Breaching covenants in private equity can make even the best deals feel shaky. When a company slips up, lenders and investors need to know their next move. Debtors should also understand the consequences of a breach to prevent one from happening.
In this article, we will discuss what a covenant is, its consequences, and how lawyers can help either party in case of a breached covenant. For more information, you can also reach out to a private equity lawyer.
What is a covenant?
Covenants, as commonly used in contracts and agreements, are legally binding terms and conditions between the two parties (e.g., a borrower and lender). Typically, these terms and conditions are imposed on the borrower (the debtor) during the life of the contract, where any violation of the covenant can have legal consequences.
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The purposes of covenants are to:
- help manage risks and protect the interests of lenders and investors
- prevent any conduct from either party that can jeopardize their agreement
- ensure that the debtor’s acts do not affect the lender, especially in financial terms
- allow the lender to take some risk and agree on the contract with the debtor
As used in loans, this video explains what covenants are and how it works:
For more discussions about private equity firms and their covenants, check out our article on how to start a private equity in Canada.
Types of covenants in legal agreements
There are several types of covenants used in contracts and private equity. As with any other agreement, the type used depends on the parties, who can also use a combination of these types.
Financial vs. non-financial
Financial covenants set targets, like debt levels, cash flow, or earnings. For example, a lender may require a company to keep its debt-to-equity ratio below a certain target.
On the other hand, non-financial covenants often require the company to do certain things, such as providing regular financial statements, keeping insurance in place, or avoiding selling key assets without the lender’s approval.
Positive/affirmative vs. negative/restrictive
A positive or affirmative covenant compels a party to perform something, while a negative or restrictive covenant prohibits the party from doing an act.
Examples of positive or affirmative covenant are the following:
- regularly submitting a report to the other party
- maintaining a credible accounting and auditing system
While examples of negative or restrictive covenants include:
- limiting the future debts that can be engaged by the debtor
- restrictions on the sale of the debtor’s assets
Standard vs. non-standard
Standard covenants are common terms applied by the lender in almost all loan or investment agreements. Since the lender usually drafts the agreement first, it inserts these covenants using its standard forms.
In contrast, non-standard covenants are special and customized terms, depending on the parties’ preferences or circumstances. These usually result from negotiations between the parties.
In most cases, standard and non-standard covenants can both appear in a private equity agreement.
What does breaching covenants in private equity mean?
Covenants are commonly used in commercial lending and private equity deals. These covenants help set clear rules for both sides and can even give early warnings if a company’s finances start to decline.
Simply, a breach happens when one of the parties breaks a covenant, whether it is intentional or due to some oversight. However, a breached covenant does not always mean that the company missed a payment. Sometimes, it means the company did not meet a target or failed to comply with its contractual obligation.
Since transactions with private equity firms are contract-based, parties just need to look in their contract to know whether a covenant is breached or not and find out the consequences. Broken covenants have a range of consequences depending on the agreement and the severity of the violation.
Examples of breaching covenants
While the parties’ agreement that defines what a “breached covenant” is, here are some common examples:
- missing regular reports, as mandated by the agreement, to be submitted either yearly or quarterly, which includes financial and/or operational reports
- paying management fees or dividends, usually without the consent of the other party, or when it is prohibited by the agreement for a certain period
What are the consequences and remedies against breaches of covenants?
Violating a covenant can result in several consequences. Again, this will depend on the parties’ agreement, and most especially, the remedy that the innocent party chooses to use.
For the lender, a breach of covenant can hinder the profitability of the transaction. For the debtor, breaching covenants can also affect their reputation and ability to get new funding.
Here are the usual consequences of breaching covenants:
- termination of the agreement
- acceleration of the terms
- demands for changes to the agreement
Here’s a video that explains how amendments and waivers work in case of a breached covenant:
Want to know more about breaching covenants and its effects? Consult the best private equity lawyers in Canada as ranked by Lexpert.
Amending the agreement or contract
Normally, the innocent party will first offer the other party a grace period (the period can be stipulated in the agreement) to correct the breached covenant. After this grace period, the parties can discuss the next step, which is either to:
- amend the agreement, usually after a compromise
- pursue other legal remedies
Waiver of the breach’s consequences
In rare cases, the innocent party can waive the breached covenant. This means that they will choose not to enforce the consequences of the breached covenant, as written in the agreement. In such a case, the innocent party may agree to let the other party fix the problem and continue with the agreement as it is.
There are many factors that the innocent party can consider when deciding whether to waive the effects of the breach. From the lender's perspective, these may include:
- the breach is just minor or too insignificant
- the borrower has a good track record
- the penalty is disproportionate to the breach
Parties can then enter into another agreement stating that any future breach will result in enforcement of the agreement as specified.
Lawsuit against the breaching party
In the worst cases, the innocent party can go to court to enforce their rights and seek damages due to the breached covenant. This is usually a last resort, especially when the other party is uncooperative, negotiations are ineffective, and a compromise cannot be reached.
When going to court, the cause of action can be any of the following:
- enforcing the agreement
- rescinding the agreement
- asking for award of damages
Before doing so, it is advisable to consult with a private equity law firm to determine if filing a lawsuit is the best remedy for the breached covenant.
How can lawyers assist clients in case of such a breach of covenant?
Private equity lawyers play an important role not only when a breach of covenant happens, but also in helping prevent breaches. They can help clients understand the agreement and what the breach means for both sides. Their role includes:
- reviewing the terms of the agreement
- explaining the possible outcomes
- helping clients decide after a breach occurs
For borrowers or debtors, lawyers can guide clients through negotiations with lenders or investors. They can help prepare explanations for the breach and suggest ways to fix the problem.
As clear records are important in these cases, lawyers can ensure that all changes, waivers, or new terms are put in writing. This protects their clients, whether lender or borrower, and helps avoid confusion in the future.
Lawyers also advise clients on how to avoid breaches of covenants. They may suggest better ways to track financial performance or improve reporting. With the right legal counsel, clients can manage the risks and keep their business relationships strong.
Breaching covenants: how to keep deals steady
While breached covenants in private equity can cause legal stress, it does not have to derail the deal between the parties. Most issues can be managed if both sides act quickly and work together. Regular monitoring and honest conversations help spot problems even before they grow.
Lawyers and advisors can help parties understand their rights and responsibilities. With the right support, lenders and borrowers can turn a breach into an opportunity to strengthen their agreement. For more guidance, it is always wise to consult a lawyer who is very familiar with Canadian laws on private equity.
Read next: Basics of private equity fund restructuring
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