Debt covenants are binding components of loan agreements. They protect the interests of the institutions making the loans by placing a restriction on the businesses that borrow money. For example, they can prevent changes in management structure or can insist on the disclosure of financial information at specific times. Loan agreements can contain one or more debt covenants of various types.
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A lender may loan money to a business because it assesses that the business has enough assets to cover the debt. These assets could be sold to recover the loan if the business does not meet repayment obligations. The lender may use a financial covenant to prevent the business from using those assets to take out other loans. This keeps lender risk at a minimum, as it would not have to share the proceeds of asset sales with other lenders if the business defaults.
Management, Control and Ownership Covenants
Management, control and ownership covenants are restrictive in nature. Loan agreements may include a covenant if the management team of the business is integral to its success. Under these terms, business owners cannot arbitrarily replace key employees. From control and ownership perspectives, a covenant could dictate the types of decisions that owners can make. For example, it may define the structure of the board of directors or prevent changes to capital structure such as new public or private share offerings.
Reporting and Disclosure Covenants
Reporting and disclosure covenants do not restrict behavior but insist on positive action. For example, a reporting covenant may state that the business must provide quarterly interim financial accounting reports. This enables the lender to identify problems early and to take any necessary steps to protect its loan investment. A disclosure covenant may require the business to report when it wins or loses major contracts with clients. This allows the lender to continually assess its loan risk.