A breach of covenant occurs when the issuer of a debt instrument violates a covenant, which is one of the terms and conditions the debtor committed to as part of the lending agreement. Depending on the type of covenant involved, there can be two types of breaches:
Breach of an affirmative covenant, if the debtor fails to perform actions he/she is obligated to perform;
Breach of a negativecovenant (also called restrictive covenant), if the debtor performs actions he/she is prohibited from performing.
In the case of corporate bonds, covenants are described in the bond prospectus.
Why Covenants are Important
Covenants are meant to protect creditors from actions undertaken by management that could worsen their position and the company’s creditworthiness, making the full and timely collection of interest and principal more uncertain.
Examples of affirmative and negative covenants that aim to protect a creditor’s position from corporate actions that may worsen their position are the following:
1. Restricted payments
These are basically limitations on how a company’s cash can be used. To avoid misuse of cash that would reduce a company’s resources available for interest and principal payments, a covenant can limit the amount of cash that can be paid to shareholders in the form of dividends and can be used for share buybacks.
These actions would favor shareholders to creditors and may not be acceptable in the case of a company with relatively limited cash flow generation, a highly cyclical business, or a leveraged capital structure.
2. Change of control put
If a company is sold to a financially weaker company, a creditor’s position may worsen, as the new entity may be less creditworthy than the acquired one. That’s why some covenants may require the acquiring company to buy back the acquired company’s debt, often even at a small premium to par value.
3. Obligation to file annual reports and other relevant documents in time
To effectively analyze a borrower’s financial health, creditors must have timely access to a company’s financial statements and other relevant documents. A late filing of relevant documentation can make the analysis more difficult and less effective.
4. Limitations on further increases in debt
A borrower’s ability to repay its debt also depends on the amount of debt the borrower has raised. Covenants can help avoid an excessive increase in debt that will worsen a borrower’s financial health and compromise its ability to face debt obligations. Examples include a ban on selling a company via a leveraged buyout, and on increasing secured debt that would have priority over unsecured bondholders.
Bank covenants, as described in bank credit agreements, may often be even more limiting than bond covenants. In many cases, a bank may require a debtor to maintain leverage ratios such as debt/equity, debt/EBITDA, or debt/EBIT under a certain threshold. These types of covenants are called maintenance covenants.
In case a covenant is breached, the bank will probably block further credit to the debtor involved and will require the covenant to be cured, generally under the threat of triggering a default.
Consequences of a Breach of Covenant
The breach of a covenant can trigger a technical default. However, the specific consequences of a breach of covenant should be analyzed on a case-by-case basis and depend on whether the creditor decides to waive the violations.
The consequences of a breach of covenant generally include:
A penalty or fee charged to the debtor by the creditor;
An increase in the interest rate of the bond or loan;
An increase in the collateral;
Termination of the debt agreement; and
Waiving the violation without important consequences.
Waiver of a Breach of Covenant
Not all breaches are treated equally, as their severity may vary and require different types of actions. For breaches that are not severe, a waive will generally be granted after the debtor and the creditor have negotiated. More specifically:
The debtor and the creditor may agree on an unconditional waiver. It can happen because the breach is particularly small and/or because it may be a result of events outside the debtor’s control.
The debtor and the creditor may agree on a waiver with the imposition of additional restrictions such as additional maintenance covenants or different ratios applied to existing covenants.
Liquidity, Financial Reporting, and Covenants
The breach of a covenant can have an impact on a debtor’s liquidity and solvency. If the covenant gives the lender the right to request the immediate payment of the loan, the debt involved becomes a current liability for the debtor, potentially altering their financial health.
Since many covenants usually rely on accounting ratios, such as debt/EBITDA, a debtor who wants to avoid breaches may have an incentive to misrepresent earnings or emphasize non-GAAP measures in the definition of the ratios used.
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