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.