Covenant Exception
Financial institutions specify covenants in loan agreements, thereby placing borrowers under certain obligations. Covenant-related exceptions occur when a borrower does not comply with one or more covenants previously agreed to in the loan agreement. Failing to proactively identify, track, and resolve covenant exceptions makes it difficult to properly assess credit risk.
Examples of Covenant Exceptions
Covenant exceptions typically occur when:
- Borrowers fail to perform a required action, or
- Borrowers take a prohibited action.
Specific exceptions may vary depending on loan agreement language, loan type, industry, and the financial institution’s relationship with the borrower. That said, common examples of covenant exceptions include:
- Failing to maintain proper insurance on collateralized property, commercial equipment, or another type of asset.
- Refusing to allow an inspection of the borrower’s inventory.
- Failing to submit required financial reports on the agreed to schedule.
- Incurring additional debt in a way that conflicts with stipulations outlined in the loan agreement.
- Failing to pay taxes, such as property or income taxes.
- Taking prohibited financial actions, such as unauthorized investments or dividend payments.
- Exceeding certain financial ratios, such as debt-to-equity or debt-to-income ratios.
Borrowers who refuse to live up to the covenants specified in their loan agreements may be subject to late fees, penalties, interest rate changes, additional collateral requirements, or even contract termination.
Tracking Covenant Exceptions
Managing covenant exceptions can be complex, especially for banks and credit unions with growing commercial loan portfolios. Borrowers are busy people, which means they may require multiple requests to obtain missing insurance policies or financial statements. Waiting until items are due (or past due) is not an effective method.
Financial institutions commonly use ticklers and spreadsheets for covenant exception tracking. Using software that offers built-in exception management, such as AccuAccount from Alogent, is another approach. In addition to supporting covenant tracking, AccuAccount can simplify other processes like policy exception reporting and audit preparation.
