Overview
Businesses need to borrow from time to time to manage and grow their business; however, depending on their financial situation, the lending institution might include certain terms and conditions in order to secure timely repayments. Even with little or no perceived risk of violation of loan agreement, having certain terms in place may help borrower businesses to deploy funds with adequate security measures and with caution. Likewise, such conservative terms and conditions might also help borrowers to be granted funds at a lower cost of borrowing at a lower interest rate as borrowers agree to accept the conservative terms offered by lenders.
However, if a business undergoes any unanticipated risk, undertakes wrong spending, or fails to collect payments from clients, having restrictive loan terms, or what are commonly referred to as “covenants,”. Read further to find out more about restrictive covenants, their purpose, unique features, potential downsides and more.
Restrictive Loan Covenants
Restrictive loan covenants are the terms and covenants that either limit, restrict, or prevent the parties from doing certain actions or actions mutually agreed upon by the parties in pursuance of a loan agreement. Such terms are also referred to as negative covenants, which can have legal and financial consequences for the borrowers. Debt covenants essentially protect the interests of the lenders while also helping borrowers agreeing to such covenants to obtain loan facilities on favorable terms as part of a lending agreement.
For instance, Company Z wishes to acquire Company D for a sum of Rs. 8 crores at a time when the time is not favorable for an acquisition in a volatile financial market. Accordingly, under Company Z’s existing loan agreement in existence with lending institution G Ltd., all the proposed investment/purchasing activities and M&A activities should be approved by the lender bank. When company Z pitches the idea, the lending institution rejects the plan, stating that the business undertaking acquisition shall be in violation of the covenant agreement. Doing so during unstable economic conditions would be putting money at risk. These terms are known as restrictive loan covenants.
Learn About Restrictive Loan Covenants
Purpose of Restrictive Loan Covenants
Creditors extending loan facilities generate a large portion of their income from lending to corporate entities. While a portion of the calculation resorts to the full repayment of principal to the extent that a certain exercise has any influence on that borrower to help ensure financial well-being, this is where restrictive loan covenants come into the picture.
Restrictive loan covenants either require or restrict certain actions in specific circumstances, serving key purposes, namely:
Aligning Incentives between the Parties:
The primary purpose of restrictive loan covenants is to ensure proper alignment of goals and objectives between the parties to a credit agreement. The lender would analyze whether the funds retained within the organization offer an adequate cash cushion or, perhaps, to repay some of its outstanding credit. For instance, where the management team wishes to allocate a hefty share of business revenues to stockholders via dividend payouts.
A typical example of the situation would be a loan agreement where there has been no clear mention of the repayment dates in the agreement, giving rise to the question regarding whether there are any incentives for a borrower to make payments on time. Any misalignment of incentives could be managed by capping dividend sums or mandating financial covenants to be net of dividend payment calculations.
Risk Mitigation:
Further, the purpose of restrictive loan covenants is to enable risk mitigation for certain risks in order to improve the likelihood of full loan repayment in a loan transaction. For example, where a borrower wishes to take on higher leverage or gear up for a business acquisition, the borrower should attempt to reduce the debt portion as soon as is feasible to maintain the leverage ratios to its industry standards or long-term expectations.
Preventing Potential Drawbacks:
Loan covenants should only be employed when specific incentives need better alignment or when mitigating a particular risk. Excessively stringent loan covenants may have a negative impact on the lender, which may include-
- Removing unattainable or unreasonable covenants: Lenders should not include covenants that are impossible to attain under normal circumstances, as this may set the borrower up for failure. For instance, where a business has a high dependence on debt for business acquisition, the debt-to-equity ratio is likely to soar during the year.
- Perceived Competition Risk: Assuming all other factors are equal, borrowers favor lenders offering debt with fewer restrictive covenants. Consistent proposals along with prospects over-applying loan covenants might lead to loss of potential business opportunities for the lending institutions.
Features of Restrictive Loan Covenants
Limit or Restrict Further Borrowing Activities
Restrictive loan covenants restrict the borrower entity from engaging further in borrowing or financing activities in pursuance of the mutually agreed loan agreement as part of their strategy to potentially minimize bad debt-related risks.
Restrictions on Business Investments
Restrictive loan covenants may potentially limit or restrict any business investments, such as the purchase of physical assets, the upgradation of machinery or equipment, real estate investments, etc., or may require seeking their approval before making or committing to any such investment. Such covenants seek to minimize risk in relation to considerable sums of investment expenses.
Limiting Merger or Acquisition Activities
Since activities such as merging with another business or acquiring other businesses may have a significant impact upon the cash flows of a business, lenders prefer to add a negative covenant restricting any merger or acquisition without their approvals. Hence, restrictive loan covenants help business entities to secure business against massive debts through restraining scope for merger activities while ensuring prevention against any mishandling of funds with higher risks.
Payout related restrictions
Lenders may limit by setting a certain limit for payouts or restrict them fully with the purpose of ensuring a healthy liquidity position for the borrower’s business. Doing so allows prevention against larger sums of cash seepage on the part of the business entity, which may have a larger bearing on the business and its ability for effective debt management.
Difference between Positive and Negative Loan Covenants
Affirmative or Positive Covenants |
Negative or Restrictive Loan Covenants |
| Affirmative covenants, commonly referred to as “positive” covenants, are added to a loan agreement requiring borrowers to execute certain actions, creating certain limitations or restrictions on the borrowers.
|
While affirmative covenants require certain actions to be performed by the borrower entity, in contrast, negative covenants place certain limitations or restrictions on the borrower to not perform certain actions. Hence the term negative covenants could be
interchangeably with “restrictive” covenants. |
| For publicly listed companies, the lender could place certain additional compliance requirements in addition to the requirements mentioned in other legislations. | Different lenders may place specific negative covenants in the loan agreement suited to their preferences depending upon the financial position of the borrower entity, existing loans, the purpose of seeking loans, etc. |
| For instance, the company shall maintain efficient compliance with SEBI and file financial reports with SEBI. Financial statements shall be audited regularly whether the borrower is public or private. | Some examples of negative loan covenants include:
Restriction on the borrower company against the issue of dividends to the members of the company unless approved by the lender. Restriction on the borrower company against any further pledge of the assets of the company since it risks the repayment of the debt for the lender in the event of default of repayment or liquidation. |
What Kind Of Firms Get Negative Or Positive Covenants?
Multiple research studies conducted on positive as well as negative loan covenants have shown that generally higher-growth firms or businesses highly dependent on lending institutions employ negative covenants in pursuance of their debt transactions, whereas firms with lesser profit margins add positive covenants in their debt agreements. Hence, in such cases, lenders prefer to have a higher degree of control over the business decisions that have a direct impact on the usage of borrowed funds.
Entering negative covenants in a loan agreement further allows the lenders to ensure a mechanism to hedge the borrowed funds from potential losses through restriction of business operations or financial activities that are a potential threat to the funds. Thus, the usage of funds for any such purpose could only be done with the consent of the lending institution via a negative covenant.
Drawbacks of Restrictive Loan Covenants
Disproportionate Financial Ratios
Sometimes negative covenants restricting maintaining certain financial ratios of a business might turn out to be unfair and prejudicial. For instance, requiring a debt-to-equity ratio of 1:1 might be too difficult for some businesses to attain.
Lack of Flexibility
Certain restrictive loan covenants may limit the ability of the borrower entity to seek further loans, which may affect the ability of the borrower to grow its business and grab new opportunities.
Excessive reporting
Restrictive loan covenants might have excessive compliance requirements that require more than frequent reporting and monitoring, making it taxing for the borrower’s business, especially when they need more funds to fulfill such requirements.
Shorter Repayment Tenures
Certain lenders putting shorter repayment tenures for the borrower that might be burdensome for the borrower’s business, potentially increasing the chances of default for the borrower failing to meet such obligations.
Risk of Default
Businesses failing to comply with the negative covenants run the risk of defaulting, leading to further fees and penalties, further hurting the credit rating of the business, and legal ramifications for the default.
Consequences of Breaching Restrictive Loan Covenants
When the borrower business entity fails to fulfill the covenants of the loan agreement, it is referred to as an event of default, which could either be a financial default (delayed repayments) or technical defaults (failure or delay in fulfilling compliances). Any breach of restrictive covenants shall be evaluated by the risk manager and shall be documented in writing by the lender institution of the violation of the loan agreement. Since all loan covenants are imperative and legally binding, all covenants are equal in nature. For instance, any inordinate delay in financial reporting could be issued by the client’s accountant, which could either be resolved within a certain number of days or weeks.
Legal ramifications of a lending organization in the case of a technical default could range anywhere from waiver to court proceedings, depending upon the severity of the breach, which is a contractual agreement from lender and borrower entity. For instance, the extent of a violation of a negative covenant should be considered in relation to the parties involved as well as the possible remedies for the breach.
However, in some cases, rather than taking legal recourse, the lender might readjust the terms of the agreement, i.e., extend the loan tenure, alter the interest terms to be paid as in kind, etc., for the borrowing term.
Conclusion
So, restrictive loan covenants can either be good or bad, contingent upon the financial health of the borrower. They can help businesses maintain certain financial and operating metrics; they can increase the borrower’s ability to be more confident to repay loans. Furthermore, loan covenants could assist businesses in tracking finances and upholding financial discipline, which could be helpful in the long run. However, having too many negative covenants could restrict a borrower’s ability to efficiently manage a business.
Further, such loan covenants could even create unanticipated conflicts between lenders and borrowers, particularly where the borrowers feel that the covenants are either too restrictive or unfair. This can be particularly challenging for businesses on a growth spurt and the lack of flexibility to accommodate their financial requirements. Hence, on one side, negative loan covenants could safeguard the lender’s interest and enable risk minimization; however, overly harsh restrictive covenants could limit the business potential for growth and investments in the long run. To be careful and mindful of all the negative impacts that the loan agreement may carry and it is advisable to read the sanction letter carefully before signing. Businesses may choose to take the help of an expert like BankKeeping to be able to understand and negotiate favorable terms from the banks.