Raman Menon was worried and concerned. He had recieved a call a short while earlier from his banker congratulating him on his loan request being approved. The sanction letter that was faxed shortly afterwards contained various conditions and the disbursal of the loan was contingent on the conditions being met. The concern Menon had was on the nature of these stipulations. He wondered whether he should accept a loan that is conditional.Conditions imposed on facilities extended by banks, also known as covenants, are imposed by banks upon a borrower to:
Preserve the borrower's financial strength.
Maintain the borrower's ability to refinance itself - the borrower (being a limited company or a business) continuing as a going concern.
Control the asset - prevent the borrower from selling assets to ensure that assets are not dissipated.
Ensure that the borrower does not do something that would be against the bank's interests.Covenants, therefore, are from a banker's perspectiveextremely important in the structuring of a loan. While a risky, unsecured loan will not become good by covenants, they will afford some comfort and a degree of control including providing warning signs should the financial position of the company deteriorate. The amount of covenants that can be imposed on a borrower would depend on:
The borrower's antecedents. Has he or she borrowed before and what is the repayment history.
The need of the borrower for the facility/loan.
The kind of facility required.
The nature of the borrower's business and the industry wherein he operates.
The borrower's financial health.
The risks involved.Covenants imposed are always negotiable and negotiated. Banks will always attempt to impose very exacting covenants. Some may be too exacting and impractical. Therefore a borrower must, at the time the facilities are being accepted ensure:
The covenants are reasonable and realistic
The covenants will not affect thegrowth or stability of the company.Very restrictive covenants can retard growth. The borrower, while appreciating the banker's need, must also consider his own. He would be extremely shortsighted if he accepts conditions that are detrimental to his interests or restricts his ability to function freely.
Covenants do not serve any purpose if they are not effective. The banker will therefore make certain that action can be taken for non compliance of the covenants. The remedies available to a banker are:
Taking an additional collateral, thereby strengthening the loan.
Seizing the assets secured and selling them.
Procuring further collateral such as a mortgage on another asset or a guarantee (preferably another bank guarantee)
Restructuring the loan
Increasing the rate of interest on the loanCovenants may be positive or negative.
Positive covenants are requirements made on the borrower to do certain acts. Some of the more common ones are:
The borrower mustpresent a monthly statement or as required information on stocks and debtors. This is usually required if stocks and debtors have been hypothecated for an overdraft working capital facility.
The borrower must ensure and maintain the assets that have been given as collateral for the loan.
The borrower must comply with all laws.
The borrower must pay taxes regularly.Negative covenants while they don't force the borrower to perform certain actions require him to ensure certain things and restrict him from certain acts. A requirement could be that no assets may be pledged or no dividend declared without the permission of the bank. These are designed to protect the lender from the dissipation of assets, to protect his security and to an extent preserve the financial strength of the borrower.
Negative covenants usually:
Restrict actions such as payment of dividends; sale of assets; limitations on additional loans; purchase of investments and the giving of additional loans;purchase of investments and the giving of advances, and mortgaging of assets.
Maintenance of financial strength (usually in the form of ratios) such as leverage and liquidity.
Specific restrictions to ensure existing management stays, on the sale of debtors, on lending to subsidiaries or group companies and on investing on group companies.Covenants are, in short, safeguards and are always tailor-made to the requirements of borrowers and lenders based on their respective weaknesses and strengths. Covenants must therefore be seen as safeguards imposed on a borrower to preserve the borrower's ability to repay the loan.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
