Breach of Financial Covenants in Loan Agreements

Borrowing money is a common practice for businesses of all sizes and types. When borrowing, most businesses understand the implications and consequences of defaulting in repayments. Many however are not so aware that other breaches, often technical breaches, can also have severe consequences and in some cases result in a chain of events that results in liquidation.

If your lender has notified you of a claimed breach of your any type of loan or financial arrangement you have, we can help you navigate the best way through during these challenging times.

What are Financial Covenants?

Financial covenants are promises made by a borrower to a lender about maintaining certain financial conditions or ratios. They act as protective measures for lenders, ensuring that the borrower remains in a stable financial position throughout the loan term. Common financial covenants include:

• Leverage Ratios: The ratio of a company’s debt to its equity or EBITDA (earnings before interest, taxes, depreciation, and amortisation).
• Interest Coverage Ratios: How easily a company can pay interest on its outstanding debt.
• Liquidity Ratios: A company’s ability to meet short-term obligations.

Consequences of Breaching Financial Covenants

Breaching a financial covenant can have serious implications:

• Acceleration of Debt: The lender might demand immediate repayment of the entire loan amount.
• Increased Interest Rates: Some agreements stipulate a rise in interest rates if covenants are breached.
• Restrictions on Further Borrowing: The company might be prohibited from taking on additional debt until the breach is rectified.
• Loss of Asset Control: Lenders might take control of collateral or assets pledged against the loan.

Defences to breach of covenant claims by Lenders

If a lender claims a breach of covenant, you might have several defences:

• Waiver: If the lender had previously been informed of a potential breach and did not take action, it might be deemed to have waived its rights.
• Material Adverse Change: Some agreements contain clauses that protect borrowers from unforeseen significant events that could impact their financial position.
• Ambiguity in Agreement: If the covenant terms are unclear or ambiguous, the borrower might argue against the lender’s interpretation.

Alternatives for Debtors

If a company is struggling to meet its obligations, several options might be available:

• Negotiation: Engage with the lender to renegotiate terms, seek waivers, or extend the loan period.
• Refinancing: Seek a new loan to pay off the current debt, ideally under more favourable terms.
• Insolvency Procedures: In England, several insolvency procedures can assist companies in distress:
• Company Voluntary Arrangement (CVA): Allows a company to agree with its creditors on repaying a percentage of its debts over time.
• Administration: An insolvency practitioner takes control of the company to either rescue it or sell its assets to repay creditors.
• Liquidation: The company’s assets are sold to repay creditors, and the company is dissolved.

Personal Guarantee implications

With many small business corporate borrowings and credit facilities, where the lender may have doubts about the security available from company assets, a personal guarantee is demanded from the company directors. A technical default on the terms of any finance can trigger an impossible situation for the business which in turn may lead to any personal guarantees given being called in. This makes the issue of technical defaults on loans even more worrying for many business owners.

We can advise and assist and have experience in protecting directors interests who have given personal guarantees, using all available defences and tactics.

As always, seeking expert legal advice is paramount in navigating these complex situations.