Publications & Resources
July/August 2008
Focus: Lending & Credit
Financial Covenants: What Good Are They Really?
By Patricia Y. Trendacosta
The following is a recent situation confronted by many of our lender clients: Sometime in 2006, a lender made an acquisition and development real estate loan to one of its very good customers. At the time the loan was made, the loan to value ratio, on an as-completed basis, was at 70%. The guarantor had maintained liquidity of $5 million, as required in the loan documents. The customer was a well-known, reputable developer in the area and the lender had made several loans on a number of this customer's projects. All loans had paid as agreed. This most recent A & D loan was different. Twelve months had passed. The value of the real property had decreased and the loan to value ratio increased to 100%. Recent activity in the stock market resulted in the guarantor's liquidity dropping to $2.5 million. There was no monetary default since the loan payments were interest only funded from loan proceeds.
If the financial covenants were intended to serve as a means for a lender to track and monitor its collateral and the financial viability of a guarantor, what good are they if there's no monetary default. Can a lender reasonably refuse to make any further advances, let alone call the loan?
The unfortunate answer is “maybe.” In this article we will discuss financial covenants, the types of covenants generally available to lenders, the importance of defining financial covenants, the need to monitor and enforce them and options available to lenders when a covenant fails.
What Financial Covenants Do
Financial covenants are often included in loan documents in order to allow a
lender to monitor performance of a company, guarantor or collateral. They
provide tools to a lender in determining whether the lender is at risk with
respect to repayment, whether directly from the borrower or through its
collateral. It enables a lender to monitor the operations of a company without
being involved in its day to day operations. If consistently used and monitored,
they could serve as an early warning signal for lenders.
Common financial covenants include the following:
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Debt Service Coverage Ratio is used frequently in real estate secured loans where the real property collateral is generating revenue.
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Liquidity typically measures the current assets of an individual in order to determine rapidity with which a person can pay off a loan.
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Tangible Net Worth covenants measure the gross assets of a company against its liabilities.
Defining Your Terms
While these covenants can be extremely beneficial, financial covenants are only
as good as the definitions. The definitions and formulas used for financial
covenants mean different things to different people. How a lender is measuring
compliance with a financial covenant may be different than that of the borrower.
The lender must understand how it is using these covenants (including the period
of time used to measure a covenant) and must make sure the borrower knows how
they are measured.
Too often, we have seen loan documents including financial covenants and ratios without definitions. From a legal standpoint, an issue surfaces as to whether the financial covenants are even enforceable if the loan document is not clear. A lender may confront a surprised borrower about a failed financial covenant. The borrower may argue that it was calculating the covenant one way and thus was in compliance.
Additionally, lender will sometimes include items in a covenant that do not help. For example, liquidity is used to measure readily available assets so that including long-term securities will inflate and not help in measuring true liquidity.
Monitoring
Monitoring is important not only for its intended purpose but also to ensure
that the covenant is enforceable. A lender that includes a financial covenant
but never measures it and then one day realizes that a borrower has been out of
covenant for several months or years gives the borrower an argument that it was
effectively waived by the lender.
Default
What are a lender's options when there is a default of a financial covenant?
A default in a single financial covenant with no monetary default is
problematic. Most courts would not look favorably in allowing a lender to sue
for judgment when there is a failure of a single non-monetary default.
However, when coupled a material adverse change (MAC clause) in the borrower’s financial condition, a lender might be able to do more. It is dependent on a whole host of circumstances and must be considered on a case by case basis. Ideally, the MAC clause would include language that expressly allows the lender to make the determination of a material adverse change in the exercise of its sole (or reasonable) judgment.
Defaults in financial covenants are also excellent opportunities to start workout discussions to determine whether there are ways for a lender to shore up the loan whether through additional collateral or guaranties or by correcting defects in the loan documentation.
When used correctly, financial covenants can be an important lending tool. However, clarity, diligence and prompt action by a lender must be employed to ensure that they remain one of the sharpest tools in the shed.
Patricia
Y. Trendacosta is an attorney with Frandzel Robins Bloom & Csato, L.C. in
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