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Best Practices in Debt Compliance: Look Beyond Year One

Before taking on a loan and agreeing to all of its lender's requirements, the treasury department needs to look beyond the first year.

Indeed, a loan may look like a good idea at the time, but during the recent Proformative webinar "Best Practices in Debt Compliance," Jeff Wallace, managing director at Debt Compliance Services, said the risk to default increases as time goes by. Businesses are more likely to break covenants with lenders when just one issue arises. If one of those covenants breaks, it gives lenders the power to completely change the credit on a loan. The more time that passes after a loan, the better the chances for a default, leading to possible bankruptcy. Business executives need to have full confidence the company will be able to survive the lifetime on the loan without breaking any aspect of the agreement.

"Default risk is a long-term risk," said Wallace. "It increases over time, and often we think that people with relatively weak compliance practices are devising or thinking that their practices are appropriate because they're thinking about the first-year risk. And basically no treasurer borrows or no bank really lends expecting a first-year default. If you determine the adequacy of your compliance practices based upon your first-year risk, you really are at risk as you move into years three, five, and seven."

Defaults Can Devastate the Firm for Years
Sometimes it's inevitable that a company will default on its loan. For that reason, decision-makers who agree to the terms of a loan must understand their next moves after a default to avoid bankruptcy. They must think about how a default can affect the company for years to come before signing any agreements.

"A default becomes a slippery slope, because as soon as you find out that you have a covenant violation, you're going to have to look at your agreement and see whether you're going to have to report it immediately to the lenders or report it at quarter's end," said Wallace. "If you don't report it, you're basically committing fraud."

Understand the Best Practices for Debt Compliance
Leaning about debt compliance will give business executives the opportunity to salvage the company in the event of a default or even avoid a devastating error altogether. Below is a list of best practices that all firms considering taking on a loan should thoroughly study before making any important decisions.

  • Build a debt compliance policy: Before working with a lender, businesses must have a plan for how they will operate when taking on debt, said Jim Simpson, managing director at Debt Compliance Services, during the Proformative webinar. By properly training the employees who will be responsible for working with the loan and ensuring it is paid on time, companies will reduce the risk of default.
  • Continue revisiting the covenant checklist: The agreement between the lender and the business will have a number of tasks that the company must complete in order to fall in compliance with the regulations of the loan. Companies that continue to remember to look at the checklist will not let any compliance protocol fall through the cracks, Simpson noted.
  • Evaluate potential issues and change the policy, if necessary: No covenant is going to be perfect, and there are going to be problems throughout the lifetime of the loan. Businesses that have forecasted for these issues will know when it might be the right time to revise their policy to comply with the lending agreement.
  • Create a procedure and reassess frequently: According to the Association of Financial Professionals' recent debt compliance survey, more than half of businesses have a set of written debt compliance procedures that describe what should be done each quarter.
  • Everyone must know their roles when working toward compliance: The same survey revealed 44 percent of respondents said it's important to have a document listing which staff are responsible for attesting to compliance with specific covenants. When everyone is aware of their tasks in complying with the lending agreement, the chances for error are significantly reduced.

By developing a robust debt compliance policy, and following the best practices for going about creating one, businesses will be able to reduce some of the risk of defaulting on loans.

To learn more on this subject,attend CFO Dimensions 2013 in New York City, August 21-22. Register with code CFODKAR for a special $649 discount here.