Documenting Indebtedness as Derivatives: Navigating Negative Covenants in Credit Documents
January 2026
Introduction
Credit agreements typically impose restrictions on a borrower’s ability to incur additional indebtedness that is not expressly permitted under the agreement (the “permitted debt covenants”). Such covenants are designed to limit the borrower’s ability to take on excessive debt that serves to dilute lenders’ claims. However, such agreements typically include exceptions that are necessary for the borrower to continue operating its business. One common example of such an exception is obligations under hedging agreements.
Introduction
Credit agreements typically impose restrictions on a borrower’s ability to incur additional indebtedness that is not expressly permitted under the agreement (the “permitted debt covenants”). Such covenants are designed to limit the borrower’s ability to take on excessive debt that serves to dilute lenders’ claims. However, such agreements typically include exceptions that are necessary for the borrower to continue operating its business. One common example of such an exception is obligations under hedging agreements.
This exception is generally designed to allow the borrower to enter derivatives transactions so that the borrower can reduce its exposure to various market risks (interest rates, oil, natural gas or other physical commodity prices, or foreign exchange). Furthermore, credit agreements often contain provisions that are designed to induce parties (often known as “hedge providers”) to enter these derivatives with the borrower. In particular, a credit agreement will often provide that a borrower’s obligations to a hedge provider under a permitted hedge are secured on a pari passu basis with the lenders under the credit agreement (such swaps are known as“secured hedges”).
However, as is often the case in complex legal agreements, sometimes the manner in which the provisions related to secured hedges are drafted may allow the borrower to enter into derivatives transactions that serve not only to hedge a risk, but also to provide the borrower with greater secured indebtedness than the credit agreement generally contemplates. This is because secured swaps may be defined to encompass not only transactions with a genuine hedging purpose, but other derivative transactions as well, and, as we discuss below, there are many ways to structure financing as derivatives.
This article presents an overview of how financing may be structured as secured swaps under credit agreements and discusses the key commercial and regulatory considerations for market participants acting as borrowers, lenders, and hedge providers.
Permitted Debt Covenants and Secured Swaps
A permitted debt covenant is generally presented as a negative covenant, i.e., generally prohibiting the borrower from incurring new indebtedness, unless an express exception under the covenant applies. These exceptions often include, among other things, loans under the relevant credit facility, prior debt, secured swaps, and indebtedness incurred in the ordinary course of the borrower’s business1. The following is a simplified example:
Each of the Borrower Parties covenants and agrees with each Lender that at all times after the Closing Date, so long as this Agreement shall remain in effect and until the Secured Obligations have been paid in full, none of the Borrower Parties will, nor will permit any of its Restricted Subsidiaries to incur, create, assume or permit to exist any indebtedness, except: (a) indebtedness under this Agreement, (b) indebtedness in existence on the Closing Date, (c) indebtedness under Hedging Agreements with respect to interest rates, foreign currency exchange rates or commodity prices not entered into for speculative purposes, (d) indebtedness in respect of purchase money obligations or capital lease obligations, and indebtedness incurred in connection with financing any sale leaseback transactions or any real property, in an aggregate amount not to exceed $[X], . . . and in each case, any permitted refinancing thereof.
“Hedging agreement” shall mean any agreement with respect to any swap, cap, collar, forward purchase or similar agreement or arrangement dealing with interest rates, currencies, exchange rates or commodity prices, either generally or under specific contingencies.
Note that, in the above example, the definition of “hedging agreement” is quite broad and elastic. Essentially, it requires that the transaction be derivative referencing certain underliers. Although the permitted debt covenant requires the secured swap to be “not entered into for speculative purposes,” neither it nor the hedging agreement definition requires that the hedging agreement be for hedging purposes. As long as a transaction refers to one of the specified underliers and is a derivative, it arguably falls within the scope of the exception to the permitted debt covenant.
Sometimes, the contractual language defining secured hedges is more precisely calibrated, explicitly requiring the relevant transaction to be for certain specific hedging purposes. By contrast, sometimes the language omits any reference to the purposes of the “hedging transactions” and even defines secured swaps more broadly as, e.g.: any and all rate swap transactions, basis swaps, credit derivative transactions, forward rate transactions, commodity swaps, commodity options, swaptions, forward commodity contracts, equity or equity index swaps or options, bond or bond price or bond index swaps or options or forward bond or forward bond price or forward bond index transactions, interest rate options, forward foreign exchange transactions, cap transactions, floor transactions, collar transactions, currency swap transactions, cross-currency rate swap transactions, currency options, spot contracts, or any other similar transactions or any combination of any of the foregoing (including any options to enter into any of the foregoing) . . . and any and all transactions of any kind, and the related confirmations, that are subject to the terms and conditions of, or governed by, any form of master agreement published by the International Swaps and Derivatives Association, Inc.
Such a broad definition would effectively encompass any transaction documented as a derivative or even any transaction documented under an ISDA Master Agreement. Although the ISDA Master Agreement is designed for derivatives transactions, it cannot be used only for such purposes. Rather, derivatives practitioners like to remark that one could sell a car under an ISDA Master Agreement. Accordingly, defining secured hedges in this manner can provide a borrower with broad flexibility.
Sometimes, the contractual language defining secured hedges is more precisely calibrated, explicitly requiring the relevant transaction to be for certain specific hedging purposes. By contrast, sometimes the language omits any reference to the purposes of the “hedging transactions” and even defines secured swaps more broadly as, e.g.: any and all rate swap transactions, basis swaps, credit derivative transactions, forward rate transactions, commodity swaps, commodity options, swaptions, forward commodity contracts, equity or equity index swaps or options, bond or bond price or bond index swaps or options or forward bond or forward bond price or forward bond index transactions, interest rate options, forward foreign exchange transactions, cap transactions, floor transactions, collar transactions, currency swap transactions, cross-currency rate swap transactions, currency options, spot contracts, or any other similar transactions or any combination of any of the foregoing (including any options to enter into any of the foregoing) . . . and any and all transactions of any kind, and the related confirmations, that are subject to the terms and conditions of, or governed by, any form of master agreement published by the International Swaps and Derivatives Association, Inc.
Such a broad definition would effectively encompass any transaction documented as a derivative or even any transaction documented under an ISDA Master Agreement. Although the ISDA Master Agreement is designed for derivatives transactions, it cannot be used only for such purposes. Rather, derivatives practitioners like to remark that one could sell a car under an ISDA Master Agreement. Accordingly, defining secured hedges in this manner can provide a borrower with broad flexibility.
Even when the definition of a secured hedge is limited to derivatives, the debtor can still exploit it to incur greater financing. This is because many types of financing can be structured as a derivative. For example:
A borrower can sell a hedge provider a call option on a commodity that is deeply out of the money (i.e., at a strike price so far below the commodity’s expected price that it is unlikely the hedge provider will ever exercise the option) and require the hedge provider to “prepay” the amount the hedge provider would need pay if the option is ever exercised, with the borrower agreeing to return that payment at the maturity of the transaction. Under this kind of arrangement, the “prepayment” is effectively a financing.
A borrower looking to achieve the same economics as acquiring an asset can enter into a total return swap with the hedge provider under which the hedge provider pays the borrower any increase in price of the asset (and any distributions on the asset), and the borrower pays any price declines in the asset as well as regular interest payment on the value of the asset. This type of arrangement effectively achieves the same result as the hedge provider lending money to the borrower secured by the underlying asset.
Once a transaction qualifies as secured swaps, the swap provider typically receives pari passu treatment in the credit facility structure, meaning that (i) the swap ranks equally with the loan under the waterfall (i.e., fees, premiums and scheduled periodic payments due under the swap get paid ratably with interest on the loan, while any breakage, termination or other payments under the swap are paid ratably with principal of the loan), and (ii) the swap and the loan are secured with equal priority by the same collateral. Note, however, that in certain cases, hedges permitted under the exception from the permitted debt covenant may be defined differently from hedges accorded favorable treatment under the waterfall.
Legal Risks of Financing via “Secured Swaps”
While a borrower may obtain additional financing structured as secured swaps under a credit facility, such transactions present certain legal risks that may arise from the contractual terms applicable to the swap providers and how such transactions may be treated under insolvency law.
First, although secured swaps are often contemplated and permitted under credit agreements, swap providers and lenders may be treated differently for purposes of the governance structure of a credit facility. For example, a swap provider may not have voting or consent rights over amendments, waivers, and other modifications to the credit facility, including with respect to changes to the waterfall and release of collateral. This could allow lenders to vote to amend the terms relating to secured swaps to, for example, impose a strict “hedging purpose” requirement, and thereby impair the swap provider’s status as a secured party and its priority vis-à-vis the collateral.
Legal Risks of Financing via “Secured Swaps”
While a borrower may obtain additional financing structured as secured swaps under a credit facility, such transactions present certain legal risks that may arise from the contractual terms applicable to the swap providers and how such transactions may be treated under insolvency law.
First, although secured swaps are often contemplated and permitted under credit agreements, swap providers and lenders may be treated differently for purposes of the governance structure of a credit facility. For example, a swap provider may not have voting or consent rights over amendments, waivers, and other modifications to the credit facility, including with respect to changes to the waterfall and release of collateral. This could allow lenders to vote to amend the terms relating to secured swaps to, for example, impose a strict “hedging purpose” requirement, and thereby impair the swap provider’s status as a secured party and its priority vis-à-vis the collateral.
Second, there may be conditions to the swap provider’s security interest that may need to be assessed to ensure the hedge is treated as secured at all relevant times. For example, sometimes a credit agreement requires any counterparty to a secured swap to always be affiliated with a lender. Consequently, the swap provider could lose its security interest if its affiliated lender assigns or sells its interests under the credit facility and loses its “lender” status (e.g., due to a forced sale triggered by other lenders’ use of a “yank-a-bank” provision that permits the replacement of non-consenting lenders to proposed amendments).
Third, the U.S. Bankruptcy Code (and other insolvency regimes) contains several “safe harbors” that protect the ability of a derivative counterparty to exercise close-out, netting, and collateral rights notwithstanding some limitations on the automatic stay and other limitations on creditors’ rights under the Bankruptcy Code2. The safe harbors also protect transfers under or in connection with derivative from avoidance as preferences or constructive fraudulent conveyances. However, whether a transaction can benefit from such safe harbors depends on whether it satisfies the “swap agreement” definition of the Bankruptcy Code (or another one of the protected contract definitions). That inquiry is generally dependent on the substance of the transaction.
Accordingly, even if a transaction qualifies under the credit agreement as a secured hedge, a court may not agree with the treatment under the safe harbors if it is nothing more than (or not much more than) a financing. If a secured hedge is not treated as safe harbored, that could introduce question as to whether the debtor would have assumption or rejection rights in relation to the transaction, which could effectively serve to provide the borrower with a free option.
Second, there may be conditions to the swap provider’s security interest that may need to be assessed to ensure the hedge is treated as secured at all relevant times. For example, sometimes a credit agreement requires any counterparty to a secured swap to always be affiliated with a lender. Consequently, the swap provider could lose its security interest if its affiliated lender assigns or sells its interests under the credit facility and loses its “lender” status (e.g., due to a forced sale triggered by other lenders’ use of a “yank-a-bank” provision that permits the replacement of non-consenting lenders to proposed amendments).
Third, the U.S. Bankruptcy Code (and other insolvency regimes) contains several “safe harbors” that protect the ability of a derivative counterparty to exercise close-out, netting, and collateral rights notwithstanding some limitations on the automatic stay and other limitations on creditors’ rights under the Bankruptcy Code2. The safe harbors also protect transfers under or in connection with derivative from avoidance as preferences or constructive fraudulent conveyances. However, whether a transaction can benefit from such safe harbors depends on whether it satisfies the “swap agreement” definition of the Bankruptcy Code (or another one of the protected contract definitions). That inquiry is generally dependent on the substance of the transaction.
Accordingly, even if a transaction qualifies under the credit agreement as a secured hedge, a court may not agree with the treatment under the safe harbors if it is nothing more than (or not much more than) a financing. If a secured hedge is not treated as safe harbored, that could introduce question as to whether the debtor would have assumption or rejection rights in relation to the transaction, which could effectively serve to provide the borrower with a free option.
Key Considerations for Market Participants
In light of the foregoing, we highlight a number of key considerations for borrowers, lenders, and swap providers in relation to transactions that may be entered into as secured swaps for purposes of permitted debt covenants.
Key Considerations for Market Participants
In light of the foregoing, we highlight a number of key considerations for borrowers, lenders, and swap providers in relation to transactions that may be entered into as secured swaps for purposes of permitted debt covenants.
Borrowers and Swap Providers
Borrowers and swap providers must conduct thorough due diligence to ensure that they understand how a proposed hedge transaction would be treated under relevant credit documentation and applicable law. These considerations would not only affect the viability of the transaction to begin with, but also the credit analysis by the hedge provider that could impact on the costs of the transaction to the borrower. Key considerations include:
Review of credit documentation: The borrower and the swap provider should comprehensively examine relevant terms in all credit documentation (the credit agreement, security/guaranty documents, and any inter-creditor agreements) that may affect a transaction’s status as a secured hedge and the hedge provider’s protections, including key definitions and other terms relating to conditions for obtaining security, the permitted debt covenant and other covenants (such as those relating to incurrence of liens and restrictions or requirements for hedging or speculation), the waterfall(s), and voting or consent rights of swap counterparties.
Protective terms in swap documentation: The swap counterparties should consider appropriate protective terms to be included in the swap documentation (which is usually an ISDA Master Agreement as supplemented by a negotiated schedule thereto), such as “Additional Termination Events” addressing what happens if the swap provider loses the security interest or pari passu treatment under the credit facility, representations regarding the treatment of the transaction and the swap provider under the credit facility, incorporation of key provisions from the credit documentation (e.g., covenants and events of default), and settlement methods (e.g., option for cash settlement in place of physical delivery).
Regulatory treatment: The swap counterparties should consider the characterization risk for purposes of safe harbor treatment under the applicable bankruptcy regime, as well as other regulatory considerations, such as reporting, business conduct, registration, and initial margin rules for uncleared derivatives3.
Lenders
For lenders, the most important consideration would be the thoughtful drafting of the permitted debt covenants and other terms relating to secured swaps to ensure that they appropriately capture what is intended to be permitted under the credit facility. This may be done by imposing a strict “hedging purpose” requirement for secured swaps, though it may not always be a panacea, especially if any particular derivative-style financing is contemplated from the outset. The key, ultimately, is to ensure that the contractual terms precisely enable all parties’ goals.
Lenders
For lenders, the most important consideration would be the thoughtful drafting of the permitted debt covenants and other terms relating to secured swaps to ensure that they appropriately capture what is intended to be permitted under the credit facility. This may be done by imposing a strict “hedging purpose” requirement for secured swaps, though it may not always be a panacea, especially if any particular derivative-style financing is contemplated from the outset. The key, ultimately, is to ensure that the contractual terms precisely enable all parties’ goals.
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