Covenants #2 of 3: Financial Covenants: Legal Language and Math Equation

𝗙𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝗖𝗼𝘃𝗲𝗻𝗮𝗻𝘁𝘀: 𝗟𝗲𝗴𝗮𝗹 𝗟𝗮𝗻𝗴𝘂𝗮𝗴𝗲 𝙖𝙣𝙙 𝗠𝗮𝘁𝗵 𝗘𝗾𝘂𝗮𝘁𝗶𝗼𝗻

Years ago, I worked with legal counsel to draft a standard DSCR covenant for my institution. I suggested using words like "plus," "minus," and "sum."

He was surprised to learn that 𝗜 𝘄𝗮𝘀 𝗮𝗽𝗽𝗿𝗼𝗮𝗰𝗵𝗶𝗻𝗴 𝘁𝗵𝗲 𝗰𝗼𝘃𝗲𝗻𝗮𝗻𝘁 𝗱𝗲𝗳𝗶𝗻𝗶𝘁𝗶𝗼𝗻 𝗮𝘀 𝗮 𝗺𝗮𝘁𝗵 𝗲𝗾𝘂𝗮𝘁𝗶𝗼𝗻.

But that's exactly what it is: 𝗹𝗮𝗻𝗴𝘂𝗮𝗴𝗲 𝘁𝗵𝗮𝘁 𝗵𝗮𝘀 𝘁𝗼 𝘁𝗿𝗮𝗻𝘀𝗹𝗮𝘁𝗲 𝗰𝗹𝗲𝗮𝗻𝗹𝘆 𝗶𝗻𝘁𝗼 𝗮 𝗰𝗮𝗹𝗰𝘂𝗹𝗮𝘁𝗶𝗼𝗻, 𝗽𝗲𝗿𝗳𝗼𝗿𝗺𝗲𝗱 𝘆𝗲𝗮𝗿 𝗮𝗳𝘁𝗲𝗿 𝘆𝗲𝗮𝗿, 𝗯𝘆 𝘀𝗼𝗺𝗲𝗼𝗻𝗲 𝘄𝗵𝗼 𝘄𝗮𝘀𝗻'𝘁 𝗶𝗻 𝘁𝗵𝗲 𝗿𝗼𝗼𝗺 𝘄𝗵𝗲𝗻 𝗶𝘁 𝘄𝗮𝘀 𝘄𝗿𝗶𝘁𝘁𝗲𝗻.

With that in mind, here are a few tips for approaching financial covenants in your commercial loan documents:

𝟭. 𝗪𝗿𝗶𝘁𝗲 𝗶𝘁 𝗹𝗶𝗸𝗲 𝗮𝗻 𝗲𝗾𝘂𝗮𝘁𝗶𝗼𝗻. 
Use precise "math" language and parentheses to show order of operations. Then define what a formula alone won't capture: which figures feed it, what source they come from, and when the covenant is tested.

𝟮. 𝗨𝘀𝗲 𝘀𝘁𝗮𝗻𝗱𝗮𝗿𝗱, 𝘃𝗲𝘁𝘁𝗲𝗱 𝗹𝗮𝗻𝗴𝘂𝗮𝗴𝗲 𝘄𝗵𝗲𝗻𝗲𝘃𝗲𝗿 𝗽𝗼𝘀𝘀𝗶𝗯𝗹𝗲. 
A covenant that's been used repeatedly, added to policy, and reviewed by counsel is worth more than one drafted fresh each time. Standard language means your analysts can test most covenants the same way, which streamlines testing across the whole portfolio. There are times when a modification or custom covenant is warranted. Just go in knowing there’s an added ‘cost’ in more internal work to track and test something that is different.

𝟯. 𝗛𝗮𝘃𝗲 𝗮𝗻 𝗮𝗻𝗮𝗹𝘆𝘀𝘁 𝗿𝘂𝗻 𝗮 𝘁𝗲𝘀𝘁 𝗰𝗮𝗹𝗰𝘂𝗹𝗮𝘁𝗶𝗼𝗻 𝗯𝗲𝗳𝗼𝗿𝗲 𝗶𝘁'𝘀 𝗳𝗶𝗻𝗮𝗹. 
Real numbers can surface wording confusion or data-availability problems before the real calculations are being performed.

It's unlikely you'll ever end up in front of a judge interpreting your loan agreement's wording. But if you do, you'll be glad you documented something clear, concise, and enforceable.

Next week: making sure your borrowers actually understand the covenant requirements they're agreeing to.