What Does the Term ‘Covenant’ Mean in My Loan Agreement in England?

Your business may require a loan for various reasons. As such, you must be aware of covenants and the consequences of breaching them. Taking out a loan may be part of a strategic commercial decision, not only due to financial struggles. For example, your business may invest in modern machinery with a high one-off cost to avoid falling behind competitors. You may forecast that investing in new equipment now may result in higher profit margins in 12 months. However, to obtain a business loan, you must agree to some strict wording, some of which are called ‘covenants’. This article will explain what a covenant in a loan agreement is, why it exists and how breaching it can impact your business.

What is a ‘Covenant’?

In brief, a covenant is a contractual promise in which your business agrees to perform a particular action or, alternatively, agrees not to carry out a specific activity. A covenant differs from other clauses in a loan agreement in that a breach of a covenant will result in more severe consequences.

Why Do Lenders Use Covenants?

The priority of a lender is to try and ensure it can recover all money lent to your business. As such, a lender will use loan covenants to try and limit your business to activities that are not adverse to making a profit (and repaying the loan). This will include restrictions on offloading company property or agreeing to further loans.

Types of Loan Covenants

Covenants relating to your company’s financial performance ensure your company does not become insolvent. They may require your business to avoid taking on other loans without the lender’s permission and paying valid invoices to avoid falling into debt. The lender wants their loan to your company to be your main priority.

Additionally, covenants tend to require your business to avoid specific actions, such as disposing of assets without the lender’s prior consent and increasing the total debt owed by the company. The lender will want your company to make money rather than lose it, so it has a greater ability to repay within the loan’s lifetime.

They may also require your company to provide information about certain activities, such as the swift provision of accounts and financial statements to the lender. Furthermore, they may compel you to inform them of potential future investments. Most lenders do not wish to be overly involved, so other than a few specific actions, they will try and leave you with discretion regarding how to run your business.

Breaching a Covenant

Breaching a covenant can have severe consequences. If your business breaches a covenant, the lender may:

• terminate the loan agreement;
• ask for immediate repayment of the loan amount; or
• commence insolvency proceedings against your company.

These reflect the worst-case scenario outcomes. You may find that some lenders are far more lenient and flexible than others. Furthermore, their attitude can depend on the exact purpose of the loan.

Are Negative Loan Covenants Negotiable?

Loan agreements and negative loan covenants are negotiable. However, this will often depend on the parties’ bargaining positions. Suppose your business is merely looking for a non-urgent loan to cover an upgrade of IT equipment, which should repay itself through increased profit within 12 months. In that case, you will have more latitude to negotiate terms with prospective lenders. However, if your business needs an urgent injection of cash to safeguard its future, you will be in a weaker bargaining position regarding the lender’s financial conditions. Instead, you are more likely to accept all but the most absurd terms.

Key Takeaways

Loan agreements are well-known for containing very serious financial covenants. While some may seem excessive, the lender’s priority is to ensure the stable economic performance of your business. Because the breach of covenants within loan agreements can have serious repercussions, it is helpful to obtain legal advice about their meaning and any potential negotiation.

If you need help with the drafting or negotiation of loan agreements, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.

Frequently Asked Questions

What happens if a borrower defaults on a loan agreement?

The lender can terminate the agreement. However, some lenders may consider the reasons for the default and give you a chance to catch up.

Can covenants be tailored to suit the purpose of the loan?

Absolutely. Some lenders are happy to include less restrictive covenants if the loan is to assist a relatively safe investment.