Summary
- Undertakings are legally binding promises made by a borrower to a lender to do or refrain from doing certain things, and can restrict a company’s ability to sell assets, take on additional debt, pay dividends, and spend earnings.
- The three main types of undertakings are financial covenants, information undertakings, and general undertakings, each designed to protect the lender’s position by monitoring and restricting the borrower’s conduct throughout the loan term.
- Breaching an undertaking can trigger a loan default and immediate repayment demand, though most agreements include a cure period of 30 to 60 days, and borrowers may seek a covenant waiver if the breach cannot be remedied.
- This article explains the legal implications of undertakings in loan agreements for business owners negotiating bank financing in Australia.
- LegalVision, a commercial law firm specialising in advising clients on commercial lending and contract law, outlines the types of undertakings and the consequences of breach.
Tips for Businesses
Review all undertakings carefully before signing, paying close attention to financial covenants and negative pledge clauses. Understand your cure period obligations in case of breach. If you anticipate difficulty meeting a covenant, approach your lender proactively to negotiate a waiver before a formal default is triggered.
Undertakings are legally binding promises a borrower makes to a lender in a loan agreement, committing to do or refrain from doing certain things. Given loan agreements impose substantial obligations on both parties, you will want to ensure you understand the legal effect of important terms like undertakings. This article explains the important legal implications of undertakings in a loan agreement.
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What is an Undertaking?
Undertakings are legally binding promises you make as a borrower to a lender to do or not do something. In some instances, undertakings can even extend to third parties, where you must ensure a third party does something or refrains from doing something.
From a lender’s perspective, undertakings are an effective way to ensure that you act in a way that does not jeopardise your ability to repay the loan to the bank. Consequently, undertakings can control your company’s ability to:
- sell its assets;
- enter into additional loans; and
- spend its earnings.
Certain undertakings will also ensure you disclose important information to the lender.
What are Common Undertakings?
There are three types of undertakings, which include:
- financial covenants;
- information undertakings; and
- general undertakings.
Financial Covenants
As the name suggests, these are undertakings that reduce your company’s ability to engage in certain financial activities like borrowing.
Financial covenants can include:
- maintenance covenants, which require your company to maintain some aspect of its financial performance to a specified target; and
- incurrence covenants, which impose financial targets that your company only needs to meet if it wishes to do specific things, such as make dividend payments or sell certain assets.
In practice, most bank covenants are maintenance covenants as they want to ensure you can make your loan repayments.
Information Undertakings
Information undertakings ensure that you continue to supply your lender with information about your company’s performance after you sign the loan agreement. This can assure the lender that you will continue to meet your obligations under the loan agreement.
Additionally, an information undertaking may obligate you to provide:
- any other information upon the lender’s request requested (a sweep-up provision);
- information you provide your shareholders; and
- proof of insurance, particularly insurance on valuable assets.
General Undertakings
Some general undertakings you might find in a loan agreement include the obligation to:
- obtain certain insurance policies;
- maintain compliance with licensing requirements and laws;
- provide your lender with access to your company’s books;
- refrain from granting security to other lenders (a ‘negative pledge’);
- not grant other lenders superior unsecured priority;
- not to lend to third parties; and
- not grant dividends at all or above a certain amount.
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What Happens if I Breach an Undertaking?
Since undertakings are legally-binding terms, breaching an undertaking can have profound consequences. Consider the following scenario.
Suppose your company enters into a loan agreement with an undertaking that your company must meet a specific sales target. The following year, your sales declined, and the company’s earnings slipped below their projected forecast. Consequently, your company could be in breach of its undertaking and default on the loan. As such, the bank may be entitled to accelerate the loan and demand immediate repayment.
In practice, the loan agreement will have a provision that sets out what is commonly called a cure period. This is a period of time between 30 and 60 days where your company can take steps to remedy the situation. If your company remedies the situation, your lender is unlikely to take legal action.
Alternatively, you can ask your lender for a covenant waiver if your company cannot remedy the situation. A covenant waiver is where the lender agrees not to enforce the undertaking you breached. Nevertheless, if your lender grants you a waiver, it will usually impose a new set of financial covenants on your company that are calculated based on its present performance.
Key Takeaways
If you borrow money, your lender will likely want to impose binding obligations on you to ensure you can repay the loan. Consequently, your loan agreement will likely contain undertakings. Undertakings impose obligations on the borrower to do or not do something. If you breach an undertaking, this can have serious legal consequences. For this reason, you should seek professional advice before signing a loan agreement.
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Frequently Asked Questions
An undertaking is a promise to do or not do something as a condition of a loan agreement. An example is an undertaking to supply your lender with quarterly pro forma statements regularly.
Are undertakings legally enforceable?
Yes. An undertaking is a special kind of contractual term. If you breach the undertaking, the bank will gain certain rights to modify or terminate the loan agreement. In practice, unless the breach is egregious, your company will usually have time to correct the breach.
A covenant waiver is an agreement by your lender not to enforce an undertaking you have breached. You may need one if your company cannot remedy a breach within the cure period. However, lenders typically impose new financial covenants based on your company’s current performance in exchange for granting the waiver.
Maintenance covenants require your company to continuously meet specified financial performance targets throughout the loan term. Incurrence covenants only apply when your company wishes to take specific actions, such as paying dividends or selling assets, making them less restrictive than maintenance covenants in day-to-day operations.
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