Negative Covenants (Restrictive)

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 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.

• 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 indentures, 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:

• Employment contracts
• Mergers and acquisitions
• 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 Covenants

Types

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

#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 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 agreement restricts one party from disclosing any information about another party. The information may include trade secrets, 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 advantage by innovating new products. Thus, he would protect the flow of the information to competitors by signing an NDA.

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.

source: pds.com.ph

Covenants are also found in the bond indentures. 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 issuers 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:

• Not altering accounting practices
• Limit on debt
• Limit of dividend payment
• Limit on contracts/leases or any amendments thereof
• Maintenance of certain financial ratios in the particular range – examples of few such ratios are:
  • Maintaining the debt/equity ratio of less than 1
  • Maintaining a current ratio of more than 1
  • Maintaining net profit margin or gross profit margin in the historical range

For Negative Covenants Examples: 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 ratio, etc.

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 payments 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)

Recommended Articles

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 –

• Debt Yield
• What is Subordinated Debt?
• Financing Acquisitions
• Long-Term Debt in Balance Sheet