How can a financially healthy company find itself in a liquidity crisis? Most times, you’ll find the reason buried deep within the fine print of your loan agreements. Most borrowers will violate a financial agreement at one point or another throughout the life of their loan.
Many businesses face technical defaults even when operations remain stable, highlighting a key issue with financial agreements. Financial contracts not only reflect risk but also influence borrowers’ outcomes. Here are eight essential covenant provisions every CFO should know.
Interest Rate Mechanics and SOFR Fallbacks
With LIBOR replaced as the market benchmark, most loan agreements will now use SOFR or other similar benchmarks for pricing. The main risk tied to a loan’s interest rate lies in the fallback terms of the contract, not just in the headline money rate.
Some agreements give lenders complete discretion to choose an alternate interest rate when the lender’s primary rate is not available and to change the spread on the rate. Thus, the ability of lenders to utilize this discretion to increase borrower interest costs is significant.
The real-time payment system and volatile interest rates leave borrowers with little planning opportunity. A better approach is to establish clear fallback formulas and guardrails for spread adjustments to ensure predictable pricing changes.
Financial Covenants
Covenants can serve both as an early warning sign to lenders and a stumbling block for otherwise sound businesses. For example, debt-to-EBITDA may seem appropriate. However, it can provide limitations if market prices change or revenue varies widely.
Covenants can cause issues due to narrow thresholds, frequent compliance testing, and mismatched definitions with accounting. Incorporating headroom, cure rights, and realistic calculations can transform covenants from risks into manageable controls.
Security Interest and UCC Filings
The security provision outlines lenders’ rights to assets if issues arise. Agreements often have broad language, covering various current and future assets. While this provides lenders with security, it restricts the borrower’s ability to secure additional capital.
As digital assets become more important, data, proprietary systems, and AI models may also qualify as collateral. In fact, New York recently amended Article 12 to specifically govern how “Controllable Electronic Records” are treated as collateral. Strengthening these clauses can protect an organization’s strategic assets and ensure access to future financing.
Cross-Default Triggers
When a business has cross-default clauses, small issues can turn into company-wide crises. A breach, no matter how small, will typically result in a default all around, especially when Fintech tools, vendor contracts, and financing arrangements are interconnected.
The most important thing is ensuring that only material defaults create broader consequences. In addition, when drafting operational agreements with cross-default clauses, ensure that operational agreements do not inadvertently place the entire capital structure at risk.
Indemnities
Indemnity clauses are an example of risk allocation becoming very real. Many contracts will set broad liability responsibilities on your company’s part, including anything from regulatory fines to third-party damages.
In today’s environment, technology-related risks like data errors or system failures are common. Overly broad indemnities can cover risks beyond your control. To mitigate disproportionate liability, it’s important to limit indemnity coverage to clearly defined risks.
Limitation of Liability
While indemnities can expand risk, limitation of liability clauses limit it. In practice, though, the limitation of liability often leads to an unfair risk distribution, with vendors minimizing their exposure while expecting more protection from their clients.
An imbalanced situation develops if a vendor’s obligations with respect to payment, reporting, or compliance are critical to either party. A proper agreement will set forth limitations of liability caps based on the actual risk for each party.
Setoff and Netting Rights
Setoff rights allow banks to withdraw funds directly from a customer’s account to cover any outstanding loan obligations. While withdrawing funds directly can seem reasonable, it can significantly disrupt business operations.
It is especially hard when the funds to be taken are operating funds, such as those used for payroll or purchases. The instant availability of funds due to the introduction of real-time payment systems may leave very little room to react.
Data Security Addenda
In today’s world, there is a very close link between financial contracts and the movement of funds and data. The security addendum of such contracts will articulate how financial information is going to be used and how it is going to be securely maintained and subsequently controlled.
Weak or poorly defined contractual provisions may result in your company being exposed to compliance risks. It could also put your company’s reputation at risk. As artificial intelligence (AI) is rapidly becoming more prevalent, there will also need to be a clearly articulated definition in terms.
Contracts should clearly define the rights of ownership of data, permitted use of such data, and whether it is permissible to use data in conjunction with machine learning. Therefore, including very specific and strong language with respect to data security will not be optional in the future.
Strategic Use of Legal Counsel
Even experienced CFOs may miss small but expensive contract details. Experienced attorneys will do the following:
- Identify potential risks that may not be apparent
- Negotiate financing for credit facilities
- Negotiate Fintech partnerships
- Benchmark transactional terms against current marketplace standards
They will assist you in ensuring your contracts are consistent with current market practices, not just standard contract templates. Working with the right finance lawyers can give you peace of mind and avoid costly mistakes.
Building Modern Financial Protections
Finance contracts have evolved into dynamic tools that shape how businesses operate, not just how they borrow or transact. Covenant, default, and data clauses do not exist separately. They influence each other and impact your business.
In an environment with automation and real-time financials, those CFOs who take the time to proactively develop their contract terms will be advantaged. Usually, the greatest risk is not with the capital but with the clause you never thought to challenge.
