Once the loan is closed and the covenants have been established, the credit officer is responsible for regular monitoring of the loan covenant. Here, I will first assume the loan covenants have been well- written and clearly outline what is measured, how it is measured, and when it will be measured.
Typically, covenant monitoring occurs during the annual term loan review, after year-end financials have been received and reviewed by the lender. Some covenants may require a more frequent review or may also be done at a time other than at the term loan review. The term review analysis should cover the required loan covenants and a comparison of the actual performance of the company in relationship to those covenants. Further explanation should be given as to why the company performed or failed to perform in line with the covenant thresholds.
Covenant Violations occur when a borrower fails to meet the threshold stated in the loan covenant. The first rule is “do not panic, yet.” In the event of a covenant violation, the lender should have the right to take remedial action under the terms of the loan agreement. Circumstances and the materiality of the violation should dictate the lender’s course of action. The degree of materiality is measured by the extent to which a violation indicates deterioration in the borrower’s ability to repay the debt. I once had a hotel owner who failed to meet his debt service coverage threshold; yet, he was current and also paid ahead on his loan every month. His cash reserves were increasing. Clearly, nothing else indicated the repayment ability of the borrower was impaired. When I looked closer, I found the owner had bought new furniture and elected to expense these items instead of capitalizing and depreciating them. This decreased his net operating income to a point of breaking the covenant. This violation was not very material since it was one time in nature, the borrower had not missed a payment, and the borrower had increasing cash reserves.
The lending officer or credit administrator is responsible for investigating and evaluating information that supports a recommended course of action given the default. A memo or section of the term loan review should identify the specific covenant violation, effective date of the violation, rationale for the action taken, and the appropriate approval for the action that is taken. Next, notification should be given to both the borrower and also, the guarantors on the note. The lender has one of four possible actions to take.
A Written Response to Reserve provides the borrower with a written notification of a covenant violation and reserves the lender’s rights under the agreement. This can be used for more significant defaults or when minor violations repeatedly occur. The communication should include the covenant violated, the lender is aware of it, the lender does not intend to waive or take any action at this time, and the lender reserves its rights and remedies to act at a future time.
A Written Unconditional Waiver is on a one-time basis and provides a borrower with a waiver of a covenant, yet reaffirms the covenant waiver does not apply to future violations. This may be appropriate to use when a borrower is financially stable, but has a good reason for the one-time violation (as with my hotel owner above). The letter to the borrower should identify the violation, list the date of the infraction, and specify the time period for which the waiver is in effect.
A Written Amendment is used when the borrower’s circumstance has changed, and they are unable to comply with an original covenant going forward. This involves a modification to the original loan agreement and should not be to bring a loan into covenant compliance when a serious weakness in the credit is evident. In some cases, an alternative covenant may be established. Using my hotel owner as an example, a proper amendment may be to clearly define how net operating income will be calculated. We could state we will add back all one-time capital purchases that were expensed and then deduct a factor of x% of gross income, figuring that some money each year will have to be spent on improving the property.
Acceleration is a viable option when a material covenant violation is accompanied by payment defaults and/or a decline in collateral value. All notices of acceleration need to be prepared by appropriate Legal Counsel to assure the lender takes appropriate steps and includes the proper language in the document.