What To Do If You Break a Bank Loan Covenant
So, you’ve just received a call from your bank informing you that you’re close to breaching, or in breach, of a loan covenant, and your bank financing may be recalled. It sounds serious, so what should you do? Faced with the prospect of losing your day-to-day funding, you’ll need to know your options and be able to make some smart choices very quickly.
This scenario is happening all too often as business performance levels in most industries are being battered by the economic downturn. In this environment, banks are becoming more vigilant in monitoring the financial performance of their borrowers and are acting to minimize the bank’s exposure to risk. Companies with bank financing must be prepared and know how to act when the bank calls to discuss your loan or line of credit.
Knowing what to expect, what steps to take, and having a backup financial plan is essential. In this article we discuss what your next steps are if you break a covenant at your bank.
What is a bank loan covenant?
A bank loan covenant is a term or condition in a loan agreement that requires the borrower to meet specific standards or requirements. Covenants can be either negative or positive and are often expressed as ratios to monitor financial performance, restrictions to limit lender risk, or any number of other conditions.
Some common examples of loan covenants include:
- Debt-to-income ratio: Limits the amount of debt the borrower can have relative to their income.
- Minimum net worth: Requires the borrower to maintain a minimum level of net worth, which is calculated as total assets minus total liabilities.
- Minimum liquidity: Requires the borrower to maintain a minimum level of liquid assets, such as cash or short-term investments.
- Minimum interest coverage ratio: Sets a minimum ratio of earnings before interest and taxes (EBIT) to interest expenses, indicating the borrower’s ability to make interest payments.
- Prohibited activities: Specifies actions the borrower is not allowed to engage in, such as assuming additional debt or making certain investments.
What do banks do if you break a loan covenant?
Even with the best planning, financial troubles can occur. You should be aware that your bank continuously monitors your loan covenants for compliance. If you break a loan covenant and your bank discovers it, they will likely notify you and look for an immediate resolution. If this happens, you should act quickly to address the issue. If the breach is not immediately rectified, the bank will likely move your loan to its special assets department, and you will be obligated to sign a bank workout agreement. This development can have serious consequences.
What is a bank workout agreement?
A bank workout agreement results from a meeting between a borrower and their lender to discuss and resolve a problem with the borrower’s loan. The agreement dictates new terms and actions to be met. If not navigated well, it can result in financial penalties, a recall of the loan, or even legal action.
The bank may stipulate one or both of the following actions in the workout agreement:
- Requirement of additional collateral: The bank may demand that you provide additional collateral, such as a personal guarantee or other assets, to secure the loan.
- Modification of loan terms: The bank may modify the terms to bring you back into compliance with the covenants. Modifications could include changing the interest rate, extending the loan term, or requiring you to make higher payments.
It’s important to note that a bank workout agreement does not guarantee a resolution to the original problem with the loan. The borrower must be able to perform the stipulations of the agreement for the loan to be successfully restructured. If the borrower fails to meet the new stipulations, the bank may take the following actions:
- Demand immediate repayment: If the breach is severe or you cannot comply with the covenants, the bank may demand that you repay the entire loan immediately.
- Take legal action: If you cannot repay the loan or come to an agreement with the bank, the bank may take legal action against you to recover the debt. Actions could include garnishing your wages or seizing your assets.
What to do if you break a bank loan covenant?
Breaking a bank loan covenant is not the end of the line, but it is a dire situation to be managed with concern. Remember that the goal is to work cooperatively with the bank toward a mutually beneficial solution.
If you find yourself in this situation, it’s essential to act quickly and take the following steps:
- Review your loan agreement: Make sure you understand the covenant and how you have breached it.
- Be upfront with your banker: It is best to be transparent and straightforward when trying to rectify the situation. Explain the circumstances that led to the breach and try to negotiate a solution.
- Take steps to fix the problem: If you can negotiate a solution with your banker, follow through immediately to get back in compliance with the loan’s terms.
- Consider seeking legal advice: If you cannot reach a resolution with your bank, you may want to seek legal advice to help you navigate the situation.
Put a backup plan in place
While you are working with the bank to resolve your current issue, it’s time to get your backup financing plan in place. If the bank decides to call their loan or line of credit, you’ll need to have a plan B ready to go on a moment’s notice.
Conventional banks monitor and regulate credit based on legacy credit scoring models that assess limited variables. Borrowers are regularly evaluated based on their financial performance and cash flow. This narrow scope imposes rigid parameters, often leading to breached covenants during economic downturns. SMEs need to have a non-bank financing option queued up, and ready to deploy should the bank recall its line of credit or business loan.
Fortunately, alternative lenders take an entirely different approach to qualifying borrowers and managing their loans. Leveraging advanced fintech technology, alternative lenders assess hundreds of credit-related data points to discover strengths and opportunities to help mitigate risk. Finding untapped credit strengths and asset utilization opportunities, these tech-enabled lenders can approve credit and support financing to the “unbankable.”
Whether you’ve broken a covenant or seek bespoke financing with credit terms explicitly tailored to your needs, now is the time to research alternative financing options.
The following alternative flexible financing options are commonly used by small and medium-sized businesses to finance their business when banks deny credit:
Taking pre-emptive action to investigate alternative funding sources will better position your business to pivot quickly and seamlessly if you cannot meet the requirements of your bank’s workout agreement.
It’s important to note that the bank’s response to breaking a loan covenant will depend on the loan agreement’s specific terms and the breach’s severity. Resolution is always possible, but only if a mutually beneficial solution is agreed to and implemented. SMEs need to have a backup plan ready to deploy immediately if required.
Having an alternate lender in the wings is not just smart – it’s necessary to ensure your business’s sustainability. The earlier you look for a non-bank solution, the more protection you have. So, researching non-bank funding alternatives is well advised when dealing with broken bank covenants. Look for a flexible alternative lender experienced in your industry. If a transition is needed, pre-planning will facilitate a smoother changeover without funding gaps.
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