Limitation on Permitted Indebtedness Covenant
(High-Yield Indenture)

Summary

This clause is a “Limitation on Permitted Indebtedness” covenant intended for use in a high-yield indenture. This clause contains practical guidance and drafting notes. A high-yield indenture is generally used to lend funds to a less credit-worthy company. In exchange for the higher risk of non-payment, the funds are generally lent at a higher premium, and the company is subject to several limitations on the transactions it engages in and how it spends its money. The “permitted indebtedness” covenant is one such covenant and is heavily negotiated. Noteholders have an interest in preserving an issuer’s cash flow and cash reserves so that the payment of excessive dividends or other investments does not deplete funds meant to service the debt. But the issuer needs adequate flexibility to operate its business, make investments, and the freedom to make reasonable dividend payments to its shareholders. The covenant is typically structured to safeguard the issuer’s cash flow-to-debt ratio by restricting the issuer’s ability to take on certain debt (often not trade receivables and other short-term debt) unless the issuer can meet the “consolidated coverage ratio” test and no default has occurred, or the debt is exempted as permitted debt. Attorneys should be aware in drafting that this clause is complicated and context-specific, and should pay particular attention to the Limitation on Restricted Payments Covenant (High-Yield Indenture) covenant, since the two clauses interact considerably. For more information on drafting an indenture, see Indenture Drafting for a Rule 144A / Regulation S Issuance.