Ongoing Monitoring with Annual Reviews and Covenants

By Nick Reynolds, Vice President/Credit Services Manager of CU Business Group, LLC

The risks associated with business lending differ significantly from those associated with traditional consumer lending.  While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied, and wider in scope.  This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.

One area in which commercial loans differ from consumer loans is ongoing monitoring requirements.  Regulators expect you to maintain an ongoing understanding of your borrower’s current financial and business conditions.  This can be a challenge if your portfolio consists primarily of smaller-dollar transactions, but at the very least you should have a program in place to monitor the financial condition of your largest business relationships.

At a minimum, an annual or periodic review is required.  These reviews can be tiered, based on dollar amount, to match the appropriate level of analysis with risk.  Lower tiers should consist of an annual review memo with a review of payment history, fresh credit reports, and updated risk rating.  Higher tiers should consist of a site visit, cash flow analysis, and collateral assessment with a complete package of updated financial information from both the business and all guarantors.  After careful analysis of the borrower’s financial condition, you must decide if the risk rating should remain unchanged.

If your borrower’s financial condition has remained stable or improved, all the better.  But this is not an academic exercise.  If the financial condition of the borrower has worsened, you need to consider how to proceed.  Usually, at a minimum, you need to have a heart to heart conversation with your borrower to determine if they share your concerns.  Ideally they do, and have a plan for improvement.  If not, you should offer the benefit of your counsel, and take care to ensure they understand your credit union’s expectations.

One common way to implement actionable performance standards is through the use of covenants.  For example, a borrower with a history of distributing too much income to the owners might benefit from a minimum debt service coverage covenant.  It is important to recognize the borrower can’t meet what he doesn’t understand, so all covenants should be clearly documented and discussed at loan inception.

Covenants are a valuable tool for identifying issues that have a detrimental effect on your borrower’s financial condition.  But a covenant won’t make a bad loan good, and it is unlikely you can change borrower behavior with a covenant.  If the business has always operated at a debt service coverage ratio of 1.0, placing a covenant of 1.25 in the loan agreement is unlikely to change that.  Similarly, if you require the business to maintain a certain level of working capital on hand, but they have never met it historically, the likelihood is slim that they will meet it going forward.  Don’t set you and your borrower up to fail; be sure your covenants are realistic and achievable.

No matter how carefully you plan, at some point a borrower will violate a covenant. When that happens, you need to determine if the violation is one that jeopardizes repayment and requires action, or if it calls for an exception.  The careful use of waivers is an important but often overlooked aspect of covenant management, because you will rarely call a loan based on a single covenant violation.  Unless you waive it properly however, you will lose the ability to use it at all.  Whether the violation pertains to a ‘due on sale’ clause in your deed of trust, or to a clause in the note restricting the borrower from transferring ownership of the business, or to a straightforward financial covenant, the waiver process is generally the same. The waiver document must specify the nature of the violation, the time period over which it occurred, and that future rights are retained.  For example, if you become aware that your borrower transferred the subject property into a trust (in violation of the due on sale clause) and you don’t waive or enforce the clause, you will lose the right to enforce that covenant in the future.  If your borrower were to sell the property at a future date, they could reasonably invoke the defense that they transferred the property once before and you didn’t enforce the covenant, signaling implicit acceptance of their actions.

One of the principal differences between consumer and commercial lending is the higher standard required for monitoring the ongoing condition and performance of your borrowers.  While this is a burden, it is also an opportunity to serve your member, and may open the door to growing the relationship in the future.

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