How to understand commercial loan agreements and avoid covenant violations

Jonathan Sigal, First Vice President of Loan Review, Senior Portfolio Officer, Wilshire State Bank

It’s not unusual for borrowers to sign a loan agreement without understanding all of its provisions. Now, those hasty decisions are coming back to roost as business owners struggle to turn a profit in a tepid economy and comply with a host of pre-existing debt covenants. To make matters worse, business owners often commit another faux pas by failing to notify their banker before a violation occurs and end up facing rising interest rates, increased collateral requirements or limited cash advances.

“In better times, bankers were often willing to overlook minor covenant violations,” says Jonathan Sigal, first vice president of loan review and senior portfolio officer for Wilshire State Bank. “Now, bankers are worried about a borrower’s financial ability to make their loan payments, so a covenant violation is serious stuff.”

Smart Business spoke with Sigal about common loan covenants and how executives can take steps to avoid a violation.

What do debt covenants typically cover or require?

Bankers use covenants to set parameters that business owners need to take into consideration when making decisions that could jeopardize their ability to fulfill their loan obligations and to ensure that the loan’s provisions are consistent with the borrower’s risk profile. They tailor the covenants to mitigate each loan’s specific risks by imposing a series of financial and reporting requirements. For example, the covenants may mandate a certain cash flow or asset-to-loan ratio, so a company doesn’t become overleveraged and borrowers can liquidate assets to make their loan payments in a pinch. Bankers may require landlords to submit a quarterly rent roll or notify their loan officer if certain situations occur. Business owners need to understand the covenants and how to comply, because violations are no longer considered a minor inconvenience, and regulators insist that bankers strictly adhere to the loan’s provisions.

What’s the best way to avoid a covenant violation?

Business owners should read the loan document and understand the covenants before signing on the dotted line, because education and awareness are paramount to avoiding a violation. Next, assess the feasibility and long-term impact of the covenants by authoring a business plan and financial forecast. It’s better to know up front if you need to boost margins or postpone additional investments in order to meet the covenants over the life of the loan. Finally, create a spreadsheet and proactively compare your monthly results against the covenant requirements so you can change course or make adjustments before a violation occurs. Since reporting usually takes place on a quarterly or semiannual basis, continuously monitoring the company’s position gives executives the opportunity to head off violations at the pass.

What should executives do if a violation is imminent or unavoidable?

Don’t wait until a violation occurs to schedule a meeting or pick up the phone. Alert your banker right away and be ready to outline what you’re doing to change the situation. Bankers have to protect their interests, so once a violation occurs, they become enforcers and often have to initiate disciplinary action. But if you lay out the problem in a letter or e-mail, and offer a viable resolution and a timeline, your banker may become your supporter and even propose ideas or possible solutions. Remember, your banker must have confidence in your managerial abilities and know that you’re on top of the situation. Finally, always document your discussions in writing and create a paper trail, since there’s no such thing as a verbal agreement in the banking world.

Is it possible to get a waiver or reduction in covenant requirements?

If a covenant is redundant or the reporting requirements prove to be too burdensome, it’s possible to have it eliminated or modified as long as both parties agree. It’s also possible to get a waiver if you can show that an adverse situation is temporary. For example, perhaps a large customer has impacted your cash flow, but they’ve recently agreed to pay invoices every two weeks, or your company has incurred nonrecurring expenses or one-time losses that are reflected in your financials. If your request to modify a covenant increases the bank’s risk, be prepared to offer something in return like transferring accounts from another financial institution or providing additional collateral, such as a deed to a second property. Bear in mind that the bank may charge a fee for modifying covenants, but in general, bankers will acquiesce without changing any terms if a covenant waiver makes sense and doesn’t impose a lot of additional work or extra risk.

Do you have any other advice for executives?

Chief financial officers and accountants are usually familiar with debt covenants, but business owners also need to understand the commitments and responsibilities, because a violation can lead to severe restrictions or even foreclosure. Ask questions during the loan documentation and drafting phase, so you can create a realistic forecast using a variety of assumptions and contemplate the business impact of fulfilling the requirements. How does the covenant define cash flow when calculating ratios and is it possible to exclude certain expenses from the calculations? Remember, a bank can re-price your debt if your company undergoes significant changes to its financial position or operating results, and how you handle a violation may factor into their decision.

Jonathan Sigal is first vice president of loan review and senior portfolio officer for Wilshire State Bank. Reach him at (213) 427-7921 or [email protected]