Debt covenants are certain statements in the loan agreement (or bond indenture) that restrict the borrower from doing certain things. The purpose of such covenants is to protect the interest of the lender, who is a bank, in case of term loans. Also known as restrictive covenants, they are classified as negative covenants (related to asset, liability, cash flow, and control) and positive covenants in relation to certain types of additional reporting to a lender.
Types of Debt Covenants
These covenants can broadly be classified between positive/affirmative and negative from the point of view of a borrower. We will first look at negative covenants, which are of primary concern while entering into the contract. Also known as restrictive covenants, these are further classified into various subcategories based on their impact areas such as asset, liability, cash flow, and control.
Restrictive / Negative Debt Covenants
Asset Related Restrictive Covenants
These covenants put certain restrictions on the assets of the borrower. The borrower either cannot break these covenants or would need to take due approval or permission before breaking. These restrictions may be in the form of the following:
- Creation of any further charges on the assets.
- Sale of fixed assets.
Liability Related Restrictive Covenants
These covenants restrict any activity affecting the liability of the company, which may include
- Taking up an additional loan.
- Repayment of an existing loan.
- Issue additional equity shares.
- The issue of deposit certificates or unsecured loans etc.
- Any disposal or reduction in promoter’s shareholding.
Cash Flow Related Restrictive Covenants
These covenants restrict the usage of the cash flow of the company.
- Capital expenditure on new projects, expansion, diversification, modernization, etc.
- Dividend payment
- Limitations on top management salaries etc.
Control Related Restrictive Covenants
Covenants on control are very embarrassing for the management because it directly impacts how they have managed the company before the debt.
- Selection of management team and bringing organizational change in consultation with the bank or financial institution.
- Appointment of Nominee Directors.
Affirmative / Positive Covenants
These covenants are affirmative or positive because they do not restrict anything but usually impose certain additional tasks on the borrower.
- Submission of financial statements from time to time as agreed in the loan agreement.
- Maintenance of certain working capital levels and net worth of the company.
- Secure debt payment by maintaining a sinking fund.
What not you have to do to obtain and maintain that loan in the company? Taking money from a financial institution is not so easy. Borrowers lose all their freedom. But, if we think from the point of view of the bank or financial institution, who is holding public money with it, has to do such due diligence before handing over that money to anybody. They have to make sure that the loan does not become bad debt.
