The Covenant That Was Never Tested
A commercial bank has a $40 million term loan outstanding to a logistics company. The loan carries a leverage covenant tested quarterly: net debt to EBITDA must stay below 4.0x. The borrower reports on a self-certification basis, and the bank's credit administration team enters the figures into the monitoring system. Nine months ago the borrower's CFO emailed a certificate showing 3.7x. Six months ago the certificate showed 3.9x. Last quarter no certificate arrived. Credit administration sent one reminder, logged it, and took no further action; the relationship manager said the borrower was "going through a busy period" and would catch up. The borrower has since announced a large acquisition funded with new debt. A junior analyst re-runs the numbers from the borrower's public filings and estimates leverage at 5.2x on a pro forma basis. The relationship manager wants to waive the covenant quietly to preserve the relationship and avoid a default classification before year-end.
1. Assess the credit risk implications of the missing certificate and the estimated 5.2x leverage. What should happen before any waiver decision is made?
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The missing certificate is itself a credit event, and it has been treated as an administrative lapse for a full quarter.
The covenant exists to give the bank an early warning and a right to act. A borrower that stops certifying while undertaking a debt-funded acquisition is exhibiting exactly the behaviour the covenant was designed to surface. The absence of a certificate should have triggered escalation at the first missed date, not a single reminder. The bank has lost a quarter of information and, on the analyst's estimate, may already be in breach.
On the 5.2x estimate: it is derived from public filings and is pro forma, so it is indicative rather than conclusive. But it is credible enough to require immediate action. Pro forma leverage after an acquisition is the right lens, because the acquired debt is real and the combined EBITDA may not materialise as projected. The bank should assume breach is likely until the borrower demonstrates otherwise with certified figures and a covenant calculation it can verify.
Before any waiver discussion:
- Demand the certificate and the calculation. Obtain the full compliance certificate, the covenant calculation with definitions applied, and the acquisition's financing documents. The bank is entitled to this under the loan agreement.
- Verify the definition. Check whether the acquisition is permitted debt, whether EBITDA is calculated on the agreed definition, and whether any equity cure or add-back applies. The gap between 3.9x and 5.2x may narrow or widen.
- Assess the breach formally. If leverage exceeds 4.0x, the bank has a contractual event. That determination belongs to credit, not to the relationship manager, and it should be made on documented figures.
- Re-underwrite. Update the internal rating, the expected loss, and the recovery analysis. Consider the borrower's liquidity, the integration risk of the acquisition, and whether the combined entity's cash flow services the debt.
- Escalate. Notify the appropriate credit committee and, if the classification is material, the risk function. The relationship manager should not control the decision.
2. The relationship manager argues that a quiet waiver avoids a default classification and protects the relationship. Evaluate this argument and describe the risks of granting the waiver as proposed.
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The argument conflates two different things: the borrower's credit condition and the bank's reporting of it. A waiver does not change the borrower's leverage; it changes only whether the bank records a breach. Avoiding a classification by waiving the covenant is not risk management, it is classification management, and regulators treat it as such.
The specific risks:
Understating the problem to the bank itself. If the loan is not classified, the bank's watchlist, provisioning, and capital calculations understate the exposure. The next set of financial statements and the next regulatory return will be wrong. That is a governance failure with a name, and it is the kind of finding that damages a bank far more than one defaulted loan.
Waiving without consideration. A waiver granted to preserve a relationship, with no fee, no additional security, no amortisation, and no information covenant, signals to the borrower that covenants are not enforced. The bank loses its future negotiating position, and other borrowers learn the same lesson.
Waiving before knowing the facts. The 5.2x is an estimate. Granting a waiver before obtaining certified figures gives away the bank's strongest lever in exchange for nothing, and the true position could be worse.
Concentration and contagion. The acquisition may have changed the borrower's business mix and its exposure to integration risk. The bank has not re-underwritten the combined entity.
The relationship manager's concern about the relationship is legitimate but is better served by a structured response. If the bank decides to accommodate the borrower, it should do so through a documented amendment: a reset covenant at a level reflecting the post-acquisition position, a fee reflecting the increased risk, enhanced reporting (monthly rather than quarterly, with audited figures), and possibly additional security or a parent guarantee. That preserves the relationship while pricing and controlling the risk. A quiet waiver preserves the relationship and transfers the risk to the bank's balance sheet without compensation.