Problem 8-5 Frisby Technologies: Violating a covenant (LO 8-3)

In late 2002, Frisby Technologies received a default notice from two of its creditors notifying the company that it was in default of the tangible net worth covenant in its loan agreements. Although the company had a period of time to cure the default, it did not expect to be able to do so. Around the same time, Nasdaq notified the company it would be delisted because it no longer met the tangible net worth or stockholders equity listing requirements.

Once the cure period expired, the lenders were entitled to accelerate the due date of the loans and increase the interest rates. The company requested a waiver of the default and indicated that if a waiver was not received, it might seek bankruptcy protection.

For a detailed discussion of Frisbys situation, see R. Craver, Default of Credit Agreement Adds to Frisbys Woes, Winston-Salem Journal, November 22, 2002.

Required:

1. What is a minimum tangible net worth covenant, and what purpose does it serve in the Frisby loan agreements?

2. Why might lenders be reluctant to waive Frisbys covenant violation?

3. Among the options available to Frisbys lenders is foreclosure: shuttering the company and selling off all assets. Why might lenders prefer to avoid this action?