What are Non-Financial Covenants?
Non-financial covenants are promises or agreements made by the borrowing party that are not financial in nature. The promises are either operational, ownership-related, positive or negative covenants, legal-related, and so on.
Non-financial covenants also serve the purpose of a safety net to the lender. They are usually undertaken by a lender as a measure to prevent the risks related to money-lending activities. By making it legally binding for the borrower to fulfill a certain condition in exchange for lending money, the lending party protects itself from the risks associated with the loan agreement.
Types of Covenants
Covenants are promises by borrowers to comply with the terms agreed upon while discussing the loan agreement. They can be either positive or negative:
1. Positive (or Affirmative) Covenants
A positive or affirmative covenant usually prescribes the condition of maintaining the operational well-being and stability of the borrowing party’s business. They are positive in nature by means of the activity they attempt to enforce or the conditions they prescribe. It is because such covenants require the borrowing party to maintain a certain level of standard or stability, which affirms the company’s health and well-being. Some examples of positive covenants include, but are not limited to:
- Requirement to maintain insurance policies for the business
- Requirement to maintain goodwill
- Requirement to maintain a certain level of a financial ratio
- Requirement to maintain the assets of the business
- Requirement to settle all employment taxes
2. Negative Covenants
Negative covenants are non-financial covenants that limit the borrowing party from performing a certain action or restrict the borrowing party from going past a certain specified limit. They are negative in nature because they are restrictive and create certain boundaries for the borrowing party that they are not supposed to cross. Negative covenants can be ownership-related, legal rights-related, etc. Some examples of negative covenants include, but are not limited to:
- Restriction on merger or acquisition deals without keeping the lender in the loop
- Restriction on investment activities, be it on capital assets, real estate, shares, and debentures, etc., without the lender’s permission
- Restriction on dividend distribution
- Restriction on the sale of assets without consulting the lender
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