In these COVID-troubled times, borrowers’ failures to meet financial covenant requirements have themselves become almost pandemic. Due to lock-downs and social distancing requirements, revenues for many businesses have seen dramatic downturns. This has resulted in defaults under many financial covenants typically found in loan documents, such as minimum debt service coverage ratios, maximum leverage covenants, and minimum EBITDA and net worth requirements.
While a lender faced with such “technical” defaults may view them as temporary and be inclined to turn a blind eye to such defaults until the economy is on more solid footing, a purely passive approach is often a mistake. Financial covenants are in loan documents for a reason: they are an early warning system to alert a lender when a borrower is facing financial difficulties. As such it is important to preserve the effectiveness of financial covenants by properly observing waiver formalities. While it may make eminent economic and business sense to waive a financial covenant default under the current circumstances, waivers should be properly documented by means of a formal notice and waiver letter or agreement with the borrower that makes clear that any waiver is limited to that particular covenant default and is not to be deemed acquiescence to future recurring or other defaults.
Why are covenant waiver letters important? Because a borrower can argue that the terms of the loan documents can be altered by the course of dealings and/or conduct of the parties. Ignoring a covenant default (especially if done repeatedly) without making clear it is a one-time or limited waiver can be interpreted as implying that the financial covenants at issue have been generally waived and compliance with them is no longer required by the lender. In essence they will be deemed written out of the loan documents.
A simple, short letter (or email) or agreement advising the borrower that (a) the lender is aware of the existence of a specified covenant default and (b) the lender will waive compliance with the covenant in this one instance, and (c) this waiver should not be interpreted as a waiver of future instances, will help avoid a course of dealing claim. The borrower should acknowledge the limited waiver in writing, release the lender from any claims, possibly pay a waiver fee to compensate the lender for addressing the need for a waiver, and agree to pay the lender’s fees and expenses. A formal waiver agreement will be of great help later on if a borrower’s economic position does not improve and results in a troubled loan or workout situation requiring a possible exercise of rights and remedies by the lender.
Finally, if a financial covenant default has occurred for multiple testing periods and has not previously been addressed or waived by the lender, HF can help you strategize as to the best approach to “rehabilitate” the covenant so as to restore its enforceability and ensure no permanent waiver of the covenant has occurred.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
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