Breach of covenants: Overview, definition, and example
What is breach of covenants?
A breach of covenants occurs when a party fails to comply with the terms and obligations set forth in a contract. Covenants are legally binding promises that dictate specific actions or restrictions, and a breach can result in penalties, financial consequences, or termination of the agreement.
For example, if a company takes out a loan with a lender and agrees to maintain a minimum debt-to-equity ratio as a financial covenant, but later fails to meet this requirement, it constitutes a breach of covenants.
Why is breach of covenants important?
A breach of covenants is important because it can have serious financial and legal consequences. Contractual covenants exist to protect the interests of both parties, ensuring that agreed-upon conditions are met. When a breach occurs, it can trigger penalties, legal disputes, or even default on obligations.
For businesses, carefully structuring covenants in contracts helps manage risks and expectations. If a breach is anticipated, negotiating waiver provisions or cure periods (time to fix the breach) can help avoid severe consequences.
Understanding breach of covenants through an example
Imagine a company secures a $5 million loan from a bank with a covenant requiring it to maintain a certain level of profitability. If the company’s financials fall below the agreed threshold, the bank may consider this a breach of covenants, potentially demanding immediate repayment or imposing higher interest rates.
In another scenario, a franchisee signs a contract agreeing to follow strict operational guidelines set by the franchisor. If the franchisee starts offering unauthorized products that violate the contract’s brand standards, the franchisor may treat this as a breach of covenants and take legal action, including revoking the franchise rights.
An example of a breach of covenants clause
Here’s how a breach of covenants clause might appear in a contract:
“If either Party fails to comply with the covenants set forth in this Agreement, such failure shall constitute a breach of covenants. The non-breaching Party shall have the right to provide written notice and, if the breach is not cured within [X] days, pursue remedies including termination of the Agreement and claims for damages.”
Conclusion
A breach of covenants occurs when a party fails to meet contractual obligations, potentially leading to penalties, legal action, or financial consequences. Clearly defining covenants and establishing remedies for breaches in agreements helps businesses manage risk, ensure compliance, and maintain trust between contracting parties.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.