Debt And Credit Risk · Intermediate · 8 minute read · No ads
Negative Covenant
Also called restrictive covenant, prohibited covenant, debt restriction
A negative covenant is a promise that limits what a borrower may do without meeting stated conditions or obtaining lender consent. Common restrictions cover new debt, liens, asset sales, acquisitions, investments, dividends and share repurchases. Exceptions called baskets allow defined amounts or types of activity.
Key takeaways
- Negative covenants restrict specified actions; they do not necessarily ban them outright. Exceptions, baskets and ratio based permissions determine what is actually allowed.
- The exact credit agreement and its amendments control the answer. A summary in a filing may omit thresholds, conditions, subsidiaries and definitions.
- Capacity can change as baskets are used, earnings move or assets are sold. A borrower with permission today may have less room after another transaction.
- A proposed action outside the available exception usually requires another permitted route, repayment, amendment or lender consent.
What is a negative covenant?
A loan or bond condition restricting the issuer from taking certain actions.
How Negative Covenant works
| Step | What happens |
|---|---|
| 01 · Find the current agreement | Include all amendments, joinders and restatements that change the original wording. |
| 02 · Identify the restricted action | Decide whether the proposal is debt, a lien, an investment, a restricted payment, an asset sale or another defined action. |
| 03 · Map every available exception | Review fixed, grower, ratio and available amount baskets plus specific transaction exceptions. |
| 04 · Calculate remaining capacity | Subtract prior usage and apply the agreement’s definitions, conditions and test date. |
| 05 · Check approvals and disclosure | Confirm whether lender consent, board approval, notice or a filing is required. |
The formula
Remaining basket capacity = permitted basket − amount already used
The permitted basket is the amount of an otherwise restricted action that the agreement allows. Amount already used includes transactions charged to that basket. Other exceptions may exist, so this simple calculation is a starting point rather than a substitute for reading the full agreement.
See how ratio tests affect covenant capacity
Ratio based baskets often depend on leverage or coverage. Learn how to calculate the underlying measures before reading the exception.
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The actions negative covenants commonly restrict
Typical sections address additional indebtedness, liens, investments, acquisitions, mergers, asset sales, affiliate transactions, restricted payments and changes to the business. The borrower usually may act within detailed exceptions. Read which entities are restricted subsidiaries because unrestricted subsidiaries may sit outside some controls.
Baskets, exceptions and conditions
A fixed basket permits a stated dollar amount. A grower basket can increase with assets, EBITDA or another measure. Ratio baskets allow unlimited or additional capacity when a leverage or coverage test is satisfied. Available amount or builder baskets may accumulate from retained earnings, equity contributions or other sources. Many baskets require no continuing event of default.
Incurrence tests versus maintenance tests
A negative covenant often works as an incurrence control: the borrower tests it when proposing a restricted action. A maintenance covenant is tested on recurring dates even if the company takes no action. A company may pass every quarterly maintenance test yet lack capacity for a dividend or acquisition.
How basket capacity moves
Capacity can be used, reclassified or sometimes restored. Agreements may allow a transaction initially charged to a fixed basket to be reclassified later under a ratio basket when financial performance improves. Asset sale proceeds may need to be reinvested or used to repay debt. Amendments can add, resize or remove exceptions.
Consent, amendments and waivers
If no exception fits, the borrower can change the transaction or ask lenders to consent. Consent may require a fee, higher interest margin, added collateral or another concession. A waiver addresses a specified breach; an amendment changes the agreement for future periods.
How investors can review negative covenants
Read the current agreement, amendments and recent filings. Search for permitted debt, liens, investments, restricted payments, dispositions and unrestricted subsidiaries. Then compare remaining capacity with management’s stated plans for acquisitions, dividends, buybacks and refinancing.
Comparison
| Covenant type | What it does | Example |
|---|---|---|
| Negative covenant | Restricts an action unless an exception applies | Limits new debt, liens or dividends |
| Positive covenant | Requires an action or continuing condition | Deliver financial statements and maintain insurance |
| Financial covenant | Sets a measurable threshold | Keep leverage at or below 4.0 times |
| Representation | States a fact when made or repeated | Financial statements fairly present the agreed information |
Things people get wrong
Mistake 01 Reading the heading as a complete ban
Most negative covenants contain numerous exceptions and baskets that can permit the action.
Mistake 02 Checking only the original agreement
Amendments can materially change basket sizes, definitions and ratio tests.
Mistake 03 Adding every basket together
Baskets may overlap, share conditions or be unavailable to a particular subsidiary or transaction.
Questions people ask about Negative Covenant
Why is it called a negative covenant?
It is framed as a promise not to take specified actions except as the agreement permits. The word negative describes the restriction, not the borrower’s financial health.
What is a covenant basket?
A basket is a defined amount or category of an otherwise restricted action that the borrower may take if the stated conditions are met.
Are dividends always prohibited by negative covenants?
No. Restricted payment covenants often contain fixed, ratio based and other exceptions. The company must have capacity under the exact agreement.
What is the difference between a negative covenant and a financial covenant?
A negative covenant limits actions. A financial covenant sets a numerical threshold, although financial tests can also determine whether a negative covenant exception is available.
What happens if a company exceeds a basket?
If no other exception applies, the action can breach the agreement. The borrower may need to resize the transaction, repay debt, obtain consent or amend the agreement.
Where can investors find negative covenants?
Public companies often file credit agreements and indentures as SEC exhibits. Search within the current document for negative covenants, limitations and permitted exceptions.
Can covenant capacity increase over time?
Yes. Grower baskets, retained amounts, equity contributions, improved ratios, repayments and reclassification provisions can change capacity.
The bottom line
A negative covenant is a rule set, not a one line prohibition. To judge whether a company can borrow, pledge assets, acquire a business or return cash, identify the restricted action, read every applicable exception and calculate remaining capacity under the current agreement. The headline basket is useful only when its definitions and conditions are understood.
Sources
- Federal Reserve, Interagency Guidance on Leveraged Lending
- Federal Reserve, Frequently Asked Questions for Implementing Interagency Guidance on Leveraged Lending
- SEC EDGAR, filed credit agreement containing affirmative and negative covenant sections
- SEC EDGAR, example filing describing debt, lien, restricted payment and investment baskets
How we produced the figuresThe $10 million proposal and $8 million basket are illustrative. The $2 million excess is calculated by subtracting available capacity from the proposed debt. Real agreements may contain additional baskets, ratio tests, reclassification rights, conditions and subsidiary limits.
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About this page. Written by Associate Professor Charles Lo, CPA, PhD and edited by Felix La Spina. Checked against reliable sources before publication. No ads and no paywall. Editorial standards · How we fact check · Corrections log · Report an error
Educational information only. Nothing on this page is personal financial, tax or legal advice. Investing involves risk, including the possible loss of principal.
