A debt covenant or more specifically, a financial or banking covenant is a solemn agreement between a lender and a borrower; whereby the borrower is required to either engage or refrain from a specific action.
The factors which play a large role in determining the scope of a covenant are (i) the degree of the risk undertaken by the lender; (ii) the nature of the borrower; and (iii) whether the loan is a secured or an unsecured loan.
The main purpose of a covenant, for an unsecured loan, is to provide more security to the lender; and although this might appear as if the covenants are obstacles creating a burden and a restriction on the borrower during its term, it is of extreme necessity in order to monitor the condition of the borrower and the terms of the loan.
Such a covenant, among other things, will include providing financial statements to the lender in order to establish whether the borrower is still in a financially viable position.
The functions of these covenants, especially in an unsecured loan, is not to restrict the borrower of its day to day activities but to rather instil in the lender the surety that the borrower will not act recklessly or partake in activities that might put the loan and the lender at risk.
Some of these functions might include that the borrower refrain from international activities without obtaining the written consent of the lender, the pari passu clause the restriction of extending any funds to any third parties, restrictions on its capital expenditure, refraining from disposing of its assets without obtaining the written consent of the lender, the borrower must remain within specific financial ratios at all times, or is restricted to undergo a substantial change in its business, the borrower might be obligated to make available to the lender financial information upon request, and further, the borrower might be restricted to incur any other debt or liabilities during the course of the loan period.
In the event that the borrower breaches any of the covenants as set out in the loan agreement, a number of remedies can be looked at, namely, the acceleration of the loan and the lender cancelling its commitments to further extend funds.
One of the most important covenants in an unsecured loan is the negative pledge.
The negative pledge reads as follows:
“The borrower will not create or permit security on its assets or those of its subsidiaries.”
The reason for the inclusion of this clause is to prohibit the borrower from encumbering any of its assets under security.
Another reason is to prohibit a situation where the borrower grants security to another creditor for one of its subsidiaries. It leaves no assets available for the lender as the unsecured creditor.
Another important covenant is the pari passu clause.
The pari passu clause reads as follows:
“The borrower’s obligations under the loan agreement will rank pari passu with all its other unsecured liabilities.”
This clause demands an equal ranking.
In the event that the borrower’s assets are distributed, the lender’s unsecured loan shall have first ranking value against any other loans that the borrower might have.
Therefore there are many other covenants which govern the borrower’s business as well as its decision making processes, in order that neither the lender nor the loan will be at risk.
The moment the lender extends capital to the borrower, the lender acquires an interest in the preservation of that capital. Therefore one might suggest that the lender, although in silence, extends a hand of management when it comes to the operations of the business in order to protect the loan granted.
The “hand of management” is exhibited by means of covenants which bound the borrower, and is enforced by the lender.
“As Ben Franklin noted 250 years ago, creditors have better memories then debtors.”