Covenant Breach

What is a “Covenant Breach”?

A breach of covenant is the violation of an agreement or promise made in a written contract. The covenants in a loan agreement are principally divided into three categories; information covenants, restrictive covenants and financial covenants.

Most covenant breaches relate to financial covenants. A typical financial covenant is when a borrowing company agrees to stay above or below a pre-agreed financial ratio such as EBITDA-based leverage, interest coverage ratio, debt to equity ratio or a cash flow based ratio.

Hence, covenants allow lenders to monitor the financial position of a borrower. A breach of covenant is typically not just a warning signal but a powerful indicator of the deteriorating financial health of a borrower with potentially serious consequences.

Typical Breaches of Covenants

The wide range of covenants means that there could be many different types of covenant breaches:

Typical Breach of Information Covenant

The most common information covenant is the borrower’s obligation to file annual reports and other relevant documents in a timely, regular manner. A late filing of relevant financials can make credit analysis conducted by the lender more difficult and less effective. However changes in accounting regulations, delays in auditing and other scenarios can result in a breach of this covenant, which is typically handled via an unconditional waiver.

Typical Breach of a Restrictive Covenant

A typical restrictive covenant is the borrower’s limitation to further increase debt. For highly leveraged companies, this covenant can help to avoid additional borrowing. However, in a difficult economic situation, the lender may agree to a conditional waiver (if it helped resolve a short-term credit squeeze for example), and allow the borrower to increase debt while forcing it to refinance at a higher interest rate.

Typical Breach of a Financial Covenant

Most covenant breaches are in relation to financial covenants. In many cases, the lender may require the borrower to maintain a certain leverage or interest cover. These covenants are called maintenance covenants. These two are the most frequently used financial covenants in debt documentation.

EBITDA based leverage = Gross or Net Debt / EBITDA

EBITDA based interest cover= EBITDA / Gross or Net Interest

Breaching a financial covenant is classified as a serious breach and the lender will look carefully at how to cure the covenant breach, typically under the threat of a technical default.

Conclusion: Consequences of a Breach of Covenant

A breach of covenant is a serious situation and in a worst-case scenario can trigger a technical default. However, as the specific consequences of a covenant breach are different for any borrower, it is essential to understand and analyze the breach on a case-by-case basis. Based on the case-specific analysis, the creditor decides the most suitable consequences of the breach, which can also be waiving the violations. The consequences of a breach of covenant can generally include the following alternatives:

• 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
• Waiving the violation without important consequences

Example: Breach of Covenant

Please calculate if the following company is currently is breach of its EBITDA based leverage covenant:

Additional Resources

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