Loan Covenants: A Better Way to Manage the Credit

Over the next few weeks, I will address the issue of loan covenants.  Covenants are promises by a party to take or not to take certain actions.  These are utilized as a means of gauging a borrower’s financial health.  Covenants do not restrict the normal operation of a business, but set limits on how much risk is acceptable before the lender has the right to be concerned about the borrower’s future and ability to repay the debt. 

I do realize that many smaller business loans do not require the covenant and covenant monitoring as the larger ones do.  But I also have seen loans that could have used better covenants and monitoring in order to keep the borrower on the right track and protect the lender.  The covenant will either require or prohibit certain actions on the part of the borrower, depending on the wording.  Affirmative covenants require actions by the borrower during the term of the loan.  Negative covenants ban certain actions that would negatively impact the borrower’s financial condition, their ability to repay, or the collateral. 

The lender should always analyze the financial risks and design covenants to protect the lender against such risks. The following are some items to keep in mind when creating a covenant:

·         *Covenants should be precisely defined, measurable, and directed at specific credit quality goals.

·         *Covenants should be reasonable and enforceable.  Do not place nonessential covenants in the loan agreement.

·         *Avoid covenants that are too restrictive or give the lender control over the borrower.  Those may present lender liability issues. 

·         *Design covenants that will alert you when the credit grows riskier than a level the lender is comfortable with.

·         *Design covenants that will alert you when the credit changes significantly from what initially existed when the loan was underwritten.

·         *Be careful in establishing covenants on existing business entities where the business does not historically meet the covenant thresholds.  These must be reviewed and explained thoroughly in detail in the credit write-up.

Covenants can be divided up into three different categories:  financial covenants, non-financial covenants and reporting covenants.  A financial covenant restricts the amount of financial risk a borrower can incur during the loan.  These are based on information contained in the borrower’s historic financial statements, projections, and the borrower’s oral and written presentation.  Non-financial covenants are not usually expressed in ratios or dollars, but still place restrictions on the borrower’s activity to protect the lender.  Reporting covenants identify what type and amount of information must be supplied by the borrower and/or guarantors and when it is required.  In future posts, I will cover the financial and non-financial covenants.  This post will focus on the reporting requirements.

Reporting requirements will focus on what information is required by the borrower/guarantor and when it is required to be presented to the lender.  Quite often, these will include tax returns, personal and corporate financial statements, rent rolls, aging reports for receivables, payables, or inventory, or a listing of capital expenditures.  When creating a reporting covenant, consideration must be given to frequency, quantity, and quality of documents.  Frequency should be such that it provides the lender current information regarding the financial condition of the firm, yet gives the firm enough time to prepare accurate financials. A commercial real estate borrower will probably not be able to present your year-end financials by January 2nd, but they should be able to have it completed prior to the end of March.  If the lender sets reporting covenants so far into the year, the information may be “stale” considering the present condition of the company.  Also, on frequency, it may be good to bunch some of the reporting covenants together. An example of this would be requiring a signed personal financial statement and personal signed tax return by May 15th of the year.

The quality of the documents should match the required quality of documents in your loan policy and write-up.  An example is if your loan policy requires audited financials for all relationships over $3MM, you should identify this as a policy exception, if you are only requiring a compilation for a loan you have over $3MM.  The quality of the financials should provide the lender with accurate information they can trust to give them the current picture of the company.

With quality of information, you should require as much as you need to see the current condition.  An example of this is on a guarantor - requiring only a personal tax return may not provide you with adequate information on the guarantor cash flow as would requiring a signed personal complete federal income tax return with all schedule K1s and W2s.  The latter will provide the credit analyst with sufficient information to determine personal cash flow.

The final thought I will make on reporting covenants is, what sort of penalty is there for the borrower who refuses to turn in the required information in a timely manner?  All seasoned lenders have stories of these “Late Larrys” or “No-Report Noels”; it means you have a credit that you really may not know what is happening.  One remedy we use is to make any missed reporting covenant as a covenant violation.  One of the remedies we reserve for a covenant violation is to increase the interest rate on the loan up to the legal limit.  The possibility of jacking up the interest rate several points seems to motivate the slow borrower into turning in information in a timely manner.