The limits of covenants

On October 5th 2010, the Flemish business paper De Tijd published a short article entitled “Banken blijven noodlijdend technologiebedrijf Option steunen” (Banks are obliged to go on supporting the technology company Option).

Option is a Belgian company manufacturing mobile modems.  Founded in 1986, still headed by its founder and overall a success story, it has nevertheless been marred by extremely violent ups and downs over the years. Presently, it is suffering from aggressive Chinese competition and is clearly in a down with an EBIT margin of minus 68% of revenues !

Due to the losses, the equity has fallen below the threshold fixed in a covenant by its two banks (Dexia and ING) and the banks have the right to call in their loans.  What do you think they did ? They waived the covenant of course (but insisted on receiving a bi-monthly financial report and are reported to be pushing for a sale of assets).

This is not surprising.  If they had insisted on the immediate reimbursement of their loans, they would have pushed their debtor into insolvency.  As the value of a technology company resides in its IP (short for Intellectual Property) and its know-how, it is extremely doubtful that the winding down of such a company  would have provided the banks with enough cash for their reimbursement.  Then, they have no choice than accepting what they had said initially they wouldn’t !  They are prisoner of their credit.

Does that mean that covenants are useless, because banks are obliged to waive them if they want their debtor to survive and reimburse them ?  Not really, because that waiver is a carrot with which they force a company to restructure and generate cash.

And if the debtor had been flushed with generic tangible assets (like real estate or power plants or listed shares), they would maybe have decided to call in the receivers.

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