Proformative presents Best Practices in Debt Covenant Management & Compliance. Special thanks Jim Simpson, co-founder, Debt Compliance Services, Al Gever, EVP & CFO, Smart Balance, Inc., Bruce Lynn, Managing Partner, The FECG
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Kenya Coconut Production Presentation by Dr. Lalith Perera
Best Practices in Debt Covenant Management & Compliance
1. THE RESOURCE FOR CORPORATE FINANCE, ACCOUNTING AND TREASURY PROFESSIONALS
Best Practices in
Debt Compliance
April 29, 2010
Jim Simpson, Co-Founder, Debt Compliance
Services
Al Gever, EVP & CFO, Smart Balance, Inc.
Bruce Lynn, Managing Partner, The FECG
2. Agenda
Topic Speaker Organization
Market Overview Bruce Lynn FECG
Importance of Covenant Jim Simpson Debt Compliance Services
Compliance
Best Practices Jim Simpson Debt Compliance Services
Corporate Perspective Al Gever Smart Balance
Conclusions Jim Simpson Debt Compliance Services
Q&A All
3. Market Overview
Banking at 12/31/09 Capital Markets after 2009
• 30% of all banks in
the US unprofitable
• Loan reserve ratio:
highest since 1930’s
• Non current loans =
391BN, > 5% of all
loans (highest in 26
years)
• Charge offs: most in
26 years
• Avg net interest
margin = 350BP (4qtr)
• ROE = 90BP
Source: FDIC
NY Times 3/15/10
4. Market Overview
Credit stnds remain
tight; few banks
loosening credit
“Tightening Standards” implies :
• More restrictive covenants • Higher loan spreads / LIBOR floors
• Lower loan limits • More collateral
• Shorter maturities
Source: Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices – Jan10
6. Agenda
Topic Speaker Organization
Market Overview Bruce Lynn FECG
Importance of Jim Simpson Debt Compliance Services
Covenant Compliance
Best Practices Jim Simpson Debt Compliance Services
Corporate Perspective Al Gever Smart Balance
Conclusions Jim Simpson Debt Compliance Services
Q&A All
7. Increased Focus on Debt Compliance
• Under the new SEC proxy rule 33-9089, companies must
disclose the Board’s role in risk oversight, including how such
risks are identified, managed and mitigated
o It is expected that this will include debt compliance because of
the potential adverse effect on access to capital
• Lenders are less forgiving regarding any covenant breach
o Lenders are using even minor technical defaults to drop the
credit or re-price the credit and charge higher fees and spreads
• Auditors are more aware of the risk of non-compliance and
paying more attention to their assurance letter of no default to
the lenders
• Senior management is more concerned about the loss of
credibility with the Board, lenders, vendors and other creditors
8. “Soft” Costs of Non-Compliance
• At least temporary loss of access to credit
• Loss of credibility with banks, the CEO, and the Board
• Press releases and 8-K public disclosure
• Diversion of management time
• Business disruption and vendor concerns
• Substantial increase in spreads and fees
• Substantial legal and audit fees
• Financial restatements and being cited by the
auditors for a “material weakness” or “significant
deficiency”
• Forced refinancing, fire sales of assets, workout, or
Chapter 11
9. The High Cost of Default
$50M 3-Year Facility, $40M O/S in $000
Years
Cost BPs Year 1 2&3 Total
Amendment/Waiver Fee 50** $250 $250
Default Interest Spread * 200 133 133
Increased Spread 200** 800 1,200 2,000
Increased Comm’t Fee 50 50 100 150
Legal & Audit Fees 250 250
Total Cost $1,483 $1,300 $2,783
Management time & Priceless
credibility
*Assumes 2 months to renegotiate
**Per CFO Magazine, June 2009, quoting an S&P 1Q09 report
10. Agenda
Topic Speaker Organization
Market Overview Bruce Lynn FECG
Importance of Covenant Jim Simpson Debt Compliance Services
Compliance
Best Practices Jim Simpson Debt Compliance Services
Corporate Perspective Al Gever Smart Balance
Conclusions Jim Simpson Debt Compliance Services
Q&A All
12. Debt Compliance Policy
• Objectives
• Assignment of responsibilities to operating and
corporate management for being knowledgeable
about what causes defaults
• Description of the quarterly compliance process
o Compliance checklist and questionnaires
o Resolution of covenant issues
• Ongoing covenant compliance
o Responsibility of timely reporting of potential
covenant issues
• Documented SOX procedures
• Loan administration
13. Covenant Compliance Checklist
• A comprehensive list of all key debt provisions
and compliance requirements
– Checklist analyzes the requirement
• Category (default event, notice, deliverable, etc.)
• Brief description
• Responsibility (often multiple)
• Timing of notification, cure period
– Checklist forms the basis for Compliance
Questionnaires
14. Financial Modeling
• The Financial Model incorporates the debt
agreements’ definitions to calculate the required
Financial Ratios
o The Financial Model calculates the current periods
ratios but also projects into the future
o Integrated with the Corporate Budgeting and
Forecasting processes
o Stress tested by Treasury to ascertain leeway in
future periods
15. Web-based Data Gathering
• Compliance data is collected via a questionnaire
forwarded to the responsible corporate parties
identified in the Checklist
o Yes/No questions with explanations for exceptions are
drafted by Treasury and Legal
o Questionnaires answered before and after quarter-
end
Only after quarter close is often too late
o Questionnaires serve as one basis for educating the
responsible parties on the actions and events that
have compliance implications
16. Exception Analysis
• The questionnaires are analyzed by Treasury and
Legal in an Exception Report which lists all issues
respondents have identified this quarter and last
quarter
o Treasury and Legal work to resolve all exceptions
• The Exception Report and the Financial Model
provide the background required for the CFO’s review
of Quarterly Certification Letter
o In addition, provides information for the SOX 302 Quarterly
Disclosure Process
17. Deliverables/Payments Calendar
• A listing of the timing of required deliverables
and payments:
o Due date
o Description, such as financial statements, auditor’s
certificate, ERISA filing, CFO certification, etc. and
well as when loan fees are due
o Responsibility (generally treasury, sometimes
Controller’s)
o References the appropriate debt section
18. Lender Management
• Pro-active and open communication with
Lenders
o Recognizes that Lenders do not like “surprises” and
adversely evaluate companies that don’t seem to
have a handle on their operating performance
o Advance warning of potential issues provides the
basis for the Lenders to be more willing to work fairly
with you
Bank credit committees are running the show these days,
and your account officers need to show them that you are
really in control
19. Company Training
• It is essential that all appropriate individuals that
may impact compliance are trained on the
requirements of the debt agreement
o Many covenants have little or no notice/cure period,
which means Treasury needs to be informed before
the fact, rather than after the fact
o Today, covenant compliance is an ongoing exercise,
not something that can wait to next quarter-end’s
compliance review
20. Agenda
Topic Speaker Organization
Market Overview Bruce Lynn FECG
Importance of Covenant Jim Simpson Debt Compliance Services
Compliance
Best Practices Jim Simpson Debt Compliance Services
Corporate Perspective Al Gever Smart Balance
Conclusions Jim Simpson Debt Compliance Services
Q&A All
22. Corporate Profile
• $250m Public Food Marketer
• Operates in Health & Wellness Space
• Went public May 2007 (thru acquisition by
public SPAC)
• Debt (part of acquisition):
o$120mm Term Loan
o$ 40mm Second Lien
o$ 20mm Revolver
24. Company Evolution
• Prior private company:
o Very entrepreneurial
o No debt
o Little controls
o Little automation
• New public entity:
o Highly leveraged (requiring careful attention to performance
against credit facilities)
o Systems focused (ERP, planning, reporting)
o SOX compliance need
25. Primary CFO & Treasurer Responsibility
Optimize
Capital Structure
Ongoing
Negotiate
Refinancing Maintaining Negotiate
3 – 6 Months Access to Financing
Capital 3 – 6 Months
Covenant
Compliance
3 – 5 Years
26. Transitions
• Manual > automated
• Internally focused > externally focused
• High risk acceptable > risk averse
• No financial planning > plan focus
27. Credit Agreements
Credit Agreement
Inefficient, risky process of ensuring compliance
28. Credit Agreements (at acquisition)
– Two individual agreements
– Each agreement 100+ pages
– Paper copy / Word document / PDF
– Quarterly review of compliance - manual
29. Compliance is More than Calculating Ratios
Affirmative Covenants
• Financial Reporting Insurance coverage
• ERISA filings Corporate events
• Legal undertakings Environmental
compliance
• Litigation reporting
Negative Covenants
• Restricted payments Permitted baskets
• Liens Stock buybacks
• Loans, leases and Change of control
guarantees Acquisitions
• Operating restrictions Hedging restrictions
30. Compliance is More than Calculating Ratios
• Reps & Warranties
• Continuing
• Post-closing
• Events of Defaults
• Payment failures
• Mandatory prepayments
• Cross-defaults
31. Solution
• Utilize automated tool to provide:
o Efficient search of credit documents
o Linking of defined terms / clauses
o Storage of compliance certificates, amendments,
bank communications
• Results:
o Dramatic reduction in time and effort
o Dramatic improvement in control
o Dramatic reduction in risk
32. Update
• November 2009 –
o Smart Balance secures a new $100m credit facility
o New bank group
o One agreement
• Automated tool provides significant support –
o Negotiation preparation
o Negotiation effectiveness
o In analysis and comparison of offerings to old
facility
o Compliance with new facility
33. Agenda
Topic Speaker Organization
Market Overview Bruce Lynn FECG
Importance of Covenant Jim Simpson Debt Compliance Services
Compliance
Best Practices Jim Simpson Debt Compliance Services
Corporate Perspective Al Gever Smart Balance
Conclusions Jim Simpson Debt Compliance Services
Q&A All
34. Web Technology
• Web technology can convert an informal,
manual process to a robust, automated process:
o Dramatically reduce the time to understand and
research a debt agreement by converting it into
hyperlinked web pages
o Automate the development of a truly compre-hensive
compliance checklist
o Convert the checklist to web questionnaires with a
database producing the exception reporting
o Convert the checklist to webcasts for training
operating and financial management
36. Conclusion
• The risks of breaching covenants are greater than
ever before because banks are eager to use even
slight technical defaults to re-price the credit risk
• The risks are now too great to leave to an informal,
manual process
• Develop a compliance policy grounded by a
comprehensive compliance checklist
• Technology can:
o Improve collaboration between Finance and the business
units
o Significantly reduce compliance time
o Minimize errors that turn into expensive defaults
37. THE RESOURCE FOR CORPORATE FINANCE, ACCOUNTING AND TREASURY PROFESSIONALS
Q&A