What are Covenants and Compliance Best Practices

What are covenants?

In the context of credit capital, financial covenants are rules that a borrower must abide by during their lending arrangement. Usually structured as ‘affirmative covenants’ and ‘negative covenants’, they list actions a borrower must take and not take, respectively.

Types of covenants

Affirmative covenants are actions a borrower must take, such as maintaining reporting requirements, correct use of proceeds and maintenance of applicable legal and regulatory status. Part of a lender’s underwriting will focus on if they believe the company has adequate procedures in place to be able to maintain practices they should already be doing. This is why in Debt vs. Equity we focused on the need for a Company to focus on credit capital requirements as early as possible in their life. 

Negative covenants are actions a borrower must not take, such as incurring further indebtedness, selling assets in a manner outside of the regular course of business or restrictions on exclusivity. Often borrowers find that negative covenants are slightly harder to maintain as there is more discretion that could be applied to determining if a covenant is breached or not. It is important to ensure that these covenants are documented as clearly as possible at the onset, and if you as a borrower are ever concerned about potential violation to address with your legal counsel and then the lender(s) as appropriate. An open line of communication with a lender who is a true partner can solve many issues before they become issues.

Why and How are Covenants Used?

As creditors want to extend loans to earn income on interest generated while ensuring the full repayment of principle, they will always want to influence the borrowers’ decisions to maintain the company's financial health. Loan covenants are great tools to achieve this objective.

Loan covenants have two main objectives by either mandating or limiting particular actions or situations. These objectives help to assist in balancing the incentives of the lender and borrower and reduce transactional (or borrower-specific) risks respectively, increasing the probability of full repayment.

What is a Guarantee?

A guarantee is an agreement by which a different entity (usually a parent entity) commits to making economic payments in the event where a borrower defaults. Guarantees can be structured in many different ways. A few examples are: 

• ‘Full guarantees’ - the entity providing a guarantee agrees to make any and all principal, interest or other fee related costs. 
• ‘Partial guarantees’ - the entity providing a guarantee agrees only to make specific payments. 
• ‘Big boy guarantees’ or ‘bad acts guarantee’ - the entity providing a guarantee agrees to make payments if any predetermined bad acts are committed (ie. fraud, misrepresentation, etc.).

Guarantees are often used by entities that are subsidiaries of a much larger and better capitalized entity. By embedding a guarantee in a lending agreement, a borrower can potentially achieve more friendly terms if the guarantee provides lenders with real comfort. However, guarantees are not free. The entity providing the guarantee will generally need to account for the guarantee appropriately and often reserve capital against the guarantee. 

Covenant Breaches

A topic that is often overlooked and therefore under-negotiated is the link between covenant breaches, cure periods and events of default (EODs). Typically, credit agreements will deal with different covenant breaches in different ways. Simply put, different breaches require different levels of punishment (similar to any punishment system). There will be some breaches that typically result in immediate EODs, such as failure to pay principal or interest, insolvency or misrepresentation. An immediate EOD should be reserved for only the worst situations that fundamentally change the lender’s risk profile immediately. Outside of these EODs, everything else is generally negotiable, especially the cure period surrounding an EOD. A cure period is the amount of time a borrower has to get themselves back on sides after realizing they are off sides. These periods can range from days to months depending on the type of breach. Large institutional lenders will typically have less room to negotiate because they try to keep terms similar across all of their lending facilities, but it is still a topic that is generally worth broaching during negotiations. Pay attention to these terms and know that they could prove to be meaningful if difficult situations ever arise. 

Covenant Best Practices

The number one best practice is to be acutely aware of the covenants you are signing up to, be on the exact same page with your lender(s) and to have a plan in place to ensure your business can track and report against covenants. Lenders will have much more flexibility with a borrower they view as a real partner than one who they view as disheveled and potentially adversarial.  

Companies rarely intend to violate covenants. They are typically violated because the company does not have systems in place to track or anticipate covenant violations. Excessive covenants will place more pressure on the middle office as each breached covenant must be documented and overseen appropriately. If they are tripped then funding can quickly dry up with an existing lender, and it can have knock-on effects making it harder to find future funding providers. Therefore, at an early stage of the business cycle, try to minimize covenants where possible to avoid this pitfall. 

It is always better to get in front of any potential covenant violations, know there is a possibility of hitting a covenant and have a direct conversation with your lender(s). For example, if the lenders are concerned that the company is maintaining a relatively high leverage, they could discuss with the founders about the use of stepping covenant which can help de-risk the company overtime, to an acceptable range, and realign incentives of both parties without imposing pressure on the management level. 

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