What is a covenant?
A covenant is an agreement between two parties specifying promises, conditions, rights, and responsibilities. Covenants are put in place by lenders to protect themselves from borrowers defaulting on payment.
It is generally used by banks at the time of sanctioning loans. The loan agreement states the limits/conditions with which the borrower must comply. Covenants include everything from financial ratios, such as a minimum interest coverage ratio, to minimum dividend payments and the levels that must be maintained in working capital.
For example, a bakery takes a bank loan to fund its operations and upgrade its baking equipment. In such a case, the bank will place a covenant in the loan agreement, which will mandate the bakery not to expand operations outside its current area of business. If the bakery decides to start manufacturing light bulbs, along with bakery items, this will be deemed a violation of the covenant.
Banks also have the option of issuing business and financial covenants that help them to check if borrowers are healthy and stable enough to pay back loans. If the covenant is violated, the lender has the right to make the loan due and payable; however, this exposes the borrower to the risk of bankruptcy – which will consequently make it incapable of paying back the loan. Banks can also waive off the default in case of a covenant breach or make other changes to the agreement, such as increasing the interest rate or disallowing any additional credit extension.
How/ Why it matters?
Lenders sign covenant agreements in case of bond issues and loans to force borrowers to operate in a financially wise manner and ensure that the repayment is seamless. However, issuers typically negotiate for the most flexible covenant they can, to safeguard their freedom to make decisions and take risks that will eventually benefit shareholders. In both cases, the end objective of covenants is to act as a safety measure that helps parties involved to achieve their goals.
Below are the types of covenants:
- Affirmative covenants require borrowers to maintain certain activities for the benefit of the business. It includes
- Payment of all business taxes
- Maintenance of financial records and other policies
- Negative Covenants are used to refrain borrowers from engaging in certain activities. It may include
- Restrictions on dividends paid
- Prevention of mergers/acquisitions without permission
- Restriction on investment in any capital requirement, real estate or other businesses without explicit permission
What are the types of bank loan covenants?
- Financial covenants are constraints based on specific items of the financial statements. They help borrowers remain within the specified bracket of ratios/other financial items. Through this tool, the lender can gauge the borrower’s activities/actions, and in case there is a covenant breach, the lender can modify the loan agreement, waive the default, or restructure the loan
For example, ABC Ltd. cannot use the term loan proceeds to increase the salary of its CEO, without the bank’s approval.
- Operating activity covenants manage how the business should be operated. Most operating activity covenants need that a business must continue to run its business, pay taxes, and follow rules and regulations
E.g. ABC ltd cannot use the term loan proceeds to increase the salary of their CEO, without bank approval
- Reporting and disclosure covenants maintain a standard of minimum communication with the lender. For example, XYZ Ltd. is required to provide periodic financial statements, keep appropriate records, and prove submission with the debt agreement when demanded
- Preservation of collateral/seniority covenants require a business to maintain the security provided for a loan and ensure the bank’s first interest/preference remains intact
For example, the company is required to maintain property and equipment (kept as security) as per the bank’s standard.
- Investment expenditure covenants tells how an entity can invest its profits. These can prevent the company from making certain capital expenditures, acquisitions and other cash investments that could be beneficial for the company’s growth
- Asset sale covenants may refrain the company from selling its assets and restrict its transfers.
- Cash payout covenants control the wealth of the firm and ensure that it is not distributing it to its stakeholders. Common covenants of this type restrict prepayment of debt – even prepayment of the bank loan itself and dividends.
- Financing covenants impose limits on the firm’s debt and introduce changes in the company’s capital structure.
- Management, control and ownership covenants control the company’s ownership structure, to keep it away from mergers, consolidation, ownership transfer, or management/board change, unless it has the bank’s approval.
What is the impact of covenant breach?
- Lowers the borrower’s stock price and credit rating: If the issuer is paying its interest and principal on time, but it is not adhering to the set guidelines, in the eyes of the lender, such a situation will increase the risk of default, which will ultimately lead to a fall in credit rating and stock price.
- Debt covenants are agreed upon as a borrowing condition that can be changed if the debt is restructured. Debt covenants can impose obligations such as forcing a company to sell its assets in order to stay within a debt covenant and adding equity funding into the borrowing company to repair the breach
- Failure to be in agreement with financial debt covenants, by any amount, may result in breach of an agreement, which can have serious consequences
- For example, a loan-to-value covenant of 65%, with a mortgage of $65 million, would need a market value of $100 million for the loan to be in compliance. If the value reduces to $80 million, the covenant may need the borrower to make due repayments to bring the loan into compliance. The borrower could be required to make a payment of $6.5 million so that it does not fail to meet loan requirements. If a borrower lacks the capital to conform, the bank could start foreclosure proceedings, or if a personal guarantee is in place, focus shifts to the guarantor to meet the debt requirements.
- In case of bankruptcy (where the borrower will not be able to pay back the loan due), instead of a covenant breach, the lender can call for a covenant waiver, wherein the lender can make changes to the agreement (such as asking for higher interest rates or working capital may require the borrower to repay enough principal to bring the loan into compliance). The borrower could be required to make a $7.5 million payment to the bank to avoid default. If a borrower lacks the capital to comply, the bank could initiate foreclosure proceedings, or if a personal guarantee is in place, the focus shifts to the guarantor to meet the debt requirements.
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