Compliance with covenants: Overview, definition, and example
What is compliance with covenants?
Compliance with covenants refers to the obligation of parties in a contract, particularly in financial agreements, to adhere to the specific promises or conditions (known as covenants) outlined in the agreement. These covenants can be either affirmative (requiring the party to take specific actions) or negative (requiring the party to refrain from certain actions). Compliance with covenants is critical in ensuring that both parties fulfill their contractual responsibilities and maintain the integrity of the agreement. In the context of loan agreements or bond indentures, for example, borrowers or issuers are required to comply with covenants that govern financial ratios, reporting requirements, and other operational conditions.
For example, a company taking out a loan may agree to maintain a certain level of liquidity (affirmative covenant) and refrain from taking on additional debt (negative covenant).
Why is compliance with covenants important?
Compliance with covenants is important because it ensures that both parties meet their obligations and that the terms of the agreement are respected. For lenders or investors, compliance with covenants offers a level of protection, reducing the risk of default or financial instability. Non-compliance can trigger penalties, accelerate the repayment of loans, or lead to a breach of contract, which can have significant legal and financial consequences. For the parties bound by the covenants, fulfilling these obligations is necessary for maintaining good standing and preserving their rights under the agreement.
For businesses or individuals entering into contracts with covenants, compliance ensures they avoid default or legal action. For lenders or investors, it provides a safeguard that the borrower or issuer will meet certain financial conditions and obligations.
Understanding compliance with covenants through an example
Imagine a company that has taken out a loan and agreed to several financial covenants, including maintaining a debt-to-equity ratio below 2:1. If the company’s debt-to-equity ratio exceeds this threshold, it would be in violation of the covenant. To remain in compliance, the company would need to reduce its debt or increase its equity to bring the ratio back into the acceptable range. If the company fails to comply with the covenant, the lender might have the right to accelerate the loan, demanding immediate repayment.
In another example, a real estate development company enters into an agreement to build a shopping mall and agrees to a covenant requiring it to submit quarterly progress reports to investors. If the company fails to provide the reports on time, it would be in breach of the covenant, and the investors might have the right to impose penalties or even halt further funding.
An example of a "compliance with covenants" clause
Here’s how a compliance with covenants clause might appear in an agreement:
“The Borrower agrees to comply with all covenants outlined in this Agreement, including maintaining a minimum liquidity ratio of 1.5:1 and submitting quarterly financial statements to the Lender. Failure to meet these covenants will constitute a default, and the Lender may take remedial action as outlined in Section 12 of this Agreement.”
Conclusion
Compliance with covenants is a vital aspect of maintaining contractual integrity and protecting the interests of all parties involved in an agreement. Whether in loan agreements, business partnerships, or bond indentures, fulfilling the covenants ensures that the relationship remains stable and that both parties meet their obligations. Non-compliance can lead to serious consequences, so it is crucial for parties to carefully adhere to all covenants to maintain financial stability and avoid legal complications.
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.