Covenant breaches are a common occurrence in credit agreements and require careful evaluation. A “cured default” occurs when a borrower violates a term of the credit agreement but takes corrective actions to rectify the breach and return to compliance with the agreed terms. In essence, it’s a chance for the borrower to fix the mistake and avoid facing the consequences of a default. Most credit agreements will have a “cured default” provision that outlines the steps a borrower must take to cure a default.
As a credit professional, you should be checking your customer’s liquidity position regularly. This includes collecting data on credit agreements, loans, and deposit accounts. If you uncover a violation, follow-up information will be needed to get a complete picture of its risk profile.
According to Martin LLP, the repercussions of a lender declaring an “Event of Default” under a loan can be severe and may include such potential lender rights and remedies as:
- Refusing to make further advances of any undrawn portion of a committed loan facility
- Increasing the applicable interest rate to a “default rate”
- Accelerating the loan and demanding immediate repayment of all outstanding loan amounts
- Commencing litigation in hopes of seeking payment on the loan
- Foreclosing on or exercising rights concerning collateral securing the loan
Types of Covenants
As outlined by KKR, covenants can be classified into three broad types:
- Positive covenants: Actions borrowers must undertake under a loan agreement (i.e. providing financial statements or maintaining adequate insurance coverage). Information undertakings require borrowers to provide regular reporting on pre-defined elements such as financial performance. General undertakings ensure borrowers uphold basic principles, such as operating in compliance with applicable laws.
- Negative covenants: Restrictions on what borrowers can do under the governing loan agreement. These covenants prevent borrowers from weakening a creditor’s position, either by extracting value or by diluting creditors’ claims through the incurrence of additional liabilities. For example, under negative covenants, borrowers may be restricted from paying dividends or transferring assets outside of the borrowing group, to affiliates, without prior approval.
- Maintenance covenants: Periodic financial tests with which borrowers must comply, such as indebtedness ratios, interest coverage, or minimum liquidity requirements. These are often referred to as financial covenants.
Remedies (Forbearance vs. Waiver):
- Forbearance Agreement: The lender simply postpones exercising its legal rights against the borrower, contingent on the borrower meeting specific requirements outlined in the agreement. These requirements might involve accelerated payments, restrictions on new debt, or limitations on owner distributions. In severe cases, the agreement could allow the lender to seize collateral or initiate foreclosure proceedings if the borrower fails to comply.
- Waiver: A waiver agreement effectively forgives the covenant violation and restores the borrower and lender to their pre-default positions. This can be beneficial for borrowers, allowing them to maintain the loan and address the underlying issues preventing compliance. The lender may also consider amending the covenants to better reflect the borrower’s current circumstances.
Credit Risk Implications
From a credit professional’s viewpoint, the need for a waiver or forbearance may indicate heightened credit risk and warrants closer scrutiny of the customer’s financial condition. Companies in sound financial health typically wouldn’t require such concessions. However, a waiver is more favorable; it allows the borrower to maintain the loan for an extended time to take the necessary steps to become compliant for future periods.
This is why it is vital to understand your customer’s credit agreements and loans. Uncovering and knowing the company’s cure provisions could help you avoid a major loss.
