FINANCIAL COVENANTS:WHAT YOU NEED TO KNOW NOW

BY:RICHARD T. HIGA, PARTNER

MCMILLAN BINCH LLP

PRESENTED AT:THE CANADIAN INSTITUTE'S

6™ ANNUAL NATIONAL SUMMIT ONCOMMERCIAL LOAN FINANCE & SECURITY

MARCH 25,2004

MCMILLAN BINCH LLP

BCE PLACE, SUITE 4400 BAY WELLINGTON TOWER, TORONTO, ONTARIO CANADA M5J 2T3

MBDOCS 1277580.3

FINANCIAL COVENANTS

Introduction:

Credit agreements are often lengthy documents with extensive representations,warranties, covenants and events of default. Despite the multitude of provisions available,insolvency lawyers and lenders invariably agree that apart from non-payment or insolvency, abreach of financial covenants is by far the main default relied upon for calling loans.

In light of this, how well do financial covenants stand-up in loan agreements? Aslawyers, it is important to understand the business concepts well enough to ensure that the keypoints are not being lost in translation from business to legal terms. This paper will provide anoverview of common financial covenants together with a summary of some of the issues thatcommonly arise in drafting those covenants.

I. WORKING CAPITAL RATIO

Financial Covenant:

Purpose:

Current Assets:

Current Liabilities:

Maintain a ratio of Current Assets to Current Liabilities ofnot less than [1.0:1.0].

Measures short term liquidity, i.e. does the company haveenough cash or assets which it can convert to cash in theshort term to cover its short term liabilities?

Depending on the nature of the business, a ratio of less than1.0:1.0, would indicate that the borrower may not be able tomeet its liabilities within the next year.

Under GAAP:

"A balance sheet classification, current assets shouldinclude those assets ordinarily realizable within one yearfrom the date of the balance sheet or within the normaloperating cycle, where that is longer than a year."1

Generally, this includes cash, short term investments,accounts receivable and inventory.

Under GAAP:

"As a balance sheet classification, current liabilities shouldinclude amounts payable within one year from the date ofthe balance sheet or within the normal operating cycle

Section 1510.01 CICA Handbook.

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where this is longer than a year (the normal operating cycleshould correspond with that used for current assets)."

Generally this includes accounts payable and the currentportion of long term debt.

Sample Definitions:

"Current Assets means, at any time, for any Person, the current assets of that Persondetermined on a consolidated basis in accordance with GAAP. [excluding accountsreceivable due from employees, shareholders or affiliates (or other non-arm's lengthparties)]."

"Current Liabilities means, at any time, and for any Person, the current liabilities of thatPerson determined on a consolidated basis in accordance with GAAP. [excluding thecurrent portion of long term debt] [excluding the portion of long term debt due atmaturity to the extent included (to the extent that such Person has satisfied theLender that such long term debt will be repaid or refinanced)]."

"Current Ratio means, at any time, and for any Person, the ratio of that Person's CurrentAssets to its Current Liabilities."

DRAFTING ISSUES

1. Since the "current portion" of long-term debt is included, all principal payments due thatyear are included. Depending on how clients set their financial projections and ratios, thesepayments may be excluded. However, in the year that a loan facility matures, the entire amountbecomes a current liability and this should be excluded in the calculation.

2. Is it clear that "Current Assets" are net of reserves for bad debts or inventoryobsolescence? In a balance sheet, inventory and receivables are presented net of reserves.Consider making that clear in the drafting, or adding the phrase "as shown on the balance sheet",to the definition of "Current Assets".

3. Should some receivables be excluded such as accounts receivable due from affiliates andemployees (i.e. intercompany loans or employee/shareholder loans) or resulting from non-ordinary course items, such as asset sales? Ask your client if there are any items that theyassumed would be excluded from the calculation. However, keep in mind that reciprocalrequests may be made from the borrower regarding exclusions from liabilities so this may lead toover-complication.

4. Ask the client for an actual calculation and a copy of the financial statements upon whichthe numbers are based. Compare that to your defined terms.

2 Section 1510.03 CICA Handbook.

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GENERAL BUSINESS ISSUES

The working capital ratio is far from a perfectly accurate test to measure short-term liquidity. While we can't draft to fix all flaws, it is important to understand someweaknesses in the test from a business perspective. The following are some examples:

(a) if the payables due in a 30 day payment cycle and A/Rs are typically collected in a 90 daypayment cycle, a liquidity issue can arise without changing the ratio (at least in the shortterm);

(b) injections of cash and asset sales can bolster cash and postpone liquidity problems in theshort term; and

(c) if a borrower is able to negotiate payment terms beyond one year, then the payable maybe reclassified as a long term liability which may distort the ratio. Consider whetherthese payables should be included in Debt for the purpose of other financial covenants.

II. DEBT TO EQUITY RATIO

Financial Covenant:

Purpose:

Example 1:

Maintain a ratio of Debt to Equity of not more than[2.0:1.0].

Measures a company's solvency or leverage.

It is measure of whether there are sufficient assets or equityon the balance sheet to support the amount of debt relativeto the nature of the business.

As a rule of thumb, businesses with stable cash flows andhigh capital expenditure requirements, (i.e. cablecompanies and utilities) can support higher amounts ofdebt.

Joe incorporates a company and injects $1,000,000 ofequity, borrows $1,000,000 under a 3 year revolving loanand buys widgets for resale of $1,000,000.

Assets:Current Assets

CashInventory

Liabilities:Long Term Debt

Shareholders' Equity:Stated Capital Shares

$1,000,000$1.000.000$2,000,000

$1,000,000

$1,000,000

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Example 2:

Sample Definition:

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Debt to Equity Ratio: $ 1,000,000 - $ 1,000,000 =1:1

It is important to understand that Shareholders' equityalways equal assets minus liabilities.

Joe then sells all of his inventory for $1,200,000 payable$600,000 in cash and $600,000 within 30 days.

Assets:Current Assets

CashInventoryA/R's

Liabilities:Long Term Debt

Shareholders Equity:

Debt Equity Ratio:

Sales

Cost of Inventory soldEarnings

$1,600,000$ 0$ 600.000$2,200,000

$1,000,000

$1,200,000

1.0:1.2

$1,200,000

($1,000,000)$ 200,000

The increase in shareholder's equity conies from the$200,000 of profit or "retained earnings"3 which is added tothe original $1,000,000 of equity injected. Note that youget the same number by subtracting liabilities from theassets i.e. $2,200,000 - $1,000,000 = $1,200,000

"Shareholder's Equity means the sum of the stated capital of all classes of shares, pluscontributed surplus, less capital withdrawals, plus retained earnings, less losses, lessdividends."

In other words it is the sum of all amounts put into the company by its shareholders less amountstaken out, plus profits less losses.

Debt. There are many variations of the definition of "debt" which depend on what theclient is trying to measure. The different options are discussed later. At its most basiclevel, debt means, "all liabilities as determined under GAAP."

1 Rough calculation assumes no taxes or other expenses.

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Commentary

This test is a measure of relative leverage/solvency. However, it is not an accurate picture ofwhether, upon realization, the assets would yield sufficient proceeds to repay the debt.

III. DEBT TO TANGIBLE NET WORTH

Financial Covenant:

Purpose:

Maintain a ratio of Debt to Tangible Net Worth of not morethan [2.0:1.0].

Same as the Debt to Equity Ratio, it is a measure ofleverage/solvency. However, one subtracts the amount of"intangible" assets from the calculation on the assumptionthat these are not "hard assets" and may not prove to haveany value to support the debt.

Sample Definitions:

"Tangible Net Worth means Shareholder's Equity less Intangible Assets [alternative:Total Assets less Intangible Assets less Total Liabilities all as determined inaccordance with GAAP]."

"Intangible Assets means intangible assets determined in accordance with GAAP [andincludes, for greater certainty, goodwill, deferred taxes and intellectual property.]"

Intangible Assets:

Financial Assets:

Under GAAP:

"An intangible asset is an asset, other than a financial asset,that lacks physical substance."4

Under GAAP:

"A Financial Asset is an asset that is (i) cash; (ii) acontractual right to receive cash or another financial assetfrom another party; (iii) a contractual right to exchangefinancial instruments with another party under conditionsthat are potentially favourable; or (iv) an equity instrumentof another entity."5

' Section 3062.05 CICA Handbook.

' Section 3860.05 CICA Handbook.

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Goodwill: Under GAAP:

"Goodwill is the excess of the cost of an acquiredenterprise over the net of the amounts assigned to assetsacquired and liabilities assumed. The amount recognizedas goodwill includes acquired intangible assets that do notmeet the criteria in BUSINESS COMBINATIONS, Section1581, for recognition as an asset apart from goodwill."6

Commentary

Confirm with the lender whether any other "soft" assets should be excluded suchas amounts due from non-arm's length parties.

It is important to note that this test may not be appropriate for some types ofcompanies whose core business depends on intangible assets. For these types of companies thetest would discount their most valuable assets, i.e. the value of trademarks such as "Coke",intellectual property held by IBM, and customer lists of large sales organizations.

Example 3: Joe uses $1,000,000 of his cash to buy a software companythat has $250,000 of A/R, and $250,000 of equipment aswell as patents and customers lists which are carried on thebalance sheet at nominal value. Joe pays a purchase pricehigher than the book value of the assets on the assumptionthat he can generate significant sales from the potentialitems.

Goodwill: $ 1,000,000 (purchase price) - 500,000 (book value of assets) -$500,000

Assets:

Current Assets:Cash $0Inventory $1,000,000A/R $ 250.000

$1,250,000

Fixed Assets/Intangible Assets:Goodwill $500,000Equipment $250.000

$750,000

Total Assets $2,000,000

' Section 3062.05 CICA Handbook.

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Liabilities: $1,000,000

Shareholders Equity: $1,000,000

Tangible Net Worth: $ 1,000,000- 500.000$ 500,000

Debt to Equity Ratio: $ 1,000,000 -s- $ 1,000,000 =1:1

Debt to Tangible Net Worth Ratio: $1,000,000 - $500,000 = 2:1

Commentary

Is this company a higher credit risk? Certainly, there are less hard assets tosupport the debt. However, if the company can generate higher sustainable cash flows as a resultof the purchase, it may actually be a lower credit risk. Accordingly, it is common to include aleverage test based on cash flows such as Debt to EBITDA.

IV. DEBT TO CAPITALIZATION

Financial Covenant: Maintain a ratio of Debt to Capitalization of not more than[0.5:1.0].

Purpose: Same as Debt to Equity Ratio and Debt to Tangible NetWorth Ratio, i.e. it is a measure of relative leverage.

Capitalization: Means the sum of Debt plus Shareholders Equity.

Commentary:

This test is simply a variation of the Debt to Equity/Debt to Tangible Net Worthcovenants. The amount of Debt is simply measured against the combination of Debt plusEquity/Tangible Net Worth vs. Equity/Tangible Net Worth alone.

Example 4:

Assets: $2,000,000Long Term Debt: $ 1,000,000Shareholders Equity $ 1,000,000

Debt to Equity: $ 1,000,000 -*• $ 1,000,000 =1:1Debt to Capitalization $ 1,000,000 + $2,000,000 = .50

V. ISSUES IN MEASURING DEBT

What should be included in the definition of Debt? One option is to include allliabilities on the balance sheet. However, usually Debt is modified to include items which look

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and feel like borrowed money. In measuring leverage, especially for the Debt to EBITDA Ratio,it is common to exclude trade payables or other liabilities which are unrelated to Debt.

Sample Definitions'.

"Debt of any Person means:

(a) all debts and liabilities of that Person for borrowed money;

(b) any obligation secured by any Lien on property owned or acquired by that Personsubject to the Lien whether or not the obligation secured thereby shall have beenassumed (and if the obligation has not been assumed, the amount of "Debt" ofsuch Person respecting such obligation shall be the fair market value of theproperty secured by such a Lien);

(c) any debt or liability of that Person representing the deferred acquisition cost ofproperty or assets created or arising under any conditional sale agreement or othertitle retention agreement even though the rights and remedies of the seller underthat agreement in the event of default are limited to repossession or sale ofproperty or assets covered thereby;

(d) any liabilities, contingent, unmatured or other, under indemnities or otheragreements of that Person to reimburse given or entered into, in connection withany bankers' acceptance, letter of credit or letter of guarantee;

(e) the amount of any Capital Lease by which that Person is bound or for which thatPerson is liable as lessee;

(f) any obligation of that Person guaranteeing any Debt of any other Person;

but "Debt" does not include for greater certainty, obligations to trade creditors incurredin the ordinary course of business."

"Capital Lease means with respect to a Person, any lease or other arrangement relating toproperty or assets which would be required to be accounted for as a capital lease on abalance sheet of that Person in accordance with GAAP. The amount of any Capital Leaseat any date shall be the amount of the obligation in respect thereof which would beincluded on the balance sheet of such Person under GAAP."

2. Hedging Contracts: The rules under GAAP for the treatment of the amount due orowing to a corporation under hedging contracts have been recently amended. The scope of thisrule is beyond this paper. However, in general terms GAAP separates hedging contracts into"accounting hedges" which meet strict guidelines for matching the risk to the amount of thehedge and "economic hedges" which do not meet this criteria. Amounts due or owing under anaccounting hedge show up as liabilities or assets on the balance sheet. Economic hedges aremarked to market and the differences in the value of the hedge are shown as income or loss itemson the balance sheet.

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Putting aside the GAAP treatment, if the borrower has entered into a largecurrency or interest rate swap under a hedge contract under which it has a large accruing liability(since its hedge is out of the money), should the amount of the liability be treated as Debt?

Practice varies on this issue. In cases where the hedging liabilities are owed to thelender, they are more likely to want to include it. Since the amount of the liability can varygreatly and may ultimately disappear if the hedge values swing in the opposite direction, aborrower may argue for its exclusion. Consider whether the positive value of a hedge should beexcluded from Tangible Net Worth.

If the borrower is required to account for the hedge as an "economic hedge" itmay take a dual hit as it will show any increase in the liability as a loss for income statementpurposes.

Measuring liabilities can also be complicated, as the borrower may want toaggregate all of its hedges and show only a net number.

Often, the amount of hedge contracts may not be material and is simply ignored.Again, has your client turned his/her mind to the issue?

Sample definitions:

"Hedge Contract means any foreign exchange contract, currency swap agreement,interest rate swap, cap or collar agreement or other similar agreement or arrangementdesigned to alter the risks of a Person arising from fluctuations in currency values orinterest rates or both, in each case, whether contingent or matured."

"Hedging Liabilities means, at any date of calculation, an amount equal to the aggregateof all amounts which would be owing to it by the Borrower under all Hedge Contracts ifthose agreements were terminated on the date of calculation."

3. Net Debt: Large borrowers with complicated corporate structures may carry a significantamount of cash on their balance sheets for operational or other business reasons. Someborrowers ask to measure Debt after deducting cash or cash equivalents. The argument is thatthe gross amount of Debt is not a true measure as the cash could be applied to repay the Debt.Generally, this is only granted in rare occasions to borrowers with a fair amount of bargainingpower. Since cash is the first thing to disappear in difficult times, it is unlikely that it can berelied upon to repay Debt in a default situation. In cases where this accommodation is made,lender's counsel should request that "cash" be limited to amounts on deposit with the lender.This would allow the lender the ability to exercise more control over the cash and exercise rightsof set-off.

Sample Definition:

"Net Debt means the Debt of a Person less the amount of cash and cash equivalents ofsuch Person [held in an account with the Lender.]"

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4. Off Balance Sheet Items. Clearly, in light of the Enron situation, lenders are looking tosee whether certain types of off balance sheet transactions should be brought back onto thebalance sheet. A common example is the "synthetic lease".7 This is a transaction where an assetis sold to an entity and leased back by the borrower. The borrower uses the proceeds of the saleto pay down its Debt and improve its balance sheet presentation. The entity then borrows thefunds to pay for the asset. The lease payments made by the borrower will be matched to enablethe entity to repay its debt. The terms of the lease allow the borrower to exclude the debt fromits balance sheet under GAAP (ie. not a capital lease etc.), and to deduct capital cost allowanceof the asset.

Under US GAAP, the rules have changed so that in transactions which involve aspecial purpose entity whose sole purpose is to buy and hold the asset transferred to it by theborrower, the debt of the special purpose entity and the asset will be consolidated back onto theborrower's balance sheet. I believe similar rules are being considered in Canada.

Other off balance sheet transactions include securitizations.

If the lender wishes to include these types of transactions in its calculation ofDebt, modifications will be required to the definition of Debt.

I have recently seen the following phrase added to the definition of Debt in anattempt to capture off balance sheet activities, "... and including for greater certainty, syntheticleases, conditional sales agreements, securitizations and other off balance sheet transactions...".Clearly, where these types of transactions are intended to be caught more comprehensive draftingis required.

5. Preferred Shares and Convertible Debentures: There are circumstances where alender may wish to include certain items which may be treated as equity under GAAP. Preferredshares which are redeemable at the option of the holder or which become redeemable upon a setdate prior to the maturity of the loan, may be viewed by a lender as Debt. Since these preferredshares represent a large liability that may become due, this may seem an appropriate inclusion.However, these liabilities will clearly rank behind a secured lender's loans upon an insolvencyand a lender may wish to disregard them.

Debentures which are convertible into shares at the option of the issuer/borrowermay be treated as equity under GAAP. Generally, the option of the issuer/borrower to convertthe debentures to shares is triggered after a period of time. As that period expires, a growingportion of the debentures may be treated as equity until the period expires when the wholeamount may be treated as equity even if the issuer/borrower has not elected to exercise its option.However, the lender may still view the whole amount as Debt.

7 Note to reader: this transaction is less common now.

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Sample wording.

"Debt.... and including for greater certainty, preferred shares which are redeemable atthe option of the holder or prior to the maturity of the [senior loan] and debentures whichare convertible into equity at the option of the Borrower."

6. Senior Debt vs. Total Debt: Depending on how the lender and the borrower have donetheir projections and negotiations, the lender may decide to employ two covenants, one in whichDebt includes preferred shares, convertible debentures and subordinated debt i.e. "Total Debt"and one in which Debt excludes these items, i.e. "Senior Debt".

Sample definition:

"Senior Debt means Debt less Subordinated Debt."

"Subordinated Debt means Debt having a maturity after the date of the [Senior Loan]which is subordinated to the [Senior Loan] on terms satisfactory to the Lender andincludes... [specify any agreed upon subordinated debt]."

This definition eliminates the lender's risk of whether the Debt is effectivelysubordinated.

Commentary:

The foregoing highlights the need for lawyers to have an effective discussion withtheir clients to ensure that a client's assumptions as to what is included in Debt will be reflectedin the financial covenants.

VI. DEBT TO EBITDA

Financial Covenant: Maintain a ratio of Debt to EBITDA of not more than[4.0:1.0].

Purpose: It is a leverage test which measures the amount of debt acompany has relative to the amount of cash flow orearnings it generates.

Another way to think about it is that a company with a 4:1Debt to EBITDA ratio would be able to repay all of itsDebt in 4 years if it applied 100% of its EBITDA to repayDebt.

Sample Definitions:

"EBITDA means, in respect of any particular period, the aggregate of the Person's netincome plus interest expense, depreciation, amortization, current and deferred income taxexpense, all as determined in accordance with GAAP."

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Example 5: Joe's company has annual sales of $ 1,000,000, sales andgeneral administrative expenses of $500,000, interestexpense of $200,000 (i.e. 10% x $2,000,000), depreciationand amortization of $50,000 (i.e. $500,000 amortized over10 years of useful life) and tax expense of $100,000.

IncomeSales $1,000,000Sales and GeneralAdministration expenses ($ 500,000)EBITDA $ 500,000Depreciation ($ 50,000)Interest Expense ($200,000)Tax Expense ($100.000)

Net Income ($150,000)

Debt to EBITDA = $2,000,000 + $500,000 = 4:1

Commentary:

Cash flow tests will capture the effects of various decisions by a company on howit finances its operations. For example, a company which borrows money to buy real estate andequipment rather than renting its premises and equipment, will have higher debt and a higherdebt to equity ratio. However, it will also have higher EBITDA which is calculated beforeinterest expense. If that same company simply rents its premises and equipment, it will havelower debt and therefore a better debt to equity ratio. However, it will have less EBITDA as rentexpense will be deducted in calculating EBITDA.

VII. ISSUES IN MEASURING EBITDA

1. Extraordinary Items: Net Income is determined before Extraordinary Items. These aregains or losses which result from unusual events that are infrequent, not normal for the businessand which do not depend on the decisions of management, i.e. essentially acts of god.

Since in theory, EBITDA is supposed to reflect a borrower's normalized cashflow, these items usually remain excluded from the calculation of EBITDA. Accordingly, aborrower may have positive EBITDA and be onside the covenant, but may actually show a largeloss as a result of an extraordinary loss. In some circumstances the loss may be so severe that theborrower may ultimately go bankrupt but in the short term comply with its Debt to EBITDAcovenant. However in this situation, it is likely that it may breach its Debt to Equity covenant asthe loss will show up as a reduction in Shareholder's Equity. Of course if the agreement doesnot contain a Debt to Equity covenant, the lender may not effectively capture this problem.

Although rare, some loan agreements do include extraordinary gains and losses in determiningEBITDA.

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Commentary

Under GAAP:

"Extraordinary items are items which result from transactions or events that haveall of the following characteristics:

(a) they are not expected to occur frequently over several years;

(b) they do not typify the normal business activities of the entity; ando

(c) they do not depend primarily on decisions or determinations by management or owners."

The requirement that extraordinary items do not typify the business or depend ona decision of management limits "extraordinary items" to acts of god.

For example, Tornado losses are not typical and would be classified asextraordinary. However, losses from strikes, currency or interest rates, crop failures, or plantclosures would not qualify as "extraordinary".

2. Non-recurring Items. Non-recurring items are not a GAAP concept. They are itemswhich are unusual or non-recurring in the business of a borrower but do not qualify as anextraordinary item under GAAP. From the borrower's perspective, EBITDA should be adjustedto exclude these items as they do not reflect "normalized" cash flows. What constitutes a "non-recurring item" is usually determined by management. This can lead to obvious issues.

This practice received a lot of press during the dot com fall out as manycompanies were reporting positive "cash flow from operations" but massive net income losses.

Many lenders are now more reluctant to allow for EBITDA to be adjusted to addback "non-recurring losses". Given that non-recurring gains may be more rare, many lenderswill agree to this.

3. Averaging. Most agreements measure EBITDA on a trailing basis over a one yearperiod either on a 4-quarter basis or 12 month basis to accommodate spikes and dips due to theseasonality of a business.

However, if the financing is made in conjunction with an acquisition, theEBITDA of the prior period will not be reflective of the future EBITDA. Accordingly, EBITDAis generally measured from the closing date.

Sample Definition:

"Rolling Period shall mean, as of the end of any Fiscal Quarter of the Corporation, theimmediately preceding four Fiscal Quarters, including the Fiscal Quarter then ending.

1 Section 3480.02 CICA Handbook.

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However, for the purposes of determining any financial calculation required hereunderfor the first three Rolling Periods ending after the date hereof, the applicable financialresults shall be annualized as follows:

(i) by multiplying the financial results required for such calculation for the firstFiscal Quarter by four in respect of the first Rolling Period;

(ii) by multiplying the financial results for such calculation for the first two FiscalQuarters by two in respect of the second Rolling Period; and

(iii) by multiplying the financial results for such calculation for the first three FiscalQuarters by 4/3 in respect of the third Rolling Period."

4. Acquisitions. If a borrower acquires a company the historical net income of the targetwill not be included under GAAP in the borrower's calculation of net income. Often theborrower is financing the acquisition and will be offside the EBITDA covenant if the historicalEBITDA of the target is not included. Accordingly, a borrower will want to include thehistorical EBITDA. The EBITDA definition must be modified to accommodate this.

In addition, a borrower may also request that the consolidated EBITDA becalculated on a pro forma basis to reflect synergies to be realized upon the acquisition. Thesynergies are usually cost savings expected to come from management's projections of areduction in expenses. This practice is less commonly accepted by lenders as acquisitions oftenresult in unexpected expenses as well as unrealized synergies.

An acquisition will usually be accompanied by large transaction costs. If thetransaction costs are upfront loan fees, no adjustment to EBITDA is required as these will beincluded in interest expense. However, if there are other significant costs, the borrower mayrequest that these be added to EBITDA as they are non-recurring, or request that the ratio beadjusted downwards to accommodate the dip in EBITDA.

5. Divestitures. When a borrower sells a company or division, the EBITDA of the divestedcompany or division arising prior to the date of sale will be included if EBITDA is measured ona trailing basis of the past year. If the proceeds are used to repay debt, the borrower will enjoyan inflated Debt to EBITDA ratio unless the EBITDA of the divested company or division isexpressly excluded.

6. Discontinued Operations. A borrower may have a subsidiary that is losing moneywhich it intends to wind-up. Under GAAP, the borrower may exclude that subsidiary from itsconsolidated financial statements (although it will show up in the notes) if it qualifies as a"discontinued operation" even if the subsidiary has not been wound up. In one example, acompany carried on a "discontinued operation" for over a year.

7. Tax Expense. Tax expense as determined under GAAP is not equal to the actual incometaxes which a company may have to pay in a given year. This results from many factors whichare beyond the scope of this paper. Generally, tax expense is defined as "tax expense as definedunder GAAP". This amount is then added back to EBITDA which is calculated before taxexpense.

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The difference between taxes determined under GAAP and the actual tax payableby a company is referred to as "deferred taxes". Where GAAP taxes exceed income tax,deferred taxes are shown as an asset on the balance sheet. Where GAAP taxes are less thanincome tax, deferred taxes are shown as a liability. A lender may wish to consider deductionsfrom the deferred or prepaid taxes which are assets from Tangible Net Worth. A borrower mayconsider requesting deferred taxes be excluded from current liabilities.

VIII. DEBT TO CASH FLOW

Financial Covenant: Maintain a ratio of Debt to Cash Flow of not less than [5:1].

Cash Flow: EBITDA less taxes paid or payable in cash, less capitalexpenditures.

Purpose: Cash Flow is used to refine EBITDA to better measure theamount of the cash available for application to Debt.

IX. FIXED CHARGE COVERAGE RATIO OR DEBT SERVICE COVERAGERATIO

Financial Covenant: Maintain a ratio of EBITDA/Cash Flow to Fixed Charges.

Purpose: Measure of whether there is enough cash flow to servicethe principal and interest obligations of the company.

Sample Definitions:

"Debt Service means, with respect to any fiscal period of the Person and its Subsidiarieson a consolidated basis, the sum of

(a) Interest Expense during such period, plus

(b) regularly scheduled payments of principal on Debt of the Corporation and itsSubsidiaries scheduled to be paid during such period (whether or not actually paidduring such period) (and excluding, for greater certainty, voluntary prepaymentsor mandatory payments made under [Section •]."

"Interest Expense means, in respect of any particular period, the aggregate of theCorporation's interest expenses and finance charges for such period as determined underGAAP which are paid or payable during such period but excluding for greater certainty,capitalized interest and amortized interest expense."

Commentary:

It can be a common mistake to merely refer to "Interest Expense" withoutexcluding non-cash items such as interest expense from amortization interest costs (such as upfront fees) and capitalized interest which is added to principal and paid at maturity.

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X. GAAP

It is important to note that GAAP is not static, it evolves over time. In addition,there is considerable discretion of management to report items differently under the same GAAPrules. Accordingly, provisions are required to ensure that there is certainty in the calculation offinancial covenants to factor out changes in GAAP or the accounting policies of a borrower.

Sample provision.

"Unless otherwise expressly provided, all accounting terms used in this Agreement shallbe interpreted and all financial information shall be prepared in accordance with GAAPas in effect as of the date hereof, consistently applied. The Borrower shall not effect anychanges in its accounting policies without the prior consent of the lenders."

XI. CONSOLIDATION ISSUES

In a secured financing involving a borrower with many subsidiaries, a lender maywish to limit the financial covenants to include only those entities over which it has effectivesecurity. Definitions referring to terms determined on a consolidated basis may be modified tobe determined on a "combined basis" which consolidates only those entities over which securityhas been given.

XII. DO WE HAVE A DEFAULT YET?

Financial covenants are stated to be tested at the end of a fiscal period such as afiscal quarter. However, the financial statement for determining compliance with those sectionsare not delivered until some time after, usually 45 - 60 days for fiscal quarters and 90-120 daysfor fiscal year ends. Often a lender may suspect that the borrower has breached its financialcovenants but has not yet received the financial statements to prove it. Is it required to fund andcontinue making advances?

While it is a condition precedent to making advances that no default has arisen, itis unclear whether a default has occurred. It is also unclear as to whether the lender can rely on adefinition of default that includes the following: "a breach with the lapse of time wouldconstitute an Event of Default". Usually the lapse of time is meant to refer to cure periods. Inpart, it will be a factual determination which will depend on what information a lender has reliedupon to establish the breach. Otherwise, it is a difficult issue. It is fairly uncommon to includelanguage in the conditions precedent which would allow a lender to not fund where it has"determined in good faith that a breach of the financial covenants has arisen". But this should beconsidered.

For further information please contact the individual listed below:

Richard T. Riga, Partner Tel: 416.865.7864McMillan Binch LLP Fax: 416.865.7048

Email: richard.higa@mcmillanbinch.com

MBDOCS 1277580.3