Let’s talk about borrowing money under revolving lines of credit.  Sometimes it’s not entirely clear whether the borrower is in default, and there’s a question as to whether they can borrow money.  Here are our facts: 

  1. The company needs to draw on its revolving line of credit, and it’s three weeks before the end of the fiscal quarter.
  2. Based on the numbers in hand, the CFO thinks the company may go into default on its financial covenants at the end of the quarter.
  3. The required “notice of borrowing” under the credit agreement requires the company to certify that there is no default at the time of the borrowing.

Can the company borrow the money?

The answer is an all too frequent “it depends.”   It would be helpful to know more.  What if the CFO learns that the company is expecting additional sales that will result in more revenue, and that revenue is expected to come in before the end of the quarter?  Once the revenue is in, the financial covenants would be met and there would be no default.  In that case, the answer is that it’s probably OK for the CFO to certify that there is no default.  If the quarter has not yet ended (assuming the financial covenants are tested only as of the last day of the fiscal quarter, as is typical for many corporate loan agreements), there is still time for the company’s performance to improve, and the CFO’s belief that there is no default would appear to be reasonable and in good faith.  

Now, let’s change our facts.  What if it’s three weeks after the quarter end.  The CFO has financial data for the quarter that indicates a default occurred at the quarter end, but the financial statements have not yet been completely finalized or delivered to the lenders.  The answer here is that the CFO probably can’t certify that there is no default, and the company probably can’t borrow the funds.

A word of caution:  One court found the company to be in breach of its credit agreement when it certified to the lenders that there was no default even before the financial covenant test period ended (similar to our first set of facts).  This was in the "Motorola" case (The Chase Manhattan Bank v. Motorola, Inc., 184 F. Supp. 2d 384 (S.D.N.Y. 2002) (PDF)).  But, in that case the outlook for meeting the covenants was very bleak.  We’ll talk about the rather unique Motorola facts in our next post.

And, of course, not every case is as clear as these sample fact patterns — often, there are many factors that should be considered and weighed (i.e., call your lawyer).   Also, note that most financial covenants need to be tested monthly or quarterly (at the month-end or quarter-end date), rather than being tested on an ongoing basis.  A continuous requirement to comply with financial covenants would change the analysis.  

More on this next time.