Covenants in loan agreements—an analysis of practices within the Swedish high-yield bond sector

Sammanfattning: A high-yield bond is a financing option for a non-investment grade corporation, enabling it to raise funds on the capital market. In light of harsher conditions for senior financing, the development of a liquid high-yield market for bonds may prove a necessary way forward to ensure global competitiveness for Swedish small and medium-sized enterprises (“SMEs”) that typically relies heavily on bilateral- and syndicated bank loans. The reasons behind issuing a bond instead of turning to senior financing alternatives or stock issuances vary, but usually it is a combination of factors concerning price, control and flexibility. As the owner of notes in a bond, i.e., a long-term, tradable debt, you are eligible to annual remuneration: every year until the bond maturity date, you collect interest. Upon the bond’s maturity, you will collect the value of your investment, known as the principal. Due to the lack of controlling rights accompanied with holding debt securities such as bonds, compared to owning shares, investors wish to employ a method for mitigating their risks towards the issuer. Predominantly, this need is accommodated through the usage of covenants. Complex covenant packages are often influential in dictating the terms and conditions of the facilities agreements governing bonds. For many investors, which covenants to employ may be hard to determine. This factor, combined with the need to tailor covenant packages to suit each specific loan agreement, has led to contrasting covenant practices within the Swedish high-yield bond sector. This is evidently supported by this study, and is in part believed to be a result of the fact that the standardized loan agreements that have evolved in the Swedish high-yield bond sector have yet to encompass covenants to any extent. Therefore, this study sets out to map the covenant practices on the Swedish market, including how covenants are drafted in each separate case, thus ascertaining their value for the investor. This objective is accomplished by comparing theoretical purposes behind covenants in loan agreements—derivative of doctrine within financial law—with the actual wording of the clauses employed in agreements within the scope of an empirical survey that has been carried out. In this process, some legal pitfalls were identified, possibly leading to diverging results when comparing the purposes behind employing a covenant with the implication in practice. The main diverging aspects between purpose and practice were found in negative pledge-covenants—due to their apparent lack of effect towards third parties under Swedish law—and within no-disposal clauses’ and no-merger clauses’ function due to the usage of the vague term material adverse effect as an outer limit for the covenants’ applicability. Certain issues related to basket sizes and specific carve-outs were also recognized. For the most part, the majority of covenants investigated did however seem to provide lenders with the level of protection that was pursued. This means that the theory and practice of most covenants corresponded. Hence, it is concluded that the purpose behind covenants as the carrier of effective enforcement rights against the borrower is fulfilled, even though some possible limitations of a few covenant clauses’ legal effect were in fact identified. This conclusion was held by adapting a pragmatic and rational view of covenant practices—not neglecting the power that is vested in the noteholders to accelerate premature payment of the notes (should an event of default under the facility agreement occur)—rather than strictly scrutinizing covenants’ effects under the law.