09.06.2020

Covenant and waivers. What are they?

A Covenant is an essential element of a loan contract; of any loan. But this is one of the most relevant and dangerous elements for the borrowers. The Waiver, you might say, is the Covenant's inhibitor.

Por Cobo Aragoneses, José Luis

Have you purchased a home? A car, perhaps? Recently started a business? And were you able to meet your obligations solely from your available savings?

The loan system, at this point, is no stranger to us.

Whether in small or large amounts, from a family member or from a credit entity: we have all turned to some form of financing at one time or another.

And the truth is that it is an essential part of our consumption process.

However, the requirements for obtaining credit are becoming increasingly strict. This is precisely what the Bank of Spain reflects in its recent survey on bank loans in Spain. Although it does not seem that the problem is that we are bad payers, but that the lenders want to be cautious. This is the context of the covenants we are talking about.

1.-So, what is a Covenant?

A covenant is essentially a clause incorporated into a loan contract. Its purpose is to “guarantee” to the lender the return of his credit. The creditor’s intention, then, is none other than to oblige the debtor to operate in a financially prudent way.

In economic practice, it is more common to find them in loans formalized with companies. This is intended to protect the cash flows generated that will repay the debt. Obviously, the restrictions imposed through this mechanism will increase in proportion to the financial risk of the borrower.

Si te ha interesado este artículo no dudes en leer:

Debt restructuring and refinancing, differences and concepts

The purpose of refinancing is to replace an existing loan with a new loan. Refinancing is carried out to obtain more favourable conditions. Restructuring is usually associated with short-term cash flow stress. The causes may be cyclical or derive from a lack of financing.

2.-Types of Covenant

There are as many types of covenants as the lender thinks appropriate. In any case, they are usually classified into three groups: do’s (positive covenants), don’ts (negative covenants) and financial covenants.

a) Do’s Covenants (Positive covenants)

Such clauses impose on the debtor the obligation to make various commitments actively.

For example:

That the borrower undertakes to maintain the same management team for the entire life of the loan.
The borrower undertakes to renew/maintain in force its administrative licenses.
The borrower undertakes to comply with all previous contracts that guarantee the continuity of its business.

b) Don’ts Covenants (Negative covenants)

Unlike the above, the negative covenants are essentially limited to specific prohibitions.

Thus, it’s usual that the lender is prevented from granting security to future creditors without the lender’s prior authorization. Or the lender is obliged not to contract new financing above certain limits.

There are many others, such as the impossibility of distributing dividends, selling essential assets…

c) Financial covenants

They are very recurrent in practice. They consist of the debtor’s commitment to maintain, during the term of the credit, certain financial ratios at certain levels. These ratios will indicate to the lender the borrower’s ability to repay.

Within this class of covenants we can identify, among others:

Interest coverage ratio, which contrasts EBITDA with interest payable.
Current ratio, which compares current assets to current liabilities.
Leverage ratio, which relates total financial debt to effective equity.

As is logical, this type of covenant is usually associated with certain reporting obligations that allow the lender to verify compliance. From the delivery of the annual accounts to the delivery of monthly financial information.

3.-What happens if i do not respect one (or several) Covenants?

Although it is true that breach of covenants is usually a cause for termination of the contract, it is not usual for this mechanism to be triggered.

Sometimes it will be essential to sell an essential asset, or the exit of a team member cannot be expected.

In these circumstances, therefore, the creditor will usually renegotiate the terms and conditions of its credit.

In this situation, so-called waivers are formed. These are temporary authorizations, upon failure to comply with one or more specific covenants. It is the debtor who, by means of a letter, must address the creditors to request permission to default. The creditors, for their part, will accept the waiver if they consider that it does not prejudice the solvency of the borrower.