Covenants #1 of 3: Don’t document a loan covenant you can’t test!

𝗗𝗼𝗻'𝘁 𝗱𝗼𝗰𝘂𝗺𝗲𝗻𝘁 𝗮 𝗹𝗼𝗮𝗻 𝗰𝗼𝘃𝗲𝗻𝗮𝗻𝘁 𝘆𝗼𝘂 𝗰𝗮𝗻'𝘁 𝘁𝗲𝘀𝘁!

I remember these words, emphatically shouted to my classmates and I from a lively credit trainer. Even though 20 years have passed since that class, I remember those words as though they were spoken yesterday.

It sounds painfully obvious. Nobody sets a covenant with the intention of creating a mess - or worse, unenforceable language in your loan documents. And yet, I still encounter situations today where covenant language is a problem.

What makes a covenant impossible to test? It doesn’t matter whether it’s a DSCR, leverage, or net worth covenant. In my experience, the most common culprit is the reference to numbers or other information that you'll never be able to obtain:
 • 𝗠𝗲𝗿𝗴𝗲𝗱 𝗲𝗻𝘁𝗶𝘁𝗶𝗲𝘀: the covenant measures one entity, but that entity's financials are merged with others for reporting and never broken out in a schedule.
 • 𝗠𝗶𝘀𝗺𝗮𝘁𝗰𝗵𝗲𝗱 𝗿𝗲𝗽𝗼𝗿𝘁𝗶𝗻𝗴 𝗳𝗿𝗲𝗾𝘂𝗲𝗻𝗰𝘆: the covenant calls for a monthly or quarterly test, but the borrower only submits annual financials.
 • 𝗨𝗻𝗱𝗲𝗳𝗶𝗻𝗲𝗱 𝗳𝗶𝗴𝘂𝗿𝗲𝘀: the covenant references a number that requires judgment to derive — maintenance CapEx being the classic example — without ever defining how to calculate it.
 • 𝗧𝘆𝗽𝗼𝘀: yes, these still happen more often than they should. I ran into an "after-distributions DSCR" covenant that very clearly added distributions to the numerator when it should have subtracted them.

My advice: Someone should be reviewing draft loan documents specifically for covenant language. Ideally, that individual should "do the math" and confirm that the financial statement requirements will provide the numbers needed to calculate covenants.

When I sat down to write this article, I had much more to say – so in the coming weeks I’ll share more thoughts on "𝗪𝗼𝗿𝗱𝘀 𝘃𝘀. 𝗠𝗮𝘁𝗵" in loan covenants.