What is Restrictive Covenant?
When a company raises debt, it is often subject to conditions, restrictions, and terms known as debt (or financial) covenants.
A restrictive covenant is a condition that restricts, limits, prohibits, or prevents the actions of someone named in an enforceable agreement. In bond obligations, restrictive covenants limit the amount issuers can pay in dividends to investors.
The purpose of debt covenants is to protect creditors by ensuring that borrowers act responsibly and make payments on time. The nature of these covenants varies widely but usually includes:
- Principal payments.
- Interest rate changes.
- Levels of financial leverage.
- Working capital requirements.
- Material contracts.
- Mergers & acquisitions activity.
- Limitations on distributions.
It’s important to differentiate between the two main types of covenants: negative and positive. Negative covenants are actions you can’t take, while positive covenants are actions you must take. For example, a negative covenant in real estate could prevent you from raising chickens on your property. On the other hand, a positive covenant could require you to mow your lawn.