Covenants of the corporation: Overview, definition, and example
What are covenants of the corporation?
Covenants of the corporation are binding promises or obligations made by a corporation in its governing documents (such as its articles of incorporation, bylaws, or contracts) or in relation to specific agreements, often with shareholders, creditors, or other stakeholders. These covenants outline the actions the corporation agrees to take or refrain from taking, such as maintaining certain financial ratios, adhering to specific business practices, or not engaging in certain types of transactions like mergers or acquisitions without approval. Covenants can be affirmative (requiring action) or negative (restricting certain actions) and are designed to protect the interests of stakeholders, maintain financial stability, and ensure legal compliance.
Why are covenants of the corporation important?
Covenants of the corporation are important because they establish clear obligations and responsibilities, helping to maintain order and stability in the corporation's operations. These covenants can provide stakeholders, such as creditors, investors, and regulators, with assurances about the corporation’s financial health, business activities, and governance. For example, covenants in loan agreements may impose restrictions on a corporation’s ability to take on additional debt or make certain investments, reducing the risk to creditors. For investors, covenants ensure that the corporation is being run in a way that aligns with their interests and that the company will not take undue risks that could harm its value.
Understanding covenants of the corporation through an example
Let’s say a company, ABC Corp., borrows funds from a bank to finance its expansion. As part of the loan agreement, the bank requires ABC Corp. to maintain certain financial ratios, such as a debt-to-equity ratio below a specific threshold, and to submit quarterly financial reports. These requirements are covenants of the corporation, and ABC Corp. agrees to uphold them throughout the life of the loan. If ABC Corp. violates these covenants by exceeding the debt-to-equity ratio, it could trigger penalties, higher interest rates, or even an immediate repayment of the loan.
In another example, a corporation, XYZ Industries, may have a covenant in its shareholder agreement that restricts the sale of significant portions of the company’s stock without shareholder approval. This covenant is designed to protect the interests of the existing shareholders by preventing any one party from taking control of the company without their consent. The covenant ensures that major decisions, like ownership changes, are made with the approval of the broader shareholder base.
An example of covenants of the corporation clause
Here’s how a covenant of the corporation clause might look in a corporate agreement:
“The Corporation agrees to maintain a minimum current ratio of 1.5:1, and to provide quarterly financial statements to all shareholders within 30 days of the close of each fiscal quarter. The Corporation further agrees not to enter into any merger or acquisition without the prior approval of a majority of the Board of Directors and shareholders holding at least 60% of the outstanding shares.”
Conclusion
Covenants of the corporation are vital to ensuring that the company operates within the bounds of agreed-upon terms, protecting the interests of shareholders, creditors, and other stakeholders. Whether in the context of corporate governance, debt agreements, or shareholder rights, covenants provide clear guidelines for business activities and help mitigate risks. By outlining specific obligations and restrictions, these covenants contribute to the corporation’s stability and the transparency of its operations. Properly crafted covenants help ensure that the corporation remains compliant with its legal, financial, and operational commitments.
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.