What are covenants?

Covenants sit in the "Covenants" and "Representations and Warranties" sections of a facility agreement or security deed, with the reporting obligations and financial tests in the schedules. Positive covenants require action: maintain insurance on the secured assets, deliver audited accounts within a set time of year end, pay tax. Negative covenants prohibit action: no extra borrowing, no sale of key assets, no related-party deals. Some apply continuously; others are snapshot tests at quarter-end or year-end.

Lenders use covenants to protect credit quality. A breach can be an event of default, which triggers the remedies in the documents: acceleration of the debt, enforcement of the security, appointment of receivers or termination. Most agreements soften this with materiality thresholds, notice requirements, a cure period (commonly 30 to 90 days) and the option of a formal waiver.

Financial covenants are central to a lender's credit risk controls. The common ones are a gearing or leverage cap (net debt to EBITDA no greater than an agreed multiple), an interest cover minimum (EBITDA to net interest expense), minimum liquidity or cash balances to protect working capital, and a net tangible assets floor that protects the lender's security value.

Good drafting fixes the test dates, spells out the calculation method (including pro forma adjustments and accounting standards), and requires a compliance certificate signed by the directors with supporting schedules. Reporting typically runs monthly for management accounts and annually for audited accounts. Lenders providing business loans and asset finance usually set covenants to fit the sector and asset class, and borrowers often stress-test the numbers under downside scenarios before signing.

A contractual covenant is enforceable when its language is clear, the parties are identifiable and any required formalities are met; vague terms like "reasonable efforts" only work if a court can apply them objectively. Non-compete covenants are tested for reasonableness of scope, duration and geography, and overbroad restraints risk being void. Courts can sever unenforceable parts, and remedies range from injunctions and damages to specific performance.

Restrictive covenants bind later owners when they are properly recorded on the title. Positive obligations generally do not run with the land, so they are handled by contract or by the limited statutory mechanisms each state provides. A full title search during due diligence reveals them, and state registries have procedures to vary or discharge covenants that are obsolete or unduly burdensome. Planning approval does not mean covenant compliance, and the reverse is also true.