Negative Covenant: Definition and Examples
What is a negative covenant?
A negative covenant (also called a restrictive covenant) is a contractual promise not to take specified actions. Lenders, bondholders, employers, or counterparties use negative covenants to limit behaviors that could increase risk or reduce value.
How negative covenants are used
- In debt contracts (bond indentures or loan agreements), negative covenants protect creditors by restricting borrower actions that could impair repayment.
- In employment or M&A agreements, they can prevent parties from competing, soliciting customers, or disposing of key assets.
- A trustee or lender typically monitors compliance and can enforce remedies if a covenant is breached.
Common types and examples
- Limits on additional borrowing (e.g., no new secured debt or no issuance of more debt until certain bonds mature).
- Negative pledge clauses preventing a borrower from using specified assets as collateral for other loans.
- Dividend or payment caps to ensure cash remains available for interest and principal.
- Restrictions on asset sales, mergers, or changes in business operations.
- Limits on executive compensation or capital expenditures.
- Non-compete and non-solicitation clauses in employment or sale agreements.
Financial covenants and measurement
Negative covenants often include financial tests and formulas (sometimes specified differently from GAAP) such as:
- Debt-to-equity ratio maximums
- Interest coverage minimums
- Fixed-charge coverage ratios
These tests define thresholds that, if violated, can trigger a default or require remediation.
Enforcement and consequences
Breach of a negative covenant can lead to:
- Event of default under the loan or bond documents
- Acceleration of debt, higher interest or penalties
- Negotiation of waivers or amendments with lenders
- Increased scrutiny or restrictions on the borrower’s operations
Effect on pricing and risk
More and stricter negative covenants reduce lender/investor risk. As a result, debt with tighter covenants typically carries lower interest rates than unconstrained debt.
Negative vs. positive covenants
- Negative covenant: requires the borrower or counterparty not to do something (restrictive).
- Positive (affirmative) covenant: requires the borrower to take specific actions (e.g., deliver financial statements, maintain insurance).
Both types are common in credit agreements; negative covenants limit operational freedom, while positive covenants impose ongoing obligations.
Key takeaways
- A negative covenant is a contractual promise to refrain from specified actions.
- They are most common in loan and bond documents but also appear in employment and M&A contracts.
- Typical restrictions include limits on additional debt, dividend payments, asset pledges, and changes in business operations.
- Stronger restrictive covenants generally lower borrower funding costs by reducing creditor risk.