A breached financial covenant is usually an event of default, even with every payment current. It gives the lender the right to charge default interest, stop further advances or accelerate the loan, though most lenders first send a reservation-of-rights letter and negotiate. The usual outcomes are a one-time waiver, an amendment that resets the covenant in exchange for a fee and tighter terms, or a forbearance agreement while the business recovers or refinances. Tell the lender before the compliance certificate does, with the cause, a forecast and a plan. If the relationship cannot recover, refinance while there is still time.
- Is a breach a default?
- Under most loan agreements, yes, even with payments current
- The lender's usual first move
- A reservation-of-rights letter and a negotiation
- Common outcomes
- Waiver, amendment, equity cure, forbearance
- What decides it
- Size and cause of the miss, the collateral, and how the lender found out
- When to leave
- When amendment terms leave no room or the loan has moved to a workout group
The covenants in a loan agreement
Covenants are the promises a borrower makes in exchange for the loan. The payment is one promise; covenants are the rest, and they exist so the lender hears about trouble before a payment is missed. Financial covenants are tested on a schedule, often quarterly on trailing twelve-month figures, and reported on a compliance certificate an officer of the business signs.
| Covenant | What it measures | What trips it |
|---|---|---|
| Debt service coverage (DSCR) | Cash flow available for debt service against principal and interest due | A drop in earnings, or new debt added without new earnings |
| Fixed charge coverage (FCCR) | Cash flow after capital spending, taxes and distributions against fixed charges | A large capital purchase, owner distributions, a tax bill in a weak year |
| Maximum leverage | Total or senior debt against EBITDA | Falling EBITDA; the debt does not have to rise at all |
| Minimum liquidity or availability | Cash on hand, or unused capacity on a line | A seasonal cash drain, a slow-paying customer, an unplanned purchase |
| Minimum net worth | Book equity, often tangible net worth | Losses, write-offs, distributions |
| Capital spending limit | Capital expenditure in the year | An unbudgeted equipment purchase |
| Reporting covenants | Timely financial statements, compliance certificates, borrowing base reports | Late statements, the most avoidable breach there is |
Banks commonly look for debt service coverage of at least 1.25x when they approve a loan, and a coverage covenant is usually set at or somewhat below the level the loan was approved at, so a modest fall in earnings can trip it. A line of credit may test fixed-charge coverage only when availability falls below a threshold, a so-called springing covenant; see the covenants on a line of credit. Know which tests your agreement uses, how each is defined and how much room you have today. The definition of EBITDA in the loan agreement is the one that counts, not the one in your P&L. See DSCR and FCCR.
What happens on a breach
Under most loan agreements a breached covenant is an event of default. Legally, that usually gives the lender the right to:
- charge interest at the default rate;
- stop further advances under a line of credit;
- accelerate the loan, declaring the full balance due;
- enforce against collateral and call on guarantees;
- in an asset-based facility, take control of collections through cash dominion.
The breach can also reach beyond the one loan. Cross-default clauses in other agreements, such as equipment notes, leases or a second lender's loan, may treat a default under this loan as a default under theirs. And if the breach has not been waived by the balance-sheet date, the accountants may have to show the whole loan as a current liability, which makes the problem look worse to everyone else who reads the statements.
In practice few lenders accelerate a performing loan over a first covenant miss. The usual first step is a reservation-of-rights letter: the lender records the default, says that accepting payments does not waive it, and invites a conversation. What follows depends on the size of the miss, its cause, the collateral, the borrower's candor and the lender's own view of the industry. At a bank, a larger or repeated breach can move the loan from the relationship officer to a special assets or workout group, whose job is to reduce the bank's exposure rather than keep the customer.
The ways through: waiver, amendment, forbearance
| Outcome | What it does | What it usually costs |
|---|---|---|
| Waiver | The lender waives the breach for one test period; the covenant stays as written | A waiver fee, and sometimes a condition that the next test passes |
| Amendment | Resets covenant levels or definitions going forward | A fee, often a higher rate, tighter reporting or new covenants, sometimes a paydown |
| Equity cure | The owner puts in cash, which the agreement counts toward the failed test | Owner capital; available only if the agreement provides for it, and usually limited in how often |
| Forbearance | The lender agrees not to use its remedies for a set period while the borrower meets conditions | Fees, default interest, milestones, usually a release of claims against the lender, and an expected refinancing or sale |
| Refinancing elsewhere | A new lender pays off the loan, and the default with it | Usually a higher price, and the cost and effort of a new process |
A waiver fits a one-off miss with an obvious cause: a large customer that paid late across a quarter-end, a one-time expense. An amendment fits a business whose new normal no longer suits the old covenants but still supports the debt. An equity cure works only if the agreement grants one and the owner has the cash; it buys a quarter, not a new covenant.
A forbearance agreement means the lender has begun planning its exit. Read it with counsel. Forbearance agreements commonly have the borrower acknowledge the debt, confirm the default and release claims against the lender, and they set milestones whose failure ends the forbearance at once. The period is time to refinance or fix the business, not time to wait.
How to approach the lender
A lender's first question after a breach is whether it can still trust the numbers, and the answer comes mostly from how it learned of the breach.
- Tell the lender first. Calculate the covenants every month, not only when the certificate is due. When a test looks likely to fail, call before the certificate arrives. A lender who hears it from the borrower is negotiating; one who finds it in the certificate is investigating.
- Put the cause in writing. What happened, when, and whether it is over. Documented, non-recurring causes are what waivers are made of.
- Bring a forecast. Monthly, for the next several quarters, with each covenant calculated in each period, and a downside case beside the plan.
- Propose the fix. A specific request, a waiver for this quarter or a reset to these levels for these periods, is easier to approve than an open question. Offer something in return: tighter reporting, a paydown from a named source, a pause on distributions.
- Keep the reporting perfect. Deliver every statement and certificate on time while the conversation continues. A reporting breach on top of a financial one tells the lender the controls are failing too.
The worst covenant breach is the one the lender discovers for itself. The second worst is the one reported late.
While negotiating, do not stop paying, move cash out of the lender's accounts, or pay other creditors ahead of it outside the ordinary course. Each of those can turn a technical default into something much harder to fix, and each will be read as a sign of what the borrower would do under more pressure.
When refinancing elsewhere is the better route
Sometimes the relationship will not recover. The loan has moved to special assets, the amendment terms leave no room, the forbearance milestones are out of reach, or the lender has decided to leave the industry. Then the right move is a refinance, started while a forbearance period or a covenant reset still gives time to run it.
A new lender will see the breach. It will read the reservation-of-rights letter, the waiver or forbearance agreement and the correspondence, and it will want the cause explained and a forecast it can believe. Private credit lenders are a common home for a business leaving a bank after a breach; they price the risk, but set covenants from the business's own forecast with more room. Where receivables and inventory are strong, an asset-based line can replace a cash-flow loan whose earnings tests no longer fit, because it lends against collateral rather than EBITDA.
The file is the conventional term-loan checklist: P&L, year-to-date P&L through last month-end, balance sheet, debt schedule and, optionally, AP aging, with the breach history attached and explained rather than left for the lender to find. In Transparent's book, 1,148 lenders write term and private credit and 235 write asset-based lines; a refinance out of a breach goes to those whose appetite fits a business in that position. If the pressure is a maturity the lender will not extend rather than a ratio, see refinancing ahead of a balloon maturity.
Common questions
- Is a covenant breach the same as a default?
- Under most loan agreements, yes: a covenant breach is an event of default even with every payment made. That gives the lender its remedies. Whether it uses them is a separate decision, and most first negotiate.
- Can the bank call my loan over a covenant breach?
- Legally, usually yes; acceleration is among the lender's remedies after an event of default. In practice lenders rarely accelerate a performing loan over a first miss. They reserve their rights and negotiate a waiver, amendment or forbearance.
- What is a technical default?
- A default that is not a missed payment: a covenant breach, a late report, an unapproved change in ownership. The name makes it sound minor, but the loan agreement treats it like any other event of default.
- Should I sign a forbearance agreement?
- It is often the best option available, but read it with counsel. Forbearance agreements typically confirm the default, release claims against the lender and set milestones that end the forbearance if missed. Use the period to refinance or fix the business.
- Will a covenant breach stop me from getting a new loan?
- It changes which lenders will look and at what price, but it does not end the search. Lenders who refinance out of a breach want the cause documented, the numbers current and a forecast that holds up.