All commercial loans have some form of non-financial covenants contained in the loan agreement and the note. These are often found in all the small print and were devised by legal minds that either draw up your loan papers personally or through your document preparation system.
The most popular are commitments a borrower makes to continue to pay any property taxes and satisfy any mechanic liens associated with the collateral property. The client agrees to continue to pay all taxes and liens as they come due, since these would constitute a superior claim on the property than the mortgage. Another common covenant is for the borrower to keep the property insured with coverage that names the lender as a lienholder or mortgage interest in the property. All lenders consider these covenants important to protecting their interest in the collateral.
The sky’s the limit on the number and type of non-financial covenants that are available for the lender to use. A good place to begin to get introduced to a sampling of these covenants can be found in a reading of a loan document set. What follows are some examples of various non-financial covenants and what they do.
Corporate Existence and Qualifications requires the borrower’s legal corporate existence and qualifications be maintained throughout the term of the loan.
Change in Ownership covenant requires the borrower request permission from the lender when the entity is considering some form of change of ownership. A change in ownership, resulting in a key guarantor giving up his ownership in the operation, may make said guarantor less likely to provide secondary support for the debt in case of a payment default.
Limiting or Prohibiting Mergers, Acquisitions, and Consolidations assures the lender that material changes in the firm and the structure of the business cannot occur without the lender’s consent.
Restrictions on Substantial Changes in the Borrower’s Business require the borrower to continue to engage in the same business or with the same franchise as he is a part of on the date of the loan. This is often used in franchised hotels or restaurants, where it is required no cancellation or change of the franchise is allowable without the lender’s approval first.
Limitations on Sale of Assets covenant prevent the borrower from jeopardizing the earning power of the business by transferring or selling off a substantial part of their earning assets. This covenant can also allow for sale of assets, but require proceeds are used to pay down indebtedness to the lender. It would be good to shore up this covenant with perfecting collateral interests in the assets you want the borrower to maintain.
Limitations on Up Streaming Funds places limits on the payments of dividends, owner’s draws, shareholder advances, and loans to affiliates. This is used to preserve capital in the company.
Capital Expense Limitations states the borrower will not spend beyond a certain amount on capital expenses until the lender approves, or the loan has been paid down to a certain level. This covenant may be appropriate in a highly leveraged situation, where the officer feels it is appropriate for the company to pay down debt prior to spending money on items that will expand their business base or scope.
A Reimbursement Covenant can be used to require the borrower to repay the lender for any funds the lender may have spent in paying taxes, insurance, attorney, or any inspection fees necessary to protect the lender’s collateral position. Usually the required reimbursement period is outlined in this covenant.
These are a few examples of non-financial covenants. Many more are possible. The additional ones that are appropriate to use should be determined prudently by the lender, and structured in a way that helps mitigate the risk in the credit.