Breaching lender covenants

Robust monitoring will give good warning of potential lender covenant breaches. This may give time to avoid them. If not, early and effective lender management can minimise their impact.

In this article Aneesh Prasad looks at the importance of understanding and monitoring lending covenants and dealing with potential breaches.

Introduction to lender covenant issues

A board that embraces good corporate governance will ensure that management forecasts are properly prepared, kept up to date and regularly reviewed. This will, amongst other things, allow the board to assess whether finance lines are within terms.

Management forecasts should also identify early warning signs that one or more lender covenants are potentially at risk of being breached.

The nature of the anticipated covenant breach will depend upon the circumstances. Raw material prices, labour costs and import duties continue to increase. Inflation is at a 30-year high. Financial covenant breaches could perhaps be the primary concern, but there may also be wider issues such as ageing debtor days, continuity of supply, or even the inability to pay debts as they fall due in the short term.

Early stakeholder management with financiers will often increase prospects of agreeing the moderation of those covenants. This will assist the board’s strategy to move quickly towards stabilisation and recovery. Conversely, failing to engage appropriately with financial stakeholders will, in certain cases, limit the options available to crisis management only.

In this article, we examine the issues that a board should be considering when faced with prospective covenant breaches, what outcomes those breaches could potentially trigger, and what steps the board should be looking to take.

What are the consequences of a breach of a lender covenant?

A covenant breach may constitute an ‘event of default’ which entitles the lender to exercise one or more rights. These may include the right to:

• charge pre-agreed default interest and other fees
• cancel undrawn commitments
• accelerate and demand early repayment
• demand cash cover
• enforce any supporting security granted in favour of the lender.

It may, however, be that the covenant breach is sufficiently minor such that the facility agreement permits the beach to be cured or remedied within a specific grace period and avoid being categorised as an event of default. The lender’s recourse options will, of course, depend upon the terms of the contractual documentation.

Options planning for lender covenants

Once the board has identified the key issues arising from the anticipated lender covenant breaches, it can begin shaping a stabilisation plan. That plan should include detailed cash flow projections and a consideration of all turnaround options. Any potential ‘deal blockers’ which may obstruct short- to medium-term goals and viability should be addressed head on.

Key elements of a stabilisation plan may include one or more of the following solutions.

Mitigation of anticipated breaches

Explore whether the board can pursue a transformation programme to mitigate or avoid the anticipated covenant breaches.

Operational turnaround and other self-help remedies will in many cases assist in the discharge of directors’ duties, and may have the added benefit of avoiding transaction costs and other expenses.

This strategy may not be available in all circumstances. Be aware that a board may be open to criticism if it embarks upon a transformation programme that has not been properly diligenced.

To understand more about organisational restructuring, click here and read our guide.

Covenant amendments/ waivers

It may be the case that the relationship with the lender is sufficiently strong such that, in the overall circumstances, the covenant can be waived or moderated by the lender in the short-term. This may be because the covenant breach does not affect the lender’s overall appetite to risk and the lender has been kept fully appraised (in advance) of the difficulties which the board have been facing. This interim remedy can provide a lifeline whilst the board addresses the underlying issues that are challenging the business.

Additional liquidity

There may simply be a looming cash requirement. The board should explore whether cash can be generated organically, or alternatively whether an injection of funding is needed from the existing lenders by way of an amendment and restatement to the existing facilities.

In some cases it may be that the preferred option, or the only option, is to seek to re-finance with another lender.

To read more about trading through financial difficulty, read our article here.

To read more about additional funding, read our guide here.

Stakeholder management – who should I inform, and when?

Where it is right to do so, keep financial and other stakeholders regularly informed and seek to manage their reasonable concerns. In particular, the board should seek to engage with the relevant lenders in an early course to agree the proposed stabilisation plan, including, where appropriate, the moderation of certain covenants.

Be aware that the lender may write to you to reserve their rights that may arise under the contractual documentation as a result of the anticipated default. Depending upon the circumstances, the lender may also ask for certain matters to be satisfied as a condition to the lender not exercising any existing or future enforcement rights. Any such conditionality should be considered carefully with your advisors as part of the board’s overall stabilisation plan.

Support available with breach of lender covenants

A well-advised board will invest in continuing relationships with all financial stakeholders, including when a breach of terms is anticipated across one or more lines. Our experience is that lenders will generally be more supportive if they are aware of the difficulties at an early stage. They will often be gate keepers to the stabilisation plan. 

The taking of early professional advice is essential to options planning and the development of a stabilisation plan which the lender(s) can seek to support. The taking of such advice will also evidence that the board are mindful to, and are taking appropriate steps to, discharge their duties as directors.