Risks of covenant breaches – material information or not?

A European example of non-disclosure in an often important area

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 11th edition:

  • “The issuer is an offshore services company which operates on a global basis serving the oil and gas market, the offshore renewable market and the market for submarine power interconnectors. The issuer charters construction support and fast support vessels, and provides installation and lay equipment for rent.
  • At the end of 2008, the issuer’s liquidity position was very tight such that the directors described it as “unsatisfactory‟ in the management report. During the first quarter of 2009, the situation worsened with the result that the issuer was in breach of its covenants at March 31, 2009. The financial statements were authorized for issue at the end of April 2009.
  • The directors‟ and auditors‟ reports both emphasized the considerable risk of not being able to continue as a going concern.
  • The issuer’s borrowings at December 31, 2008 included 7 loans in different currencies. The notes to the financial statements disclosed that “key financial covenants include; no dividend, free cash requirement, pledge accounts, various equity requirements and limitation on the ability to incur new debt”. Further, the notes indicated that there was “ample” compliance with all covenants as at the balance sheet date. No additional information about the covenants was included in the financial statements. Upon request from the enforcer however, the issuer confirmed that, at December 31, it had been close to breaching the covenants in respect of free cash-flows and equity ratio requirements.”

The enforcer (as ESMA likes to term it) found that the issuer should have disclosed additional information about the covenants relating to each loan or group of loans, including the amount of headroom. It also found that the subsequent breach of the covenants represented a material event after the reporting period and should have been disclosed under IAS 10.21. This finding flows, as the report sets it out, from the basic requirement in IFRS 7.31 for an entity to disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which it’s exposed at the end of the reporting period. Indeed, the most surprising thing about the example may be that this is all it flows from – that IFRS 7 doesn’t more specifically address disclosure requirements relating to covenant breaches .

It’s no doubt arguable that information about possible non-compliance with covenants doesn’t constitute material information in every single situation where it exists: perhaps, for example, a particular arrangement comes with multiple tests, some of which the lender only inserted in the agreement as a matter of form, and doesn’t really care if they’re met or not (although, of course, the question may arise of how the borrower can be certain of that, in the absence of a formal waiver). The ESMA report doesn’t specify whether any or all of the loans in question were classified as non-current, and would become current as a consequence of a covenant breach, or whether they were already classified as current, but possibly at risk of becoming (so to speak) even more current as a result of the breaches. Practitioners would likely be more attuned to the importance of disclosure in the former situation, because of the impact on a major aspect of balance sheet presentation; they might attach less importance to the matter where everything is already classified as current. This lower priority might seem to be tacitly endorsed by IAS 1, which devotes several paragraphs to appropriate classification in such circumstances, but doesn’t say anything about disclosure (except relating to loans classified as current liabilities, for which covenant breaches are rectified or grace periods are granted after the end of the reporting period).

Still, other situations exist where information about possible challenges in complying with covenants is certainly material, and this seems to have been one of them. If nothing else, it seems outright misleading to refer to “ample” compliance with covenants where that isn’t the case. More broadly, it seems here that forthrightly discussing the covenant situation would be relevant to fully disclosing the material uncertainties relating to events to conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, as required by IAS 1.25. Again, even if something is classified as a current liability, that doesn’t necessarily make disclosure irrelevant; current liabilities come with different degrees of urgency, and different potential consequences for immediate liquidity.

Regarding the breaches after the end of the reporting period, the ESMA report notes: “the enforcer argued that identification of which covenants were breached after the end of the period, the new covenants required as a consequence of the breaches and acknowledgement of the consequences for the maturity analysis for financial liabilities as at the year-end were all relevant to the issuer’s situation. The enforcer also pointed to the apparent inconsistency between the information provided in the directors’ report and that which was included in the financial statements.” Being inconsistent with other regulatory documents, of course, is all but fatal to any argument for appropriate financial statement disclosure. Overall, the message here isn’t to burden readers with primarily technical information of no real consequence, in cases where information about covenants would be no more than that. But it seems foolhardy to tell the world no alarms are going off, when the bell is plainly ringing (even if, for now, not that loudly) in your ears…

The opinions expressed are solely those of the author

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