Covenant breach

The most important facts in brief:

1. A covenant breach is a key indicator of a company's potential financial problems and a risk for lenders. Such a breach of covenants in the loan agreement can have significant legal and financial consequences, which is why management must act quickly. Here you can find out exactly what a covenant breach is, what legal consequences and economic consequences it entails and what measures the management must take.
2. The risk of insolvency can be reduced through early analysis and strategic action. A professional restructuring concept is the key to securing the company's future and maintaining the trust of lenders.

What is a covenant breach?

Covenants are contractual conditions that companies must comply with vis-à-vis lenders. These covenants are divided into two categories:

• Financial covenants: Key figures such as leverage (net debt/EBITDA), gearing (total debt/equity) or debt service cover ratio (free cash flow/debt service), which must be complied with regularly and represent an early warning system for lenders.
• Non-financial covenants: Reporting and information obligations as well as other requirements that ensure creditor protection through provisions such as negative pledge or cross-default clauses.

If the borrower fails to meet the agreed financial covenants or breaches another condition in the loan agreement, this constitutes a breach of covenant or covenant breach.

Legal consequences of a breach of covenant?

A covenant breach has various legal consequences:

• Special right of termination: Lenders can terminate the contract prematurely if contractually stipulated cure periods have not been met.
• Drawdown block: In the case of revolving loans or working capital lines, further borrowing can be blocked.
• Increased interest rates and post-collateralization obligations: Lenders can insist on collateral and demand higher interest rates.
• Reporting obligations and sale of receivables: Increased transparency requirements and the possibility of selling receivables to third parties.

Economic consequences of a covenant breach?

A covenant breach entails considerable economic risks.

Termination of the loan can lead directly to insolvency, as the company is rarely in a position to repay the full amount in the short term.

Even if lenders refrain from terminating the loan, the contractual drawdown block can result in the company lacking liquid funds for business operations. This makes it more difficult to continue operations and increases the risk of illiquidity.

Obligations of the management in the event of a covenant breach

In the event of a covenant breach, the managing directors are faced with the challenge of ensuring creditor protection on the one hand and safeguarding the continued existence of the company on the other, while at the same time involving other corporate bodies.

Obligations that serve to protect creditors:

• Check insolvency maturity: The management must check whether the company is insolvent or overindebted and possibly file for insolvency;
• Prohibition of payment in the event of insolvency: from the point of insolvency, the management may only make payments that serve to maintain business operations.

The obligation to safeguard the portfolio requires:

• Analyzing and eliminating the causes of the crisis: a restructuring concept is often required to address the causes of the crisis;
• Avert termination: start negotiations with financiers on adjustments ("covenant reset") or suspension ("covenant holiday") of the financial covenants as early as possible;
• maintain business operations, e.g. conclude standstill agreements with creditors and take out bridging loans.

Involvement of other corporate bodies:

• Comply with reporting obligations: The management must report regularly to supervisory bodies and, if necessary, convene shareholder meetings
• if half of the share capital or share capital is lost, the shareholders must be informed and a shareholders' meeting or general meeting must be convened;
• The management of a GmbH generally requires the approval of the shareholders' meeting
  • for the implementation of a restructuring concept,
  • when filing for insolvency due to imminent insolvency (no obligation to file for insolvency) or
  • upon initiation of reorganization proceedings in accordance with the StaRUG
• In the case of AGs and SEs, the Executive Board is obliged to observe the corresponding approval requirements of the Supervisory Board.

Restructuring concept as a way out of the crisis

A restructuring concept is essential to give creditors and stakeholders confidence and to minimize liability risks. It serves the following objectives:

• Exclusion of the risk for the company's creditors of being held liable themselves in the event of subsequent insolvency for aiding and abetting the delay in filing for insolvency;
• Exclusion of the risk of avoidance by the insolvency administrator for all legal transactions concluded by a company in crisis without a viable restructuring concept;
• Prerequisite for restructuring privilege for loans from stakeholders who acquire shares in the company for the purpose of restructuring;
• Information basis for the corporate bodies (management, supervisory board) for the exercise of entrepreneurial discretion when deciding on restructuring measures (business judgment rule)

Requirements for a restructuring concept

The essential components of an effective restructuring concept include

• A comprehensive analysis of the economic situation,
• the definition of a stable and sustainable business model and
• concrete measures for crisis management.

A restructuring concept that complies with IDW Standard S6 is legally secure and provides a basis for the long-term stabilization of the company.

This article provides a non-binding overview of the subject area covered and does not replace legal advice. For further information or personal advice, please do not hesitate to contact us:

• Dr. Stephan Brandes