Friday, March 16, 2012

How Can My Loan be in Default if I Never Missed a Payment?

Delinquent loans, mostly residential, are constantly in the news, so it is easy to understand why some business owners may lose track of the fact that missed payments are not the only way to get in trouble under commercial loans, or leases or joint venture agreements, for that matter.

Contracts, and a loan is just a type of contract, typically contain a number of promises, “covenants” in legalese, that the parties make to each other. In a business loan, the lender promises to lend money, and, in return, the business promises to repay that money plus interest. The borrower’s promises don’t stop there, however, and a failure to keep any one of those promises, a breach of covenant, can result in foreclosure or bankruptcy as easily a failure to make payments.

A front-page story in a recent Denver Business Journal highlights the importance of these covenants. A local redeveloped retail center is in foreclosure despite the developer never having missed a single loan payment. Unspecified loan covenants are cited as the issue.

Loan covenants can be expressed as things the borrower must do (affirmative covenants) and things the borrower cannot do (negative covenants). Affirmative or negative, it doesn’t matter; breach of either can land you in the same trouble as missing payments.

Crocus are one of spring's pleasant surprises. Don't let loan covenants be an unpleasant one.
Covenants about the company’s finances typically get the most notice. These promises, in theory, are designed to help the borrower avoid getting to the point of missing payments. Requiring the borrower to maintain a minimum net worth relative to the loan is a common covenant, as are limitations on the ability of the business to pay compensation or dividends to its owners.

Restrictive covenants not explicitly about finances are also part of the loan package. These covenants may be buried in pages and pages of loan documents, and are sometimes ignored in the rush to make sure the financial aspects of the loan make sense. Not anticipating the limitations these covenants impose on your business may hamstring your company, usually at the worst times.

For example, you may not surprised by a covenant that limits the borrower’s ability to sell its business without paying off the loan (though prepayment penalties may still apply), however, more than one business has been surprised to learn that they need their bank’s consent to acquire another business, even if borrowed money isn’t used in the deal.

Medical marijuana poses a special problem for Colorado property owners. A typical covenant in a commercial real estate loan requires that the property be used in compliance with laws. Legal under Colorado, not legal under federal law; what’s a landlord with a loan to do? The safest choice is to not accept the tenant without lender consent.

Your best opportunity to negotiate flexibility into your loan covenants is, of course, BEFORE you sign the loan. Have your lawyer explain the proposed covenants to you and decide then what you can and can’t live with. Use the threat of losing your loan to another lender to your advantage. Attempting to negotiate a forbearance agreement after your lender has threatened to call, or even called, the loan for breach of covenant is a poor second option.

South Dakota's Badlands should be seen; the badlands of covenant breach should be avoided.

There is one more covenant to consider: the term of the loan. Even if you have paid the loan on time and haven’t violated any covenants, the bank may still choose not to renew your at the end of its term. Business loans have short terms, 5 years typically, (distinguished from lines of credit that are renewed annually). These loans don’t fully amortize, meaning large balances, or balloons, have to be repaid or refinanced at the end.

In this lending environment, take no chances and start renewal discussions early enough for you to negotiate with new lenders in case your current lender says no or imposes unacceptable terms on you. Lastly, be sure to include your business lawyer in the process. Avoid potential loan issues on the front end is always easier than negotiating out of them later on.

1 comment:

  1. Wonderful blog! I appreciate it. I'm sure the lender would consider you in default. But the lender doesn't make the law. The question is whether you are legally in default under the definition in federal law. If you're not legally considered in default then the lender can't do most of the nasty things mentioned in this article. Be careful! thanks! @Melinda G.

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