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Tips for Drafting Better Bank Covenants

Banks typically use financial covenants in loan documents for a variety of purposes.  However, breach of a financial covenant can have serious consequences for the borrower, including default.  Given the high stakes, banks should be cautious in carefully drafting financial covenants so that covenants are clear, enforceable and not easily manipulated.

One typical financial covenant for a line of credit is a covenant that limits advances under the line of credit by a formula based on eligible accounts receivable.  In defining eligible accounts receivable in the covenant, it is key to make the formula based on the number of days past the invoice date instead of the due date. 

An example demonstrates the difference.  A bank may wish to restrict eligible accounts receivable to those less than 90 days old on the assumption that receivables over 90 days are less likely to be paid.  If the bank defined the covenant as “90 days past the invoice date,” then this is a clear statement about when the 90 days period begins and ends.  If an invoice isn’t paid 90 days after the date the invoice is issued, then the account is excluded.

If the bank defined the covenant as “90 days past the due date,” a borrower could have payment terms with a customer of Net 45.  This would mean that a borrower could include accounts that were actually 135 days beyond an invoice date, as opposed to 90 days.  In addition, the problem could be expanded if the borrower agreed to further extend a due date with a customer.

A carefully worded financial covenant can avoid unintended consequences and can help the bank avoid a situation where the bank’s position is unclear.