What You Should Know About Breaking Debt Covenants
A loan covenant is a mutual commitment, in writing made by the bank and the borrower that both parties agree to honor during the term of the loan.
Loan covenants typically come in three varieties: (1) affirmative, (2) negative and (3) financial.
Financial covenants require that your company maintain a certain amount of liquidity or certain financial ratios. As an example, your company may have to maintain a minimum net worth or an EBITDA profit level.
In All Cases …
In all cases, the purpose of covenants is to provide a tripwire for the bank and to give them an early warning of a potential problem. They also serve to satisfy bank regulators as to the safety of the loan.
How can you tell if you are possibly going to violate a loan covenant, especially a financial one? Revenue is declining, cash is really tight in the business, your line of credit is pretty much maxed out and/or payables are stretched. One or more of these are early indicators that you may have problems with your loan.
Makes One Of Three Typical Errors …
Typically, management of companies in this condition makes one or more of three errors in dealing with their lender. The first is not communicating early and often with their lender.
(1) They submit the financials and let the lender come to them.
(2) The second is not managing their business to insure compliance with the loan covenants. A good example of this is paying bonuses or dividends that put the business out of compliance.
(3) The third is communicating with the lender, but not having a realistic, or any, plan to provide confidence to the lender that loan compliance can be restored in a timely manner.
If You Violate A Covenant …
If you violate a covenant, your lender has multiple remedies at its disposal and will generally choose from them as it sees fit, depending on the severity of the default.
If the default is fairly innocuous such as failing to submit your financial statements on time, the bank may simply extend the deadline. If the default is more serious, such as taking out another loan without getting the approval of your lender, the remedy may be much more serious; as halting any additional lending; applying new deposits toward reducing the existing balance; or simply calling the loan and giving you a certain period to find a new lender and pay off the existing debt. For violations in between these extremes, other options include issuing forbearance agreements. These usually come with increases in interest rates and fees associated with the forbearance agreement.
Out Of Compliance Loans …
Once a loan becomes out of compliance, the lender may assign the loan to a workout or “special assets” officer. Assuming it’s not an extreme violation, this officer will typically spend one to three months just monitoring the loan. This is to determine the level of confidence that the lender has in the borrower. Depending on the plan of recovery and the performance against that plan, the lender may issue a longer term forbearance agreement or may waive performance of a specific covenant. If performance is weak, assume that the lender will be looking at alternatives for recovery.
In our practice, we have worked with companies that have entered into loan agreements with covenants that, with any financial analysis, showed that they would be in violation of a covenant almost as soon as the loan was executed.
Loan covenants are negotiable and if a loan is a good deal for the borrower and the lender, a compromise can generally be arranged that satisfies both party’s needs.
Remember That Lenders Want To …
If you have violated a covenant and the violation is not egregious, remember that lenders, especially banks prefer keeping a business as a customer. Banks are often selling other services to a customer such as cash management, credit cards, retirement plans, etc. An ongoing business can be a good revenue source for a bank, even if the loan is having a few technical issues.
Note the term “technical” in the last paragraph. This means that any loan violations do not involve failing to make payments. Once payments are missed, the bank must declare the loan in default and that triggers the need for additional reserves on the part of the bank. Reserves are tied up capital that cannot be put to work earning money in the form of new loans. Once this occurs, you can be certain of swift response from your lender.
Breaking a covenant is never good news. But with a quick, well planned response, it need not be fatal to the business.