Virtually all businesses will seek outside capital at some point.  Since most businesses aren’t in a position to offer additional equity shares, their only option is to borrow funds from a bank or other lender.

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While the terms of business loans vary depending on the business, anticipated use of proceeds, type and size of loan, and the lender’s particular lending requirements, all business loans contain covenants.  A covenant is essentially a promise.  Loan covenants, then, are simply promises made by the borrower that are part of the loan agreement.

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An affirmative covenant requires the borrower to do something while a negative covenant prohibits the borrower from doing something.  An example of a widely used affirmative loan covenant would be one where the borrower promises to provide the lender with periodic financial data.  A negative covenant would be where a borrower promises to not encumber already collateralized assets.  Maintaining, meeting, or exceeding certain performance ratios and metrics can be either affirmative or negative covenants, depending on how they are written.

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Most business loan covenants are reasonably straightforward, if not entirely understood by either the borrower or the lender.  More on this in a moment.  The practical problem with loan covenants is that few borrowers pay little if any attention to them, which, if breached, can cause the lender to declare the loan in default.  It’s all too common for a business owner to focus on receiving the funds, make a note of when repayments are due, and then file away the loan documents without realizing he may have to submit quarterly or annual financial statements to the lender that reflect satisfactory performance metrics.

 

A business owner will also encounter a problem if he submits financial statements that are questioned by the lender.  This is usually connected to certain performance covenants.  If, for example, the borrower must maintain a specific inventory turnover ratio or days sales of inventory threshold, or refrain from discounting collateralized inventory below a certain price point, then the borrower’s compliance should be fairly easily deduced by the lender from the borrower’s financial statements.  Unfortunately, what appears crystal clear to the borrower doesn’t always appear that way to the lender, who will then ask the borrower for clarification or additional information.

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In these instances, the issue is not whether the borrower objectively failed to comply with the loan performance covenants.  Rather, it’s a situation where the borrower delivered financial statements that the lender could not rely upon because they were confusing, incomplete, or possibly inaccurate.  This situation becomes complicated if the lender doesn’t communicate its concerns with precision to the borrower or if the borrower simply doesn’t understand the concerns of the lender.  Loan files usually migrate through several different departments before settling with a loan compliance officer who has no prior relationship or familiarity with the unique attributes of the borrower’s business.  The learning curve for both parties can be steep. 

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We can help

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As forensic accountants, Aho & Associates has extensive experience helping borrowers and lenders resolve loan compliance issues.  We can: 

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• Act as liaison between borrower and lender to satisfy the lender’s requests for additional information and answer the lender’s concerns

• Provide forensic accounting services by reconstructing inaccurate, incomplete, and poorly maintained financial statements

• Accurately calculate performance metrics and investigate and clarify variances in financial statements

• Coordinate provision of tax data between the borrower’s tax preparer and the lender

• Create templates that will reduce the borrower’s burden of meeting ongoing loan compliance requirements.