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Negative Covenants (Restrictive)

Updated on April 30, 2024
Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What are Negative Covenants (Restrictive)?

A Negative or restrictive covenant is merely a bond covenant that prevents one party from performing certain actions in other words, it is a promise that a company makes for not exceeding certain financial ratios unless and until the bondholders agree the same, and it can be of three types non-disclosure, non-solicitation and non-compete.

Negative Covenants (Restrictive)

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Negative covenants in finance are crucial safeguards, protecting lenders by restricting borrowers from detrimental actions. Embedded in loan agreements, these constraints ensure borrowers maintain financial stability. By preventing risky behaviors, negative covenants help lenders mitigate potential losses and sustain confidence in financial transactions, fostering a secure lending environment for both parties involved.

Key Takeaways

  • Negative covenants are contractual clauses or restrictions in loan agreements or bond indentures that limit specific actions or activities by the borrower or issuer.
  • The purpose of negative covenants is to protect the interests of lenders or bondholders by imposing restrictions that help preserve the credit quality and financial health of the borrower or issuer.
  • Negative covenants often prohibit actions such as incurring additional debt, paying dividends, selling assets, or entering into certain types of transactions without the consent of the lenders or bondholders.
  • By imposing negative covenants, lenders and bondholders aim to reduce the risk of default and protect their investments by maintaining the financial stability and liquidity of the borrower or issuer.

Negative Covenants Explained

Negative Covenants are restrictive covenants that restrict one party from taking on some operations or work in a financially prudent way so as to safeguard the interests of the other party. These are found in most of the agreements. The agreements could be a merger or acquisition, employee contracts, bond indenturesBond IndenturesIndenture is a legal agreement between two or more parties to meet their respective obligations. It is a common term used in the bond market to provide the lender and borrower with the necessary comfort in the transaction in the event of one defaulting party.read more, etc. It is mentioned in agreements but faces enforcement problems. If negative covenants are violated or breached, it may take a long time to be settled by a court of law. Further, it will be costly for both parties, given that the damage is already done.

Negative Covenants are used in almost all types of contracts/agreements:

This can be used as a part of an agreement, or it could be a separate agreement as a whole. It serves different purposes depending on the type of contract; however, it is generally done to prevent one party’s interest over the other party.

Also, have a look at Bond CovenantsBond CovenantsDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching.read more

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Types

Let us understand the different types of negative covenant bonds and other such agreements through the detailed explanation below.

Negative Covenants Types

#1 – Non – Compete Agreement

A non-compete agreement is mainly written in employment contracts or acquisition contracts.

During acquisition, the new owner, when it takes over a Company and its business, signs a non-compete agreement such that the old owner of the business does not start the same business again and starts competing. The non-compete agreement is usually for a specific period of time and for a region. The new owners of the business usually pay non-compete fees to the original owners for not entering into the business.

Non-compete agreementsNon-compete AgreementsA Non-Compete Agreement is a contract signed by an employee who agrees not to compete with the employerread more also restrict employees from joining a competitor or opening the business the same as that of the Company he is employed with. This is usually done to restrict employees from being a competitor of the Company after attaining necessary training, skills, and experience. Such non-compete agreements in employee contracts vary from 6 months to 2 years.

#2 – Non-Solicitation Agreement

A non-solicitation agreement restricts professionals, employees from soliciting the customers or clients from their previous employees. Consultants, in general, get to know the clients very well, they may be tempted to start their own business and solicit the clients of their employer, or they may join a competitor and solicit the clients to the new employer. Such an agreement restricts them from doing so.

#3 – Non-Disclosure Agreement

A non-disclosure agreementNon-disclosure AgreementA non-disclosure agreement (NDA) is a legal contract in which the signatories promise not to reveal confidential information outlined in it to a third party.read more restricts one party from disclosing any information about another party. The information may include trade secretsTrade SecretsTrade secrets are any valuable information regarding a company’s processes or operations guarded and concealed from the public eye. The company actively protect them and they are available to only a limited number of people. As a result, they possess the potential to be licensed or sold for profit.read more, proprietary information, innovations, or any other information which may harm the business of the owner of such information. E.gResearch scientists, pharmacists, working in laboratories and other researchers are bound by such agreements. They work on new products and innovations, and their employer would like to have a competitive advantageCompetitive AdvantageCompetitive advantage refers to an advantage availed by a company that has remained successful in outdoing its competitors belonging to the same industry by designing and implementing effective strategies that allow the same in offering quality goods or services, quoting reasonable prices to its customers, maximizing the wealth of its stakeholders and so on and as a result of which the company can make more profits, build a positive brand reputation, make more sales, maximize return on assets, etc.read more by innovating new products. Thus, he would protect the flow of the information to competitors by signing an NDANDAThe full form of NDA is termed as Non-Disclosure Agreement. It is defined as the Legal contract of a confidential agreement entered between two or more parties (covered under the Indian Contract Act, 1872) to restrict the parties from disclosing any confidential information & proprietary information shared by the contracting parties during the validity of the agreement.read more.

Negative Covenants in Video

 

Bond Indentures

The use of restrictive covenants in very much prevalent in the world of bond indentures as well. Let us understand the intricacies through the discussion below.

negative covenants example

source: pds.com.ph

Covenants are also found in the bond indenturesBond IndenturesBond indenture or bond resolution is a core legal document that serves as a contract binding upon the bond issuer and the bondholder. It comprises all the bond-related information, like details of the issue, its purpose, bond issuer's obligations and rights of the bondholders.read more. Such restrictive covenants are placed to safeguard the interests of the bond investors. These are used in the bond issues to protect the investors’ money, and they restrict the bond issuersThe Bond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more from taking risky bets or such material changes, which may impact the investors. However, the more the number of negative covenants, the lesser the interest rate on such bonds. The restrictive covenants list may include:

For Negative Covenants ExamplesCovenants ExamplesCovenant 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: A company wants to borrow $ 100 Mn of debt, but the loan agreement has a restriction on the payment of dividends. The dividend paid to the shareholders cannot exceed $ 1 per share in one year.

In Bond indentures, the covenants can be of two types.

  1. Operation Covenant: Operational covenants are those which relate to operations of the Company. They put restrictions on the operations of the Company, which can be – the borrower has to meet certain disclosure requirements, it cannot take certain operations or line of business, maintain a certain level of insurance.
  2. Financial Covenant: Financial covenants are like maintenance of finances and financial ratios at a certain level, e.g., debt to equity ratio of 2:1, minimum working capital requirements, maintenance of interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, etc.
Debt Covenants

source: akelius.com

Lenders like to have negative covenants to bond issues so that the borrower operates at a certain level of risk and thus ensures that the lender’s money is safe. If the borrower violates negative covenants, it is considered as a “technical default.” Although the borrower might be paying interest and principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more violating negative covenants may lower its credit rating.

Employment Contracts

Employment contracts have non-compete and non-disclosure agreements in general. Employees are restricted from disclosing any information they have during their employment and to compete with their employer. The employer tries to secure his interests as he has invested time and money on employees by giving them initial training, skills, and experience. The employee might have access to some information that may be trade secrets, proprietary information, or such other data or information which may affect the employer. Thus, by signing a non-disclosure agreement, the employer legally ensures that such information is not passed to the competitor.

Negative Covenants Vs Affirmative Covenants

Understanding the distinctions between negative and affirmative covenants is essential for both lenders and borrowers, as they collectively shape the parameters of financial agreements, balancing risk mitigation and proactive financial management. Let us do so through the comparison below.

Negative Covenants

  • Negative covenants are restrictions imposed on borrowers in financial agreements to prevent specific actions that could jeopardize their financial health or compromise the interests of lenders.
  • It often limits excessive debt issuance, dividend payments, or changes in capital structure without lender approval.
  • Also, it restricts the sale or transfer of significant assets without lender consent.
  • It limits engaging in certain high-risk ventures or mergers without prior approval.
  • Primarily serves to protect lenders by minimizing the risk of financial instability or actions that could negatively impact the borrower’s ability to meet loan obligations.
  • Fosters a conservative financial approach by preventing aggressive or high-risk strategies that could jeopardize the borrower’s financial standing.

Affirmative Covenants

  • Affirmative covenants, in contrast, are obligations and actions that borrowers commit to perform, ensuring certain proactive steps are taken to maintain financial health.
  • Mandates regular submission of financial statements to lenders.
  • Requires the maintenance of adequate insurance coverage.
  • Obliges adherence to all relevant laws and regulations.
  • Affirmative covenants foster transparency, enabling lenders to assess the borrower’s financial health through regular reporting.
  • Ensures that borrowers take proactive steps to sustain their financial well-being, contributing to a more stable and predictable financial relationship.

Frequently Asked Questions (FAQs)

What is the significance of negative covenants for lenders or bondholders?

Negative covenants give lenders or bondholders a level of control and protection by limiting the borrower’s or issuer’s ability to take actions that could increase financial risk or harm the creditor’s interests.

Can negative covenants be modified or waived?

In some cases, negative covenants can be modified or waived through mutual agreement between the borrower or issuer and the lenders or bondholders. Therefore, this typically requires obtaining the consent of a specified percentage of the lenders or bondholders, as outlined in the loan agreement or bond indenture.

What happens if a borrower or issuer breaches a negative covenant?

A borrower or issuer violating a negative covenant can trigger a default event. As a result, the lenders or bondholders may have the right to accelerate repayment of the loan or demand an immediate refund of the bonds, take legal action, or enforce other remedies specified in the loan agreement or bond indenture.

This has been a guide to What are Negative Covenants? Here we explain its types, examples in bond indentures, and compare them with affirmative covenants. You may learn more about Fixed Income from the following articles –

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