Covenants: Overview, definition and example
What are covenants?
Covenants are promises written into a contract that spell out what one or both parties must do (affirmative covenants) or must avoid doing (negative covenants). These commitments are legally binding and set clear rules for how the parties should act under the agreement.
You’ll often see covenants in financial deals, real estate contracts, and business partnerships. They’re there to make sure everyone sticks to the agreed terms, keeps things fair, and avoids misunderstandings.
Why are covenants important?
Covenants matter because they set clear rules for how both sides must act under a contract. They outline specific responsibilities and restrictions, helping to avoid misunderstandings and reduce the chances of disputes. For example, in a loan agreement, a covenant might require the borrower to keep their finances in good shape or stop them from taking on more debt without permission.
For businesses, covenants act as a safety net, ensuring everyone sticks to the deal and acts fairly. Breaking a covenant is a breach of contract, which could lead to penalties, legal action, or even the contract being terminated.
Understanding covenants through an example
Imagine a company secures a loan from a bank to expand its operations. The loan agreement includes covenants requiring the company to maintain a debt-to-income ratio below a certain level (affirmative covenant) and to avoid paying out dividends to shareholders until the loan is fully repaid (negative covenant). These covenants protect the bank by ensuring the company prioritizes repaying the loan and maintains financial stability.
If the company violates these covenants—for example, by exceeding the debt limit or paying dividends early—the bank could demand immediate repayment or impose penalties.
Another example involves real estate. A covenant in a property deed might prohibit the construction of commercial buildings in a residential neighborhood, ensuring that the property is used only for housing.
An example of a covenant clause
Here’s how a covenant clause might appear in a contract:
“The Borrower agrees to maintain a minimum cash reserve of [$X] at all times during the term of this Agreement and shall not incur additional debt exceeding [$Y] without prior written consent from the Lender. Failure to comply with these covenants shall constitute a breach of this Agreement.”
Conclusion
Covenants are a critical part of many contracts, providing structure and clarity by outlining what parties must or must not do. They help protect the interests of all involved and reduce the risk of disputes or misunderstandings.
Whether you’re borrowing money, buying property, or entering into a business agreement, understanding covenants ensures that you know what’s expected of you and what you can expect from others. They’re more than just legal terms—they’re the guardrails that keep contracts enforceable and relationships clear.
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.