Covenant compliance monitoring

Your facility has covenants. You need to test them and certify compliance. Building a systematic approach prevents surprises and preserves your relationship with lenders.

Types of covenants

Portfolio covenants (tested monthly or with each borrowing)

These protect lenders against collateral deterioration:

Delinquency triggers (e.g., 60+ DPD < 5% of pool)
Concentration limits (e.g., no state > 15%)
Eligibility thresholds (e.g., weighted average FICO > 680)
Pool composition (e.g., no single loan > 2% of pool)
Performance triggers (e.g., monthly CNL < 1%)

Financial covenants (tested quarterly)

These ensure the originator remains financially healthy:

Minimum tangible net worth (e.g., originator TNW > $10M)
Minimum liquidity (e.g., unrestricted cash > $3M)
Maximum leverage (e.g., total debt / TNW < 4:1)
Minimum profitability (e.g., positive net income trailing 4 quarters)

Servicing covenants (tested annually or upon trigger)

These maintain servicing quality:

Servicing quality standards
Modification limits (e.g., no more than 10% of pool modified)
Staffing requirements
Backup servicer appointment requirements

Building a compliance testing calendar

For each covenant, know exactly when it is tested, where the data comes from, and who is responsible.

Covenant Type	Testing Frequency	Data Source	Lead Time Needed
Pool DQ triggers	Monthly with BBC	Servicer tape	5 days
Concentration limits	Monthly with BBC	Servicer tape	5 days
Financial covenants	Quarterly	Financial statements	15 days
Servicing standards	Annual	Servicing audit	60 days
Originator financial	Annual	Audited financials	90 days

For each covenant, document:

Exact threshold and calculation methodology
Where the data comes from
Who prepares the calculation
Who reviews and signs off
Escalation path if approaching breach

Documentation requirements

Officer’s certificate

Most facilities require a signed certification from an officer (CFO, CEO, Controller) attesting to compliance. This is a legal document. The officer certifying is personally representing that the numbers are accurate.

A typical certificate states:

All representations and warranties remain true
No event of default has occurred
All covenants have been tested and are in compliance
Attached schedules show the calculations

Supporting schedules

The certificate summarizes; the schedules show the work. Include:

Detailed calculations for each covenant
Source data references
Period-over-period comparison
Clear indication of compliance or breach

Audit trail

Keep records of how you calculated each covenant, what data you used, and who reviewed it. If there is ever a dispute, you need to reconstruct the calculation. Maintain:

Source data files (loan tapes, financial statements)
Calculation workbooks with formulas visible
Email approvals and sign-offs
Final submitted documents with timestamps

Approaching a covenant breach

You are at 4.8% delinquency against a 5% trigger. What do you do?

Do not wait

Call your lender before you breach, not after. “Our delinquency is at 4.8% and trending slightly higher due to [reason]. We expect to be at or near the 5% trigger next month. Here is our plan.”

Proactive communication builds trust. Surprises destroy it.

Know your cure rights

Most facilities have cure periods (15-30 days) and sometimes equity cure rights (inject capital to reduce exposure). Read your documents before you need them.

Common cure mechanisms:

Cure period - Time to bring covenant back into compliance
Equity cure - Inject cash or subordinated debt to restore headroom
Collateral substitution - Remove non-performing assets
Prepayment - Pay down facility to reduce exposure

Prepare a remediation plan

If you are breaching a delinquency trigger, what are you doing to improve collections? If it is a financial covenant, can you raise capital or reduce expenses?

Your remediation plan should include:

Root cause analysis
Specific actions being taken
Timeline for improvement
Projected trajectory back to compliance

Options: cure, waive, or amend

If you breach, you have three options:

Cure within the cure period - Fix the issue before it becomes an event of default
Request a waiver - Lender temporarily forgives the breach (usually with conditions)
Request an amendment - Permanently change the covenant threshold

Waivers and amendments cost money ($25K-100K in fees) and may come with tighter terms elsewhere. Better to avoid the breach.

Covenant compliance testing checklist

Monitoring covenant headroom

Do not wait until covenant testing to know where you stand. Track headroom continuously:

Covenant	Current	Trigger	Headroom	Trend
60+ DQ	3.5%	5.0%	1.5%	Stable
CA concentration	14.2%	15.0%	0.8%	Rising
TNW	$12.5M	$10M	$2.5M	Stable
Liquidity	$3.8M	$3M	$0.8M	Declining

The “trend” column is critical. A covenant with declining headroom needs attention even if it is currently compliant.

Reporting requirements - Full reporting calendar
Borrowing base certificate - BBC preparation
Portfolio surveillance - Early warning indicators