Equity cures

Alex Innes continues to look at how banks can manage the risk of lending

Equity cure provisions, as we know, allow an injection of cash into the finances of a struggling borrower to avoid or cure a financial covenant default. Straightforward enough. However, the recent case of Strategic Value Master Fund v Ideal Standard International Acquisition SARL and others highlights the need for lenders to carefully consider how those provisions are framed and illustrates the dangers of loose drafting.

An equity cure usually operates on a fairly simplistic level so that the right is exercised, cash injected and the offending covenants are then retested to take into account the additional cash. The precise scope of the cure is, however, often heavily negotiated, with particular focus on how the additional equity is to be treated when retesting the financial covenants.

It may be agreed that the cash injection can simply be used to increase cash flow and EBITDA. Or, given those applications are generally more borrower-friendly, it may be that the lenders will require funds to be applied to reduce borrowings, either by prepayment or by placing the relevant sums in a blocked account.

In the Ideal Standard case, the equity cure enabled the borrower, on breach of a financial covenant, to inject cash proceeds by way of new ‘equity’ or ‘subordinated debt’ to allow recalculation of the financial covenant and remedy of the breach.

To contribute the new equity, a member of the borrower’s group withdrew £75m from a cash pool. It then repaid an existing inter-company loan provided to it by the borrower, which the borrower used to repay loans owed by it to its parent company.

The parent company then immediately refinanced the borrower to the tune of £75m, creating new ‘subordinated debt’, which the borrower lent on to the other group company, which finally returned the funds to the cash pool from which they were drawn in the first place.

This sequence of events had succeeded in returning everything to where it was before and, although a cleverly structured work-out from the point of view of the borrower, needless to say that did not reflect where the lender expected to be. In pursuing the following litigation it was argued by the lender that the purpose of the equity cure was in fact that new money be injected into the borrower’s finances to improve its ‘financial health’ and this had clearly not been achieved through what was little more than an exercise in creative accounting.

Although that is perhaps a fair reflection of what most of us would expect the cure to achieve, the argument was rejected by the court on the grounds that, although the provisions in the facility allowed funds to be injected through new ‘equity’ or ‘subordinated debt’, that was without further limitation or specific requirement that those injections should result in continuing financial benefit to the borrower. The observation was that “a company in financial trouble would not usually be regarded as improving its financial health by going further into debt…[it] would be like paying one’s mortgage interest by using a credit card”.

The transactions did amount to the lending of additional ‘subordinated debt’ to the borrower, which could be incorporated into the recalculation of the financial covenant, thus ‘curing’ the breach. But in practical terms they had no beneficial impact on the borrower’s finances as they were then paid out to return the group to its original position.

In light of this, it’s important to ensure that equity cure provisions are drafted tightly toavoid this kind of artificial scenario where the result of ‘creative accounting’ is to achieve an effective remedy of the breach and avoidance of default without making any ‘real’ injection of capital or improvement in the condition of the borrowing entity. Both parties need to be clear on what the equity cure can and is actually intended to do, and that should be reflected in the facility provisions.

Semple Fraser LLP is one of Scotland’s leading commercial law specialists, offering advice of the highest quality across a range of areas. With lawyers qualified in both Scots and English law, we are able to deliver a full banking service throughout the UK. The Banking & Finance Group of Semple Fraser LLP has expertise in all areas of banking and property finance, and works closely with the other specialists areas of the firm to provide the complete service to clients.

For more information on these topics, please go to www.semplefraser.co.uk, or contact Alex Innes on 0131 273 3771 or alex.innes@ semplefraser.co.uk

Alex Innes is Head of the Banking & Finance Group of Semple Fraser LLP.

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