Covenant breaches are on the rise — this article outlines five key steps lenders should take to respond quickly, protect their rights, and manage risk in an evolving credit environment.
In recent months, credit providers of all types, including private credit and traditional bank lenders, have increasingly faced borrower defaults based on loan covenant breaches, whether due to financial distress, operational challenges or changing market conditions. Prompt and strategic action is essential to protect lenders’ interests, in the event of such breaches, to preserve available remedies.
The following are five practical actions lenders should consider following a covenant breach:
1. Assess the Default and Review Loan Documentation
Upon learning of a potential covenant breach, lenders should promptly review the relevant loan documents to confirm the impact of such a breach and, in particular, if such a breach constitutes a default or event of default. This includes identifying the specific covenant breached, the applicable notice and cure periods, and any rights or remedies available under the governing agreements. Particular attention should be paid to a cure period — if one is provided — since such a period may allow the borrower to remedy the default before the lender can exercise certain remedies. Lenders should carefully track the start and end date of any cure period, as taking action (or failing to act) during this time may have significant implications for the lender’s rights. A thorough assessment ensures that the lender’s response is grounded in the contractual framework and that all procedural requirements are met.
2. Communicate with the Borrower
Open and timely communication with the borrower is key. Immediately upon learning of a default, lenders should notify the borrower in writing of any covenant breach and related default or event of default, referencing the specific covenant and relevant provisions of the governing agreements. Communications should outline any applicable cure periods and request the borrower’s plan for addressing the breach or default. Lenders should be mindful that granting extensions, accepting late performance, or failing to enforce rights may inadvertently result in a waiver of the breach or default or other rights under the governing agreements. Likewise, failing to timely notice any default, including a covenant default, may give rise to a waiver defense by borrower. Additionally, lenders should be aware of the potential threat of lender liability, which can arise if communications with the borrower are overly intrusive, coercive, or if the lender is perceived as exercising excessive control over the borrower’s operations. Careful, measured communication helps manage expectations, reduces the risk of lender liability, and may facilitate a resolution without the need for formal enforcement of remedies.
3. Document the Breach or Default and Ensuing Communications
It is critical to create a clear and contemporaneous written record of any covenant breach, along with any related defaults or events of default. Lenders should document the facts surrounding the event, including the date of discovery, communications with the borrower, and any internal discussions or decisions. This documentation may be essential in the event of future disputes or enforcement actions. Lenders should also carefully document the breach(es) in writing via notice to the borrower pursuant to the notice provisions in the parties’ loan documents. Prompt notice to borrower is key to preserving lender’s rights and remedies.
4. Assess Potential Amendments/Waivers
When a borrower breaches a financial covenant, lenders typically seek to address the increased credit risk through targeted amendments to the credit facility. The following are practical recommendations for the types of amendments that lenders may want to consider in response to covenant breaches and related defaults:
- Waiver of the Financial Covenant Default (with Conditions)
Assuming the covenant is not essential to the continued operations of the business, lenders are often willing grant a waiver of the specific covenant breach, but such willingness is typically made subject to certain conditions, such as the payment of a waiver or amendment fee by the borrower or other form of considerations. This approach allows the lender to formally acknowledge the default while maintaining leverage and extracting compensation for the increased risk.
- Suspension or Resetting of Covenant Tests
A common amendment is the temporary suspension of one or more upcoming financial covenant tests, often for a quarter or longer. Alternatively, lenders may agree to “reset” or soften the ratios for future test dates, making them more achievable in the near term and ramping up to stricter requirements over time. This provides the borrower with breathing room to improve performance while still maintaining lender oversight.
- Replacement of Ratio Covenants with Alternative Performance Milestones
Instead of traditional ratio-based covenants (such as DSCR or FCCR), lenders may propose replacing them with simplified performance thresholds, such as minimum EBITDA, revenue, or liquidity requirements tested on a monthly or quarterly basis. These alternative covenants are often easier to monitor and may be more closely aligned with the borrower’s current financial situation.
- Modification of the Covenant Testing Period
Lenders may be open to adjusting the lookback period for covenant calculations. For example, lenders may consider shortening the trailing twelve-month (TTM) period to focus on more recent, improved performance, or allowing the borrower to use average results from better-performing quarters to offset weaker periods. This can help the borrower avoid technical defaults if recent trends are positive. But it should be noted that this approach is not common in the market.
- Expansion of Add-Backs in “Adjusted EBITDA” Calculations
Since many covenants are based on “Adjusted EBITDA,” lenders may agree to expand the list of permitted add-backs to EBITDA, including additional restructuring costs, legal, and audit fees, or severance expenses (sometimes subject to a cap). This can help a borrower improve its covenant compliance without fundamentally altering underlying business performance.
- Tightening of the Borrowing Base
Independent of financial covenants, private credit lenders, and others in the ABL market, may be open to waiving a covenant breach in exchange for an amendment to the borrower’s borrowing base formula to limit the borrower’s ability to borrow against certain categories of collateral, such as aged accounts receivable or foreign/in-transit inventory. This reduces the lender’s risk exposure while still providing the borrower with access to liquidity.
- Imposition of Additional Reporting or Monitoring Requirements
Lenders may require more frequent financial reporting, enhanced cash flow forecasts, or additional certifications from management as a condition to any amendment or waiver. The increased transparency that this additional reporting helps the lender monitor the borrower’s ongoing performance and risk profile.
- Other Targeted Amendments and Agreements
Lenders may also propose other targeted amendments or agreements to mitigate increased credit risk. These can include:
- Requiring a “keepwell” agreement, which is a contractual commitment by a borrower’s parent or sponsor to provide financial support to the borrower to ensure that it can meet its obligations to the lender;
- Requiring the injection of additional capital into the business, so as to recapitalize the borrower and demonstrate commitment by the borrower’s owners going forward, by exercising applicable equity cures, mandating sponsor equity contributions or requiring other forms of new money, such as convertible notes or junior debt; or
- Entering into a forbearance agreement that includes a temporary waiver of existing defaults, which provides temporary relief while the borrower works to rectify its financial position or negotiate a more permanent restructuring.
Any forbearance or modification agreement with the borrower should include a full release by the obligors of all claims against the lender, along with an acknowledgement of the defaults and indebtedness owed.
5. Evaluate and Consider Available Remedies
Lenders should carefully consider the range of remedies available under the loan documents, which may include acceleration of the loan, imposition of default interest, or enforcement of collateral rights. The decision to exercise remedies should be informed by the lender’s overall relationship with the borrower, the likelihood of cure, and the potential effect on recovery.
Covenant defaults can unfold fast and carry consequences that ripple through a deal. Navigating them effectively requires a clear grasp of both legal and commercial dynamics. Early actions like consulting counsel, providing timely notice to borrower of defaults, reassessing deal strategy and progressing through each of the above considerations can position lenders to respond decisively and protect their interests.
Shams Billah navigates complex loan agreements for lenders and borrowers, orchestrating deals ranging from $1 million to $10+ billion and is a go-to advisor for credit funds, global asset managers, and private equity firms. As the Co-Chair of Barnes & Thornburg’s Debt Finance Group and leader of the Private Credit team, Shams leverages his broad market knowledge to structure senior, mezzanine, and subordinated loans, as well as complex inter-creditor arrangements. He also supports clients faced with debt restructurings and bankruptcies, negotiating workouts and debtor-in-possession and exit facilities with precision.
Aaron Gavant helps his clients navigate virtually all types of distress, restructuring, and bankruptcy scenarios across a range of industries. In the restructuring arena, Aaron champions the interests of a diverse set of stakeholders from financial institutions and indenture trustees to non-traditional credit providers, committees and buyers and sellers in distressed M&A transactions.
Gregory Plotko advises creditors, distressed investors and corporate debtors on virtually all types of insolvency, restructuring and bankruptcy litigation matters. He counsels clients on rights and remedies of various debt holders, handicapping legal outcomes, returns on investment (recovery ranges and timing) as well as analyzing capital structures, credit covenants and indenture provisions. Greg also has deep experience in special situations lending, alternative financing, litigation funding and claims trading.
Lisa Wolgast focuses her practice on creditors’ rights and bankruptcy issues, representing creditors in and out of bankruptcy in state and federal court. Lisa also represents borrowers in workouts and restructuring matters. Her practice also includes complex commercial litigation and arbitration.
