Loan covenant disputes likely to impact almost all industry sectors unless lenders and investors work to find resolution

Loan covenant disputes caused by the coronavirus crisis are likely to impact almost all industry sectors in the coming year, unless lenders and investors work together to resolve problems caused by covenant breaches.

We expect more loan covenant disputes, outside of the real estate sectors, to occur as the coronavirus crisis continues to hit revenues and profits at businesses. Breaches of covenants on loans were a major cause of disputes between banks and customers following the credit crunch in 2008-09.

Background

A loan covenant is a condition set by the lender which borrowers must not breach. They are designed to protect lenders from the deteriorating financial position of borrowers.

Common financial covenants on loans which commercial borrowers must not breach include: cashflow coverage ratio, based on the borrowers’ projected next quarter results, and interest coverage ratio, which measures the borrower’s ability to pay interest on loans over a specific period. 

As some of the most common financial covenants are based on forecasts of profits or turnover banks may already view many borrowers to be in breach of their covenants.

If a borrower breaches a covenant, a lender can increase the interest rate on the loan (including a possible additional arrangement fee) to make up for the increased risk.

In rarer circumstances, the lender can accelerate repayment of the loan in full, refuse to make any further advances of funds under the loan and exercise any rights under any securities granted in its favour.

How should businesses approach the issue?

It is likely that some businesses will resist any higher interest rates imposed by lenders by arguing that the exceptional circumstances caused by the coronavirus means they cannot afford to pay higher rates on loans. 

In addition, they will argue that some breaches are purely technical in nature and if not for the occurrence of the coronavirus their underlying business would still be viable and strong. Disputes may also focus on additional restrictions the lenders may also try to impose on the borrower in return for retaining the loan.

Disputes between borrowers and lenders soared after the financial crisis. This time around there is a real desire to work together to avoid the pitfalls of the last financial crisis. However, some disputes will be unavoidable as banks have to protect their shareholders’ interests.

If you feel your business is reaching the limits of your covenants with your bank then you should approach them as soon as possible especially if there is a syndicate of banks involved. It’s easier to negotiate with your bank when the covenant test dates are still in the future.