Covenants: Overview, definition, and example
What are covenants in a contract?
Covenants in a contract are legally binding promises or obligations that one party makes to another. These commitments may require a party to take specific actions (affirmative covenants) or to refrain from certain actions (negative covenants) during the term of the agreement. Covenants ensure that the terms of the contract are followed and help regulate the behavior of the parties involved.
For example, a borrower in a loan agreement might covenant to maintain a certain debt-to-income ratio or refrain from taking on additional loans without lender approval.
Why are covenants important?
Covenants are important because they set clear expectations and obligations for the parties involved, helping to protect the interests of all parties and reduce the risk of disputes. By defining specific actions or restrictions, covenants help ensure compliance with the terms of the agreement.
For SMBs, covenants provide essential safeguards, especially in agreements like loans, partnerships, or vendor contracts, where performance and compliance are critical to the success of the relationship.
Understanding covenants through an example
Imagine a loan agreement where the borrower agrees to an affirmative covenant:
- “The Borrower agrees to maintain a debt-to-equity ratio of no more than 3:1 at all times during the term of this Agreement.”
This ensures the borrower remains financially stable and capable of repaying the loan.
An example of a covenants clause
Here’s how a covenants clause might appear in a contract:
“The Parties agree to the following covenants: (a) The Borrower shall provide quarterly financial statements to the Lender within 30 days of the end of each quarter; (b) The Borrower shall not incur additional indebtedness exceeding $50,000 without prior written consent from the Lender; and (c) The Borrower shall maintain adequate insurance coverage for its operations, as specified in Exhibit B.”
Conclusion
Covenants are key components of contracts that establish obligations and restrictions, ensuring the agreement is followed as intended. They help maintain trust, regulate behavior, and protect the interests of all parties involved.
For SMBs, including clear and enforceable covenants in contracts is essential for managing risk, ensuring compliance, and fostering successful business relationships. Well-crafted covenants provide a strong foundation for the smooth execution of agreements.
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.