Mastering the Art of the Covenant

by Kevin Trabaris
Kevin Trabaris
Edwards Maxson Mago & Macaulay LLP

Each borrower is unique, so the covenants in their loan documents should be as well. Kevin Trabaris of Edwards Maxson Mago & Macaulay LLP outlines the importance of crafting highly specific covenants and consistently monitoring and enforcing such agreements.

You know your borrower. You know their business and financial practices. You know the financial covenants you will require in their loan package. So, you hire a lawyer to draft the documents. When you receive the initial draft of the loan agreement, you quickly scan the financial covenants to make sure the correct numbers are plugged in. Once you do, you’ve done your job and can put it aside to work on something more interesting.

Not so fast.

There is no such thing as a generic financial covenant. Better put, there are generic covenants, but there are no generic borrowers. Each business is different and has unique business operations and financial methods. You may have the correct ratio in what appears to be the desired covenant, but is it written correctly for your borrower? Will the numbers add up with the financial test you expected?

Take a fixed charge covenant, a financial covenant often utilized in asset-based lending. It can be written along the lines of:

The borrower will not permit the ratio of income available for fixed charges to fixed charges plus lease rentals and interest expense to be less than X to 1.

This sample covenant was purposely drafted to illustrate the point that financial covenants need specificity. The first problem in this example is that nothing is tied to a period of time. In other words, when is this covenant calculated and over how many months or years? Is the ratio evaluated at any time, or calculated as of the last day of the borrower’s fiscal or a calendar quarter? Is it calculated as of the last day of the agreed period? When does the time period used to calculate the covenant start? Is it calculated at the end of, say, June but over a rolling period of time? For example, a covenant (depending on type) calculated as of the end of a month but to reflect the 12 prior months would also reflect the previous 12 months when it is calculated on the following month. If left undefined by the lender or in a credit memo, most attorneys (or, at least one I know) will initially draft the financial covenant using “at any time.”

Read My Mind

Here is a truism about financial covenants: They can be written in a variety of ways to achieve the same result. Below is another simple example of a fixed charge coverage ratio that some prefer:

The borrower will not, at any time, permit the ratio of EBIT to interest expense and lease rentals before taxes to be less than [ ___ ]x. “EBIT” means earning before interest expenses, taxes and lease rentals.

Frankly, I would not use this example or the previous one, as they both lack the clarity I prefer to see. For example, does this covenant language include consolidated earnings and only rentals of leased real property (as opposed to equipment leases) or exclude rentals from a property owned by an affiliate? Also, many lawyers draft the ratio in the form of a ratio (e.g., 1.32:1.00) as opposed to the less formal (1.32x) so there is no misunderstanding what “x” means to a judge or jury unfamiliar with its use. Ambiguity is a lawyer’s nemesis.

Stop Defining Yourself

It is not unusual to see covenants with no defined terms as the first fixed charge covenant example showed earlier in this article. However, it is more common to have the terms defined and even defined terms in the definitions. A large credit agreement for a loan of hundreds of millions or even billions of dollars may have several hundred pages of defined terms. It’s really a matter of economics and necessity. For example, with a 20-page loan agreement for a $1 million loan with borrowers with less experience with loan covenants or complex internal financial accounting, it may not make sense to spend the time (and lawyer fees) to define anything. After all, the borrower may not even bother to read the carefully crafted definitions and may not understand them even if they do. However, if this same borrower genuinely understands accounting, or if its operations or financial accounting veer away from generally accepted accounting principles or the common use of some financial or mathematical terms, it may be necessary to define the terms. For example, a borrower with a small, inconsequential subsidiary may necessitate the crafting of a non-consolidated covenant or use consolidated income but not consolidate fixed costs.

For a loan with a larger and more experienced borrower or for a large amount, you may decide it is a best practice to define every single term so there will be no misunderstandings going forward. This is what you commonly see in syndicated loan agreements, as one example. This is the better route for risky transactions, since, in such a case, it is crucial that everyone is on the same page.

Tidal Waive

Choosing a number to plug into a financial covenant is purely a business matter as are choosing which covenants to use and ensuring that your attorney drafts them as they are intended to be read. Lawyers likely do not know your borrower and cannot read your mind.

One concern with lenders to “story” credits is covenants must be as tight as possible. After all, one of the main benefits of financial covenants is to create an early warning system, allowing a lender to address issues before they mature into systemic disasters. However, if a lender asks for a covenant that is too restrictive, it may be to the lender’s detriment. For example, if the covenant is continually breached by the borrower, the lender must respond to the default each time. If a lender neglects sending a waiver letter (or otherwise to address the covenant such as with an amendment) more than once, it runs the risk of being deemed by a court to have waived enforcement of the covenant. Waiver is a legal concept where, in this context, a court may review the lender’s pattern of voluntarily failing to enforce the covenant and decide it has relinquished its right to enforce it at all in the future. This is a real problem and not an example of lawyers worrying over trivialities to gin up legal fees.

Spear or Missile

I’ve heard clients describing some covenants as big or little, or as important or unimportant. If you do this – STOP. Everything in a lender’s loan document needs to be taken seriously and treated as important in determining risk with a transaction, as it is impossible to know what every judge in every jurisdiction will consider enforceable.

In any event, financial covenants should always be considered a crucial part of a loan transaction. A lender should treat a violation of a financial covenant with the gravity and attention it would with a non-payment default. The minute a lender becomes aware of such a breach, it should send a reservation of rights letter and drag its borrower to the metaphysical table to determine how to handle the issue going forward. If the lender is willing to overlook the covenant default once, it should send a waiver letter. It should specify the violation and state it applies to no other default currently existing or arising in the future. If the lender agrees to amend the covenant, it must be documented in writing. If the grace period has elapsed and the lender determines the risk is not acceptable anymore, it should send a default letter that may include, if bankruptcy is not imminent, a forbearance period so that the borrower can find a take-out lender.

Summing It Up

Some asset-based lenders are more concerned with devising a borrowing base than crafting financial covenants. It is true that a borrowing base will act as a funnel, restricting the release (and requiring the return) of the lender’s funds based on solid asset collateral coverage. Financial covenants serve a different purpose. They can look broader or narrower at the operations of a borrower, and some serve as canaries in a mine, alerting the lender that there is danger ahead. In any event, financial covenants need to be carefully drafted and actively monitored and enforced.

ABOUT THE AUTHOR: Kevin Trabaris focuses on commercial finance transactions and is a partner of the law firm Edwards Maxson Mago & Macaulay LLP.