Negative Covenants in Loan Agreements – Think Through What You Really Want To Add

By: Serge Filatov, Esq.

When documenting a loan, lenders often have to determine which negative covenants they want to add to their loan agreement. Before determining which negative covenants to add, it is important to understand the purpose of negative covenants.

What Are Negative Covenants?

Negative Covenants are restrictions in a loan agreement which are inserted for the following reasons: (i) to help establish guidelines for business operation, (ii) assess continued creditworthiness, (iii) identify problems before an event of default occurs, and (iv) ensure that the borrower can repay its loans to the lender.

What are examples of Negative Covenants? Examples of commonly used negative covenants include the following:

Indebtedness Limitations . These provisions restrict the ability of the borrower to take on additional debt other than the loans made under the loan agreement. The purpose of such a covenant is to ensure that the borrower does not take on more debt than it can repay and to restrict the borrower from having other creditors who will compete for repayment.

Lien Limitations . These provisions restrict the borrower’s ability to encumber any of its assets other than the lien put on by the lender or other approved third parties. The provisions protect lenders against other creditors by restricting who can be a secured creditor.

Fundamental Change Limitations . These provisions restrict the borrower’s ability to enter into any transactions that fundamentally change the borrower’s business, such as mergers, sales of substantially all of the borrower’s assets or liquidations. The restrictions ensure that the borrower maintains the same business during the life of the loan and that the borrower does not incur indebtedness or become subject to liens as a result of a transaction such as a merger.

Material Agreement Change Limitations . These provisions often restrict the borrower from amending the terms of any material agreements, such as a sales contract with a significant customer or borrower’s underlying governing documents. The restrictions helps ensure borrower continues to maintain a business which is similar to the business that existed at the time when the lender made its credit decision about the borrower.

Sale of Asset Limitations . These provisions restrict the borrower’s ability to sell, transfer or dispose of its assets outside of the ordinary course of its business. The restrictions ensure that the borrower’s assets remain substantially the same during the life of the loan. This is especially important for loans which are collateralized by the borrower’s assets.

Equity Payment Limitations . These provisions restrict the borrower from making payments to its equity holders, for example including making any distributions and equity redemptions or repurchases of the borrower’s equity. The restrictions ensure that the borrower will repay the lender prior to making payments to its equity holders.

Investment Limitations . These provisions restrict the borrower’s ability to make investments, including any loans, advances, equity purchases, note purchases, and asset acquisitions. The restrictions help ensure that the borrower will use its cash to pay down its debt to the lender rather than using it for investments.

Affiliate Transaction Limitations . These provisions restrict the borrower from entering into transactions with affiliates, or require that any such transactions are at least on an arm’s length basis and on terms no less favorable to the borrower than it could obtain if the transaction was with a third party. The restrictions help ensure that the borrower does not transfer its assets to a party which is not part of the loan and also ensures that the borrower does not enter into sweetheart deals which are not favorable to it.

Capital Expenditure Limitations . These provisions restrict the borrower from making capital expenditures, usually not exceeding a certain amount in any fiscal year. Since the funds used to make the capital expenditures could otherwise be used to repay the loan, lenders often put in restrictions to limit cash flowing out of the borrower.

Prepayment Limitations . These provisions often restrict the borrower from prepaying its loan early. Sometimes prepayments are not allowed at all while other times lenders will allow prepayments but will add prepayment penalties if a borrower tries to repay principal early. These restrictions help ensure that the lender will meet certain earnings targets on the loan.

Material Adverse Effect Limitations . These provisions often are used as default triggers so that if a borrower suffers any change which could cause a material adverse effect to its business, it is automatically in default under the loan. The provisions are often broad and provides the lender a catch-all provision to use in a problem loan scenario.

The above list of negative covenants is just a sample of the various restrictions that can be used to protect a lender. Additionally, each of these covenants can be written with exceptions and carve outs to accommodate a borrower based on a borrower’s unique situation.

If you are an institutional lender, don’t just rely on “stock” covenants. If you are a private lender, think hard about whether you want to add covenants to your loan. Either way, carefully consider what restrictions you want to put on the borrower based on the borrower’s risk profile and use restrictions that work for the specific deal.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

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