What to do when a Loan Covenant is Broken

Spring is here, the time when a many commercial and agriculture loans have current financials turned in from borrowers.  Oh, what wonders await the lender who has to gather all this information, carefully inspect all the data, and make judgements on the current risk inherent in the credit! 

At the same time annual information is required, often loan covenants need to be tested.  This is assuming that you have put financial performance covenants in your loan agreement, which is the subject of another blog.  So the question is what do you do when your customer has broken a loan covenant?

Loan agreements usually spell out a variety of remedies that are at the lender’s disposal when a covenant is broken.  Some of these options may be to assess a default interest rate, charge additional fees for breaking the covenant, or even accelerating the remaining principal balance of the note.  Sometimes, any of these remedies are available, but the lender will choose to use none of them.  What actions should the lender take regarding loan covenant violations?

One course of action that is often done by lenders is to just ignore the covenant with no notification to the customer.  This can create a problem since courts have determined that a lender ignoring loan covenants may cause him to forfeit possible remedies that he has since he is establishing a precedent on how violations are handled.  In other words, if you decide to ignore your customer failing to meet his debt service covenant several years in a row, you may give up your ability to enforce it when you need to.

So, what is the proper actions when covenants are broken but the lender decides to not enforce a remedy?  A covenant violation letter should be drafted and sent to the borrower.  The letter should state what the loan covenant standard is, when the covenant was tested, how the covenant was calculated, and the result of the calculation.  The letter should outline any remedies that are being taken. 

If no remedy actions are being taken, the letter should also outline what possible actions the loan agreement places at the lender’s disposal and that the lender not electing to utilize a particular remedy today, does not set any precedent wherein the lender cannot select that remedy that is outlined in the loan agreement in the future. 

Another benefit of utilizing covenant violation letters is that it proves to the customer that you are indeed paying attention to his performance.  It opens up discussions to help deal with possible greater problems before they become terminal to the borrower.  A covenant violation letter can provide good grounds to allow the customer to see what problems you see in the company.

It also is a good tool to show your examiner or auditor that you indeed are looking at the credit and properly monitoring it.  What better way to show that you are properly monitoring the credit, than to have both your calculations and also correspondence with the borrower in the file when it is inspected? 

Covenant violation letters are an essential tool in properly managing a credit when the financial performance has failed to meet expectations, but is not troublesome enough yet to require utilizing more severe remedies.