Negative Covenant

What Is a Negative Covenant?

A negative covenant is an agreement that limits a company from participating in certain activities. Think of a negative covenant as a vow to avoid something. Negative covenants are likewise alluded to as restrictive covenants.

For instance, a covenant went into with a public company could limit the amount of dividends the firm can pay its shareholders. It could likewise place a cap on leaders' salaries. A negative covenant might be found in employment agreements and Mergers and Acquisitions (M&A) contracts. Notwithstanding, these covenants are quite often found in loan or bond documents.

Grasping Negative Covenants

At the point when a bond is issued, the elements of the bond are remembered for a document known as the bond deed or trust indenture. The trust indenture features the obligations of an issuer and is directed by a trustee to safeguard the interests of investors. The trust indenture likewise specifies any negative covenants that the issuer must stick to.

For instance, the negative covenant might limit the ability of the firm to issue extra debt. In particular, the borrower might be required to keep a debt-value ratio of something like 1. The lending agreement or indenture wherein the negative covenant seems will likewise give point by point recipes, which could conceivably adjust to the Generally Accepted Accounting Principles (GAAP), to be utilized to compute the ratios and limits on negative covenants.

Common limitations placed on borrowers through negative covenants incorporate keeping a bond issuer from giving more debt until at least one series of bonds have matured. Likewise, a borrowing firm might be restricted from paying dividends over a certain amount to shareholders so as not to increase the default risk to bondholders, since the more money paid to shareholders the less accessible funds will be to make interest and principal payment obligations to lenders.

Generally, the more negative covenants exist in a bond issue, the lower the interest rate on the debt will be since the restrictive covenants make the bonds more secure according to investors.

A negative covenant diverges from a positive covenant, which is a clause in a loan agreement that requires the firm to make certain moves. For instance, a positive covenant could require the issuer to uncover audit reports to creditors occasionally or to sufficiently safeguard its assets. While positive or affirmative covenants don't limit the operations of a business, negative covenants really limit a business' operations.

Features

• A negative covenant is an agreement that confines a company from participating in certain activities — it is a vow to avoid something.
• For instance, a covenant went into with a public company could limit the amount of dividends the firm can pay its shareholders.
• A negative covenant stands out from a positive covenant, which is a clause in a loan agreement that requires the firm to make certain moves.
• Common limitations placed on borrowers through negative covenants incorporate keeping a bond issuer from giving more debt until at least one series of bonds have matured.