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Common Control Terms Sought by Financing Partners

Posted by Ryan M. Newburn | May 03, 2021 | 0 Comments

Every party in a lending or business agreement attempts to secure their position through the legal contract created. In many cases, there are certain control terms that are sought by financing partners in order to ensure that debts are paid and that they have security in the event that it appears a borrower may remain unable to continue to pay a debt. Understanding common control terms in these types of agreements can help ensure that your legal and financial rights remain protected. Consider visiting with an experienced business attorney at Newburn Law, to learn more about your rights specific to your contract or agreement.

Negative Covenants

One of the more common control terms sought by financing partners including negative covenants. Negative covenants are specific restrictions within a loan agreement that occur for the following reasons:

  • Help establish parameters for the operation of a business
  • Allow for continued assessment of creditworthiness
  • Identify issues more easily prior to a default
  • Ensure that the borrower can actually pay the loan to the lender

Some of the types of negative covenants may include the following:

  • Indebtedness limitations that limit the ability of the borrower to take on any other additional debt
  • Lien limitations that prohibit the borrower to encumber assets other than the original lien
  • Prohibitions on changing lines of business, merging with another company or selling material assets
  • Agreement limitations that prohibit a borrower from changing or amending any of the material clauses in material agreement
  • Sale of assets limitations that prohibit a borrower from selling, disposing or transferring identified assets
  • Investment limitations that prohibit a borrower from investing in any other loans, advances, or other purchases instead of paying down their loan
  • Prepayment limitations that prohibit a borrower from paying any of the loan in advance
  • Affiliate limitations that prohibit a borrower from making legal agreements with any affiliate
  • Adverse effect limitations that will trigger a default if there are any material adverse changes to the business

Understanding these negative covenants and how they may impact your contractual obligations can prove challenging and legally complex. Consider visiting with our legal team to learn how an experienced business attorney at Newburn Law can help explain these terms so you can make the best decision for your financial future.

Leverage Test

In some lending agreements, a financing partner will want to include a leverage test in order to have additional financial control. A leverage test calculates the ratio between the Consolidated Total Net Debt on a certain date to the Consolidated Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) at a particular point in time. Essentially, this leverage test allows a lender to ensure that the borrower will have enough free cash flow to repay their loan obligations.

Deposit Control Agreement

A deposit control agreement is a binding agreement that requires that the secured party (lender), the debtor, and the bank that maintains the deposit account will all comply with the instructions and guidance created regarding the disposition of funds. A deposit control agreement allows funds to be directed without the further continued consent of the debtor under UCC § 9-104 while maintaining the lender's secured position in such funds. Additionally, a deposit control agreement allows the lender to have control over the bank deposit account, and therefore the security interest in that deposit account is perfected.

Duty To Act in the Ordinary Course of Business

One of the most common control terms sought by financing partners to be included within their agreements is the limiting and narrowly created phrase “duty to act in the ordinary course of business.” This phrase is intended to prohibit certain actions on the part of the borrower. The purpose of this restrictive phrase is to give the debtor the opportunity to continue to operate their business, but not in such an unusual way that it might expose the lender to any undue risk of loss. The typical definition of “ordinary course of business” is anything within the typical routine of that particular business. While there subjectivity included in the phrase, if a business owner can show the questioned actions have been engaged in previously in a regular manner, they will likely be able defend their actions as part of the ordinary course of business.

Some of the examples of how this phrase can limit a borrower can include the following:

  • Limiting the ability of a debtor to grant a lien on his or her assets, except for those liens that might arise in the ordinary course of business
  • Also, the agreement may stipulate that the borrower may not sell any of its assets, except for those sales done in the ordinary course of business
  • Limiting the ability of a debtor to sell excess inventory if that is not typically done in the course of business

This is a provision that can become challenging, especially since there is a great deal of interpretation that could occur between the parties. It is important to note that when courts have ruled on what is considered “ordinary course of business,” they have typically taken into account the common practices in a particular industry, the frequency of previous transactions, the traditions and historical precedent of the borrower's actions, how substantial the transaction or event was related to the overall business, and whether or not the transaction related to the business as a whole.

Contact an Experienced Business Attorney at Newburn Law

Entering into any type of financing agreement can prove legally challenging and most contracts are filled with control terms and clauses that could potentially bind one party in a way they did not foresee or expect. Learning more about the common control terms sought by financing partners can help you make a better decision regarding any potential contracts or agreements you may wish to sign. Consider visiting with an experienced business attorney at Newburn Law to ensure you aren't caught off guard by what your financing agreements will, and will not, allow you to do.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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