How a Major National Bank Used a Technical Default to Extract its Pound of Flesh

It was a great relationship going in. All handshakes and smiles. “We are happy to make this real estate loan and we don’t need the practice’s business banking. I mean, it would be nice, but that’s fine…” until it isn’t!

This is a story of just how incredibly important each and every covenant can be in a borrower’s loan documents. Understanding and monitoring your obligations will help you be prepared if:

• The relationship turns sour,
• Personnel or policies change in a way unfavorable to the borrower, or
• Regulators require the bank to trim its portfolio.

“LET THE BORROWER BEWARE”

In this particular case, a large specialty group in the northeast failed to meet a bank ratio covenant, which triggered a technical default. In most scenarios like this, the lending bank will work with the borrower to cure the breach or make sure it is not repeated. This bank felt that there was an implicit agreement by the borrower to consider shifting its depository business. The borrower felt there was no such obligation and, as it was a not a stipulation of the loan agreement, did not plan to move deposits. That did not sit well with the lender and when the borrower missed on a covenant ratio, the bank did not hesitate to make its point … in spades! The bank gave the borrower three options. It could:

a) move its accounts to this bank,

b) pay back the loan, or

c) pay a penalty of $275,000.

When William Congreve wrote that “Hell hath no fury like a woman scorned,” he obviously had never met an unhappy banker.

By sharing this experience, it is the writer’s hope that future borrowers may never find themselves in such a position by following CMAC’s three “Covenant Canons.”

1. Negotiate – Don’t agree to something that you don’t fully understand or feel may be troublesome. Try to recognize what security the bank is seeking and look for a better way to provide it.

2. Test – Some formulas can be rather complex. Sit down with the bank and have them use your historic performances as examples so that you can fully understand the method of testing and assure yourself that you would meet the standards now and in the past.

3. Monitor – Things change. By constantly testing, you should never be surprised by a breach of a covenant. By going to the bank early, you will either find a way to work around the breach with the bank or have advance notice to seek other options.

The Easiest Technical Defaults

While most borrowers are focused on numbers and ratios, other breaches, generally involving reporting, can be subtle and just as deadly. One of the least noticeable and most pervasive is the reporting requirement on personal guarantees. We consider this reporting requirement a much greater risk than the guarantee itself. Consider a group of 20 partners who are required, by virtue of their personal guarantees, to send their personal financial information to the bank within 30 days from the end of a period and just one of them does not make the deadline. Bingo!

A Better Ending

In the case of the northeast borrower, CMAC negotiated with the bank to find a more palatable outcome for all parties. The bank raised the fixed rate by just a few basis points with an understanding that it would reduce the rate back to its original level should the borrower ever move its deposits. A soft landing, admittedly, but one that we all would have rather avoided.

The bottom line is that every provision in a loan agreement can be important no matter how mundane it may appear. Understand your obligations, make sure you are comfortable meeting those obligations, and monitor your performance to ensure compliance!