A negative covenant prevents a party, particularly a business or property owner from conducting a certain act. Negative covenants are created by the parties in agreeance of a certain condition. This typically occurs when one business promises another to not compete in the same business or line of work.
A negative covenant ensures that a party will not engage a specific activity. For example, imagine a cake company is sold to a buyer, one of the conditions of the transaction can be that the seller of the cake business promises not to open a competing business within the same shopping center. Negative covenants cannot prevent a party from entering a specific business in for the indefinite future.
Negative covenants typically are not for an unlimited period of time. Doing this is a violation of a party’s rights. Another example may be for a party to not sell the same product with the same ingredients. Using the cake company example above, this may involve a negative covenant that restricts the seller to use the same ingredients.
Negative Covenant’s in the Bond Market
Negative covenants are also referred to as a restrictive covenant, because like the term implies it is a restriction on the rights of one party to perform a specific act.
A negative covenant can also apply to businesses that restrict members of the company from earning an income above a certain threshold or cap an employee’s bonus.
A negative covenant oftentimes involves a CEO putting a cap on the maximum percentage the CFO can get for company financing such as additional loans, or additional spending. It is common for employment agreements to state the maximum capacity of a party’s job role, such as an employee being able to perform a specific role and not another. The role of parties is typically defined in an agency or employment agreement. This ensures all parties are informed of their roles.
A negative covenant in financing for a company may involve a provision that states the maximum debt-to income ratio that a company can take on.
Negative Covenant’s and Bonds
A bond is officially issues as a bond deed. The bond deed states the various duties that issuers are required to abide by with the intent to protect the interests of investors. Companies that engage in business with bonds may have negative covenants attached to their business model. An example of this includes a provision in a company business model that highlights the maximum debt the company can borrow. This includes verifying debt- to income ratios, expected growth, and others. The type of arrangement a business manages affects the type of formula a company may use making or not making specific business decisions.
Example of Restrictions in a Negative Covenant
Restrictions may include prevention of purchasing new bonds until old bonds have matured and have the ability to hypothetically cash out if they desired. Firms that issues bonds may be restricted from issuing dividends over multiple large parties. This is done to prevent bondholders from increasing the risk of default to pay bondholders and having less available money to pay back principal payments to the issuing party.
