What are Positive 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 called “positive” debt covenants because of the activities they enlist or the conditions they prescribe. It is because the covenants require the borrowing party to maintain a certain level of standard or stability for the business, which affirms the company’s financial health and well-being.
Usually, the breach of a positive debt covenant-related agreement usually results in the lender gaining certain control rights such as calling the entire loan amount, seizing assets or collateral (if previously agreed upon) in exchange for the breach of a covenant agreement, or charging a higher interest rate on the loan than what was already in place.
Features of Positive Covenants
1. Requirement to maintain a certain specified limit of ratios
Positive debt covenants may be in the form of a requirement for the borrowing party to maintain a certain limit for financial ratios. It can be for one specific ratio, or a set of ratios, depending on the lender’s terms and conditions. The most popular ratios that are commonly used by lenders are solvency ratios such as debt/(EBIDTA – capital expenditure), liquidity ratios such as quick assets/current liabilities, or profitability ratios such as net earnings/net sales.
While it may seem restrictive in nature when a company needs to maintain a certain financial ratio, they are more of a maintenance of a good financial standing, which will ultimately help in boosting rather than restricting operations. Hence, such types of covenants are regarded as positive debt covenants.
2. Requirement to keep in check insurance policies affecting the business
Positive debt covenants can also come in the form of a requirement to carry all appropriate and required insurance policies for the business. It is usually done with an aim to protect the business from any prospective losses or unfavorable events happening in the economic, financial, operative, or social environment in the near future.
3. Requirement to pay taxes
Positive debt covenants may also be in the form of a requirement to pay taxes. It may specifically concern income tax, corporate tax, or employment tax.
4. Requirement to maintain the total assets of the business
Positive debt covenants may come in the form of a requirement to safeguard and maintain the total assets of the business. It is specifically done for net worth-related debt covenants, where the loan agreement focuses on the upkeep of the borrowing party’s net worth. Lenders prefer such a type of positive debt covenants for the basic fact that net worth is usually a good indicator of whether or not the borrower will be able to support its current debt levels.
Company XYZ applies for a loan from Bank ABC. The loan amount is $12,000,000. After evaluation of the company’s financial statements and credit history, the bank agrees to grant the company a loan for $10,000,000, provided the latter agrees to certain conditions put forward by the bank in the loan agreement.
During a thorough evaluation of the company’s financial statements, the bank noted that a considerable value of assets was sold off in the past financial year to settle a long-term loan. However, financial projection statements formulated showed positive projections for the upcoming financial year.
Hence, the bank put forward a condition that it will lend to the company provided the latter maintains a minimum tangible net worth of $1,000,000 for the duration of the loan. It is an example of a positive net worth debt covenant because it requires the borrowing party to maintain certain aspects of its business rather than restricting in any way its operations.
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