For many individuals, the end of April brought a sigh of relief as both the first quarter and tax season drew to a close. Unfortunately, while everyone was focused on tax season, it was easy to overlook that the end of one season signaled the beginning of a new one: loan covenant compliance season.
Many commercial loan documents have three kinds of covenants that are particularly relevant at this time of year: reporting covenants, performance covenants and operating covenants. These covenants appear in loans of all shapes and sizes – including real estate and corporate finance transactions – and while timely compliance with such obligations can yield positive outcomes, the failure to timely comply can result in correspondingly negative results. In order to prevent unintentional covenant defaults and remind borrowers of the benefits that compliance can bring, a quick review of the information and evidence of compliance these covenants typically require is advisable at this time of year.
Financial Reporting Requirements
First, most commercial loan documents contain a variety of financial reporting requirements that have either just become due (or potentially delinquent) or are just about to become due. These requirements traditionally apply to borrowers and guarantors alike. For example, as a baseline check of the financial health of the entities involved in a lending relationship, lenders routinely require that their borrowers and guarantors provide copies of tax returns within a set number of days following the filing of such returns with the Internal Revenue Service (IRS) and/or any applicable state and local equivalents. Many lenders also require a multitude of other financial documents, i.e., personal and/or corporate financial statements, net operating income statements and rent rolls, among others. Samples of these types of covenants can include language such as:
a. not later than 60 days following each March 31, June 30, Sept. 30 and Dec. 31 that the Loan is outstanding, annual audited financial statements of Borrower
b. the Borrower shall deliver to Lender, within 45 days after the end of each fiscal quarter, an unaudited balance sheet and statement of profit and loss for Borrower as of the end of such fiscal quarter, together with all supporting schedules, including a current rent roll or leasing status report
c. not later than 60 days after filing with the IRS, a true and complete copy of the federal tax returns, including all schedules, of Borrower and of Guarantor
With any financial reporting covenants, the time for monitoring compliance with the applicable delivery deadlines for such reports is particularly relevant. If they have not already begun to do so, within the next few weeks, lenders will start checking their records to see if their borrowers and guarantors have delivered the requisite materials and, if not, will likely be calling to ask when to expect them.
Second, many commercial loan documents also require a number of performance-based covenants, ranging from minimum debt service, debt yield and/or fixed charge ratios to liquidity and net worth requirements. Again, covenants of this nature are found in both real estate and corporate finance transactions. Many performance-based covenants also contain objective measures by which the lender can determine compliance. Some samples of these types of covenants include:
a. within 60 days each March 31, June 30, Sept. 30 and Dec. 31 that the Loan is outstanding, the Borrower shall deliver to the Lender a certificate setting forth the Debt Service Coverage Ratio for the Property as of both the end of such quarterly period and the 12-month period preceding the date of calculation
b. within 60 days after the end of each quarterly period and each fiscal year of Borrower, the Borrower shall deliver to the Lender a certificate setting forth the Total Debt to Tangible Net Worth Ratio as of the end of such quarterly or annual period
c. within 45 days after the end of each fiscal quarter, a Borrower Covenant Compliance Certificate, signed by a duly authorized officer of Borrower, to the effect that at all times during the then-ended fiscal quarter, the Borrower and the Property were in compliance with the respective requirements set forth in the Loan Documents
There can be both positive and negative repercussions to compliance with these types of performance-based covenants. Beyond the obvious failure to deliver such certificates constituting a default under the loan, some other negative consequences can include triggering events such as a) loan resizing obligations, b) cash sweeps, c) limitations on distributions, d) more stringent reporting requirements on a going forward basis and e) increased liability under a guaranty or liquid assets covenant.
On the other hand, timely compliance can result in a) availability of earn out funds, b) burn off of guarantor liability as a property stabilizes, c) interest rate reductions as certain benchmarks are achieved and d) the release of certain lender required reserves. Admittedly, borrowers are more likely to remember to timely deliver certificates when an interest rate reduction is on the line, but a holistic review of all of a borrower's obligations are just as important. No borrowers want to find that a failure to deliver tax returns has created covenant defaults and prevented them from reaping the benefits of reduced interest rates or the ability to make distributions of available funds to its constituents.
Lastly, many loan documents contain various requirements on how a particular borrower conducts its business. These types of covenants range from the borrower being obligated to simply "timely pay all applicable taxes" to prohibiting the borrower from making distributions unless and until the performance covenants discussed above are in compliance. As the close of tax season tends to coincide with the members, shareholders or partners of borrowers needing funds to satisfy their respective tax obligations, compliance with operating covenants goes hand in hand with compliance with both financial reporting requirements and performance-based covenants.
Considerations and Takeaways
In short, spring brings many loan document covenants to the forefront and is a great time for both borrowers and lenders to carefully review upcoming covenant deadlines. If compliance with such covenants are not carefully monitored and tracked by all parties, this time of year can be particularly problematic for both borrowers and lenders.
To the extent that borrowers become aware that potential compliance issues may exist, rather than simply delaying submittal of the requisite information to avoid a conversation about a potential default, we suggest that borrowers proactively reach out to lenders to request a) additional time to comply with the covenants, b) a one-time waiver of a particular covenant or c) a modification to the loan to address the inability to meet the covenant in question. As many loans have servicers with which a borrower does not necessarily have a relationship, getting in touch ahead of a potential default may require more lead time and should not be delayed. In such cases, it becomes even more important to be ahead of any issues.
Putting a lender on notice that there may be an issue sooner rather than later generally leads to the lender's perception that the borrower is trying to do the right thing instead of trying to hide the non-performance and allows the relationship between borrower and lender to flourish. Likewise, if compliance with the covenants reaps positive benefits to borrowers, the relevant materials should be sent to lenders without haste and receipt confirmed well ahead of any deadlines.