What it is:
How it works (Example):
For example, let's assume Company XYZ wants to borrow $10 million from Bank ABC. The loan agreement contains negative covenants that limit Company XYZ to $0.10 per share in dividends per year and prevent it from issuing additional debt without Bank ABC's consent.
Negative covenants can exist in employment agreements and even merger or acquisition agreements, but they are most common in lending agreements and bond indentures. Covenants, in general, can be financial or operational in nature.
Operational covenants often require borrowers to maintain their physical assets to a certain standards, meet minimum disclosure requirements, engage only in permissible business lines, or maintain a certain level of insurance.
Financial covenants are frequently ratios that the borrower is required to stay above or below (a 2:1 debt-to-equity ratio or interest coverage ratio, for example), but there are usually also restrictions on debt levels and minimum working capital requirements.
The lending agreement or indenture in which the negative covenant appears will also provide detailed formulas to be used to calculate the ratios and limits on negative covenants. It is important to note that in many cases these formulas do not conform to generally accepted accounting principals (GAAP). For example, the negative covenant may include leases in a debt-limit calculation, or it may consider capital leases as an expense. As a result, it is very important that borrowers scrutinize covenants before borrowing.
Why it Matters:
Lenders attach negative covenants to bond issues and loans as a way to force the borrower to operate in a financially prudent manner that most ensures it will repay the debt. Issuers, on the other hand, usually negotiate the most flexible covenants they can so they have the freedom to make decisions and take risks that might ultimately benefit the lenders and the shareholders. Thus, the more negative covenants a bond issue has, the lower the interest rate on those bonds tends to be.
Violating a negative covenant can trigger a technical default. This means that although the issuer is making interest and principal payments on time, it is not operating within the agreed-upon guidelines and is thus increasing the risk of nonpayment in the eyes of the Lenders or bondholders. Often borrowers have a certain amount of time to remedy (or "cure") the technical default (for example, the borrower must lower its debt-to-equity ratio within thirty days), but technical defaults often lower the borrower's credit rating and stock price.