The Relationship Between Proactive and Reactive Covenant Compliance

When looking at the proactive vs reactive debate, it is worthwhile to note that the two approaches share a cause-and-effect relationship and are not entirely independent. Covenant compliance drawn up without proactive measures are more susceptible to contract breaches, which would require reactive approaches to resolve. A lender who needs to set up efficient internal control and performance review parameters runs the risk of experiencing unforeseen covenant breaches in the future.

On the other hand, an efficient and thorough proactive approach can assist in mitigating risks and identifying impending covenant breaches. Since it is always better to be aware of an approaching risk or breach before it occurs, the proactive approach over the reactive approach makes better sense. In managing a contract breach due to the development of an unforeseen scenario, the reactive approach may prove necessary.

What is Covenant Compliance?

 

In finance, Covenant Compliance is a contractual agreement between two parties in which the borrower and the lender agree on the conditions under which a loan gets approved. The borrower is assenting to comply with the covenants of the agreement set by the lender, set up as a framework to protect the interest of both parties.

 

There are generally two types of covenants implemented by lenders. The first is the financial covenant, metrics, and ratios the borrower must maintain. Examples of financial metrics include debt-to-equity, interest coverage, and working capital, to name a few. The second type of covenant is non-financial, which includes limitations on the incurrence of additional debt, restrictions on asset sales or acquisitions, prohibitions on changes in management or control, and other non-financial aspects.

 

As mentioned, since the proactive approach mitigates the risk of any breach, it is usually the preferred method for covenant compliance. 

Measures Taken in a Proactive Approach 

 

Numerous proactive measures are available to the borrower and lender to maintain compliance. Key among these is the implementation of effective monitoring systems and communications channels that allow for swift identification of current problems and impending challenges, involving keeping track of key financial ratios, monitoring the borrower’s financial health, and keeping an open dialogue regarding possibilities of any potential issues.

 

Another important step in the proactive approach process is scenario planning, which accounts for possible changes in the business environment or how breaches could occur. A clear and thorough assessment of the borrower’s financial strength assists a lender in implementing sound financial management practices. These practices include budgeting and cash flow forecasting, which are vital in ensuring that the borrower and the lender undertake a profitable venture.

 

With careful negotiations and planning to ensure its maintainability, all parties are more likely to be aware of risks and ground realities of performance needed and the systems and processes under which the covenants will be adhered to. 

 

The benefits of a proactive approach are two-fold: It not only mitigates the risk of breach, but it also has the potential to prevent a breach from causing irreparable damage to the relationship between involved parties. 

Measures Taken in a Reactive Approach

 

There are some overlapping features between the proactive and reactive approaches. Borrowers and lenders can avoid compliance breaches by monitoring financial ratios and maintaining strong communication channels to correct the situation. Once a breach occurs, they can take certain reactive measures to uphold compliance. 

 

One of these is remedial actions, which involve the borrower undertaking necessary actions to rectify the contract breach, including negotiating with the lender, proposing solutions, and implementing corrective measures. 

 

Often, how a violation has occurred sets the path for its rectification. The breach of a collateral covenant can only be resolved by the borrower negotiating terms, offering new collateral, or reaching a new agreement.

In case of a financial ratio covenant breach, the borrower must propose a plan and collaborate with the lender to assess whether injecting additional capital or restructuring the debt is necessary. 

 

A reactive approach may increase costs and penalties, damaging relations between the parties. In many cases, the lender’s propensity to assist in either rectifying the situation or defaulting on the loan depends on the situation and the mindset of the concerned parties.

Penchant for Proactive with the Reality of Reactive

While the ideal scenario would be no breach in compliance, there still can be breaches or lapses, despite taking every proactive measure to safeguard from this. Borrowers and lenders operate in a reality where both proactive and reactive have utility and may be called upon to resolve a particular issue. Better preparation and risk analysis provide a better ecosystem for the overall health and stability of the borrower. Potential breaches are identified and dealt with before they arise.

 

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