Cleanup Clause: Everything You Need to Know
A cleanup clause is a set of requirements that can be included in a financial contract pertaining to a line of credit.3 min read
A cleanup clause is a set of requirements that can be included in a financial contract pertaining to a line of credit. They are used as a means to prevent borrowers from using their credit as a source of permanent or long-term financing.
Definition of Cleanup Requirement
Cleanup requirements are conditions that are normally written into a contract involving lines of credit that renew on an annual basis. These require borrowers to pay off outstanding balances on their credit line and cease to further utilize their credit for a set period of time. A cleanup requirement is typically used as a way to prevent a borrower from utilizing their credit as a means of permanent or long-term financing.
It is worth noting that cleanup requirements are becoming less and less commonly used by most banks these days. Many lenders don't see a need to require their customers to clean up their credit so long as interest and principal payments are made in a timely manner. Cleanup requirements are also sometimes known as "annual cleanup." The thought process behind a cleanup requirement is usually to make sure businesses don't rely too much on their credit and that their sales revenue is serving as their primary income source.
Without restrictions like this in place, it is possible that a company might use their credit rather than the earnings they are generating to pay recurring costs such as the following:
When a company is relying on their line of credit to pay these recurring costs, it may be a good indication that they are not generating enough revenue to sustain their business or pay off debts. This can potentially lead to a cycle in which a company obtains one line of credit after another to pay their bills, rather than generating the necessary income to do so. This cycle can continue until the company has exhausted all of their options for credit.
The terms included in a cleanup requirement can call for borrowers to clear out their balance and maintain a zero balance for up to 90 days over a 12-month period. Other requirements in a cleanup clause may state that a customer can't incur any overdraft fees for 30 to 60 days in a year while they utilize a revolving line of credit. They may also require that the current outstanding balance stays within a certain limit.
A customer may find themselves required to keep their principle balance below a specified percentage of their full credit line, for example, which will ultimately force them to either pay down their balance or restrict their use of the credit line to keep the balance within those restrictions. Cleanup requirements can be used to help a financial institution reduce potential exposure by offering a measure of certainty that their clients are not accruing debt that they will ultimately be unable to repay.
In terms of acquisition finance, a cleanup period is the period of time during which a borrower has the opportunity to remedy events that relate to a group of companies that have been acquired and are in breach of the terms of the facility agreement that documents the facilities that were used to provide funding for the acquisition. In broad terms, events such as this won't be considered default events during the course of the cleanup period as long as the following conditions are met:
- They are capable of remedy.
- They are taking steps to remedy the breach.
- The borrower didn't approve the circumstances that gave rise to the breach.
A lender will typically agree to a cleanup period if financing for a particular bid for a publicly listed limited company. Other cases that may warrant a cleanup period include when borrowers haven't been able to fully carry out their due diligence on a group of target companies.
Cleanup Clause Law and Legal Definition
Cleanup clauses are provisions included in contracts pertaining to loan agreements. They state that any loans are required to be repaid by a specified deadline, after which additional loans won't be given to the debtor for a set period of time. This is known as the "cleanup period." A cleanup clause can also apply to revolving lines of credit.
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