A covenant is a formal promise in a contract or a deed to do, or to refrain from, a particular act. In finance the word means a promise written into a loan, a credit agreement or a bond indenture. It obliges the borrower to do something, such as hand over financial statements, or to refrain from something, such as giving another lender a lien on the same collateral, for as long as the debt is outstanding. Covenants of that kind are tested on the schedule or the trigger the agreement sets.
Affirmative, Negative, and Financial Covenants
The split is by what the promise asks of the borrower.
An affirmative covenant requires an act. Federal risk retention rules write one such set out in full, so that to count as a qualifying commercial loan the loan documentation has to include covenants that require the borrower to provide the loan servicer with the borrower’s financial statements and supporting schedules on an ongoing basis, but not less frequently than quarterly (12 CFR 244.16(a)(3)(i)). The same paragraph goes on to require insurance, tax payment, inspection and maintenance covenants on the collateral (12 CFR 244.16(a)(3)(iv)).
A negative covenant forbids an act or caps it. The same rule requires covenants that prohibit the borrower from retaining or entering into a debt arrangement permitting payments-in-kind, and that impose limits on the creation or existence of any other security interest or lien over the pledged collateral, on the transfer of assets serving as collateral, and on any change to the borrower’s name, location or organizational structure (12 CFR 244.16(a)(3)(ii) and (iii)).
A financial covenant is a measured number the borrower has to hit. The banking agencies name the usual ones, listing credit agreement covenant protections including financial performance such as debt-to-cash flow, interest coverage, or fixed charge coverage, together with reporting requirements and compliance monitoring (Interagency Guidance on Leveraged Lending, 2013). Those measures are ratios built out of the statements, so the covenant is only as settled as the classification underneath it, and where the agreement forgoes its own definitions the GAAP classification decides the covenant, a point the quick ratio works through on working capital.
Maintenance Covenants and Incurrence Covenants
Financial covenants divide again by when they get tested, and a credit agreement filed with the SEC defines the two apart this way. A maintenance covenant is a covenant by any borrower to comply with one or more financial covenants during each reporting period, whether or not such borrower has taken any specified action. An incurrence covenant is a covenant by any borrower to comply with one or more financial covenants only upon the occurrence of certain actions of the borrower, including a debt issuance, dividend payment, share purchase, merger, acquisition or divestiture (credit agreement filed with the SEC).
The practical difference is what can break one. A maintenance covenant can be broken by a period that simply came in worse than planned, with the borrower doing nothing at all. An incurrence covenant can only be broken by an act, so a borrower that stays still cannot fail it. A loan whose contracts do not require the borrower to comply with any maintenance covenant is a cov-lite loan in that same agreement’s wording, whether or not incurrence covenants still apply. The definition then takes the label back in one case: the loan is deemed not to be cov-lite if its contracts cross-default to another loan, debt obligation or credit facility of the same borrower that carries one or more maintenance covenants, or if the loan ranks pari passu with such a facility, meaning it sits equally in right of payment (credit agreement filed with the SEC).
Where Covenants Show Up in a Firm’s Work
The covenant package is computed off the closed numbers, so it lands on whoever prepares the statements. What happens after that depends on the client. The three rules below reach SEC filers and public debt only, so a private company client is bound by none of them and answers to its own agreement, plus the classification consequence at the end of this section.
On public debt issued under an indenture qualified under the Trust Indenture Act, the obligor, meaning the party that owes on the securities, has to certify compliance. It must furnish to the indenture trustee, not less often than annually, a brief certificate from the principal executive officer, principal financial officer or principal accounting officer as to his or her knowledge of the obligor’s compliance with all conditions and covenants under the indenture, and that compliance is determined without regard to any period of grace or requirement of notice provided under the indenture (15 U.S.C. 77nnn(a)(4)). Read the second half of that carefully, because a covenant the borrower is still inside a cure period on is a covenant it is not complying with.
On a client filing financial statements with the SEC, a breach still open at the reporting date gets disclosed. The facts and amounts concerning any default in principal, interest, sinking fund or redemption provisions on an issue of securities or credit agreements, or any breach of covenant of a related indenture or agreement, which default or breach existed at the date of the most recent balance sheet being filed and has not been subsequently cured, are stated in the notes to the financial statements, and if acceleration has been waived for a stated period beyond that date, the amount of the obligation and the period of the waiver are stated (17 CFR 210.4-08(c)). A waiver does not take the breach out of the file, it changes what has to be said about it.
Covenants reach the equity section too. The most significant restrictions on the payment of dividends by the registrant are described, with their sources, their pertinent provisions, and the amount of retained earnings or net income restricted or free of restrictions (17 CFR 210.4-08(e)(1)). A covenant capping distributions is one of the sources that description has to name.
What a breach does to classification is the separate question, and that one reaches every borrower rather than only a filer. It is worked through in long-term liabilities.
What a Covenant Is Confused With
A covenant on real property. This one attaches to land rather than to a borrower, and it binds whoever holds the land next. Federal rules use that mechanism directly: where a recipient of federal financial assistance transfers real property, the transfer document has to contain a covenant running with the land assuring nondiscrimination, on the condition set out in the same section (28 CFR 42.504(e)). Nothing in it is tested against a financial statement, and no lender waives it.
A covenant in an ordinary contract. Here the word means only a promise to do or not do something, with no lender, no ratio and no testing schedule. The one a CPA firm meets most often is a covenant not to compete signed on a practice sale, which turns into a question about how the purchase price is allocated rather than a credit question, and how to value a CPA firm works that through.
Common Questions
They are the promises the parties keep owing each other after the contract starts running. In a credit agreement that is why a borrower is still delivering financial statements and holding ratios years after the money was advanced, and federal rules describe the same thing when they require loan documentation to include covenants that require, prohibit and impose limits on the borrower’s conduct (12 CFR 244.16(a)(3)).
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own covenant schedule and debt classification work through a trial task before anything client facing depends on it.
