Covenants in loan covenants can have at least two purposes.
The first purpose is to prevent management from taking actions that would disadvantage the lender. An
example might be a covenant that limits dividends. Without the limit on dividends, management would be
able to borrow heavily, pay the cash out as a dividend and leave the company an empty shell for the lender.
A limit on dividends prevents this.
The second purpose is to provide lenders an opportunity to stop the loan ahead of the scheduled maturity in
the event of deterioration of the company. Companies can deteriorate because of shocks that management
has no control over. If these shocks reduce the ability to repay the debt, covenants that capture the risk of
non-payment can allow the lender to call the debt before the risk of non-payment gets too severe.
Covenants can provide the lender with an early out.
1. What is a minimum tangible net worth covenant, and what purpose does it serve in the Frisby loan agreements?
2. Why might lenders be reluctant to waive covenant violation?
3. Among the options available to Frisby’s lenders is foreclosure: shuttering the company and selling off all the
assets. Why might the lenders prefer to avoid this action?