The emperor's new clothes: of illusion and reality - financial covenants in market instruments

• Author: John Jeremie
• Position: Lecturer, Faculty of Law, University of the West Indies, St. Augustine, Trinidad
• Pages: 145-164

THE EMPEROR'S NEW CLOTHES: OF ILLUSION

AND REALITY - FINANCIAL COVENANTS

IN MARKET INSTRUMENTS

JOHN JEREMIE*

INTRODUCTION

Over the past twenty years1 high volume, high

frequency

lending has

come to define the commercial landscape of

the

world's leading capital

markets.2 Both in substance and in form large scale business finance

bears little relationship to small scale consumer finance.3 The sheer

volumes and concomitant risks inherent in large-scale lending are

unknown in domestic finance.4 Paradoxically, lending form in large-

Lecturer, Faculty of Law, University of the West Indies, St. Augustine,

Trinidad.

1 See Egbert 'The Globalization of Financial Markets: Opportunities for

Corporations and Financial Institutions* World Banking, January 1987, at

23;

Report on the 14th IOSOCO Conference, Butterworths Journal of

international Banking and Financial Law, November 1989 at

p.493.

2

Ibid.

3 There is an excellent discussion of the dichotomy in Gold 'Relations

between bank's loan agreements and IMF stand-by arrangements'(1983)

I.F.L.R. (Sept.) pp. 28-35; See also Mauger, 'Sovereign Debt

Restructuring: The Practical Background' [1986] 2 J.I.B.L pp.100-118; as

well as Sovereign Lending: Managing Legal

Risk,

(Euromoney

Publications Ltd., 1984).

4

Ibid.

There are, of course, many recent illustrations of both international

led and domestic led failures. In Japan, the Tokyo Kyowa and Anzen

failures, though large in real terms, were brought on by fundamental

domestic risk credit assessment concerns. In Trinidad and Tobago, the

spectacular failure fifteen years ago of the Kirpalani's Holding Group was

also commonly perceived to be attributable to domestic type risk concerns.

The recent Barings Bank International failure, on the other hand, is

commonly perceived to have been the result of large scale cross border

risk management gone awry.

scale finance does not reflect the greater risk.5 When tested against

traditional notions of credit there is a noticeable absence of security

and quasi-security devices in large-scale lending documentation when

compared with smaller scale lending documentation. It is now perhaps

a general characteristic of the former that obligations are supported by

flexible covenants and of the latter that they are reinforced by security.

The current trend in the development of international practice is

defined, therefore, by an increasing reliance on financial covenants and

a diminishing resort to traditional security.6 The reasons for this shift

in emphasis are not readily apparent. A legal practitioner has an

immediate and perhaps logical difficulty in attempting to rationalize

why a lender in a large scale financing should voluntarily abandon the

tried and tested security devices at his disposal. Nevertheless, capital

market instruments are made by but not for lawyers. The indisputable

fact is that financial covenants now define capital markets. But the

prevalence of the covenants beg an enormous policy question. Ought

the covenants to be given an effective sanction now? It is logical to

suggest that if the covenants are not perceived to be effective, then the

policy of the law ought to be against intervention. On the other hand

if the market expects enforcement, then, in default of a logical

objection in policy or principle which might serve to deny

enforcement, the covenant ought probably to be enforced.

An answer may not be impossible to find but is necessary to a

resolution of the first policy question: Is there a market expectation

now that financial covenants ought to be enforced? As the credit

market becomes increasingly sophisticated and competitive, lending

form has become increasingly less rigid. A shift in emphasis from the

overt security strictures to more informal arrangements is perhaps

inevitable. Herein lies the rub: Should a shift in substance necessarily

follow a shift in form? The argument that more liberal and less

5 In Bond Brewing Holdings Ltd. & Ors. v National Australia Bank & Ors.

the Supreme Court of Victoria wryly commented in the context of large

scale corporate financing that 'recent experiences have shown lenders that

all the covenants in the world are no substitute for good old fashioned

security'. ([1990] A.C.S.R. p.444 at 450 at lines 5-10).

6 See the narrative of the Full Court in Bond Brewing, supra n.5.