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Debt Covenants: Educating Senior Executives on the Risk of Non-Compliance

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I  would like to try once again to generate some discussion within the group.

How do you effectively “sell” committing resources to covenant compliance? Do you think that finance has a chance in folding this under an ERM framework? Compliance is often managed outside of the treasury function, how does treasury work with internal audit or accounting to get debt compliance on the radar screen?

Answers

Topic Expert
Sunil Thukral
Title: Controller/Technical Accounting Advisory..
Company: Consultant
(Controller/Technical Accounting Advisory/ SEC Reporting, Consultant) |

Ernie,

The non-compliance of the debt covenants would result in default, which can have a material impact on any company.

Hence, the companies I have been involved with in the past, non- compliance of the debt covenants has always been on the radar screen of the senior executives. Also the US SEC has been vigilant for the non-compliance of the debt covenants and have insisted that the companies provide proper disclosures in their MD&A if they are in a "breach" or a "potential breach" in the debt covenants and the impact thereof.

It would be interesting to see what others in the group have to say on this issue.

Scott Lane
Title: CFO and CRO
Company: TPG Credit Management
(CFO and CRO, TPG Credit Management) |

Agree, should be on radar screen of senior management. Has been where I have worked.

This is one of those binary operational risks in my view: if it works nobody cares but if it blows up there are serious problems.

If one is struggling to get senior management's attention, perhaps the best approach is to highlight for them what happens if non-compliance / default were to occur.

Peter Sullivan
Title: Manager Enterprise Risk Mgt
Company: FirstEnergy
(Manager Enterprise Risk Mgt, FirstEnergy) |

I agree with the prior two comments posted. It is binary and folks don't care unless the covenants are breached. One way to bring attention to the issue is to stress test it. If you have a risk group, they should be able to help. The two ways to deal with this is how large of a loss would the entity (or subs if applicable) have to sustain in order for that covenants to be breached. Taking the discussion one step further, you could stress revenue to find the break point. Another approach would be to look at expense items that flow to OCI like the pension true up. How low would the pension discount rate have to go before there was a pension impairment that flowed to OCI? How much would investments have to go down for the impairment to occur.

Tino Go
Title: Controller
Company: Ross Environmental Services
(Controller, Ross Environmental Services) |

I'm curious, how do other professionals do their EBITDA and balance sheet forecasting? I expect that there are a lot of Excel models used to project the future. The problem I have encountered with Excel models is that they are easily "broken" when running different business scenarios, or in the hands of anyone but the model's author.

Topic Expert
Sunil Thukral
Title: Controller/Technical Accounting Advisory..
Company: Consultant
(Controller/Technical Accounting Advisory/ SEC Reporting, Consultant) |

I have primarily used Excel modelling - however, I agree with your comments that the Excel model do get broken down easily and if you do not keep proper controls it also does not provide any continuity due to lack of proper documentation.

For example, if somebody is preparing some results based on a Excel modelling for you - I will suggest that you implement some spreadsheet ground rules for your company (e.g. - hard coded numbers should be in blue colour, currency should be properly identified if dealing in more than one currency, adding comments for the data source, adding a tab that provides a summary of the data source and any other relevant source of information, version control, password protection of formulae, etc.). Will also like to hear from other members as to what type of spreadsheet controls they have introduced.

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