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What Is a Negative Covenant?
Let me explain what a negative covenant is—it's an agreement that stops a company from doing certain things. You can think of it as a promise not to take specific actions. We also call these restrictive covenants.
For instance, if a public company agrees to one, it might cap how much in dividends they can pay shareholders or limit executives' salaries. You'll find negative covenants in employment deals and M&A contracts, but they're most common in loan or bond documents.
Key Takeaways
- A negative covenant is an agreement that restricts a company from engaging in certain actions—it's 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 gets issued, its details are in a document called the bond deed or trust indenture. This indenture outlines the issuer's responsibilities, and a trustee oversees it to safeguard investors' interests. It also lists any negative covenants the issuer must follow.
Take this example: a negative covenant might block the firm from issuing more debt. Specifically, you could see a requirement to keep the debt-equity ratio at no more than 1. Also, negative pledge clauses in loans stop the borrower from using pledged assets as collateral elsewhere.
The loan agreement or indenture spells out detailed formulas— which might not always match GAAP—for calculating ratios and limits on these covenants.
Borrowers often face restrictions like not issuing more debt until existing bonds mature. They might also be barred from paying dividends above a set amount to shareholders, reducing default risk for bondholders since more money to shareholders means less for interest and principal payments to lenders.
In general, the more negative covenants in a bond issue, the lower the interest rate you'll see on the debt, as these restrictions make the bonds seem safer to investors.
Remember, a negative covenant differs from a positive one, which requires the firm to do things like provide regular audit reports to creditors or insure assets properly. Positive covenants don't limit operations much, but negative ones can seriously restrict how a business runs.
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