Breach of Covenant

What is Breach of Covenant?

Breach of Covenant happens when the parties involved in a contract fail to comply with the promises made in the agreement. The defaulting party that has breached the covenant is liable to get sued for the occurred damages.

Key Takeaways
  • Breach of Covenant happens when the parties involved in a contract fail to comply with the promises made in the agreement.
  • In simple words, a covenant is a written promise that cannot be violated.
  • The defaulting party that has breached the covenant is liable to get sued for the occurred damages.

Meaning of Covenant

In simple words, a covenantCovenantCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more is a written promise that cannot be violated. Covenants are a part of many financial contracts. For example, banks may include a clause in a lending contract that prescribes the borrower to keep a certain ratio of debt and equityRatio Of Debt And EquityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more. In case of a violation, the bank will impose a penalty on the borrower.

Example of Breach of Covenant

Let us understand the concept with a simple example.

  • Anderson is working in the R&D team of an FMCG company. At the time of joining, he had entered in a non-compete agreement with the company. Non-compete agreements impose certain employment restrictions on the employees.
  • So, the contract stated that it would be considered a Breach of Covenant if Anderson quits this organization and joins another FMCG company within three years.
  • If Anderson violates this clause, it would be treated as an offence, and he would be liable to get sued. The employer can ask the court or judiciary to impose restrictions against Anderson, which he would have to comply with at all cost.

Hence, it is important to note that this clause acts as a saviour when people disobey a contract’s terms. So, it is always included in a contract to protect both the parties’ rights and interests from any severe damage arising from a breach.

What are the types of Breach of Covenant?

Breach of Covenant

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We will now take you through these types to help you understand the concept in detail.

#1 – Breach of Affirmative Covenant

This type of breach is also called a positive covenant. Here, the agreement demands a party to do certain things as a part of keeping the deal. For example, while extending a loan, the affirmative covenant will list certain conditions that the borrower will need to fulfil.
The lender can put together any conditions like regularly showing audited reports, abiding the rules or timely payment of the instalments. Violating any of these clauses will qualify as a breach. As a punishment, the lender may demand immediate repayment of the loan.

#2 – Breach of Restrictive Covenant

In a restrictive covenantRestrictive CovenantA negative or restrictive covenant is a bond covenant that prohibits one party from taking certain actions, or, to put it another way, it is a pledge made by a firm to not exceed certain financial ratios unless and until the bondholders agree. Non-disclosure, non-solicitation, and non-competition are it's three types.read more, the contract restricts a party from performing certain acts. For example, the lender of a loan may prohibit the borrower from taking future loans until the existing ones have been repaid. Such a clause is also called a negative covenant. The borrower will attract a penalty for the breach of a restrictive covenant.

Consequences of Breach of Covenant

The following points will explain what a court can order in case of such a breach –

  1. Remedy for damages incurred by the aggrieved party: One way of settling such disputes is by ordering the defaulter to provide monetary compensation to the aggrieved party for the incurred damages.
  2. The Injunction to prevent a repeat of the breach: If the dispute cannot be settled by monetary compensation, the court orders for an injunction. It demands the defaulting party to end the breach and restricts it from doing it again in the future. In addition, both the parties are asked to continue with the terms of the agreement.

The Route of a Waiver

In case you are wondering if the defaulters have any remedy for breach of covenant, then the answer to that is a waiver. When the breach and damages occurred are non-severe in nature, the affected parties can take a waiver route. In case of an unconditional waiver, the defaulters aren’t imposed with monetary compensation or any other provisions.

It is important to understand that the unconditional waivers are very different from conditional waivers. In conditional waivers, the aggrieved party agrees to waive its right to go to the court on fulfilment of certain conditions it imposes on the defaulter.

The conditions could be demanding the payment of the penalty, or the compensation for the collateral that was a part of the contract.

Importance

  • Protecting the secrecy of the aggrieved party’s confidential information. In addition, it also ensures the protection against the damages caused to the aggrieved party.
  • It ensures due payment of the compensation in case of damage to the aggrieved party.
  • The court also enforces and ensures lawful completion of the contract agreement.
  • In case of lending, the positive and negative covenant try to ensure the financial stability of the borrower and timely recovery for the creditor.

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This article has been a guide to What is Breach of Covenant and its Meaning. Here we discuss the two types of covenant breach (Affirmative & Restrictive) along with examples, importance, and consequences. You can learn more about from the following articles –