Meaning and definition of Covenant
Covenant generally refers to a promise in an agreement, or any other formal debt indenture, that certain activities will or will not be conducted. Putting it simple, it is a clause in a contract that asks one party to carry out, or refrain from carrying out, certain things. Generally, the main purpose of a covenant is providing higher security to a lender. A covenant includes everything from minimum dividend payments to the levels that are obligatory to be maintained in working capital.
Scope of covenants
The covenants exist for the purpose of safety. Covenants can restrict anything from the height and size of buildings to materials used for construction to external issues like color of paint and holiday decorations.
Aspects of Covenants
The main aspects of covenants include:
1. Affirmative covenant
Affirmative covenant includes those activities which should be carried out affirmatively during the term of the loan agreement. A large number of these requirements include activities the borrower would perform in any case without being instructed by a lender, like pay its taxes, meet its financial obligations, and comply with laws. Other covenants are issues that work to conserve the cash flow of the borrower on a specific business line and usually keep its nose to the grindstone.
Some of these include:
- Ordinary course of conduct
- Tax payment
- Insurance maintenance
- Access to information
- Books and records
- Maintain condition of assets
- Additional collateral
- Deposit accounts
- Real estate
2. Negative covenant
Negative covenant includes activities which are carried out on the instructions of senior lender. A large number of these activities include things which a borrower would not carry out otherwise. The rest are projected to keep the borrower paying attention on running its business in the normal course and repaying the debt of the senior lender.
Some of the important negative covenants include:
Modification of subordinated debt documents
- Sale of assets
- Restricted payments
- Prepayments and cancellation of debt
- No mergers
- Change in the nature of business