One of the most important sections in a standard loan agreement between a corporate borrower and bank lenders is the negative covenants section. Negative covenants place restrictions on the borrower’s ability to carry out certain actions, such as taking out additional debt obligations or selling certain assets of the business. The negative covenants are intended to ensure that the borrower will be able to repay its existing debt obligations under the loan agreement.

While the negative covenants are tailored to the specific circumstances of the loan and the company’s business and financial condition, there are a number of common negative covenants. Standard negative covenants include a limitation on indebtedness, limitation on liens, limitation on restricted payments, limitation on investments, limitation on asset sales, limitation on fundamental changes, and limitation on affiliate transactions.

The negative covenants attempt to strike a balance between enabling the lenders to restrict the company’s activities in order to ensure that the loan will be repaid with providing the company enough flexibility to meet its business and operational needs. The borrower and its restricted subsidiaries, or the company’s subsidiaries that are part of the credit group, must comply with the restrictive covenants.

The limitation of indebtedness covenant restricts the ability of the borrower and its restricted subsidiaries to incur new debt obligations beyond what is specified in the loan agreement. In loan agreements, this provision is often based on a maintenance test that specifies the maximum amount of new debt that can be assumed and the categories of allowed debt.

The limitation on liens covenant restricts the ability of the borrower and its restricted subsidiaries to incur new liens on assets. A lien is a legal claim on property or assets used to secure a payment of debt. The limitation on liens covenant is designed to protect the lenders from other creditors asserting competing rights to the assets of the borrower or its subsidiaries.

The limitation on restricted payments covenant restricts the ability of the borrower and its subsidiaries to make certain payments, such as dividends, distributions, and share repurchases. The goal of the limitation on investments covenant is to prevent funds from being depleted from the credit group and to make sure the borrower has adequate funds to repay its existing debt to the lenders.

The limitation on investments covenant restricts the ability of the borrower and its restricted subsidiaries to make new investments. Similar to the limitation on restricted payments covenant, the goal of the limitation on investments covenant is to prevent funds from being depleted from the credit group and to make sure the borrower has adequate funds to repay its existing debt to the lenders. Investments are typically defined to include equity purchases, bond purchases, and asset acquisitions. Loan agreements will typically carve out certain categories of permitted investments.

The limitation on fundamental changes covenant restricts the ability of the borrower and its restricted subsidiaries from entering into transactions such as mergers, dissolutions, liquidations, or the sale of all or substantially all of the borrower’s or a restricted subsidiary’s assets. Such fundamental change transactions may be permitted under certain circumstances specified in the loan agreement.

The limitation on affiliate transactions covenant restricts the borrower and its restricted subsidiaries from entering into certain contractual arrangements with affiliates of the company. This provision is intended to protect lenders by limiting transactions that may not be negotiated on an arms’ length basis due to the close relationship between the company and the affiliated party. Such affiliate transactions may result in less favorable terms for the borrower than an arrangement negotiated with an independent third party.

Other negative covenants that may appear in a loan agreement may include a limitation on sale-leasebacks, limitation on modifications to material agreements, and limitation on capital expenditures.

The violation of negative covenants typically triggers an immediate event of default. This means there is no grace period for getting back in compliance. An event of default has serious consequences for the borrower and gives the lenders the right to require default interest to be paid. The lenders also have the right to make the loans immediately due and payable and foreclose on collateral.