What are Negative Covenants (Restrictive)?

Negative Covenants are used in almost all types of contracts/agreements:

  • Employment contractsMergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read moreBond documentsLand use/ Rent agreements etc.

This can be used as a part of an agreement, or it could be a separate agreement as a whole. It serves different purposes depending on the type of contract; however, it is generally done to prevent one party’s interest over the other party.

Also, have a look at Bond CovenantsBond CovenantsDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching.read more

3 Main Types of Negative Covenants (Restrictive)

Let us see the types of negative covenants in various transactions/agreements:

#1 – Non – Compete Agreement

A non-compete agreement is mainly written in employment contracts or acquisition contracts.

During acquisition, the new owner, when it takes over a Company and its business, signs a non-compete agreement such that the old owner of the business does not start the same business again and starts competing. The non-compete agreement is usually for a specific period of time and for a region. The new owners of the business usually pay non-compete fees to the original owners for not entering into the business.

Non-compete agreementsNon-compete AgreementsA Non-Compete Agreement is a contract signed by an employee who agrees not to compete with the employerread more also restrict employees from joining a competitor or opening the business the same as that of the Company he is employed with. This is usually done to restrict employees from being a competitor of the Company after attaining necessary training, skills, and experience. Such non-compete agreements in employee contracts vary from 6 months to 2 years.

#2 – Non-Solicitation Agreement

A non-solicitation agreement restricts professionals, employees from soliciting the customers or clients from their previous employees. Consultants, in general, get to know the clients very well, they may be tempted to start their own business and solicit the clients of their employer, or they may join a competitor and solicit the clients to the new employer. Such an agreement restricts them from doing so.

#3 – Non-Disclosure Agreement

A non-disclosure agreementNon-disclosure AgreementA non-disclosure agreement (NDA) is a legal contract in which the signatories promise not to reveal confidential information outlined in it to a third party.read more restricts one party from disclosing any information about another party. The information may include trade secretsTrade SecretsTrade secrets are any valuable information regarding a company’s processes or operations guarded and concealed from the public eye. The company actively protect them and they are available to only a limited number of people. As a result, they possess the potential to be licensed or sold for profit.read more, proprietary information, innovations, or any other information which may harm the business of the owner of such information. E.gResearch scientists, pharmacists, working in laboratories and other researchers are bound by such agreements. They work on new products and innovations, and their employer would like to have a competitive advantageCompetitive AdvantageCompetitive advantage refers to an advantage availed by a company that has remained successful in outdoing its competitors belonging to the same industry by designing and implementing effective strategies that allow the same in offering quality goods or services, quoting reasonable prices to its customers, maximizing the wealth of its stakeholders and so on and as a result of which the company can make more profits, build a positive brand reputation, make more sales, maximize return on assets, etc.read more by innovating new products. Thus, he would protect the flow of the information to competitors by signing an NDANDAThe full form of NDA is termed as Non-Disclosure Agreement. It is defined as the Legal contract of a confidential agreement entered between two or more parties (covered under the Indian Contract Act, 1872) to restrict the parties from disclosing any confidential information & proprietary information shared by the contracting parties during the validity of the agreement.read more.

Restrictive Covenants in Bond Indentures

source: pds.com.ph

Covenants are also found in the bond indenturesBond IndenturesBond indenture or bond resolution is a core legal document that serves as a contract binding upon the bond issuer and the bondholder. It comprises all the bond-related information, like details of the issue, its purpose, bond issuer’s obligations and rights of the bondholders.read more. Such restrictive covenants are placed to safeguard the interests of the bond investors. These are used in the bond issues to protect the investors’ money, and they restrict the bond issuersThe Bond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more from taking risky bets or such material changes, which may impact the investors. However, the more the number of negative covenants, the lesser the interest rate on such bonds. The restrictive covenants list may include:

  • Not altering accounting practicesAccounting PracticesAccounting practice is a set of procedures and controls used by an entity’s accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor’s reliance while auditing the financial statements.read moreLimit on debtLimit of dividend paymentLimit on contracts/leases or any amendments thereofMaintenance of certain financial ratiosFinancial RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more in the particular range – examples of few such ratios are:
  • Maintaining the debt/equity ratioDebt/equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more of less than 1
  • Maintaining a current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities
  • read more of more than 1
  • Maintaining net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization’s overall profitability after incurring its interest and tax expenses.read more or gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more in the historical range

For Negative Covenants ExamplesCovenants ExamplesCovenant refers to the borrower’s promise to the lender, quoted on a formal debt agreement stating the former’s obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more: A company wants to borrow $ 100 Mn of debt, but the loan agreement has a restriction on the payment of dividends. The dividend paid to the shareholders cannot exceed $ 1 per share in one year.

  • Maintaining the debt/equity ratioDebt/equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more of less than 1
  • Maintaining a current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities
  • read more of more than 1
  • Maintaining net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization’s overall profitability after incurring its interest and tax expenses.read more or gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more in the historical range

In Bond indentures, the covenants can be of two types.

  • Operation Covenant: Operational covenants are those which relate to operations of the Company. They put restrictions on the operations of the Company, which can be – the borrower has to meet certain disclosure requirements, it cannot take certain operations or line of business, maintain a certain level of insurance.Financial Covenant: Financial covenants are like maintenance of finances and financial ratios at a certain level, e.g., debt to equity ratio of 2:1, minimum working capital requirements, maintenance of interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company’s current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company’s liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, etc.

source: akelius.com

Lenders like to have negative covenants to bond issues so that the borrower operates at a certain level of risk and thus ensures that the lender’s money is safe. If the borrower violates negative covenants, it is considered as a “technical default.” Although the borrower might be paying interest and principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more violating negative covenants may lower its credit rating.

Negative Covenants in Employment Contracts

Employment contracts have non-compete and non-disclosure agreements in general. Employees are restricted from disclosing any information they have during their employment and to compete with their employer. The employer tries to secure his interests as he has invested time and money on employees by giving them initial training, skills, and experience. The employee might have access to some information that may be trade secrets, proprietary information, or such other data or information which may affect the employer. Thus, by signing a non-disclosure agreement, the employer legally ensures that such information is not passed to the competitor.

Conclusion

Negative Covenants are the restrictive covenants that restrict one party to take on some operations or work in a financially prudent way so as to safeguard the interests of the other party. These are found in most of the agreements. The agreements could be a merger or acquisition, employee contracts, bond indenturesBond IndenturesIndenture is a legal agreement between two or more parties to meet their respective obligations. It is a common term used in the bond market to provide the lender and borrower with the necessary comfort in the transaction in the event of one defaulting party.read more, etc. It is mentioned in agreements but faces enforcement problems. If negative covenants are violated or breached, it may take a long time to be settled by the court of law. Further, it will be costly for both parties, given that the damage is already done.

Negative Covenants Video

This has been a guide to What are Negative Covenants? Here we discuss the three types of negative covenants – non compete, non-disclosure, and non-solicitation. We also discuss a restrictive covenant example found in bond indentures. You may learn more about Fixed Income from the following articles –

  • Debt YieldWhat is Subordinated Debt?Financing AcquisitionsLong-Term Debt in Balance Sheet