Covenant (Contract) - Explained
What is a Covenant in a Contract?
Written by J. Mance Gordon
Updated at April 19th, 2024
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What is a Covenant?
A covenant in legal and financial terms refers to an agreement or condition as part of an agreement. In a contract, a covenant by a party ensures the other party that it will not take action or prohibits the party from taking certain action.
What is a Covenant in a Loan Agreement?
Loan covenants come in two forms: affirmative covenants and negative covenants.
What is an Affirmative Covenant?
In an affirmative (or positive) covenant of a loan agreement, a borrower is required to maintain different positive actions. These actions include but are not limited to the maintenance of optimum insurance levels, requirements to send over financial audits to the creditor, compliance with set regulations, maintenance of accounting records, and possibly maintenance of credit ratings. When an affirmative covenant is violated, there is a tendency of outright disqualification. However, in some cases, the borrower might be granted a grace period to take care or correct the violation. If he is unable to do this, the lender is entitled to declare default and call the loan.
What is a Negative Covenant?
Negative covenants unlike positive covenants usually target what a borrower is not allowed to do rather than what he is expected to do. These covenants are set up to refrain the borrower from causing harm to their credit ratings, which may in turn impair their ability to repair the loan. Negative covenants are mostly in the form of financial ratios which borrowers are required to preserve at the time of the financial report. Some covenants require a borrower to maintain a certain amount of debt to earnings ratio, and this amount is not expected to surpass a designated maximum amount in order to prevent the company from getting into more debt can it can repay. Another example of negative covenant is the interest coverage ratio which states that a business earnings before interest and taxes (EBIT) must be higher than the interest payments by a designated multiple. This ratio helps prevent any occurrence of the inability of a borrowing entity to repay its existing loans by making sure that it generate enough earnings.
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