Having been a 'red line' for many lenders not so many years ago, deemed cures are now an accepted part of the mid-market landscape. Nevertheless, there are hidden pitfalls in the standard market approach.
What is a "deemed cure"? The term deemed cure needs to be distinguished from two related concepts – an equity cure and a Mulligan's clause – with which it is frequently confused.
- An equity cure is a provision that allows for a financial covenant breach to be "cured" by the injection of cash into the group by a sponsor or equity holder (or, more infrequently, the allocation of surplus group-cash overfunding for the purpose of the cure (and for gross covenants only)).
- A Mulligan's clause – which is rarely, if ever, seen in the UK mid-market – provides for a "financial covenant' event of default only upon a breach of a financial covenant on two (and even more rarely, consecutive) test dates.
A deemed cure provision can be distinguished from a Mulligan's clause by the fact that, upon the first financial covenant breach under a deemed cure provision, the event of default is triggered but if the borrower is back in compliance with the financial covenant by the next test date without the lender having accelerated the loan, the initial event of default is deemed cured from the subsequent test date. The borrower's subsequent compliance with the financial covenants is deemed to have cured its historic breach.
A potential pitfall: 'forced inertia'
Equity cures are now an established part of the UK leveraged finance mid-market, and it would be unusual to see a facilities agreement without such a provision. Deemed cures were traditionally a "red line" for credit teams at many lenders, who found the idea that a breach could be cured without an intervention by the sponsor to be objectionable. However, deemed cures have become a fixture of mid-market term sheets and full-form documentation, and, more often than not, we see equity cures and deemed cures in the same document.
Care must be taken, however, to ensure that the period permitted for delivery of financial information together with the time allotted for injection of equity cure funds and the grace period attaching to a financial covenant event of default do not combine to effectively tie the hands of a lender during the period following an initial breach. This danger can be illustrated by way of a worked example.
In a typical loan agreement, financial covenant test dates occur at three month intervals. Delivery of the compliance certificate is required within a set period following the relevant quarter date (often within 45 days, but sometimes up to 60 days following the quarter date). It is therefore conceivable that a lender may not be informed of a covenant breach until 60 days after the test date.
Under a standard equity cure provision, the borrower can then deliver a certificate up to 10 business days following the delivery of the compliance certificate (that is, up to two and a half months following the test date), evidencing an intention to procure funds to be injected into the group in order to cure the breach. Upon delivery of such certificate, the borrower is then typically afforded a further 10 business days (so up to three months following the test date) before the injection of funds to cure the breach is required to be made.
If such equity injection is not made at this point, it is arguable (under many precedent documents) that the borrower can then take advantage of any grace period that applies to the financial covenant event of default. By virtue of having signalled that its intention was to procure an equity cure, it would have bought itself up to 100 days during which the lenders have no choice but to sit on their hands.
At this stage, the period of time between the event of default becoming actionable and the earliest opportunity for the borrower to submit its next compliance certificate and take advantage of the deemed cure provision may be drastically reduced. For many lenders, this would represent an alarmingly abridged period for the purposes of considering their most appropriate response (and in large clubs convening meetings for this purpose).
Safeguards and sensible mitigation
There are a number of ways to mitigate the consequences of the stark example outlined above:
- Lenders often argue that the notice evidencing intention to procure an equity cure injection should be legally binding.
- The period for injection of the equity cure should be concurrent with – rather than consecutive to – the period for delivery of the notice of intention to procure an equity injection.
- Lenders may seek wording to ensure that any grace period applying to a financial covenant event of default runs in parallel with the period for equity cure, and is not additional to this period.
- Deemed cures are frequently expressed as being capable of exercise not more than once, and their use counts towards the total cap on equity cures.
- Equally, equity cures will usually not only be capped (three or four times over the life of the loan) but are also not available in consecutive quarters or twice in any financial year.
- It should be expressly stated in the deemed cure provision that the event of default occasioned by the initial breach is actionable up until the delivery of the compliance certificate evidencing subsequent financial covenant compliance.
While many would argue that the subsequent covenant compliance means that lenders are effectively (at least in a practical or reputational sense) barred from taking action following an historic breach, the inertia forced upon lenders by the manipulation of the time periods associated with equity cures can be frustrating for lenders.
As set out above, there a number of the measures that can be taken to minimise risk in this scenario. If you would like to discuss this further, please contact Laurie Keel or Max Millington, or your usual OC leveraged finance contact.