Recently, we have been periodically receiving inquiries regarding the operation of covenant terms under Russian law. This is primarily related to the desire to use covenants in loan agreements and bonds, as well as the intention to assess the feasibility of including relevant terms in a contract to obtain a higher credit rating. We have analyzed existing arbitration practice to understand whether covenants have been tested in Russian arbitration courts and what the specifics of such litigation are. The results of this study indicate that a stable judicial practice of granting covenants full judicial protection is currently emerging.
To prepare a special review of arbitration court practice regarding covenants, we analyzed 896 judicial acts from the "KonsultantPlus" legal information database, adopted between January 1, 2010, and October 10, 2011, in disputes related to loan agreements. As a result of the research, we managed to find 29 judicial acts in which covenant terms were given legal assessment. Out of 29 judicial acts, in 26 cases the courts satisfied claims for early repayment of loans and/or recovery of increased interest, based on covenant breaches. In two judicial acts, the lawfulness of using covenants in contracts was confirmed (claims to recognize them as invalid were denied).
DEFINITION OF COVENANTS
Covenants are commonly understood as contract terms whereby the debtor undertakes promises that it itself and/or related third parties will perform certain actions (affirmative covenants) or refrain from performing them (negative covenants). Covenants can be expressed both as a description of actions (full and timely tax payment) and as a description of their consequences (increase in credit rating or sales volume).
Traditionally, covenant terms include actions whose performance the debtor can promise (e.g., not to pledge certain property and not to change its main business activity). In this sense, covenants are contrasted with events of default, which include circumstances regarding which the debtor cannot give promises (e.g., a material adverse change in the market). If provided for in the loan agreement, a breach of covenants can lead to a loan default (the arising of the right to demand early debt repayment).
CONSEQUENCES OF NON-COMPLIANCE WITH COVENANTS
The contract parties stipulate at their discretion the consequences that ensue from a breach of covenants. The most common consequence of such a breach is granting the creditor the right to demand early repayment of the debt owed to it. Other consequences of covenant breaches include the creditor's right to increase the interest rate, demand provision of additional security, and demand amendments to the loan agreement in the form of additional covenants and/or replacement of covenants with stricter ones.
Compliance with covenants, conversely, can lead to favorable changes in financing terms, if provided for by the deal's conditions. In particular, covenant fulfillment may be linked to a reduction in the interest rate, the possibility of extending the provided financing term, or a reduction in the amount of security for it.
FUNCTIONS OF USING COVENANTS
The use of covenants aims to ensure the full and timely repayment of the debt. This is achieved, firstly, by restricting actions that contradict the interests of the creditors of this debt. For example, such covenants include the following terms: restriction of dividend payments; attraction of additional financing from other creditors; pledging assets to secure obligations to other creditors; using other banks for depositing revenue from its activities; alienation of fixed production assets and other material assets.
Secondly, debt repayment is ensured through the timely receipt of information and the ability to promptly begin protecting one's interests, including by asserting claims for debt repayment. For this, information covenants are used, aimed at obtaining information about the debtor's activities, its financial position, and current state of affairs; as well as financial covenants, whose task is to use financial metrics to fix the deal parties' understanding of a situation where the debtor is in a risk zone and corrective actions are necessary (including by asserting a claim for early debt repayment or its restructuring). Thus, an early warning system for potential debt repayment difficulties is created.
REVIEW OF COVENANTS BY ARBITRATION COURTS LEVELS AND REGIONS OF ARBITRATION PRACTICE
Currently, covenant terms are analyzed in judicial acts adopted at different levels of the arbitration court system. Of the 29 judicial acts we found, two were adopted by the Supreme Arbitration Court of the Russian Federation (SAC RF) and 27 were adopted by courts of eight different arbitration districts. The largest number of judicial acts concerning covenants were adopted in the arbitration courts of the Moscow District (13 out of 29) and the West Siberian District (4 out of 29). Overall, this indicates that covenants during the studied period have received fairly broad practice consideration in arbitration courts (both vertically and horizontally within the arbitration court system).
Importantly, the Presidium of the SAC recently published a review of judicial practice for resolving disputes related to the application of the Civil Code provisions on loan agreements, which has recommendatory force for arbitration courts and concerns the resolution of disputes over restrictive (negative) covenants. The Presidium of the SAC indicates as recommended the practice of recognizing as lawful the terms of loan agreements regarding the borrower's obligation to refrain from certain actions, including concluding certain types of transactions, provided the borrower's actions are sufficiently specified, the obligation to refrain from them is limited in time, and the assumption of such obligations is connected to receiving a property benefit (a loan). Thus, the Presidium of the SAC put an end to the contradictory judicial practice regarding whether restrictive covenants violate the provisions of Article 22 of the Civil Code on the nullity of waivers or other transactions aimed at restricting legal capacity and capacity to act.
During the studied period, we encountered only two covenants that were recognized as invalid by some arbitration courts. One of these covenants (an obligation to maintain a certain volume of credit turnover in the creditor bank) was recognized as invalid only in one judicial district (FAS of the North Caucasus District), while arbitration courts of other judicial districts recognized this covenant as valid (FAS of the Ural District, Ninth Arbitration Appellate Court, and Eleventh Arbitration Appellate Court). Another covenant (a promise not to attract additional loans from other banks) was recognized as invalid only in the FAS of the West Siberian District. However, specifically for this type of covenant, the Presidium of the SAC cited as recommended the practice where such covenant terms are recognized as valid.
TYPES OF COVENANTS
The studied judicial acts consider not a single type of covenant, as was the case in previous periods when restrictive covenants on opening or using accounts in other banks were challenged. On the contrary, during the studied period, a fairly wide range of different types of covenants became the subject of judicial proceedings, including the following:
1) the debtor's obligation not to carry out reorganization and liquidation (to notify of a decision on reorganization and liquidation), and the debtor's obligation to avoid bankruptcy;
2) the debtor's obligation not to change its main type of activity (or to preliminarily notify of a decision to change the main type of activity);
3) the debtor's obligation to inform about changes in the debtor's management bodies and in the debtor's charter documents;
4) the debtor's obligation not to allow a deterioration of its financial position;
5) the debtor's obligation to provide annual and quarterly accounting reports;
6) the debtor's obligation not to allow breaches of its obligations arising from other legal grounds (cross-default);
7) the debtor's obligation not to allow claims against it for an amount that jeopardizes the debtor's performance of its obligations under the contract;
8) The debtor's (debtor's group of companies) obligation to maintain a certain volume of credit turnover on the settlement account in the creditor bank.
COVENANTS IN JUDICIAL CASES
In the practice of past years, arbitration courts referred to covenants only as an additional ground for early repayment of the contract debt, and satisfied the creditor's claim for early recovery of the loan based on a delay permitted by the debtor. Currently, a breach of covenants is an independent ground for satisfying creditor claims arising from the breach of covenants. Some judicial acts even provide a definition of covenants. A breach of covenants is recognized by arbitration courts as sufficient grounds for applying the consequences associated with their breach.
CLAIMS FROM WHICH CASES CONCERNING COVENANTS ARISE
Arbitration courts provide legal assessment and apply covenants when considering disputes over recognizing covenant terms of a loan agreement as invalid, over the creditor's exercise of the right to demand early loan repayment due to a covenant breach, as well as over the recovery of penalties and/or increased interest under the contract.
1. Claim to recognize covenants as invalid
Debtor claims to recognize a covenant as invalid for restricting the debtor's right to exercise its rights at its discretion were considered quite rarely by arbitration courts during the studied period. Currently, arbitration practice almost always recognizes the inclusion of covenants in a loan agreement as lawful. In support of the lawfulness of using covenants, arbitration courts refer to the principle of freedom of contract (Article 421 of the Civil Code) and the basic principles of civil legislation (Article 1 of the Civil Code). Arbitration courts indicate that "by signing the loan agreement, the borrower agrees to all its terms, i.e., assumes obligations to fulfill all terms of the agreement. Accordingly, these terms are binding on the parties."
2. Claim for early debt recovery
The creditor's right to demand early loan repayment upon a breach of covenants is the most common consequence of a covenant breach applied in arbitration practice. Arbitration courts recognize as untenable the borrowers' arguments about the invalidity of the loan agreement term on the creditor's right to demand early loan repayment upon a breach of covenants. Arbitration courts indicate that these terms comply with the principle of freedom of contract (Article 421 of the Civil Code) and correspond to the bank's right to early recover provided loans and accrued interest upon the borrower's breach of contract obligations (Article 33 of the Federal Law No. 395-1 of 02.12.1990 "On Banks and Banking Activity"). Furthermore, "the list of grounds for early loan repayment established by law is open, therefore the parties are entitled at their discretion to provide for other grounds for early loan repayment."
3. Claim for recovery of penalties and increased interest
Another consequence of a covenant breach is the arising of the creditor's right to recover a penalty or increased interest on the loan. In arbitration practice, this consequence of a covenant breach is used only if the borrower (borrower's group of companies) violated the obligation to maintain a turnover of funds on the debtor's (debtor's group of companies) settlement accounts in the creditor bank in a certain amount agreed by the parties. Meanwhile, a wider spectrum of covenants can be used in loans and bonds, whose non-compliance will lead to a change in the interest (coupon) rate.
PRACTICE OF APPLYING THE GENERAL COVENANT ON NOT ALLOWING DETERIORATION OF FINANCIAL POSITION
Currently, in Russian banking practice, it is common to include in the loan agreement, instead of financial covenants (based on specifying certain financial indicators), a term on the borrower's obligation not to allow a deterioration of its financial position.
If the creditor receives information providing grounds to assume that there is a threat of deterioration of the borrower's financial position or such deterioration has already occurred, the creditor obtains the right to demand early loan repayment from the debtor.
The terms of the loan agreement do not contain specific financial indicators of economic activity that the debtor must comply with.
As indicators of a deterioration in the borrower's financial position, arbitration practice accepts the following circumstances: the emergence of overdue debt under the loan agreement; the borrower's request for an extension of the loan repayment term due to financial difficulties under one of the loan agreements concluded between the parties; the presentation of a claim for recovery of a large sum of debt under some agreement of the borrower; a decrease in the size of the borrower's assets.
PROSPECTS FOR USING COVENANTS IN BOND ISSUES
For a long time, the idea has been cultivated in the Russian capital market that, unlike loans, bonds should not have collateral security and should contain covenants. In this case, borrowers can use their property as security to attract loan funds from banks, and after exhausting this possibility, resort to borrowing on the bond market, which represents an unsecured instrument.
We nevertheless believe that soon covenants (as well as pledges and subordination) will be used more actively on the Russian bond market, as this will allow assigning bonds a credit rating higher than that of the issuer itself. This, in turn, expands the circle of investors and can lead to a reduction in the cost of attracted financing. Such a consequence of using covenants (along with other credit enhancers) is relevant for most potential corporate borrowers, as well as for securitization and project finance transactions.
CONCLUSION
A positive trend in arbitration court practice is the widespread recognition of the lawfulness of covenants (in case of their challenge) and the provision of judicial protection to the creditor in exercising rights based on covenant breaches. Most covenants receive judicial protection regardless of the type and wording of the relevant terms. Although arbitration courts sometimes refer to covenants only as an additional ground for early repayment of the loan agreement debt, the shift towards recognizing the lawfulness of including covenants in loan agreements is obvious. In Russian lending practice, the use of covenants is now much more noticeable than before the crisis. The further development of the bond market should also lead to the application of adequate credit risk management methods, including through the use of covenants.