What happens if you breach a debt covenant?

A covenant breach is serious, but it does not automatically mean that a lender immediately takes control or demands repayment. The outcome depends on the covenant, the loan wording, any cure period, the company’s wider position and the lender’s decision.

The best response starts before the test is failed: confirm the facts, update the cash forecast, involve advisers and speak to the lender while credible options remain.

What has actually happened?

A covenant is a contractual promise. Financial covenants test numbers such as minimum cash, revenue or debt service. Information covenants require reports or notices. Negative covenants restrict actions such as taking new debt or selling assets.

A breach may immediately constitute an event of default, become one after a grace or cure period, or be capable of remedy under a specific mechanism. An event of default is a defined trigger that can give the lender additional contractual rights.

Read the exact agreement and identify the relevant entity, test date, calculation, threshold, notice duty and remedy. Do not assume that correcting the operational problem automatically removes the legal default.

The first 48 hours

1. 1Recalculate the test using the contractual definitions and preserve the supporting evidence.
2. 2Check related clauses: notice, draw conditions, repeating representations, cross-default and events of default.
3. 3Update the short-term cash forecast and identify all payment dates.
4. 4Tell the board and engage finance and legal advisers.
5. 5Prepare a factual lender update and a proposed path forward.

Avoid taking a new draw, moving assets, paying shareholders or signing another financing before checking whether the agreement permits it.

Notification

Many agreements require prompt notice of an actual default and sometimes an expected one. The deadline may be shorter than the normal reporting cycle.

A useful notice separates confirmed facts from forecasts. State the covenant, period, calculation, size of the miss, cause, liquidity effect, corrective action and request to the lender.

Early communication does not guarantee accommodation. It does give the lender more time to assess the request and signals that management understands the problem.

Cure periods and cure rights

A cure period is time allowed to remedy certain breaches before further consequences arise. Some failures, such as a late report, may be curable by delivery. A negative covenant breach may have no practical cure because the prohibited action has already occurred.

An equity cure is a specific mechanism allowing new equity proceeds to repair a financial test in the agreed way. It is not automatically available and may be limited by timing, frequency, amount or how the proceeds enter the calculation.

Do not wait for cure-period expiry to approach the lender. The business issue and cash position may continue to worsen while the contractual clock runs.

Waiver, amendment and reset

A waiver is the lender’s agreement not to exercise specified rights for a particular breach. It should identify exactly what is waived and whether related defaults or draw conditions are covered.

An amendment changes the loan documents. A covenant reset is an amendment to future thresholds, often accompanied by revised forecasts, reporting, pricing, fees or other protections.

A waiver of one breach does not necessarily waive the next test or change the covenant permanently. Confirm the effective period and every condition.

What the lender may ask for

The lender’s objective is usually to improve confidence in repayment. It may request:

• more frequent financial and cash reporting;
• a revised budget and recovery plan;
• additional equity or restricted cash;
• tighter covenants or controls;
• a waiver or amendment fee and higher pricing;
• reduced or cancelled undrawn commitments;
• asset-sale or refinancing milestones; or
• additional security, where legally and commercially available.

The borrower should model the whole package. A temporary waiver that creates an unachievable covenant next quarter may only defer the problem.

Potential default consequences

Depending on the agreement and required lender decisions, consequences can include blocking further drawings, default interest, cancellation of commitments, acceleration of the loan, cash control or enforcement of security.

Acceleration means making outstanding debt immediately due. Enforcement means using contractual or security rights to recover value. These are not automatic outcomes of every covenant miss, but they are real downside rights.

A breach may also trigger cross-default in another agreement, affect directors’ decisions, complicate fundraising or create disclosure obligations. Review the company’s complete financing and legal position.

How lenders usually think

A small technical failure that is corrected quickly differs from a breach showing that the company is running out of cash. Lenders consider cause, severity, liquidity, management credibility, investor support, repayment prospects and whether the recovery plan is realistic.

The lender may prefer a workable amendment to enforcement when the viable business and repayment outcome are better preserved. That incentive should not be mistaken for an obligation to agree.

Negotiating the solution

Present a request that solves both the current breach and the forward credit issue. Include updated actuals, a monthly base and downside forecast, actions with owners and dates, and the specific waiver or amendment required.

Keep alternatives alive where possible: new equity, cost reduction, asset sales, refinancing or a strategic transaction. Know the company’s cash deadline and the approvals each option needs.

Document every agreement. Supportive conversations are not a waiver unless the authorised parties complete the required legal process.

Common mistakes

• Assuming the calculation is wrong without checking the contractual definition.
• Waiting until the certificate or payment date to disclose a forecast breach.
• Seeking a one-period waiver without fixing the next test.
• Treating investor interest as committed cash.
• Continuing restricted actions while a default is outstanding.
• Giving different forecasts to the board, lender and investors.

The bottom line

A covenant breach creates a contractual problem and often reveals a business or liquidity problem. Address both.

Confirm the wording, notify promptly, show a credible downside plan and negotiate a documented solution before time and cash remove the available choices.

Where to go next

• Covenants in growth lending explains the promises and tests that govern the facility.
• Events of default sets out the contractual triggers that give lenders additional rights.
• Amending or extending a growth debt facility covers waivers, resets, extensions and additional commitments.
• What happens if a company cannot repay growth debt? covers the options and risks when repayment becomes uncertain.