Loan Covenants

Representations and Warranties

Representations and warranties are promises on the part of the borrower in relation to existing matters. The bank relies on the truth of the representations or warranties in advancing the loan.

There are usually representations and warranties in relation to such basic matters as the borrower’s legal capacity, absence  of  adverse litigation,  insolvency, the accuracy of existing information, the priority of the loan. There will usually be a clause to the effect that there has been no material adverse change between the loan agreement and drawdown date.

The representations should represent the truth and accuracy of the facts on which the loan has been underwritten. The bank will have obtained information and documents to vouch the borrower’s personal and financial status. If any material matter turns out to be false or inaccurate, this will usually be an event of default, entitling the bank to demand repayment and enforce.

Generally, when misrepresentation has taken place, the bank can terminate the commitment to lend. Where a fraudulent or deliberate misrepresentation is made by a third party, there may be a right to sue for compensation for loss incurred.

Covenants and Conditions

A covenant or condition is a promise by the borrower which applies throughout  the loan agreement. Breach of covenant generally entitles the bank to terminate the loan and demand repayment. A wide range of covenants, varying significantly in scope and sophistication is possible.

Breach of covenant can also be a means of bringing the borrower “to the table” for negotiation, even if it is not desired to declare an event of default and resort to full enforcement. This may give the opportunity to re-negotiate the security or the other terms of the loan agreement.

The nature and extent of the covenants and conditions in the loan agreement will depend on the nature of the loan. More extensive covenants and conditions are likely to be required for commercial, construction and development loans than for property investment loans.

Covenants required for owner occupied mortgages will be less onerous. In the case of  owner occupied mortgage property, there will usually be an obligation to occupy the property as principal residence for the borrower. Letting and sharing occupation will generally be prohibited.

In the case of commercial and development loans, there are likely to be detailed covenants in relation to the borrower, particularly in the case of a company.  Any factor which might point to the risk of the insolvency of the borrower is likely to be a breach of the loan covenant. The lender will wish to have the power to accelerate the repayment of the entire loan monies at the earliest sign of financial distress, if only to allow it to negotiate a better position.

Covenants can require the borrower to meet certain standards. For example, there may be financial conditions affecting the borrower’s business and the security  as shown in the accounts.  Financial covenants may set out limits and ratios for financial performance. These may be set by reference to the borrower’s projections and the bank’s minimum necessary requirements.

There may be a commitment by the borrower to maintain a minimum net worth.  This is more common in corporate loans.  There may be limits on other outstanding exposure.  There may be commitments on profitability, liquidity, interest cover and other key ratios.

Information covenants entitle the bank to information and act as an early warning mechanism.  Annual accounts, management accounts, cash flow statements, forecasts and budgets may be required. The borrower will generally be obliged to furnish important information, such as financial accounts or management accounts. The bank will usually be entitled to specific information and to access to books and records.

There will be covenants to protect the value of the security. Insurances and licences will be required to be maintained. A negative pledge clause is an undertaking not to create a further security over the assets to any entity other than the bank.

There may be restrictions on substantial acquisitions and disposals. In the case of a company, there may be requirements and limitations on paying dividends.

Events of Default

An event of default is a circumstance that entitles the bank to terminate the loan and demand repayment of the entire loan monies. Typically, an event of default will also constitute circumstances in which a mortgage or charge can be enforced. The following are common events of default;

• failure to pay or late payment. Late payment will often signal deterioration in cash flows and is an early warning signal,
• cross default. If a borrower defaults under another loan obligation or fails to pay on a court order, this will be indicative of insolvency. There may be a domino effect of other enforcements.
• breach of loan condition;
• commencement of insolvency;
• change of control. This may apply to a company borrower, where the key sponsors cease to control the company.  This is effectively a change of identity of the borrower;
• material adverse change; this is frequently used as a sweep up clause to protect the lender against unforeseen circumstances. There must be some substantial basis in order to use the clause.

Certain events of default may have a grace period in which the borrower can remedy the default. On default, the bank will usually have a number of rights.  It may cancel undrawn parts of the facility. It may demand the entire loan monies and may enforce the security.

The bank may not necessarily wish to take all or any of these actions. The appropriate course may be to negotiate with the borrower to remediate the position. The renegotiation may involve increased margin tighter covenants,  reduced loan to value, more security etc.