Keeping the faith Featured

8:00pm EDT June 25, 2009

Occasionally, business owners run afoul of their loan agreement and fall victim to costly covenant violations. According to Mary Patton, a commercial banker with FirstMerit Bank, you can avoid these pitfalls by understanding and complying with the terms and conditions of your agreement.

“Frankly, there are some clients that don’t even realize they have a loan agreement,” says Patton. “It’s important to understand what is in it and what the expectations are.”

The loan agreement typically lays out the bank’s expectations and the financial requirements of the borrower. It is used to preserve the company’s financial capacity and capabilities to repay to assure the continuing ongoing support and providing of loans and capital to a business.

Smart Business spoke with Patton about how to avoid covenant violations and what to do if you’re faced with one.

What are the most important things borrowers need to know about loan agreements and covenant violations?

The most important factor, especially today, is to remember that nobody likes surprises. Many typical loan covenant violations happen when a client asks for a waiver for something that could have been brought to the bank’s attention prior to the actual event occurring. For example, you may have a covenant that limits your capital expenditures to no more than $250,000 you purchased $500,000. So you violated the covenant because of that. But, if you talk to your banker and explain what’s going on, if you make them aware of the situation, they will typically provide you with the opportunity to help fund that capital equipment or provide you a prior written consent right upfront.

What should a company do if it believes a breach of the loan agreement has happened or is happening?

Bring it up and discuss it with the banker. Explain what occurred, why it happened and what you’ve done to correct it. The next step would be to request a waiver of that covenant violation from the bank. Typically, the bank will waive the covenant, provided that it sees you have actually done something to correct the problem.

And, the bank needs to see the reasoning behind it and how you plan to cure the violation. Sometimes they are not curable. But, you need to show what you’ve done differently. Maybe you’ve made some management changes so it won’t happen again. That significantly goes into the bank’s reaction to those violations. There is typically a cost associated with a waiver of a covenant, so the company can expect some type of a fee or a possible restructuring that could occur from the covenant violations.

What should a company do if it believes a future violation will be unavoidable?

Again, the more upfront you are and the more information you provide, the more flexibility you’re going to get in return. Banking is relationship-driven. If you know you’re not going to be able to meet a financial covenant because of the economic conditions we’re all facing, communicate, communicate and communicate. Let the banker and the bank know. Be upfront about it. Even if things are looking bad, don’t cut off communications.

The majority of the anxiety is created when you know that you’re going to violate the covenant and you don’t tell your banker. Then, you don’t know what’s going to happen when it comes time to try to get a waiver. That’s what creates the anxiety. Sometimes companies will shy away from the violation. Then, at the end of the year, the bank receives a covenant waiver request from its accountant. That’s something the bank would rather know about right when the trouble began.

What are the keys to successful communication with your bank?

There should be monthly and/or quarterly meetings, as well as face-to-face meetings at the shop, so the banker has the ability to see the operation and see what’s really going on at the business. Monthly financial reviews with the banker can help. Show them the good; show them the bad. Financial statements are a form of communication. Constant communication preserves the long-term relationship between a company and its bank. Open communication speaks of the management’s capabilities, capacity and character.

What types of things can be done to prevent a violation?

There are certain things that can be done within the operation. It could entail things the company has done to enhance sales, things that could be done to improve cost structure or to enhance your overall profitability. It could even be things like changing the way in which you extend credit to customers — perhaps you are going to do more due diligence.

Another example is bringing in a management firm to help identify issues and problems within the organization. Another way to cure a potential violation could be a capital injection. Typically, it revolves around something in the operation that you’ve identified as a cost. If the problem isn’t easily curable, you may get into a situation where you need to get additional collateral, a capital injection, or you may need some debt restructuring. The key is to communicate. Understand what you’ve agreed to and understand the bank’s expectations.