There are two major ways a lender can declare a covenant default, that is, a default that results not from the failure to make a loan payment, but one that results from a change in the borrower’s financial condition. Typical commercial loan documents require the debtor to maintain certain minimum financial conditions, such as specified levels of inventory, debt coverage, net cash on hand and the like. Pretty boring stuff. The pinch point for the loan parties is how to craft the loan documents so that the lender’s need to declare a default in the face of a borrower’s deteriorating financial condition is balanced by the borrower’s need to have some measure of predictability.
One aspect of financial covenants that is worth greater consideration is whether the default should be triggered by “incurrence” or “maintenance “of a proscribed financial condition. In simple terms, a “maintenance" trigger can be pulled if the borrower fails to continuously meet a financial covenant as reflected at the end of each quarter, each fiscal year, or whatever time period the agreement specifies. On the other hand, an "incurrence" test triggers an immediate default at whatever point in time the covenant fails. Each test triggers on a different event, and each has advantages and disadvantages.
For example, suppose the documents contain a maintenance test measured at the end of each fiscal quarter: At quarter end, after financial statements have been prepared, the borrower would be obligated to inform the lender that the financial covenant has not been maintained. Accordingly, since borrowers don’t like to "rat themselves out," the lender most likely will not know about the default until after the financial statements have been prepared and presented to the lender.
On the other hand, an incurrence test means that the default occurs simultaneously with the breach of the covenant. However, the lender will likely not know about the covenant default until after those same financial statements have been prepared and delivered. Sometimes, though, the lender will have sufficient information to trigger an incurrence test earlier than would happen under a maintenance test.
Accordingly, the lender will be pushing for an incurrence trigger, while the borrower will want a maintenance trigger, since the maintenance trigger will ordinarily give the borrower additional time to deal with the problem, or simply postpone the inevitable.
This post was written by attorney Rick L. Knuth