Conditions imposed on facilities extended by banks, also known as covenants (here Debt Covenants) are imposed by bankers upon a borrower to:
- Preserve the financial strength of the borrower.
- Maintain the borrower’s ability to refinance itself – the borrower (being a limited company or a business) continuing as a going concern.
- Control the assets – prevent the borrower from selling assets thereby ensuring that assets are not dissipated,
- Ensure that the borrower does not do something that would be detrimental to the interests of the Bank.
Debt covenants, therefore, are from a banker’s perspective extremely important in the structuring of a loan.While a risky, unsound loan will not become good by covenants, they will afford some comfort and a degree of control including providing warning signs should the financial position of the company deteriorate. The amount of covenants that can be imposed on a borrower would depend on:
- The antecedents of the borrower. Has the borrower borrowed before and what has his repayment history been .
- The need of the borrower for the facility/loan.
- The kind of facility required.
- The nature of the borrower’s business and the industry wherein he operates.
- The borrower’s financial health
- The risks involved.
Debt covenants imposed are always negotiable and negotiated. Banks will always attempt to impose very exacting covenants. Some may be too exacting and impractical. Therefore a borrower must, at the time the facilities are being accepted ensure:
- The covenants are reasonable and realistic.
- The covenants will not affect the growth or stability of the company. Very restrictive covenants can retard growth.
- The borrower, while appreciating the banker’s need must also consider his own. He would be extremely shortsighted if he accepts conditions that are detrimental to his interests or restricts his ability to function freely.
- Covenants do not serve any purpose if they are not effective. The banker will therefore make certain that action can be taken for non compliance of the covenants. The remedies that are available are to a banker :
- Taking an additional collateral, thereby strengthening the loan.
- Seizing the assets secured and selling them.
- Procuring further collateral such as a mortgage on another asset or a guarantee (preferably another bank guarantee)
- Restructuring the loan
- Increasing the rate of interest on the loan (The risk/ return factor).
Debt Covenants may be positive or negative.
Positive debt covenants are requirements made on the borrower to do certain acts. Some of the more common ones are:
- The borrower must present a monthly statement or as often as required information on stocks and debtors. This is usually required if stocks and debtors have been hypothecated for an overdraft working capital facility. The banker uses the monthly statement to check drawing power and to ensure that the items hypothecated exist and are adequate. Periodically bankers inspect the clients’ factories and offices to physically verify the existence of the assets.
- The borrower must insure and maintain the assets that have been given as collateral for the loan. This is to ensure that if there is a fire or other catastrophe, the borrower does not lose anything.
- The borrower must comply with all laws and regulations.
- The borrower must pay taxes regularly.
Negative debt covenants while they don’t force the borrower to perform certain actions, require him to ensure certain things and restrict him from certain acts. A requirement could be that no assets may be pledged or no dividend declared without the permission of the Bank. These are designed to protect the lender from the dissipation of assets, to protect his security and to an extent preserve the financial strength of the borrower.
Negative debt covenants usually:
1. Restrict actions such as:
- Payment of dividend
- Sale of assets
- Limitations on additional loans
- Purchase of investments and the giving of additional loans.
- Purchase of investments and the giving of advances.
- Mortgaging of assets.
2. Maintenance of financial strength (usually in the form of ratios) such as:
- Leverage
- Liquidity
3. Specific restrictions:
- Ensure existing management remains.
- On the sale of debtors.
- On lending to subsidiaries or group companies.
- On investing in group companies.
Debt covenants are, in short, safeguards and are always tailor-made to the requirements of borrowers and lenders based on their respective weaknesses and strengths. Debt covenants must therefore be viewed as safeguards imposed on a borrower to preserve the borrower’s ability to repay the loan.