The Nature of Covenants: Affirmative vs. Negative

In the field of contract law, covenants are critical components that outline the obligations and restrictions of the parties involved. Affirmative or positive covenants and negative or restrictive covenants are the two main categories of covenants. In order to maintain the operational stability of company or assets, the parties are required to take certain steps under the affirmative covenants. Negative covenants, on the other hand, place restrictions on conduct that may be detrimental to the purposes of the agreement. It is critical to understand the differences between these covenants in order to develop strong agreements that protect the interests of all parties. Let’s compare these 2 types of covenants, delving into the key features of each:

Depending on the terms of the contract and the individual requirements of the parties, affirmative covenants can take different forms:

1. Financial Reporting Covenants - To provide transparency and allow the lender to monitor the borrower's financial health, require the borrower to submit frequent financial statements or reports.
2. Maintenance Covenants - To protect the collateral values, require the borrower to keep equipment, assets or other property in good working order.
3. Insurance Covenants - To protect against potential loss or damage, require the borrower to obtain and maintain sufficient insurance coverage.
4. Compliance Covenants - To ensure legal and regulatory compliance, require the borrower to comply with all applicable laws, rules and contractual obligations.
5. Operational Covenants - Include commitments that relate to the company's day-to-day operations, such as maintaining certain operating standards, business procedures or staffing levels.
6. Debt Service Covenants - Make sure the borrower has enough cash flow to make the debt payments by requiring them to reach established debt service coverage ratios.
7. Dividend Covenants - Ensure that retained earnings are used for business sustainability and expansion by prohibiting the borrower from paying dividends until certain financial requirements are met.

Now let’s explore some common types of negative covenants:

1. Debt Restriction Covenants - Limit the amount of debt that the borrower can take which will prevent them from taking on too much debt and jeopardizing their ability to repay what is already owed.
2. Dividend Restriction Covenants - Preserve cash flow for loan repayment and operating requirements by prohibiting the borrower from paying dividends or sharing profits to shareholders until specific financial requirements are met.
3. Asset Sale Covenants - Prevent the borrower from selling, leasing or otherwise disposing of critical assets without the lender's permission to protect the value of the collateral.
4. Capital Expenditure Covenants - A borrower's ability to make capital expenditures is limited to avoid overspending that could harm their financial stability.
5. Merger and Acquisition Covenants - Limit the borrower's ability to enter into a merger, acquisition or other major business combination without the lender's consent to protect the lender from changes in the borrower's corporate structure that could affect creditworthiness.
6. Investment Covenants - Prohibit the borrower from engaging in certain financial activities that may endanger their financial condition, for example, risky or speculative investments.
7. Change of Control Covenants - Prevent the borrower from changing ownership or control without the lender's permission to maintain stability in the company's management and operations.

After explaining the common types of covenants, it is important to examine how affirmative and negative covenants work in real-world scenarios. To understand their usefulness and advantages, let's examine two notable cases, one with an affirmative covenant and the other with a negative covenant.

Example of affirmative covenant - Amazon's Loan Agreement with Bank of America

In 2018, Amazon entered into a loan agreement with Bank of America, which included an affirmative covenant requiring Amazon to provide regular financial reports to the bank. This covenant ensured that Bank of America could monitor Amazon's financial health and performance on an ongoing basis. Amazon has provided Bank of America with information and assurance of its financial stability by complying with this agreement. As a result, the bank was able to assess Amazon's ability to repay the loan and make defensive choices about how best to handle it.

Example of negative covenant - AT&T and Time Warner Merger Agreement

In the merger agreement between AT&T and Time Warner in 2016, a negative covenant was included that restricted Time Warner from engaging in certain actions, such as incurring additional debt or making significant asset sales, without AT&T’s approval. This covenant was intended to preserve the value and stability of Time Warner during the period leading up to the completion of the merger. Prior to the completion of the merger, the existence of this negative covenant helped ensure that Time Warner maintained its operational and financial stability by preventing actions that could reduce its value. For AT&T, this protection was important because it ensured that the asset they were buying would continue to be stable, protecting their investment.

Ultimately, affirmative and negative covenants are essential to preserving the harmony and integrity of contractual arrangements. By understanding and skillfully executing these covenants, businesses and lenders can form stronger and more trustworthy associations and pursue their shared goals with greater confidence.

Prepared by: Seda Janazyan, Business Analyst at CFOnline.co