What are Negative Covenants (Restrictive)?
A Negative or restrictive covenant is merely a bond covenant that prevents one party from performing certain actions or in other words it is a promise that a company makes for not exceeding certain financial ratios unless and until the same is agreed by the bondholders and it can be of three types non-disclosure, non-solicitation and non compete.
Negative Covenants are used in almost all types of contracts/agreements:
- Employment contracts
- Mergers and acquisitionsMergers And AcquisitionsA merger and acquisitions (M&A) agreement refers to an agreement between two existing companies to merge into a new company, or the purchase of one company by another, which is done generally to benefit from the synergy between the companies, expand research capacity, expand operations into new segments, and increase shareholder value, among other things.
- Bond documents
- Land use/ Rent agreements etc.
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.
3 Main Types of Negative Covenants (Restrictive)
Let us see the types of negative covenants in various transactions/agreements:
#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 agreements 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 restricts 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 solicits the clients to the new employer. Such an agreement restricts them from doing so.
#3 – Non-Disclosure Agreement
A non-disclosure agreement restricts one party from disclosing any information about another party. The information may include trade secrets, propitiatory information, innovations, or any other information which may harm the business of the owner of such information. E.g., Research scientists, pharmacists, working in laboratories 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 a benefit availed by a company that has remained successful in outdoing its competitors in the same industry by designing and implementing effective strategies in offering quality goods or services, quoting reasonable prices and maximizing the wealth of its stakeholders. by innovating new products. Thus, he would protect the flow of the information to competitors by signing an NDANDANDA is a non-disclosure agreement, a 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 agreement's validity..
Restrictive Covenants in Bond Indentures
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.. 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. from taking risky bets or such material changes, which may impact the investors. However, the more the number of negative covenants lesser is the interest rate on such bonds. The restrictive covenants list may include:
- Not altering accounting practicesAccounting PracticesAccounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements.
- Limit on debt
- Limit of dividend payment
- Limit on contracts/leases or any amendments thereof
- Maintenance of certain financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. in the particular range – examples of few such ratios are:
- Maintaining the debt/equity ratioDebt/equity RatioThe 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. of less than 1
- Maintaining a current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities of more than 1
- Maintaining net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses. or gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold. in the historical range
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.: 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.
- 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.
- 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., etc.
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. but violating negative covenants may lower its credit rating.
Negative Covenants in 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 had 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, the 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 are the restrictive covenants that restrict one party to take 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., etc. It though mentioned in agreements but face enforcement problems. If negative covenants are violated or breached, it may take a long time to be settled by the court of law. Further, it will be costly for both parties, given that the damage is already done.
Negative Covenants Video
This has been a guide to What are Negative Covenants? Here we discuss the three types of negative covenants – non compete, non-disclosure, and non-solicitation. We also discuss a restrictive covenant example found in bond indentures. You may learn more about Fixed Income from the following articles –