Main duties of banks include giving loans and facilities. This venture, brings profits to banks, nevertheless, it is full of risks. The associated risks are numerous, however, let’s take legal risks as example. This risk includes many issues as choice of the applicable law, jurisdiction and others including documentation. The loan agreement could be a bomb in the hands of the bank. Therefore, attention is required while drafting docs with the intention of giving full security to the bank.
To give security, the loan agreement shall include clear covenants. A covenant is a promise on the part of the borrowers to uphold certain conditions stated in loan agreements. Covenants are to protect creditors from risk associated with lending and compel borrowers to maintain their physical assets and forbid them from taking certain actions that could affect the equity. A loan covenant is a condition in a commercial loan that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met. Violation of a covenant may result in declaring default event, applying penalties, or calling the loan. The legal provision in the agreement providing for calling the loan, in other words the “Acceleration Clause”. Once the buyer defaults, all future payments due under the loan are “accelerated” and deemed to be due and payable immediately. This works as an injection and the purpose is to help the lender ensure that the risk attached to the loan does not unexpectedly deteriorate prior to maturity. From the borrower’s point of view covenants often appear to be an obstacle at the time of negotiating a loan and burdensome restriction during its term. It is important to mention that, covenants may be waived, either temporarily or permanently at the sole discretion of the lender, however, this depends on the merits of each case and varies from bank to another.
Even if the borrowers continue to pay the loan on time, they may perform certain actions that jeopardize their ability to pay back. To protect from risk, the lender may ask the creditor to enter into a covenant, which helps dictate the terms under which business remains eligible for a loan. Usually, covenants include maximum debt-to-equity ratios that the company must observe. Lenders calculate this ratio by dividing any debt a company owes by the amount of equity the company owns. The debt-to-equity ratio is the relationship between a company’s total debt and its total equity. Covenants can require a business to take out a certain amount of insurance as well as prescribe what business liens are permitted. In what’s called a negative loan covenant, creditor’s limit how much a company can owe at any given times and establish the payment schedule for dividends, if any are offered. Also, restriction regarding mergers, acquisitions, divestiture and investments in capital.
Potential creditors use the current ratio to measure a company’s ability to pay off short-term debt. If a covenant is broken, the lender has the right to extract penalties from the borrower, including enforcing its obligation or restricting further access to the business’s line of credit or other actions. Banks shall always put clear loan covenants and explain them to their clients at negotiations. This makes the deal acceptable to both parties.
Dr. AbdelGadir Warsama
LEGAL COUNSEL
Email: AWARSAMA@WARSAMALC.COM
