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Dimitrios V. Siskos Default, Reserves and Covenants To: Dr. Igor Gvozdanovic October 10, 2014 This paper
Dimitrios V. Siskos
Default, Reserves and Covenants
To: Dr. Igor Gvozdanovic
October 10, 2014
This paper is submitted in partial fulfillment of the requirements for the degree of Doctorate of Finance
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Contents

Contents………

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Abstract………………………

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Project subcontracts…………………………………………………………………………………

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What are the advantages and disadvantages of loan covenants?.....………………….…..……..

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“Project finance covenants are not particularly important for the successes of

 

projects”. Discuss……

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Of what special significance in project finance are Security agreements?……………………….

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References…………………………….……………………………………………......................

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October 10, 2014

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Default, Reserves and Covenants

Siskos V. Dimitrios

Swiss Management Center (SMC) University

October 10, 2014

Abstract

Complexities in project finance can have negative consequences on the delivery, operation, and profitability

of a project and can affect both lender and borrower in a similar way. This fact leads businesses into signing

numerous subcontracts within the overall framework of the project financing. A similar action to mitigate

such complexities is to sign loan covenants that affect, mostly, the actions of the borrower. Initially, the paper

describes the four types of contracts; second, it determines the pros and cons of the loan covenants; it

examines whether financial covenants are important for the successes of projects or not, and last, it explains

the role of security agreements and their special role in project finance.

Keywords: Project, Contractor’s bond, Representations and warranties, Events of default, Reserve accounts,

Loan covenants, Security agreements.

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Project subcontracts

During a project life-cycle, the project financing faces a big number of complexities which can be

subject to numerous subcontracts within the overall framework of the project financing plan. Some of these

contracts are:

Contractor’s bonds

A contractor's bond is a financial assurance that a contractor will complete a job to a client's

satisfaction. Hence, it provides ways of securing the performance of contractors, subcontractors and suppliers

in the event that a particular job is not performed as desired (Fight, 2006). The single most important reason

which contractors need to purchase a contractor bond is that the bonds prevent project owners from losing

money.

Representations and warranties

A representation is a statement by a contracting party to another contracting party about a particular

fact that is correct on the date when made, while a warranty is the contracting party being asked to represent

and ‘warrant’ certain facts (Fight, 2006). There are several purposes which representations and warranties are

important in project finance: they both endeavor to provide remedies for misrepresentation in the event of an

inaccuracy; they may operate as block against the borrower; and they may enable the lender to cancel the

commitment and accelerate the loan if they are linked to an event of default (Haynes, 2010).

Events of default

The conditions added for the purpose in a loan agreement is generally called the events of default

(Agarwal, 2001).Events of default in a project financing are similar to those in any classic commercial

lending situation. These include technical defaults, financial events of default and mechanistic events of

default (Fight, 2006). They are useful in that they put the lender into a position of power in being able to

threaten termination and thus negotiate from a position of strength (Haynes, 2010).

Reserve accounts

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Project portfolio includes financing documents as reserve accounts, to maintain several accounts within

the project. For example, the Debt Service Reserve Account (DSRA), as one of them, is a key component in

almost every project finance term sheet and financial model. Establishing a reserve account satisfies the

beneficiaries of the reserve account and reduces the cost of debt (Crawley, 2013) as well as it ensures that the

project entity is protected in the event of any future legislative (Fight, 2006).

What are the advantages and disadvantages of loan covenants?

Covenants are restrictions that are written into loan or bond contracts that affect the actions of the

borrower. For example, if a credit institution finds a borrower in violation of a loan covenant, it has the right

to call the loan which means, demand its immediate repayment. The advantages of loan covenants are

categorized into four functions:

  • 1. They place some restraint on the danger that a company may become financially distressed (Fight, 2006). This may be happened, for example, by setting a level of allowable leverage 1 (usually debt to earnings ratios).

  • 2. Covenants can increase a lender's incentive to monitor, while in the same time it provides the banker with an early warning in case of a company is beginning to have problems (Rajan and Winton, 1995).

  • 3. They give lenders additional credit protection placing restrictions on the borrower to be met on an ongoing (e.g. quarterly) basis (Bank of England Quarterly Bulletin, 2007).

  • 4. Covenants ensure that the banks are well informed, supportive and less likely to impose draconian measures on management which may serve to unpredicted market events (Fight, 2006).

However it is recognized that covenants are not a universal panacea and, hence, there are some

disadvantages of loan covenants. At first, the borrower may have to pay a slightly higher interest rate for a

covenant loan, although this is not universally true. A borrower that pays more for such a loan may end up

overpaying if it performs as expected or better and does not use the additional flexibility of the incurrence

1 A simple leverage ratio framework is critical and complementary to the risk-based capital framework.

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style covenants (Goodison, 2011). Furthermore, setting tight appropriate levels for ratio covenants may be a

limitation for the borrower because it will place unnecessary restrictions and may trigger an unwarranted

default (Fight, 2006). For the lenders, there is one argument which claims that they may ultimately recover

more if an underperforming borrower is given time to improve its performance without the pressure of

financial maintenance covenants and the costs and distractions (Goodison, 2011).

“Project finance covenants are not particularly important for the successes of projects”. Discuss

The financial covenants included in the various agreements are important not only to the investors but

also to all stakeholders. The project financial covenants examine all possible eventualities, as the minimum

equity to debt level, the restriction on the payment of dividends, or the minimum debt coverage ratio. Project

covenants reveal the state of the firm during the borrowing period. According to Achleitner et al. (2012), if it

is ‘‘good,’’ equity holders remain in control and might even reap private benefits, otherwise financial

covenants are violated and the company is in ‘‘technical default’’, control rights shift to lenders, who then

have the right to call their loans. If the call is executed, the borrower might be forced into bankruptcy.

However, when covenants are too restrictive, they are likely to constrain a borrower’s optimal

management strategies and might even trigger a default that is not warranted (Mather and Peirson, 2006).In

the opposite, when the covenants are too loose or they are absent, the risks tend to increase. Reports in the

financial press regularly provide evidence about the importance of covenants for the success of projects. For

example, a recent report on the exposure of a major Australian bank, ANZ, to the financially troubled UK

group, Marconi, states ‘the company was so popular that banks’, including ANZ, ‘agreed to lend billions of

pounds without requiring covenants to protect their investment (Mather and Peirson, 2006). Hence, project

finance covenants are important for the successes of projects, but their use should be reasonable and be

performed with the intention to improve the company position and not to intimidate it.

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Of what special significance in project finance are Security agreements?

A “Security agreement” is a loan document that creates or provides for an interest in personal property

that secures payment or performance of an obligation (Chernuchin, 2011). Regarding project finance, the

security agreements seek to take effective control over the contracts and keep them in place to enforce

security (Fight, 2006). For example, during the late 1970's, the United States had established a network of

bilateral Social Security agreements that would coordinate and control the U.S. Social Security program with

the comparable programs of other countries.

In project finance, lenders aim to be able to take control of and transfer all material project assets in the

event of a problem with the project financing. Security agreements hold a significance position in project

finance as long as they balance this expectation against the fact that in certain jurisdictions the granting of

security may just not be possible (Coles, 2009). As such, early stage planning and agreement on the scope of

security can save much time and effort. On the other hand, in many projects, security agreements are settled

for some specific tangible assets. However, the realizable value of such items in a project financing is not of

great significance in relation to the overall debt, but they do have value (Fight, 2006).

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References

Achleitner, A.-K., Figge, C., and Lutz, E. (2012). Drivers of Value Creation in a Secondary Buyout: The

Acquisition of Brenntag by BC Partners. SSRN eLibrary

Agrawal, A. (2001). "Common Property Institutions and Sustainable Governance of Resources," World

Development, Elsevier, 29(10), pages 1649-1672.

Barad, M., (2010). A Study of Liquidity Management of Indian Steel Industry, thesis PhD, Saurashtra

University.

Chernuchin, C. (2011), Understanding The Terms Of Security Agreements, The Practical Lawyer.

Coles, I. (2009). Project Finance Documentation (PDF). Mayer Brown. Retrieved 2014-28-05.

Crawley, N. (2013). Debt service reserve account (DSRA), financial modeling considerations, Retrieved on

28 May 2014: http://www.corality.com/training/smart-campus/blog-list/blogs/october-2013/debt-

service-reserve-account-%28dsra%29,-financial-mod

Fight, A. (2006). Introduction to Project Finance. Essential Capital Markets. Elsvier 1st Edition.

Goodison, E. (2011). Covenant-Lite Loans: Traits and Trends, Prac. Law J ..

Haynes, A. (2010). The Law Relating to International Banking, Bloomsbury Professional.

Mather, P., Peirson, G. (2006), Financial covenants in the markets for public and private debt, Accounting

and Finance, 46 (2), pp. 285-307.

Rajan, R. G. and A. Winton (1995). Covenants and collateral as incentives to monitor.The Journal of

Finance 50(4), 1113-1146. Bank of England Inflation Report, (2007), pages 18 and 20.

October 10, 2014

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Dimitrios V. Siskos