Covenant Definition

What Is a Covenant?

In its broadest sense, a covenant is a promise, agreement, or contract between two parties. As part of the covenant, the two parties agree that certain activities will or will not be carried out.

Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. Covenants in religion often convey the binding relationship between a deity and humanity.

Understanding Covenants

Regarding business, covenants are most often represented in terms of financial ratios that must be maintained such as a maximum debt-to-asset ratio or other such ratios. Covenants can cover everything from minimum dividend payments to levels that must be maintained in working capital to key employees remaining with the firm.

Once a covenant is broken, the lender typically has the right to call back the obligation from the borrower or take measures to reduce the lender’s risk. Generally, there are two types of primary covenants included in agreements: affirmative covenants and negative covenants. In addition, a third type of covenant—financial covenants—is sometimes separated into its own category.

Affirmative Covenants

An affirmative or positive covenant is a clause in a loan contract that requires a borrower to perform specific actions. Examples of affirmative covenants include requirements to maintain adequate levels of insurance, requirements to furnish audited financial statements to the lender, compliance with applicable laws, and maintenance of proper accounting books and credit rating, if applicable.

A violation of an affirmative covenant ordinarily results in outright default. Certain loan contracts may contain clauses that provide a borrower with a grace period to remedy the violation. If not corrected, creditors are entitled to announce default and demand immediate repayment of principal and any accrued interest.

Negative Covenants

Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants restrict or forbid something from happening. Common examples include restricting a company from issuing dividends to its shareholders, restricting management fees from being paid to related parties, or restricting the amount of debt a business can carry.

A negative covenant can be circumnavigated with specific overriding approval of the covenant issuer. For example, imagine a company that wants to embark on a merger but is not allowed to due to a negative covenant. Should the opposite party in the covenant agree to release the restriction, the company can proceed. This may also be the case during the acquisition of real estate, capital investments, or disposition of assets.

Numerical or Financial Covenants

Last, a covenant can be tied to a specific numerical metric. This metric is often financial and may be a single number or calculation to derive a certain ratio for value. A financial covenant is often monitored closely over time as it is the most likely covenant to suddenly change.

The argument could be made that a financial covenant is actually a positive or negative covenant. For example, imagine a company being required to maintain a certain financial ratio above a certain calculated amount. Since this is imposing a requirement, it could technically be classified as a positive covenant. However, some view positive or negative covenants as a single outcome (i.e. a company must maintain GAAP records). Meanwhile, financial covenants evaluate operating performance to ensure the overall health of the entity.

In business, financial covenants are often separated into maintenance covenants or incurrence covenants. Maintenance covenants often stipulate operating performance that can not be breached. An example is the interest coverage ratio to ensure a company has sufficient earnings to cover interest assessments. Incurrence covenants occur when a company takes action that impacts financial performance. For example, a company must maintain its debt-to-equity ratio above 0.40; should it wish to raise more debt, it must ensure it satisfies the incurrence covenant.

Types of Covenants

Different industries and sectors have different types of covenants. In general, it’s pretty common to see both positive and negative covenants across different industries.

Debt Covenants

Debt covenants have been the example used most within this article. A debt covenant arises when an entity works with a financial institution to take out a loan. To secure the loan, the entity must agree to meet certain criteria, not perform certain activities, and maintain good financial standing.

Debt covenants can also impact the lender. For instance, imagine a company secures a line of credit and hopes to use this line over the next several years. It is in the company’s best interest to partner with a bank that maintains good financial standing and manages operational risk. Therefore, the borrower may impost covenants on the lender as part of the agreement to ensure the borrower will have long-term capabilities of securing financing.

Property Covenants

A property covenant is an agreement between multiple parties that stipulates how real property or real estate will or will not be used. These types of covenants may restrict the landowner or require specific action to be taken. For example, homeowner association covenants often require property to have trees trimmed to a certain length or outline how parking spaces are to be utilized.

Some property covenants will « run with the land » or exist in perpetuity regardless of who the owner is. For example, a property covenant may restrict the type or quantity of livestock allowed on a property. Should this covenant be transferrable to any new owner in the future, the covenant is tied to the land.

Law Covenants

While covenants are legal agreements by their nature, covenants are also simply part of the legal system. Law is a form of covenant, as law covenants are often negative covenants that restrict an individual or company from performing certain actions. The law may explain the outcome of what will happen should the covenant (law) be broken. Any common law intended to prevent criminal activity is an example of a law covenant.

Religious Covenants

Covenants are often found in religion, as a deity often makes promises or agreements to the people of the world or requires something of humankind. Although examples of religious covenants within the Bible are discussed below, covenants are a common part across Christianity, Islam, Hinduism, or Buddhism.

There are two types of covenants in the Bible. First, condition covenants are promises from God that certain outcomes will occur. However, for God to fulfill his part of the covenant, humanity must do its part first. In the first two chapters of Genesis, God promises Adam that blessing and curses depend on the faithfulness of mankind; by eating forbidden fruit, Adam broke the conditional covenant.

Second, the Bible includes unconditional covenants which are promises from God that he will fulfill an oath with his divine power without any associated conditions. By creating a rainbow after Noah survived the flood, God essentially promised to all of mankind that such destruction would not happen again. No further requirement was needed from mankind to make this happen.

Covenant Violations

A covenant violation—often called a breach of covenant—is failure to uphold the agreed upon terms of a covenant. Whether a party failed to execute a positive covenant, performed a task it shouldn’t have as outlined by a negative covenant, or wasn’t able to maintain certain operational metrics, the contract has been broken.

Debt Covenant Violations

A bond violation is a breach of the terms of the covenants of a bond. Bond covenants are designed to protect the interests of both parties, where the inclusion of the covenant is in the bond’s indenture, which is the binding agreement, contract or document between two or more parties.

When an issuer violates a bond covenant, it is considered to be in technical default. A common penalty for violating a bond covenant is the downgrading of a bond’s rating, which could make it less attractive to investors and increase the issuer’s borrowing costs. For example, Moody’s, one of the major credit rating agencies in the United States, rates a bond’s covenant quality on a scale of 1 to 5, with five being the worst. This means that a bond with a covenant rating of five is an indication that covenants are being violated consistently.

Other Violations

In general, a party may have legal recourse to seek compensation for damages should a different party have breached a covenant. For property, failure to comply with association rules or covenants may result in fines or liens. Though an HOA can not force a homeowner to sell their home, other types of property covenants may call for liquidation or transfer of ownership.

Failure to comply with law covenants results in fines, penalties, fees, or more serious legal punishment. When you park your car on the side of the street, you are subject to the covenant that stipulates you pay for that space during a specific time. Should you fail to comply, you are subject to a parking ticket. Any court proceeding or case is an example of a failed covenant.

Last, different religions uphold different consequences for not adhering to specific teachings. The Quran states that should someone stray from believing in Islamic teachings, Allah will never forgive them nor will He guide them « to the right way ».

Example of Bond/Debt Covenants

As part of its 2021 annual report, Amazon.com, Inc. publicly disclosed its note payable obligation. Because of the potential importance and restriction of covenants, it chose to publicly state that the notes were not subject to any covenants.

Alternatively, Apple, Inc. also report notes payable, though there are terms and conditions as part of their debt obligation. The following excerpt from its 2021 annual report outlines exceptions the limitations on additional interest on the notes:

« The Company will, subject to the exceptions and limitations set forth below, pay as additional interest on the Notes such additional amounts (“Additional Amounts”) as are necessary in order that the net payment by the Company or the paying agent of the Company…will not be less than the amount provided in the Notes to be then due and payable. »

Apple further discusses covenants restricting consolidation or merger activity. Their covenant states they may perform these activities as long as:

• « we are the continuing entity, or the resulting, surviving or transferee person (the “Successor”) is a person (if such person is not a corporation, then the Successor will include a corporate co-issuer of the debt securities) organized and existing under the laws of the United States of America, any state thereof or the District of Columbia and the Successor (if not us) will expressly assume, by supplemental indenture, all of our obligations under the debt securities and the applicable Indenture and, for each security that by its terms provides for conversion, provide for the right to convert such security in accordance with its terms;
• immediately after giving effect to such transaction, no default or event of default under the applicable Indenture has occurred and is continuing; and
• in the case of the 2013 Indenture, the trustee receives from us an officers’ certificate and an opinion of counsel that the transaction and such supplemental indenture, as the case may be, complies with the applicable provisions of the 2013 Indenture. »