The Essence of Negative Covenants
A negative covenant is an agreement that restricts a company from engaging in certain actions. Think of a negative covenant as a promise not to do something.
For example, a covenant entered into with a public company might limit the amount of dividends the firm can pay its shareholders. It could also place a cap on executives’ salaries. A negative covenant may be found in employment agreements and Mergers & Acquisitions (M&A) contracts. However, these covenants are almost always found in loan or bond documents.
Key Takeaways
- A negative covenant is an agreement that restricts a company from engaging in certain actions — it is a promise not to do something.
- For example, a covenant entered into with a public company might limit the amount of dividends the firm can pay its shareholders.
- Common restrictions placed on borrowers through negative covenants include preventing a bond issuer from issuing more debt until one or more series of bonds have matured.
- A negative covenant contrasts with a positive covenant, which is a clause in a loan agreement that requires the firm to take certain actions.
Understanding Negative Covenants
When a bond is issued, the features of the bond are included in a document known as the bond deed or trust indenture. The trust indenture highlights the responsibilities of an issuer and is overseen by a trustee to protect the interests of investors. The trust indenture also stipulates any negative covenants that the issuer must adhere to.
For example, the negative covenant may restrict the ability of the firm to issue additional debt. Specifically, the borrower may be required to maintain a debt-equity ratio of no more than 1. Likewise, negative pledge clauses in loan contracts restrict the borrower from using the pledged asset as collateral for other loans.
The lending agreement or indenture in which the negative covenant appears will also provide detailed formulas, which may or may not conform to the Generally Accepted Accounting Principles (GAAP), to be used to calculate the ratios and limits on negative covenants.
Common restrictions placed on borrowers through negative covenants include preventing a bond issuer from issuing more debt until one or more series of bonds have matured. Additionally, a borrowing firm may be restricted from paying dividends over a certain amount to shareholders to minimize the increase in default risk to bondholders, since more money paid to shareholders means fewer funds available to meet 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 due to the added security perceived by investors.
Differentiating Between Negative and Positive Covenants
A negative covenant contrasts with a positive covenant, which is a clause in a loan agreement that requires the firm to take certain actions. For example, a positive covenant might require the issuer to disclose audit reports to creditors periodically or ensure adequate insurance coverage for its assets. While positive or affirmative covenants do not limit the operations of a business, negative covenants materially limit a business’ operations.
Related Terms: restrictive covenant, positive covenant, debt-equity ratio, GAAP, default risk.
