Negative Covenant
Candlefocus EditorA negative covenant is a contractual term included as part of a loan agreement and as a "promise not to do something" that can significantly affect the lender's ability to get paid back. They are typically written in the form of a restrictive clause that limits the borrower's activities. This ensures that the lender's money is used properly and that the borrower doesn't increase their risk of default.
Negative covenants can include a wide variety of restrictions, but some of the most common are limiting the amount of dividends the borrower is allowed to pay, preventing the borrower from taking on additional debt, limiting investments the borrower can make and requiring the borrower to maintain certain financial ratios. Other covenants may include prohibitions on actions such as mergers, paying off other debts or taking other specific actions without the express permission of the lender.
Negative covenants are used to protect the lender's interest in a loan agreement and usually demand regular reporting from the borrower. The lender can choose to enforce these covenants whenever they perceive that the borrower is at risk of defaulting on the loan. The severity of the consequences for a violation of the covenant varies, but commonly can involve the borrower having to put a certain amount of money in escrow or taking other corrective measures until the situation is resolved.
As a result, negative covenants are an important protective measure that lenders use in order to mitigate their risks. Without such covenants, lenders would have far less control over how their borrowers utilise the money they lend out, making it much easier for borrowers to default on their loan. As a result, having strong negative covenants in loan contracts is essential for lenders to ensure they are adequately compensated for the loan they provide.