Breach of Financial Covenants in Loan Agreements

Borrowing is common for businesses of all sizes. While most understand the consequences of missed repayments, they may overlook the risks of breaching other loan terms. Even a technical breach can trigger serious consequences and, in some cases, set off a chain of events leading to liquidation.

If your lender alleges a breach of a loan or other financial agreement, we can help you assess your position, explore available options and manage the potential consequences.

What are Financial Covenants?

Financial covenants are promises made by borrowers to maintain certain financial conditions or ratios throughout a loan term. They help lenders assess and manage credit risk. Common examples include:

• Leverage ratios: Measures of debt relative to equity or earnings, such as EBITDA.
• Interest coverage ratios: Measures of a company’s ability to meet interest payments.
• Liquidity ratios: Measures of a company’s ability to meet short-term obligations.

Consequences of Breaching Financial Covenants

A covenant breach can have serious consequences, depending on the agreement and the circumstances. These may include:

• Acceleration of debt: The lender may become entitled to demand immediate repayment.
• Increased interest rates: The agreement may provide for higher interest following a breach.
• Restrictions on further borrowing: Additional borrowing may be restricted.
• Enforcement against security: The lender may be entitled to enforce security over company assets.

Defences to breach of covenant claims by Lenders

The available arguments depend on the agreement and the facts. Potential issues to consider include:

• Waiver: Whether the lender has clearly waived its right to rely on the breach.
• Interpretation of the agreement: Whether the covenant has been correctly interpreted and applied.
• Compliance and calculation: Whether the alleged breach is supported by the relevant financial information and calculations.

A lender’s awareness of a potential breach does not automatically mean that it has waived its rights. The precise wording and conduct of the parties must be assessed.

Alternatives for Debtors

Where a company is struggling to comply with its financial obligations, possible options include:

• Negotiation: Seeking a waiver, revised covenant terms or an extension of the repayment period.
• Refinancing: Exploring alternative finance to repay or restructure existing borrowing.
• Insolvency procedures: Depending on the company’s circumstances, options may include:
• • Company Voluntary Arrangement (CVA): An arrangement with creditors to repay debts on agreed terms.
  • Administration: A process intended to rescue the company or achieve a better result for creditors than immediate liquidation.
  • Liquidation: A process involving the realisation of company assets and distribution of proceeds to creditors, followed by the company’s dissolution.

The appropriate approach will depend on the company’s financial position, the lender’s rights and the prospects of reaching an agreement.

Personal Guarantee implications

Small businesses may be required to provide personal guarantees from directors where the lender considers the company’s assets insufficient security. A technical default can therefore put directors’ personal assets at risk if the lender is entitled to enforce a guarantee.

We advise businesses and directors on covenant breaches, lender negotiations and potential personal guarantee exposure. We help assess available arguments and practical options to protect their interests.

Early legal advice can help you understand your position, manage the risks and identify a way forward.