Covenant light: the new look for small business loan contracts

Last year we asked if small business lending could end up like consumer lending.

Well, it is certainly heading that way.

There are some important recent developments that will fundamentally change small business loan contracts. Obligations normally imposed by lenders are being dialled back or removed for small business borrowers. Because of this, the new contracts are being called “covenant light”.

And don’t think that this only affects an insignificant minority of business borrowers. According to estimates from the Australian Bankers’ Association (ABA), more than 95% of bank business customers will qualify as “small business”.

Although the changes are being led by the major banks, they will flow on to the whole market, because the banks’ contract terms will become the industry standard.

Lenders will need to review their business loan terms as the industry norms shift.

Carnell Report recommendations

The Australian Small Business and Family Enterprise Ombudsman (ASBFEO), Kate Carnell, conducted a review of the small business lending practices of the major banks and other lenders in 2016. Her report was released on 3 February 2017. Its recommendations were mostly directed at the banking industry.

The ABA announced its response to the recommendations of the Carnell Report on 20 April.

Default triggers

The Carnell Report proposed that for all loans below $5 million, where a small business has complied with loan payment requirements and acted lawfully, the bank must not default a loan for any reason.

Putting this in perspective, the ASBFEO recommendation goes further than the regulation of lending to consumers under the National Credit Code. Under the Credit Code, there is no regulation of what constitutes a default event, except in the limited case of reverse mortgages. Yes, there are things that have to be done when an event of default occurs, like issuing a default notice, but the Credit Code generally does not dictate what can or cannot be an event of default.

The ABA instead has proposed “covenant light” credit contracts for small business. For new or renewed standard form credit contracts to small business customers, the ABA says that the banks will remove all general adverse material change clauses and limit specific events of non-monetary default to:

  • unlawful behaviour;
  • insolvency, bankruptcy, administration or other creditor enforcement;
  • misrepresentation;
  • use of the loan for a non-approved purpose;
  • dealing with loan security property improperly or without consent;
  • a change in beneficial control of a company except as permitted;
  • loss of a licence or permit to conduct business; and
  • failure to provide proper accounts or to maintain insurance (after a reasonable period).

Banks will also remove financial indicator covenants as default triggers. However this will not apply for loans for property investment, property development or specialised lending transactions including margin lending, loans to SMSFs, bailment, invoice discounting, development finance, foreign currency loans, and tailored cash flow lending.

Banks will continue to have the right to value existing security assets during the life of the loan, but the “covenant light” contracts will not specify loan to valuation ratio (LVR) as a trigger for enforcement.

Definition of small business

A “small business” under the ABA’s proposal will be one which has less than 20 employees (or 100 for a manufacturing business) and less than $10 million in annual business turnover, and where the total credit exposure of the business group, including related entities, is less than $3 million. This would be measured at the initiation of the loan facility (so a business that became a “big business” after the loan was set up would presumably continue to have the benefit of being treated as a small business customer – although that is not clear). This definition is the same one that the ABA has adopted for the revised Code of Banking Practice in response to the recent independent review of the Code by Phil Khoury.

According to the ABA, loans with a limit of $3 million would typically cover more than 95% of a bank’s business customers. It seems clear, then, that these reforms are going to affect the vast majority of business bank customers: the small business loan contract will be the standard business loan contract.

The ASBFEO believes that the $3 million loan limit adopted by the ABA is “restrictive and unworkable”. Ms Carnell says that aggregating loans by related entities would include loans taken out by directors of the business and their partners, and this will “exclude a very large number of small businesses and make a nonsense of the ABA’s claim that its response will cover 95 per cent of business customers.”

It is not clear to us that the ABA definition would include loans to directors and their partners, as alleged by the ASBFEO. The ABA response refers to the total credit exposure of the “business group”. In our view, directors and their partners would not normally be considered part of a “business group”. However this should be clarified by the ABA.

Other recommendations

Despite these differences, the ABA has agreed to a number of the other Carnell Report recommendations.

It supports increasing the minimum notice period to 30 calendar days for changes to general restriction clauses and covenants, to give borrowers more time to respond and react to a potential breach of conditions. There will be exemptions when more rapid changes are permitted, such as where a business goes into voluntary liquidation.

The ABA also supports the proposal that for small business loans, banks must provide borrowers with decisions on roll-over at least 90 days before the loan matures. However, banks will not be required to rollover the loan on the same terms.

Disclosure is to be improved by banks providing a summary document of the clauses and covenants that may trigger defaults or other detrimental outcomes for borrowers, and by the use of simpler, more clearly written loan contracts for small business customers.

Banks are also developing guidelines for valuation practices and for the appointment of investigative accountants and receivers, administrators and liquidators for small businesses and farmers, which will address the issues raised regarding these practices in the Carnell Report.

Unfair contract terms changes

ASIC and the ASBFEO have also leaned on the big four banks in relation to unfair contract terms for small business.

Small business contracts have been subject to unfair contract terms legislation since 12 November 2016. In March 2017, ASIC and ASBFEO jointly announced that they had reviewed standard form small business loan contracts from eight lenders and found a failure to take sufficient steps to comply with the new obligations.

Since then, a roundtable has been hosted by the two agencies and they have extracted a commitment from the big four banks to “comprehensive changes”.

The changes overlap to some extent with the covenant light contract regime, and include:

  • removing “entire agreement” clauses that exclude representations etc. made outside the contract document;
  • removing financial indicator covenants such as LVR covenants;
  • removing material adverse event clauses;
  • significantly limiting indemnification clauses; and
  • significantly limiting unilateral variation clauses.

These changes are going to be made to contracts entered into from 12 November 2016, which means that existing small business customers with contracts from that date will be contacted and notified of a change to their contract, where applicable.

Market impact

The main overall effect of the changes to small business contracts is that there will be fewer grounds on which a bank lender will be able to call a default. Quite possibly this will lead to a tightening of credit criteria for business lending: loan contracts will have a higher risk for lenders, and so they will write less of them.

Patrick Dwyer and Kathleen Harris
Legal Directors