Bank covenants and personal guarantees have this in common as far as manufacturers and others in the productive sector are concerned. They are the forgotten or uncharted reefs that can sink even the best run enterprise.
Peter Isaac has written the Banking Column in The Journal, the official publication of the New Zealand Institute of Chartered Accountants, for many years and now he gives us the benefit of his long experience with . . . . .
The Two Deadliest Bank Traps for Manufacturers: Covenants and Guarantees
Hidden trap No.1.
The long forgotten personal guarantee letter.
These undertakings are carefully husbanded by the banks. One of the main reasons that they filter out of the consciousness of the manufacturer who has signed the letter is that the undertaking was given for a specific project. Perhaps the acquisition of new plant or premises or a project. The loan for the plant, premises, or project having been repaid and with interest then the proprietor believes that the guarantee undertaking has become void. It is though very much current and alive from the bank's point of view. A personal guarantee remains a personal guarantee. Much more. It overrides limited liability which bankers instinctively dislike.
Immediately upon reading this proprietors must write to their bank or banks and formally ask if they are holding any undertakings of personal guarantees relating to their company and its shareholders. Replies must be written. Verbal assurances are not enough ********.
Hidden trap No.2.
The banking covenant.
This well camouflaged trap rests on the widely held notion by absolutely everyone, even those within the financial sector itself, that a loan during its pre-arranged term cannot be called in if interest is still being paid on it. This is not true.
The bank covenant in practical terms is a promise. In this promise the borrower pledges, i.e. covenants, themselves to the effect that their situation, especially their financial position, will remain constant for the term of the loan. One of the main purposes of the covenant is to stop the borrower taking on new debt or assuming it.
This is a sharp tooth trap for the manufacturer determined to pounce on an opportunity to bring scale to their operation. A trap, because however rational it appears to the manufacturer, it might with a sense of equal opportunity give a bank an excuse to call in a loan. In some ways a bank covenant is an early warning device implanted by the bank within the company, and often without even the conscious knowledge of that company.
It is planted to give the bank advance notice of a borrower moving intentionally or unintentionally into a situation in which they just might find it difficult to continue paying the interest or even paying back the entire loan..
Bank covenants come in two main categories. Affirmative covenants require the borrower to meet certain standards defined by the bank, such as maintaining a minimum level of liquidity, revenues or profitability. Negative covenants are intended to restrain the borrower from taking specific actions, such as adding more debt, making investments or replacing top management, without the bank's approval.
In fairly recent times we have seen banks invoke their covenants on two areas of the productive sector; foresters and manufacturers. Banks now rigorously police their covenant ratios and are often reluctant to take the word of borrowers as represented by their submitted financial data.
Manufacturers should not imagine that however rigorously compiled, that their financial balances are proof enough for their bank.
Though banks are increasingly de-centralising putting serious decision-making down to teller level, they are with equal determination centralising their loan policing. So smiles at the manufacturer's own high street bank may be matched by frowns at a distant and remote loan-vetting unit.
Some covenants do give the bank the right to pounce at any time and conduct its own spot audits especially in regard to collateral buffers.
Bank covenants are much more difficult than is often imagined by organisations that are bound by them. In addition to the standard dashboard ratios such as cash flow for debt service, working capital, and debt-to-equity, a bank covenant will cover eventualities for any sign of irrational exuberance in any form. Generous spontaneous dividends from manufacturers to shareholders are just one example here. In this one instance generosity is not viewed as a virtue. Not by a covenant-holding bank, anyway..
Bank covenants require the borrower to maintain the collateral provided for a loan and ensure the bank's senior lien position, as they describe it, remains unqualified. Any kind of charge placed on assets may trigger a sudden and unanticipated bank reaction.
Manufacturers are sometimes tempted to take a short and risky position to cover a project. The bank may be watching unseen and however temporary the dodgy passage may be, it could be long enough to trip a covenant.
These covenants beguile the unwary simply because with their biblical sounding resonance they seem to apply to a different epoch and era.
Immediately upon reading this you must ask formally at your bank or banks:-
a) What covenants they are holding in relation to your business with the bank.
b) Ask to see these covenants. Are you happy with them? Contrary to a widely held belief these covenants can be re-negotiated. They can be re-negotiated to chime with your current circumstances. Instead of those of just the bank.
Peter Isaac | | MSCNewsWire |