA) template, or a similar lender in-house template, there is a high chance it will encompass most or all of the restrictions referred to below.

A second consideration is whether a given restriction is absolute or qualified. Qualified restrictions permit actions in certain circumstances, e.g. if below a certain value, involving specific parties such as group companies, or in the ordinary course of business.

Additional Borrowing

A standard LMA-form loan agreement contains a covenant that the borrowers will not incur any further borrowings. This is a very common restriction as lenders want to prevent borrowers having too much debt.

It may be possible to agree ‘Permitted Borrowings’ or ‘Permitted Indebtedness’ with the Lender which may include borrowing from the borrower’s shareholders or borrowing small sums for particular purposes (e.g. entering into financial leases for trading purposes). Even if borrowings are permitted, consider whether the increased debt would cause a breach of any financial covenants in the loan agreement.

Even if the loan agreement doesn’t have the above “carve-outs”, the Lender may be willing to give consent to the additional borrowing, provided it is subordinated to the Lender’s loan (i.e. the subordinated lender agrees that its loan is to be repaid only once the main Lender’s loan is repaid). If the Lender agrees, it is recommended that the agreement is documented in writing, e.g. in a waiver and/or consent letter. This is generally a commercial decision and may depend on your relationship with the Lender.

New Security

As with additional borrowing, giving new security in favour of anyone other than the Lender tends to be prohibited under a commercial loan agreement. Likewise, any associated security documents are likely to also contain a negative pledge where the borrower promises not to create new security over its assets.

Check whether there is a definition of ‘Permitted Security’ in your loan agreement – if there is, it means that such security ranks after the Lender’s security and the second ranking security holder would have entered into a deed of priority or a subordination agreement with the Lender which will regulate the relationship between the two secured creditors should the security become enforceable.

Disposals of Assets

Loan agreements (and security documents) often put strict limits on a borrower’s ability to dispose of or to deal with its own assets. Even seemingly innocuous activities like the granting of new leases of a part of a property or amending an existing lease in relation to the property that has been charged in favour of the Lender under a loan agreement tend to be prohibited, and the Lender’s prior written permission may be a requirement of any dealings.

It may be possible to carve out a functional ‘Permitted Disposal’ definition to allow your company to go ahead with some of its regular activities.

This definition may include:

• an intra-group disposal (if the buyer is within the Lender’s security “net”);
• getting rid of obsolete/redundant assets (provided they are replaced with new assets of at least the same value);
• selling assets for fair value on arm’s length terms (provided the Lender has a charge over the proceeds of sale);
• assets up to a certain percentage of net assets of the borrower per year; or
• assets where sale proceeds are used to prepay the loan.

You will need to check whether there is a ‘no change of business’ covenant in the loan agreement and whether the disposals would possibly constitute a substantial change of business under this covenant. Consider also the impact of the disposals on meeting any financial covenants.

Acquisitions

Restrictions on acquisitions tend to be rarer, but can be present as acquisitions may impact a borrower’s ability to repay its loan. If there is a ‘no acquisitions’ covenant in the loan agreement, check whether it contains any exceptions, i.e. a ‘Permitted Acquisition’ or a ‘Permitted Transaction’. This could include situations below a certain threshold, with the lender’s consent, or provided security is given over the newly-acquired assets.

As with disposals, the impact of acquisitions on meeting financial covenants is also important to consider.

Dividends

A ‘No dividends’ covenant may explicitly prohibit the payment of dividends, and potentially also share redemptions.

Qualification may be negotiated through including a ‘Permitted Distribution’ or ‘Permitted Transaction’ definition – to allow a payment to be made provided that it does not affect the borrower’s ability to pay interest on the loan and meet repayment instalments, as well as compliance with financial covenants.

You will also need to check whether there are any restrictions on (or conditions for) paying dividends in the company’s articles of association and, in that case, whether there are any restrictions on amending the articles in the loan agreement.

If you have any questions about potential restrictions that may be contained within your loan documentation, please get in touch with our Real Estate Finance team.