You Violated a Loan Covenant. Now What?
Monday, May 24, 2010; 12:00 AM
By Randy Myers
Fledgling New York City-based filmmaker Vigil Chim understood that she could get into trouble if she missed a monthly payment on her bank line of credit. So she always paid on time.
What Chim didn't realize was that there were other ways her line of credit could get her into hot water. Beyond requiring timely repayment, virtually every bank loan contains additional stipulations, or covenants, that must be met to keep the loan in good standing. Chim inadvertently overlooked one of those stipulations last year when she maxed out her credit line and triggered an early repayment clause. It took her three months to convince her bank to temporarily revise her loan terms so she could keep her head above water.
Violating a loan covenant doesn't have to be a disaster for your small business, but it can be if you don't know which covenants are included in your loan documents and, as a result, fail to respond promptly and effectively when you violate one.
Covenants typically come in three varieties: affirmative, negative and financial, notes Bruce Levine, an attorney at the New York City-based law firm of Herrick, Feinstein LLP. They basically break down as follows:
Affirmative covenants require that you do certain things like submit financial statements to the bank and/or carry liability insurance.Negative covenants preclude you from doing certain things, such as taking on additional debt or selling assets without your lender's approval.Financial covenants require that your company maintain certain liquidity or performance ratios. For example, your company may have to maintain a minimum net worth or generate a certain level of pre-tax profits.
If you violate a loan covenant, your lender has multiple remedies at its disposal and can generally choose from them as it sees fit, depending upon the severity of the default. If you do something fairly innocuous--fail to submit your financial statements on time, for example--your bank may simply extend your deadline. If the issue is more serious--maybe you've taken out another loan without getting your bank's permission--your bank may call its loan, halt any additional lending to you, exercise its right to seize any assets you posted as collateral, or initiate legal action to recover its money. Alternatively, says Kate Lister, an entrepreneur, former banker and co-author of "Finding Money: The Small Business Guide to Financing," your bank may impose more onerous terms and conditions on your loan. "If you're not personally guaranteeing the loan, they may require it," she warns. "If your house isn't already pledged, they may want to add it. They may want to move to a strict, asset-based lending situation."
To minimize the fallout, lawyers and bankers generally agree that you should contact your lender as soon as possible once you discover you've violated a loan covenant or are about to do so. Waiting can arouse suspicions about your integrity and allow whatever problems you're confronting to multiply.
"Be open and forthright with your bank," says Nat Wasserstein, managing director of NS Wasserstein & Company LLC, an end-stage crisis management firm based in Sparkill, New York. "If they find things out later on that were supposed to be disclosed, the situation could get worse very fast."
That said, Levine notes that you should be sure to draft a plan for correcting your problems before approaching your lender. "Certainly, if you see that you're not going to be able to make payments coming up, you want to tell the bank," he explains. "But it would be good to have projections showing the bank why it looks like things will be OK. If you just go in and tell them business is getting worse and you just lost your three biggest customers, that's not going to help. That bank will want to know what you're going to do about it."
Make sure your plan is realistic and detailed, with financial projections linked to your new business strategy. Explain how you ran afoul of your loan covenants, and how you're going to get back into compliance. You may want to let your banker meet the people who will be responsible for helping you execute your plan, giving them a chance to showcase their expertise. If possible, consider adding to your executive team a financial manager with experience in successful turnarounds.
Come up with a convincing recovery plan, and your bank may be willing to change the terms and conditions of your loan to your benefit.