Well-managed commercial loans will use reporting and financial covenants to establish standards on how the borrower needs to perform. So what should be done if a covenant is violated? Too many lenders either ignore the violation or write about it in an annual internal review and not communicate with the customer. Is this the proper way to handle when a covenant is broken?
In order to answer this, we must first look at your loan closing paperwork. In the commercial or agricultural loan agreement, covenants should be clearly defined. Each covenant should identify what is to be reported to the lender, when it is reported, how covenant ratios are calculated, and also remedies the lender has when a covenant is broken. If you state the covenant but do not have a list of what can happen if it is broken, then there is no way to enforce the covenant in the lending contract.
The loan agreement should identify a covenant violation as a condition of default on the loan. The remedies provided to the lender will include everything from doing nothing to foreclosing on the collateral and calling the entire loan due. A variety of options should be available to the lender, allowing various actions to get the loan back on the right track. An example here is to use the right to place a default rate on the loan when financial statements are not provided in a timely manner.
When a covenant is violated, it is important to notify the borrower of what the covenant is and what the violation is even if no action will be taken by the borrower. This is best done with a covenant default letter, which shows not only the violation and the covenant standard, but also what actions will be taken right away from the lender. If actions are not taken or certain acts are not taken, then language needs to be in the letter that acknowledges the lender’s continued right to treat future covenant defaults differently than the current one.
A failure to notify the customer of a covenant default raises the risk that a court will nullify the lender’s right to enforce a covenant in the future, if the lender desires to do so. This could severely restrict the remedy options available to the lender after a default, causing the credit union or bank to live with a substandard loan than using their using covenants to make it better. The court’s logic has been if the lender allows the substandard loan to continue year after year and now wants to enforce a covenant that has been violated but never shown to the borrower, it cannot be done, since the lender has set a precedent by its actions. The actions will supersede what is in the written loan agreements.
The lesson here is not to ignore covenants altogether, as good covenants provide a valuable communication tool between the borrower and the lender. The lesson here is to follow through on covenants and notify the borrower when they are violated, what actions you are taking, and how you reserve and all future actions at the lender’s disposal to those which are included in the note and loan agreement. The covenant violation letter becomes an important tool in proper management of the credit.