An Overview of Sacred Rights Credit Agreements: Insights and Analysis

What are Sacred Rights?

The term "sacred rights" is defined as "the right of the holder of a security interest or other creditor under an agreement that encumbered property shall not be sold or otherwise disposed of except in certain specified manner and subject to specified conditions." The terms "sacred rights" and "sacred assets" are often used interchangeably. They encompass rights you have as a secured creditor, such as the right to exercise remedies or be paid proceeds from the disposition of collateral . In term sheets for a new loan or documents accompanying the purchase of a distressed company, you might see a list of prohibitions on acts by the company or its lenders, bondholders, and may include limitations on entrepreneur salaries, bonuses, acquisitions, investments and capital expenditures. It is important that investment professionals receive covenant compliance certification, such as with sacred rights credit agreements to ensure the sacred rights accompanying the loan will be properly enforced.

Legal Authority for Sacred Rights

The foundation for sacred rights is established within the statutory framework of the United States Code and regulations of the Securities and Exchange Commission (SEC) and the Federal Energy Regulatory Commission (FERC). Depending on a person’s rights, enforcement of those rights and remedies may vary by forum—some may prefer federal courts, while others may choose the FERC as their adjudicatory body. In addition to the statutes and regulations governing sacred rights, there are also sources of common law, such as case law (for example, the Burford v. Sun Oil Co. task elements), that inform the rights and obligations of parties with sacred rights. For example, Burford identifies the requirements for a claimant to establish a cause of action under Section 19(a) of the Public Utility Holding Company Act of 1935 (PUHCA) which, though repealed, has essentially been carried over as a prohibition in the 2005 PUHCA law, codified as Section 1262 of the Energy Policy Act of 2005 (EPAct 2005).

Typical Terms of Sacred Rights Clauses

The sacred rights credit agreement is a complex creation intended to balance the competing interests of lenders and borrowers with respect to untested state law. Provisions differ, but most sacred rights covenants have the following features:
The sacred rights covenant as an event of default Under the sacred rights covenant, in the event that any state law prohibited the enforcement of any sacred rights in any material respect, but such failure related solely to such property, events of default would be triggered, and the remedies would be the right of enforcement of remedies with respect to such property as well as the right to accelerate the loans. __ Under the sacred rights covenant, the granting of certain exceptions to prohibition on enforcement of rights in any state law that is narrowly tailored to the specific property in question shall not constitute a waiver or a waiver with respect to the prohibition in general. Failure to assert an event of default or exercise a remedy is an encouragement to do so in the future Restrictions on securing additional debt For the sacred rights covenant to be effective, lenders must be able to have a reasonable degree of confidence that no amendments to the sacred rights covenant affecting so-called sacred properties will be agreed to or permitted in the future that negatively affects those properties. As a result, the sacred rights covenants will typically permit the secured credit agreement borrower to allow certain amendments to its sacred rights covenant, but only where the amendment does not alter the sacred rights covenant in any material respect. Similarly, if the lender is going to take on additional secured indebtedness, sacrilege risk increases and the lender needs to have a reasonable confidence that the new secured creditor’s claims will be subordinate to the lender’s claims. Preliminary arrangements and procedures In the event that the lender has actual prior knowledge of a bank document provisions, and as long as such provision does not prohibit in any respect new secured creditors with respect to the asset, the lender is generally exempt from any obligation to limit new secured creditors. Liquidated damages provisions Since the lender is taking on additional risk, it may negotiate for a late payment fee. Where the lender has to enforce its right to remedies to protect the value of its collateral, that lender has not only cash flow problems and remediation issues but its portfolio may be negatively affected by the borrower’s sacred properties. Under these circumstances the lender may have to compensate for the potential loss of market liquidity for the receivable, agreement or contract.

Differences between Sacred Rights and Other Covenanants

Sacred rights differ from common covenants found in credit agreements such as: financial covenants, liens, swaps and change of control. Financial covenants are intended to impose ongoing limits on the borrower while sacred rights are focused on events that cannot happen. Although sacred rights are focused on prohibiting certain actions by the borrower, under the test set forth in In re Calpine, they may not be considered "negative" because they also may permit other action if the lender consents. For example, the sacred right prohibiting an unsuccessful bid of a loan investor for stock would not prevent a successful bid for stock of the borrower. The prohibition is triggered only if the loan investor is unsuccessful in acquiring the stock. In contrast, a typical negative covenant would simply prohibit the borrower from entering into any agreement with its loan investors for the purchase of stock.
Another difference between sacred rights and other negative covenants in a credit agreement is the timing of the restriction. Most negative covenants are tested at the time of the restricted action. Sacred rights, on the other hand, will be triggered only when a potential conflict of interest arises. For example, the sacred right would not be triggered merely because the borrower had an investor who was interested in acquiring stock in the borrower, even if there is an exclusivity agreement restricting the purchaser from acquiring shares.
Some agreements provide for a "materiality threshold" (too small to have a significant impact, such as a 1% ownership threshold). As a practical matter, easily acceptable, small ownership holdings should not affect the business. Retailers, for example, may need to grant their employees equity in order to motivate performance. Institutional stockholders are unlikely to sell all of their stock (even at a profit) because they lose any opportunity to participate in appreciation.
Because of this de minimis exception, sacred rights are even more effective than negative covenants in protecting the borrower from the risks inherent in having parties with conflicting objectives serving together in a limited role through participation rights.

Negotiation and Documentation of Sacred Rights

When negotiating a new credit agreement, a lender will typically seek to include a "sacred rights" clause limiting the ability of a borrower and its affiliates to amend or alter the rights of the lenders. This clause protects the lender against the borrower and certain of its affiliates taking a vote (if required) for the purpose of amending the credit document and thereby somehow adversely affecting the lender. Typically, lenders will seek to limit this to either all first lien lenders or only those first lien lenders of the class which is being adversely affected.
Say, for example, the second lien debt (remaining with the original lender) is paid down to zero from a sale of assets to a third party (the purchaser of company X). The borrower now wishes to obtain a new term loan (term loan II) to pay the first lien lenders an amount equal to termination value on their existing swap contracts and pay down to zero the remaining first lien lenders’ advance base revolving line of credit that is outstanding as a result of the new assets holding the advance base account. The borrower obviously cannot use the proceeds of the term loan II financing to pay down for free to zero the remaining first lien lenders’ balance in the ABR revolver. This type of transaction can be viewed as a principal reduction requiring a pro rata pay down on the first lien lenders’ revolving line. The lender in this situation may object to this pay down action if there is a secondary market for their first lien debt in the amounts provided by the company from the proceeds of the term loan financing. In other words, they’re looking at the secondary market for a value on their debt before and after the transaction, and they may want to assert that the value of their debt is adversely affected by being able to pay down their debt for free to zero (even when comparing apples to apples for net debt value to net asset value).
The way to solve the above problem is that the sacred rights clause must specify that such transactions are being done under the "standard borrower rights" provision that is commonplace in a credit agreement . These types of standards can be negotiated to a greater or lesser extent. The question is whether the lender and borrower have an agreement to use the standard borrower rights for all of these types of transactions. If so, this is one of those types of transactions that joins the pantheon of standard borrower rights. In a scenario like the above, when the loan documents don’t have a specific carve out for standard borrower rights, the lender may try to assert that it has a right to vote one way or another on the amendment of the credit agreement to amend the existing sacred rights clause to allow this amendment. This has the effect of negating the standard borrower rights clause, because once that standard borrower rights clause is written, it becomes a sacred right of the borrower to amend that without lender consent.
One possible solution is for the borrower to simply exclude loans of that category from the sacred rights clause altogether for purposes of the borrower right provision, thereby making it a borrower right for purposes of that provision. For example, sacred rights provisions are usually worded to exclude transactions involving the grant of liens in collateral securing pre-existing debt (such as a loan secured by equipment of the company X being sold to the purchaser). In such an instance, the lenders do not get a say in whether the collateral securing the preexisting debt will be removed from the company’s assets in order to incur new debt secured by the same assets.
There are many ways to address these sensitive provisions in loan documents. What certain practitioners may find important to focus on is recognition in the loan documents of what is economically reasonable and in the interest of the equity holders. If the sale price to the third party is compensation for some type of activity that has made that company more valuable than other companies of its kind in the industry, shareholders will often recognize the need to reduce their debt load so that the borrower can do more debt service on the remaining debt going forward.

Impact of Sacred Rights on the Obligors

The significance of Sacred Rights is that a borrower that has adequate notice of the proposed transaction (and presuming there are no state law issues) can opt‐out of particular transactions where a Sacred Rights are in effect. In those situations, if extra protection is desired, a borrower can seek an amendment or waiver to scrub the provision from the credit agreement.
In situations where a borrower had negotiated for a more restrictive contractual Covenant and it is later being imposed through the Sacred Rights provision, the borrower is basically forced to seek a consent from its lender(s). In such circumstances, a borrower is really at the mercy of its lender(s) as to whether it will seek the consent. All in all, Sacred Rights are a double‐edged sword for a borrower because while they do provide protection in certain situations, they can also allow for the imposition of contractual terms that the borrower otherwise may not be subject to.

Recent Trends

In the past few years, there have been a number of developments that have affected the use of sacred rights provisions in credit agreements and caused issuers and lenders to examine them more closely. Given the continued growth of the market for securitization, it is not surprising that the prevalence of sacred rights provisions has grown in such deals. Originally, sacred rights provisions were popular with issuers, because they could be easily sold to an investor who might be sensitive to restrictive provisions. As a result of this dynamic, some credit agreement sponsors published "market surveys" that stated that their sacred rights provisions were customary for the relevant market.
However, this past spring , the Rating Agency Standards of Corporate CDOs published by the Bond Market Association’s ABS CDO committee (the ABS CDO Committee) expressed gravest concern with sacred rights. The ABS CDO Committee stated that "environmental protection, tax, and other issues may arise which present risks to investors in special-purpose vehicles that are extremely difficult or impossible to mitigate." The ABS CDO Committee thresholded its concerns for managers through a list of ten questions for managers (the Ten Questions), including prohibitions on divesting certain assets and covenants regulating the use of proceeds. These Ten Questions are available from www.bondmarkets.com/media/pub_hist/files/cdo/050719CDOguide.pdf.
The perception of sacred rights as a "hot button" has also led several investment banks to examine their technology and deal flow with respect to sacred rights and prohibitions on the divestment of certain assets.