Loan covenants, also known as financial covenants or debt covenants, are an important part of loan agreements. An outsourced general counsel can help you customize covenants based on your institution’s level of risk and other factors. There are several types of loan covenants you may include in loan agreements with your borrowers. There are also several ways you can enforce compliance with these covenants.
Loan Covenant Services from an Outsourced General Counsel
Creating and enforcing loan covenants can be a complex process. An outsourced general counsel can help with a wide range of situations for loan covenants, such as:
- Loan covenant drafting
- Documenting covenant compliance
- Advising on covenant non-compliance
Because every borrower and every loan situation is different, it may help your institution to have your banking law attorney customize covenants to each transaction. For example, some factors that may inform which covenants you include in the loan agreement include loan size or the borrower’s industry.
There are several types of loan covenants, most falling into four categories: cash flow, leverage, liquidity, and net worth. Each has pros and cons, which is why it may be beneficial to work with your outsourced general counsel for guidance.
Cash flow loan covenants are generally measured by EBITDA (earnings before interest, tax, depreciation, and amortization. However, cash flow covenants may not give your institution the whole picture of the borrower’s repayment ability.
Leverage covenants generally require the borrower to maintain a certain ratio of debt to cash flow. This may help prevent the borrower from taking out more debt that increases the risk of them defaulting on your institution’s loan.
Liquidity is another common type of covenant, which includes a measure of cash on hand, marketable securities, inventory, receivables, etc. This loan covenant can also help reduce the risk of loan default.
Net worth is a common covenant for community banks and is a measure of the borrower’s assets less their liability. However, it’s important to note that net worth is generally based on GAAP (generally accepted accounting principles), which may not be the same as market value.
Depending on the loan, your institution may benefit from including some or all of these types of loan covenants for borrowers to comply with.
Legal Advice for Loan Covenant Non-Compliance
For borrowers who are non-compliant with loan covenants, your institution may be able to take several different actions. Which actions you take depends on the level of risk for your institution. For example, in some cases it may make sense to take less drastic action if the relationship with the borrower is important for your bank.
Some things your institution may do for covenant non-compliance include:
- Enacting penalty payments
- Increasing interest rates
- Increasing the amount of collateral
- Demanding full repayment
- Terminating the loan agreement
Your community bank attorney can offer guidance and support to help you determine a course of action for instances of covenant non-compliance.
As you can see, loan covenants play an important role in minimizing risks for lenders. Therefore, getting legal advice for loan covenants may help your institution protect its interests.