Debt covenants are contracts that force specific conditions on borrowers in return for providing a loan. These debt covenants can require that borrowers cannot take on more debt or follow specific accounting practices.
Methods of Enforcing Compliance
Debt covenant compliance can be maintained through mandatory audits. Auditors may periodically review the financial files and records to ensure no new debt was acquired and all debt payments were made on time. Auditors may also verify all necessary authorizations were given before major financial transactions. Lawyers may review legal records to ensure there are no unreported lawsuits against the debtor.
Penalties of Non-Compliance
If a borrower is in non-compliance, they can be required to become compliant within a grace period. If they cannot become compliant with the debt covenant, the lender can demand immediate payment in full. Subsidiary companies may be liquidated by the parent company.
Debt Covenants After Non-Compliance
If the lender chooses not to call the debt in and leaves the debt covenant in place, the debt is still classified as short-term debt. The lender can choose to keep the debt covenant in place and collect the debt in full if the debt covenant is broken again.