Negative Covenant

What is a Negative Covenant?

A negative covenant, also known as a restrictive covenant, is a covenant that restricts one party from carrying out certain actions. Sometimes the agreement involves some form of compensation to the party that consents to the restriction. Negative covenants are considered legal, but some of their provisions have been found to limit the ability of a party to conduct business activities normally.

For example, non-compete agreements limit one party from competing in an economic activity that will directly affect the economic activities of another party. In such cases, the person signing the non-compete agreement should receive some form of compensation that relatively equals the value of what is given up. Negative covenants are found in employment contracts, mergers and acquisitions, bond documents, and land use.

Types of Negative Covenants

A negative covenant can be found in separate agreements or as part of a larger contract or agreement. They are often used by companies when hiring new staff or independent contractors. During mergers and acquisitions, the seller may be required to sign a negative covenant that prevents direct competition or disclosing vital information about the business.

The following are the main types of negative covenants:

1. Non-Compete Agreement

In an employment contract, a non-compete agreement restricts an employee from competing directly with the employer for a specific period and within a defined geographical area. Ideally, this provision prevents an employee from leaving the employer’s business and starting a similar business next door, especially after receiving training and experience at the employer’s cost. Most non-compete agreements restrict employees from competing with the company for a period of six months and can sometimes go up to two years. In some states, such as in California, there is a standing ban on non-compete agreements due to the potential negative effects they have on trade and competition.

Non-compete agreements are also used in business sales. When a new owner takes over the ownership of a business, the previous owner may be required to sign a non-compete agreement. The agreement restricts the original owner from competing with the new owner in the same business for a specific period and within a specified geographical location. However, the new owner should provide adequate consideration (either monetary or other benefits) to compensate the original owner for the loss of income.

2. Non-Solicitation Agreement

A non-solicitation agreement is a negative covenant that restricts one party from soliciting employees or customers from another party. If an employee leaves an organization, the non-solicitation agreement prohibits him/her from soliciting business from customers whom the employee did business with on behalf of the employer. Such agreements are not limited in time and geographical location, as is the case with non-compete agreements.

The non-solicitation agreement also applies in professional practice where consultants and professionals are prohibited from soliciting business from the current clients of their former employer. These professionals include auditors, accountants, nutritionists, engineers, electricians, doctors, etc. They have built close relationships with their former employer’s clients, and they may be tempted to solicit business from the clients of their former employer.

3. Non-Disclosure Agreement

A non-disclosure agreement restricts one party from disclosing proprietary information, trade secrets, innovations, or other information that the actual owner uses in the ordinary course of business.

For example, consultants in an IT company may be granted access to some proprietary data like secret formulas and access codes, and the employer may require them to sign a confidentiality agreement to prevent the data from being used outside the business. The agreement may also be used when engaging independent contractors who are not full-time employees of the company.

Negative Covenants in Employment Contracts

The most common negative covenants in employment contracts are non-compete and non-disclosure agreements. The agreements prohibit employees from taking certain actions that may disadvantage their employer either during employment or post-employment.

Employers introduce negative covenants to secure the investments they have incurred on employees through training and experience. The employer may also give the employees access to sensitive information. In this case, the non-disclosure agreement ensures that this confidential information does not get into the competitor’s hands.

Negative Covenants in Bond Issues

In a bond issue, the features of the bond and the responsibilities of the issuer are contained in a document called the trust indenture. The document details the negative covenants that the bond issuer must adhere to once the bond has been issued to investors.

One of these restrictions is that the bond issuer should not issue more debts until the others have matured. In some trust indentures, the issuer is required to maintain a debt to equity ratio of not more than one.

Also, the bond issuer may be restricted from paying dividends beyond a certain limit. The lenders introduce the provisions to reduce the risk of default in making timely principal and interest payments.

Issues with Negative Covenants

One of the main problems facing the implementation of negative covenants is enforcement. The covenants are designed to prevent employers or businesses from losing their customers, employees, and proprietary information. However, when these acts are committed, the enforcement process takes a long time to complete as attorneys argue out the facts in a court of law, whereas the damage has already been done.

The process also becomes costly as the court proceedings may be lengthy. It increases the amount of money payable to lawyers representing the employer, who is also the plaintiff in the case presented to the court of law.

What is an Affirmative Covenant?

An affirmative covenant, also referred to as a positive covenant, is a promise that requires a party to adhere to specific terms of the agreement. It is the opposite of a negative covenant, which requires a party to avoid doing something.

An example of an affirmative covenant is an agreement between a mortgage lender and a borrower, requiring the latter to maintain the collateral used for the loan until the loan is fully paid up. In a bond issue, an affirmative covenant protects the interests of the issuer, as well as that of the bondholder.

Additional Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and advancing your career, we highly recommend the additional CFI resources below:

• Bond Issuers
• Debt Covenants
• Letter of Intent
• Material Non-Public Information
• See all valuation resources
• See all equities resources