Bank Covenants - Don’t Set It and Forget It

Lawyers don’t like to admit this, but the details of most contracts are quickly forgotten once signed. As long as each side is happy with the status quo, there’s no need to dig into things like indemnity and limitation of liability.

But if your business has an outstanding loan or line of credit, an attitude of set it and forget it is a huge mistake. In the middle of loan agreements are typically two sections called Affirmative Covenants and Negative Covenants. These sections lay out at length what you commit to do for the lender (affirmative covenants) or promise not to do (negative covenants).

Many covenants are simple – for example, there is often an affirmative covenant to notify a lender of a change in business name or address. Covenants can, however, be onerous and restrict how your business operates. It’s not unusual to have covenants that prevent taking on more debt, require approval to form subsidiaries, prohibit entering new lines of business, or mandate a minimum amount of cash you must retain on hand.

The reason you have to be careful with covenants is breaking them can have devasting consequences. Loan agreements often give you very little time, if any, to fix a broken covenant. And once a covenant is violated, the bank often has the right to demand full repayment of the loan or impose some other harsh penalty. So while not likely, you could in theory lose your business for one technical violation of loan covenant.

So what do you do?  Three tips:

1.       Read and understand your covenants before you sign them – don’t rely solely on outside counsel to do this for you. If you see a covenant you will struggle to meet, discuss that with the lender on the front end. While loan agreements sometimes have minimal room for negotiation, it’s best to flag any obvious issues before you sign.

2.       Have your counsel write you a summary of key covenants immediately after the deal closes. Covenant language is often overly complicated and lengthy, and having a plain English summary will prove useful in the long term. Refer back to this document often, such as when doing a major transaction.

3.       If you are at risk of violating a covenant, start a conversation with your lender early. Lenders are more likely to respond favorably to an open dialogue. They have little incentive to declare a default if there is a path to paying off the loan, so a cooperative relationship is in your best interests. 

Most importantly, don’t set it and forget it.

*This blog is intended to provide a general summary of best practices and does not constitute legal advice. You should consult with counsel to determine the exact legal requirements in a given situation.