Understanding Covenants: Contracts, Types, and Examples

What Is a Covenant?

Covenants are formal agreements specifying actions parties will or won't take, crucial in finance, property, and religion. In finance, they frequently appear in loan and bond terms to safeguard mutual interests. These covenants establish limits to maintain financial integrity. Conversely, religious covenants highlight divine commitments to humanity. Understanding covenants in these fields highlights their governance power.

Fundamental Elements of Financial Covenants  

In business, covenants usually involve financial ratios that must be kept, like a maximum debt-to-asset ratio. Covenants can cover everything from minimum dividend payments to levels that must be maintained in working capital to key employees remaining with the firm.

If a covenant is broken, the lender can ask for repayment or take steps to lower their 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.

What Are Affirmative Covenants?

An affirmative covenant in a loan requires the borrower to take 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.

Understanding Restrictions in Negative Covenants  

Negative covenants prevent borrowers from taking actions that could harm their credit or repayment ability. The most common forms of negative covenants restrict or forbid something from happening. Common examples include restricting a company from issuing dividends, paying management fees to related parties, or carrying too much debt.

A negative covenant can be bypassed if the issuer grants specific approval. 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.

Delving into Financial Metrics and Covenants

A covenant can also be linked to a specific financial metric, often a single number or ratio. 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. Some view positive and negative covenants as a single outcome. 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 payments. Incurrence covenants occur when a company takes action that impacts its 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.

Diverse Types of Financial and Property Covenants

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

The Role and Impact of 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 impose covenants on the lender as part of the agreement to ensure the borrower will have long-term capabilities of securing financing.

Key Insights into 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 (HOA) covenants often require property to have trees trimmed to a certain height 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 transferable to any new owner in the future, the covenant is tied to the land.

Legal Covenants and Their Implications  

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.

Exploring Religious Covenant Types and Traditions

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 the types of religious covenants specifically within the Bible are discussed below, covenants are a common part of Christianity, Islam, Hinduism, and Buddhism.

There are two types of covenants in the Bible. First, conditional 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. 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.

Addressing and Managing Covenant Violations

A covenant violation—often called a breach of covenant—is a 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.

Understanding 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 cannot 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.

Lastly, 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 or 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.

Conversely, Apple Inc. also reports notes payable, though there are terms and conditions as part of their debt obligation. The following excerpt from its 2021 annual report outlines the exceptions and 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
• "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."
  

The Bottom Line

Covenants play a critical role in formal agreements across different domains, including finance, property, law, and religion. They outline specific actions or restrictions to safeguard the interests of involved parties. In finance, lenders use covenants to ensure financial stability by requiring borrowers to meet certain financial ratios. Property covenants regulate land use, while legal covenants restrict certain activities to uphold law and order. Religious covenants signify profound commitments between deities and humanity. Understanding the intricacies and potential consequences of both affirmative and negative covenants helps individuals and businesses make informed decisions and avoid legal and financial repercussions.