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Protect Yourself Against Inaccurate Compliance Certificates
Lending & Restructuring Alert
December 2006
Authors: Paul A. Rubin

Lenders should revisit their standard loan agreements to protect themselves in case borrowers submit inaccurate financial compliance certificates. A recent case illustrates that lenders may be unable to collect interest payments if language in their loan agreements is not sufficiently specific regarding the consequences should their borrowers submit fraudulent or inaccurate compliance certificates.

The case. A borrower submitted inaccurate compliance certificates to several lenders. The loan agreement included a pricing grid under which the interest rate was fixed as the sum of a floating base rate plus an "applicable margin," which fluctuated depending on the "reported" leverage ratio, calculated with reference to the borrower's compliance certificate for the preceding four fiscal quarters. After the borrower filed for bankruptcy, the senior lenders argued to the bankruptcy court that they were entitled to over $187 million in retroactive interest payments because of the faulty compliance certificates. They reasoned that if the compliance certificates had been accurate when they were submitted, the borrower would have been required to pay a higher interest rate. The borrower's unsecured creditors argued that the lenders were not entitled to retroactive interest because the loan agreement covered only the "reported" leverage ratio, but not the "actual" leverage ratio.

The lenders' unsuccessful arguments. The lenders contended that they were covered by the broad provisions in the loan agreement, all of which are typical in syndicated loan transactions. These include: (i) a representation and warranty by the borrower that reported financial information was materially accurate on applicable dates, (ii) an affirmative covenant that reported financial information was accurate, (iii) an affirmative covenant requiring the borrower to provide revised financial information upon discovery of any material inaccuracy, and (iv) an event of default triggered by a material misrepresentation. The lenders also argued that, aside from the loan agreement's protections, they were entitled to relief under tort theories of fraud and misrepresentation.

The bankruptcy court's holding. The court carefully focused on the language of the loan agreement—what was covered, and more importantly, what was not. The court noted that the loan agreement did not provide for a recalculation of the applicable margin if the borrower's compliance certificates were inaccurate. The court pointed out that the lenders protected themselves by providing for the highest possible margin if the borrower failed to deliver a certificate of compliance, but included no protection if the borrower submitted inaccurate or fraudulent certificates. In the court's opinion, it was foreseeable that a borrower might submit inaccurate compliance certificates. Accordingly, it held that the lenders should have protected themselves by including explicit language in the loan agreement, and that they could not rely on boilerplate provisions in the loan agreement to plug the hole in their agreement.

The court also rejected the lenders' argument that they were protected under tort law. Despite assuming that the borrower knew that the compliance certificates were inaccurate, the court held that tort law is "restitutionary" in nature, protecting only those who have suffered actual losses (i.e. out-of-pocket expenses). The court held that the only real losses in a case like this would be losses of principal, but not lost interest.

What this case means for you. There is always a risk that borrowers will submit inaccurate compliance certificates and financial reports. So prudent lenders who want to make the most of their floating margins will ensure that their loan agreements base the relevant calculation of the "applicable margin" on actual, not reported, financial results, and include a mechanism to retroactively adjust the payment(s) due if they discover that the borrower submitted a compliance certificate that was inaccurate in any material respect. Including such language should help lenders get the benefit of their intended bargain, without resorting to the costs, delay and risks of litigation.

For further information regarding these or other lending issues, please contact Paul Rubin at 212-592-1448 or


Herrick's Bankruptcy, Business Reorganization and Creditors' Rights Practice Group represents a broad range of clients having varied interests in the bankruptcy, workout and reorganization arenas. From Fortune 500 corporations to small public and private companies, our clients include all of the major players in the bankruptcy process: debtors, creditors' committees, secured and unsecured creditors, trustees, financial institutions, investment banks, asset-based lenders, insurance companies, pension funds, purchasers of assets, landlords, claims traders, equipment lessors and licensors.

Herrick's Lending Practice Group represents financial institutions in syndicated and non-syndicated financing transactions, including secured and unsecured loan facilities and acquisition financing, and leveraged buy-outs involving both public and private companies. Our lending experience includes foreign exchange and multi-currency transactions, documentary letters of credit and bankers' acceptance facilities and credit enhancement for municipal bond issues. 

Copyright © 2006 Herrick, Feinstein LLP. The Lending and Restructuring Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.