Creditors use protective covenants in bond indentures to protect their interests by restricting certain activities of the issuer that could endanger the creditor's position. Similarly, banks employ loan covenants to ensure that the borrower uses the funds for the stated purpose. Auditors (or trustees, in the case of bond issues) must certify that the borrowing firm has not violated the covenants. If a covenant is violated, then the debtor is in technical default, and the creditor can require immediate repayment of the bond issue or the loan.
The American Bar Association's Commentaries on Debentures provides a summary of the typical covenants found in bond agreements. These covenants can be divided into four basic categories: (1) those restricting the issuance of new debt; (2) those restricting dividend payments; (3) those restricting merger activities; and (4) those restricting the disposition of the firms assets. Bond covenants that restrict subsequent debt financing are by far the most common type. The provisions are typically stated in terms of accounting measures in order to make them easier to monitor. The issuance of debt may require any new bond issue to be subordinate to existing debt. This restriction is designed to prevent the firm from increasing the riskiness of existing debt by issuing new bonds with a superior, or equal, claim on the firm's assets. Other covenants may prohibit outright the issuance of additional debt unless the firm maintains certain prescribed financial ratios between tangible net worth and long-term debt, tangible assets and long-term debt, and income and interest charges.
Creditors also attempt to limit stockholders' ability to transfer assets to themselves through dividend restrictions. Bond covenants that restrict dividends are necessary to protect bondholders against the payout of assets that serve as collateral. In the extreme case, shareholders could vote to pay themselves a liquidating dividend leaving only an empty corporate shell. Most dividend restrictions refer not only to cash dividends, but also to share repurchases. Payout restrictions generally require that dividends can be paid only from earnings generated subsequent to the borrowing or earnings above a given amount. There are also frequently restrictions on a borrower's ability to increase dividends from existing levels.
Bond covenants allow merger activity only if certain conditions are met. Mergers can have a negative effect on existing bondholders if the acquiring firm has more debt in its capital structure than the target firm, or if the debt of the acquiring firm matures sooner than the debt of the target firm. Thus, bond covenants allow mergers only if the net tangible assets of the combined firms meet a certain minimum dollar amount or are greater than a certain fraction of long-term debt. The merger-related covenants could also make the merger contingent on the absence of default after the transaction is completed.
Debt covenants that restrict asset disposition decisions take the following forms: (1) restrictions on common stock investments, loans, and extensions of credit; (2) restrictions on the disposition of assets; and (3) covenants requiring the maintenance of minimum levels of assets. Assets that provide collateral cannot be disposed of under the provisions of the indenture agreement.
In addition to restrictions on the activities of the firm, covenants may also be expressed in the maintenance of certain levels of accounting-based measures, such as retained earnings, working capital, net assets, and debt-to-equity ratios. These affirmative covenants are generally related to the restrictions above by limiting a certain activity if the accounting variable drops below a certain level.
To protect the surety of their loans, banks also require covenants in loan agreements. Loan covenants are similar to those found in bond issues, and are of two primary types. Affirmative covenants describe actions that a firm agrees to take during the term of the loan. These include such activities as providing financial statements and cash budgets, carrying insurance on assets and against insurable business risks, and maintaining minimum levels of net working capital. Negative covenants describe actions that a firm agrees not to take during the term of the loan. These may include agreements not to merge with other firms, not to pledge assets as security to other lenders, or not to make or guarantee loans to other firms. Another common restriction, especially with closely held companies, is a limit on officers' compensation. The covenants in private lending agreements often modify generally accepted accounting principles. For example, off-the-balance-sheet debt may be included in calculating the debt-to-equity ratio.
[ Robert T. Kleiman ,
updated by Ronald M. Horwitz ]
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